An early decision in the birth of a company is the jurisdiction in which to incorporate or organize.  Actually, I see this as a very easy question.  However, there is no shortage of legal advice (sometimes bad, which usually is free) out there.  For whatever reason, choice of jurisdiction seems to be a popular target and Nevada seems to be the darling (with Wyoming the first-attendant).  I thought it would be worth quick discussion.

As far as I am concerned, an entreprenuer generally should only consider incorporating or organizing her company in one of two jurisdictions: 1) the state of your principal place of business or 2) Delaware.  If you are based in Utah, form a Utah company.  Otherwise form a Delaware company.  The only exception for this (again, in my opinion) is you might consider forming the company in another state if you foresee moving the business in the future to that state.  There are certain reasons to favor Delaware over Utah (e.g., certain investors — typically VCs — might request or require it), but for a number of reasons, Utah is the natural choice for a Utah-based company.

Now you have my position, let me explain.  Incorporating (and for convenience, by “incorporating” I am including forming all non-corporate entities), in a state where you are not principally located comes with certain costs.  These costs can be monetary, time, administrative, risk, etc.  For one, you likely will need to hire a service to act as registered agent in that state.  You may need to use that service (or some other) to make all your state filings for you.  If you don’t, you need to deal remotely with the office of the Secretary of State of the state in which you incorporate.  You will need to qualify (and maintain the qualification) to do business in the state where you actually conduct your business.  You will need to find an attorney who is licensed to practice in the jurisdiction or is at least familiar with the business statutes and laws of that jurisdiction.  It is unusual to find lawyers in Utah who are licensed in and familiar the laws of other states (with the possible exception Delaware, California and to a lesser degree New York).  Finally, some states tend to be more difficult to work with than Utah administratively speaking.

Costs are costs.  They are not bad, per se, but the costs of incorporating in a foreign jurisdiction may not be worth it when compared to its benefits.  Probably the most commonly touted (and usually false) benefits of incorporating in a foreign jurisdiction are tax savings.  If somebody tells you that you can avoid income tax (either from the employee or company perspective) by simply organizing your company in Nevada, Wyoming, Texas or any of the other handful of income tax-free states, you likely are getting bad advice.

Generally speaking, employees are taxed by the state in which they performed the services for which they earned their wages.  The jurisdiction of formation is a separate question from employee income tax.  For instance, if you work in Utah, Utah will levy income tax on your Utah-source wages.  Incorporating or organizing in a income tax free jurisdiction will not get you out of those taxes unless your wages are tied to work performed in that state.  Many of us work for companies incorporated in a foreign jurisdiction (e.g., DE, CA, etc.).  However, none of us are receiving a tax bill from those states unless you perform work there.  The same is true for avoiding taxes. 

The same is also true for corporate income tax.  States generally weigh three items in determining whether an company owes income taxes in a state: location of property, location of sales, location of employees.  Realistically speaking, there is little or no tax benefit for a company based in one state to incorporate in a tax-free jurisdiction unless it has some actual business nexus with that state.

Another benefit touted for states such as Wyoming or Nevada are the company-friendly corporate laws.  While there may be some beneficial aspects of the laws of those states, in my opinion, they are relatively small for the average company compared to the costs of incorporating in those states and probably not worth the costs of doing so.

To be sure, Nevada and Wyoming are fine states and their laws are equally fine.  Indeed, were I an attorney located in Wyoming, I predict I would be saying to incorporate in only in Wyoming of Delaware.  In addition, incorporating in a foreign jurisdiction certainly will not destroy your company, but the costs associated with doing so are real and the benefits largely are immaterial.

I was quite proud of my first foray into the blogosphere.  In fact, I had great ambitions to write a whole series of legal related posts for the entreprenuer.  However, the only two comments (the verbal kind) I received on my first post essentially were that it is the most boring thing they have ever read (and one of people saying this is a tax lawyer!).

Accordingly, I am revising my plan (though not giving up on addressing legal issues for the entrepreneur).  The posts hopefully will be less “bookish,” more practical and marginally more interesting.

With that in mind: Entity Formation

There are certain types of businesses that will form as partnerships, S-corporations, etc., but odds are, your decision of the type of entity you want to create likely will be a binary one between an LLC and a traditional “C” corporation.

