Company Valuation and Dilution — the Minimum You Should Know to Raise Capital and Issue Stock

How should company stock be allocated among founders, employee stock options, and financial investors?   What happens to everyone’s share of the company when new stock is issued?  How do you know how much of the company should be offered to new financial investors?  These are the fundamental questions regarding valuation and dilution that we will be addressing at our next  workshop on April 22nd  hosted by ExtraSlice Smart Space.  Carter Mackley will review basic capitalization table mathematics, dilution, and pre-money valuation metrics.  He will show how to use the Startup Valuation and Dilution spreadsheet (download here)  to analyze the dilutive impact to founders of alternative fundraising scenarios.

When:

Where:

ExtraSlice – The Place for Tech

3600 136th Place Southeast, #300

Bellevue, WA 98006

View Map

Attendance is free of charge.

Company valuation and dilution – The minimum you must know to set up your company and raise capital.

How should company stock be allocated among founders, employee stock options, and financial investors?   What happens to everyone’s share of the company when new stock is issued?  How do you know how much of the company should be offered to new financial investors?  These are the fundamental questions regarding valuation and dilution that we will be addressing at our next  workshop on December 15th  hosted by extraSlice Smart Space.  Carter Mackley will review basic capitalization table mathematics, dilution, and pre-money valuation metrics.  He will show how to use the Startup Valuation and Dilution spreadsheet (download here)  to analyze the dilutive impact to founders of alternative fundraising scenarios.

When:

Where:
extraSlice Smart Space – extraSlice Inc. 2375 130 Ave NE,. Bellevue,, WA 98005 – View Map

REGISTER

 We will look forward to seeing you there.

 

Seed and Angel Round Legal Documents Primer.

What is the difference between common stock, participating preferred stock, non-participating preferred stock, bridge notes, and convertible notes with valuation caps?

Next Monday (May 4, 2015) Carter will be covering this topic at a workshop sponsored by ExtraSlice, an incubator in Bellevue.  Carter will review the basic startup financing agreements and cover what Founders need to understand to raise funds from friends and family, angel investors, or venture capital firms. He will give a brief overview of the fundraising process, then focus on the contractual and supporting legal documentation involved when you sell stock or other types of equity to investors. The overview will cover preparation of the Term Sheet, the Cap Table and the Purchase Agreement. Carter will also cover the federal and state securities laws that regulate these types of private placements and what it takes to comply. Lastly, hewill give a brief update on what is happening with crowd funding

When: Monday, May 4, 2015 from 6:30 PM to 9:30 PM (PDT)

Where: extraSlice Inc, 2375 130 Ave NE, Bellevue, WA 98005

Seating is limited.  Please RSVP to carter.mackley at mackleylaw.com.

Oregon Crowdfunding Law – A Better Way?

I just got off the phone with a lawyer in Oregon’s Department of Finance and Corporate Securities and I am quite enthused with what they are doing with Oregon’s crowdfunding law.    Like Washington, the company using the law must be incorporated in the home state. But the level of agency review is much more limited than in Washington.  Under Oregon DFCS Rule 441-035-0110, the issuer must file a notice with the DFCS at least seven days before beginning an offering or publishing an advertisement.  The Notice must contain information about the company and the offering but the disclosure is not onerous.

Other differences from Washington’s 2023

  • $250,000 maximum (Washington’s is $1,000,000)
  • $2,500 maximum individual investment (wealthy people in Washington can invest up to 10% of their income)
  • Must meet in person with a business technical service provider (nothing like this in Washington)
  • Reports to shareholders do not have to be made publicly available (a big negative of Washington’s law)
  • No escrow requirement (another negative of Washington’s law)
  • Disclosure document must state offering minimum amount, if any.  (I.e., you don’t necessarily need minimum commitment before you close the round.  In Washington, you do.)