While LLCs and corporations have many similarities (e.g., limited liability), they also have a number of differences.  The principal one of these is the tax treatment.  Corporations pay their own taxes.  LLCs do not.  Income and losses of an LLC flow through to the owners of the LLC, who pay any taxes directly.  This means that to the extent a corporation makes a dividend of taxable income, that income will be taxed twice (once at the corporate level and once at the shareholder level).  This can be a very significant benefit.  People often focus on this “double taxation” issue and assume LLCs are the superior business vehicle.  All else equal, that is true.  However, not all else is equal.

A number of factors tend to favor corporations over LLCs.  For example:

• due to the flow through nature of LLCs, the admnistrative burden of keeping track of capital accounts, allocations, distributions, etc., in LLCs can be quite high.  This is largely non-existant with corporations.  Quite possibly, the tax savings associated with LLCs may be outweighed by administrative costs.
• the “double tax” only is an issue to the extent (1) a corporation has taxable income AND (2) the corporation issues a dividend.  Most early stage companies are not going to fall in that category.
• VCs rarely invest in LLCs (primarily because they don’t want pass-through income).  If you are going to raise VC money, you need to be a corporation.
• Because LLCs are highly driven by tax issues, legal fees tend to be higher with certain types of LLCs.
• Operating agreements can be very complicated (and costly) documents to create.  By comparison, bylaws (the corporate functional equivalent) generally are very straightforward and inexpensive to create.
• The more an LLC wants to “look like” a corporation (i.e., equity incentive plan, different classes and series of membership interests, etc.), the more expensive they become.  Corporate stock option plans, separate classes and series of stock, etc., while not necessarily “cheap” to create, generally are must less expensive by comparison.
• Although LLCs apparently date back to 1892, they are a relatively new creation in the United States.  The body of law surrounding corporations is better understood, better settled and more predictable than LLC law.

While LLCs have many beneficial characteristics, one should not focus on potential tax benefits to the exclusion of other relavent factors.  While there may be an argument that some corporations would be better off structured as LLCs, there is good reason corporations outnumber LLCs.

I must confess I am much more comfortable writing a contract than a blog.  Being unsure of what topic might be more salient to ConnectBlogs readers has resulted in weeks of not posting.  Much is written in Connect about entrepreneurship.  I work and have worked with a good number of entrepreneurs, their companies and those who invest in them.  There are a number of legal matters that regularly face those in the entrepreneurial world.  I have decided there might be some value in a series of blogs related those legal matters.  My hope is that at least some of you will find this blog worthwhile and useful, if for nothing else, to get you thinking about these issues.  My intent is not to give legal advice and my ramblings should not be construed as such (if you didn’t recognize, that was my CYA disclaimer).  Actually, my hope is that some of you will respond and even challenge me.  I would love this to be a collaborative effort.

I should also note that I plan to keep these posts fairly short.  I am doing this for two reasons: (1) to enable me to post more often and give the impression I am more of a productive blogger than I really am and (2) I don’t like reading long blogs and figure I am not alone.

With that, Topic 1…

Part 1:  Entity Formation - To Form or not to Form?

There is a lot to say here, and I could see this topic turning into several subtopics.  However, I’ll start from the beginning with what I think are some basic considerations.

Suppose you just invented a better mousetrap or perhaps a kit to make a snowman.  You begin having visions of success and decide quit your secure day for your shot at independent wealth.  What are the next steps?  Putting aside the bothersome details of creating and executing on a business plan, you need to determine whether to create a formal entity through which to operate your business, and if so, when (and what type - which I’ll cover on another post).  I can think of few if any good examples where a serious business endeavor (or at least one that has more permanence than, say, a lemonade stand or a yard sale) should not to form a business entity.  I recommend doing this prior to beginning business operations.  Businesses operated without creating a formal legal entity are deemed to be either sole proprietorships (1 owner) or general partnerships (more than 1 owner).  Sole prioprietorships and general partnerships offer little or no protection from personal exposure to the liabilities of the company (including those arising from lawsuits).  Better said, there isn’t a legal distinction between the sole prioprietorship or general partnership and their respective owners.  In other words, you could lose much more than just your investment in the company.  To the extent you begin business operations before you create a legal entity, you are exposing yourself (and most people don’t want that).  If you must conduct business operations before creating an entity, be careful (not to say shouldn’t be careful after you create an entity).

[Next topic: Entity Formation - Choice of Entity]

The recent plane crash with a young couple, leaving behind two small children makes me think how important it is for any parent of minor children to have a Will.  A Will allows you to determine who will be the gaurdians of your children should something happen to you - the decision is yours!  If you die without a Will the court will deceide who will be raising your children and in many cases that decision is fraught with conflict between two sets of grandparents who both love the grandkids and want raise them.  Why let the court make such a decision.

 In Utah it is perfectly legal to hand write a will (a holographic will) if the signature and material portions of the document are in your own handwriting (doesn’t need to be witnessed or notorized).  So at very least, have a hand written document, signed by you that says who will be guardian of your minor children should you die.
 

 

 

 

 

I am working right now with clients who started a business as partners 5 years ago and everything was happy and working well. Now they are in a fight and want to split; however they have no agreement to facilitate the split-up or to valuate the company. It is a mess. Every business with partners should have buy sell agreement so when problems arise (fighting, death, disability, retirement etc.) they have a plan already in place.

Once or twice a year, I get a call from someone who wants to get a patent. They saw some cool product while they were traveling and would like to a get a patent on the product in the U.S.

You can’t. In order to get a patent, you have to be an inventor. If you did not invent it, you cannot get a patent on it. You could avoid telling the Patent and Trademark Office that you did not really invent it. Of course, that would be fraud. Your patent would be worthless and you may get sued over it. If you see something cool overseas - buy it. Import it if you want. Just don’t try to get a patent on another person’s invention.

This blog post is intended for informational purposes only, and should not be construed as legal advice or as pertaining to specific factual situations. Consult with an attorney concerning your own needs and circumstances and to obtain any legal advice with respect to the topics discussed in this post.

I recently spoke with a client about a promoter that apprached them trying to raise money for a $6m deal and he was $2m short.  He was seeking investors to generate the $2m.  His promise was an 18% return on investment and security by having a lien on the land which was the purpose of the deal (of course the lien is shared with all the other investors).  My question to my clinets is why would anyone who has the land to use as collateral seek a pool of investors and offer them an 18% return on their money when he could go to a bank and get a loan for the $2m for far less interest.  Read the paper, watch the news and you learn that there are way to many examples of these promoters scaming people and taking their life savings.  It’s always a better move to aviod these “to good to be true” deals and avoid being the next story in the paper. 

On one consistent thread of most start-up businesses is the lack of money. Many companies put off speaking with an intellectual property attorney in an attempt to conserve resources. However, this approach is usually pennywise and foolish.

Any start-up company ought to perform at least five basic steps up front. These need not cost much money and can help the business avoid substantial harm down the road.

1. Do a trademark search.
Your company name or the name of your leading product may sound pretty cool. Unfortunately, it probably sounded pretty cool to the other company that adopted it before you did. Thus it is a good idea to conduct a trademark search before you launch your product or begin building brand loyalty. You can spend about $500.00 for a trademark search through an attorney, the attorney will typically look not only at your exact name but variations used by potential competitors that may raise trademark issues. While no trademark search is a guarantee that there will not be conflicts in the future, it significantly reduces the risk. At a bare minimum, do your own trademark search at www.uspto.gov. A little bit of your time now will save many headaches later.

2. Consider patent issues.
Many tech oriented companies are familiar with the need to obtain patent protection. However, if there is something truly unique about your product that you believe provides a competitive edge, it is wise to have at least an initial consultation with a patent attorney. This will probably run you $200.00 to $300.00 for an hour of the attorney’s time. It may save you hundreds of times that in the long run and improve the chance you will properly protect your inventions.

At a bare minimum, every business person should know that you have one year from the date that a product is first sold, offered for sale, or in public use in which to file a patent application. Wait one day longer and you have dedicated any invention you may have made to the public. Additionally, if foreign markets are of concern, please note that a U.S. patent application must be filed prior to any public disclosure of the invention. You will then have one year in which to take steps to preserve any patent rights in foreign countries.

3. Get your employment agreements in order.
A start-up company may face a significant competitive threat from its own employees. If the employees decide that they can do better by going into competition, you may have little recourse if non-compete and other employment related documents are not in place from the beginning. Therefore it is strongly advisable to have any employees sign employment agreements which restrict any use of confidential company information and, for those employees who may pose a competitive threat, which prevent them from competing directly with the company for a reasonable period of time.

4. Ensure ownership of your intellectual property.
Many small companies use independent contractors to save on costs, and to provide greater flexibility. An independent contractor, however, will generally have greater rights to ownership of any work which he or she creates. If you hire an independent contractor to write code, come up with company design, or otherwise do anything which may involve company inventions, trademarks, or copyrightable materials, it is critical to have contracts which will vest all ownership of the intellectual property in the company. No matter how friendly the independent contractor seems today, he or she may subsequently claim that they own part or all of your important company intellectual property. An ounce of prevention in this regard is worth many pounds of cure.

5. Protect confidential information/trade secrets.
Virtually any company generates confidential information. While it may not be as important as the actual formula of Coca-Cola, it is probably important to the competitiveness of your company. It is not uncommon for renegade employees or others with access to confidential information to use that information to the competitive disadvantage of the company. By the time that happens, however, the horse is usually already out of the barn.

Reasonable steps should be taken from the outset to protect the company confidential information. Client lists and term sheets which are not publicly available and cannot be easily deduced should be provided only to those who need to know within the company. Documents containing confidential information, to the extent practicable, should be stamped confidential and should not be left in open view.

Likewise, any scientific or technical information which provides a competitive advantage should be protected.

The Utah courts have traditionally been very favorable toward the protection of confidential information and enjoining parties who attempt to misuse it. However, one of the first questions will always be did the company take reasonable steps to protect the confidentiality of the information. f not, there will be little recourse.

The preceding steps need not cost a lot of money. In fact, with the possible exception of a technology based company, it should amount to a fairly small percentage of early expenditures. Neglecting them will cost many times the perceived savings down the road.

This blog post is intended for informational purposes only, and should not be construed as legal advice or as pertaining to specific factual situations. Consult with an attorney concerning your own needs and circumstances and to obtain any legal advice with respect to the topics discussed in this post.

Steve Jobs posted an excellent article today backing a DRM-less music file for the masses. That means you play the file when you want and where you want independent of music players. Even iPods. From Jobs's callout to the big four record companies: "If [DRM] were removed, the music industry might experience an influx of new companies willing to invest in innovative new stores and players. This can only be seen as a positive by the music companies... Convincing them to license their music to Apple and others DRM-free will create a truly interoperable music marketplace. Apple will embrace this wholeheartedly." UPDATE: iTunes currently protects songs that are already DMR-less at emusic.com. Not to side with the big record lables, but perhaps Steve is up to something else. More here.

As a follow up to my post on January 24th - Here are 4 things to do if you already have the problem customer. (High Maintenance – Low Pay, etc.).

1. Get money up front. If a customer is a slow pay customer, inform them that all future work will require payment up front. If you lose the customer over this, it is probably a customer you do not want to have long-term anyway. If not, you can continue to work with the client with assurance you will get paid.

2. Renegotiate the terms. If a customer has obtained a discounted rate or special accommodations based on a promise of substantial work, do not be afraid to go back and renegotiate. It is usually better to say, “We provided this discount based on your representation that you would be bringing $50,000 worth of work a year. We can no longer justify giving you this discount in light of your actual volume.”

3. Set clear boundaries with the customer. If a customer is overly demanding for the amount of work they receive, simply tell the customer that the amount of work provided does not justify the demands. Indicate what you believe to be reasonable accommodations for the customer and stick to it. You may lose the customer or the customer may conform to your requirements. Either way, your business will be better off.

4. Fire the customer. Despite what a new business may think, some customers are simply not worth having. For example, I recently had a customer who expected us to continually give him discount work. When he would have a question about any matter he would demand an immediate response to a question on some trivial matter. Needless to say we terminated our representation of him. The amount of revenue lost was very small and it enables us to give better quality service to those customers who value the relationship.

This blog post is intended for informational purposes only, and should not be construed as legal advice or as pertaining to specific factual situations. Consult with an attorney concerning your own needs and circumstances and to obtain any legal advice with respect to the topics discussed in this post.