Oregon’s law, in contrast to Washington’s, was passed by rulemaking, not by statute, so you know it has the support of the Oregon DFCS.  And unlike Washington, their law is being used. I found at least eight or nine Oregon companies that are using the rule to raise money.  Obviously, this law won’t help Washington companies, but if it is successful in Oregon, perhaps authorities here in Washington will see feet to making changes in our law.

Oregon’s crowdfunding rules and a FAQ prepared by the DFCS can be found here:  http://www.dfcs.oregon.gov/securities/raise_capital.html

 

Seattle Angel Conference Workshop: Washington’s new crowdfunding law—Is it right for your startup?

WHEN:  January 6, 2015 @ 6:00 pm – 8:00 pm
WHERE:
SURF Incubator, Suite 700
999 3rd Avenue
Seattle, WA 98104 USA
Hosted by Seattle Angel Conference COST:  $10

Register here.

ESHB 2023, the Washington Jobs Act of 2014, has been effective since November.  Is this new fundraising mechanism right for your Company?  Carter Mackley will review the new law and compare it with other fundraising methods such as SCOR offerings, Circleup.com, and presenting to local angel groups.  Carter will review the forms for filing a 2023 Offering or a SKOR offering in Washington and tell you how to initiate a crowdfunding offering.  You can read more about the Washington Jobs Act here.

SCOR Registration — an alternative to 2023 Crowdfunding?

The well-kept secret is that Washington and many other states have already had in place a way to sell securities very similar to Washington’s recently effective crowdfunding law,  ESHB 2023.   Referred to as the “Small Company Offering Registration” or “SCOR”, this other method of registering a stock offering has  been around since the 1990s, but seldom used.  The DFI reports that they only had 9 SCOR offerings in Washington since 2005 (as of October 2014).  It is not clear why SCOR offerings have not been popular, given that the DFI has gone out of its way to provide helpful information on its website and to help companies complete SCOR offerings even when not represented by legal counsel.

Similarities between SCOR and  ESHB 2023

Washington Internet Offerings – Both types of offering allow you to sell up to $1,000,000 of equity securities per year to Washington residents using the internet.

DFI Review.  Both types of offering require you to prepare an offering memorandum that must be reviewed and approved by the DFI.  The same staff members at the DFI administer both programs.  The form for SCOR offerings, called the U-7, is used by all states using the SCOR process.  The form for  ESHB 2023 was recently finalized and it can be found here.  Both forms ask for much of the same information, but the  ESHB 2023 form is the DFI’s own form and they have tried to make it more user friendly than the U-7.

GAAP Financials.  For both offerings, financial statements are required for the last fiscal year.  They must be prepared in accordance with Generally Accepted Accounting Principles, including preparation of footnotes.   ESHB 2023 also requires that you provide the most recent fiscal quarters for partially completed years.

500 Shareholder Limit.  The 500 non-accredited shareholder limit applies to both offerings in the same way.  (Section 12(g) of the Securities and Exchange Act requires registration under that Act if a company with $10 million or more in assets has more than 2000 shareholders or more than 500 shareholders who are non-accredited investors.)

Minimum Amount and Escrow Agent.  Under both offering methods, you will be required to set a minimum funding amount (minimum dollar amount of subscriptions received) before you can close any subscriptions.   Before you reach the minimum funding amount, all funds must be held by an escrow agent, which you, the issuer, must hire.  Before they approve the offering, the DFI will carefully review your minimum target and require you to raise it if they think it is too low to accomplish your business plan.

Differences between SCOR and  ESHB 2023

Available for non-Washington Companies.  To do a SCOR offering, it is not necessary to be incorporated or have your primary operations in Washington, but offers and sales are limited to Washington residents (unless you do a regional offering – see next topic).  So, for example, a Seattle startup that was incorporated in Delaware could use the SCOR registration without the need to reincorporate in Washington.

Coordinated Regional Offerings.  Under SCOR, there is a process for doing coordinated regional offerings using protocols developed under the auspices of the North American Securities Administrators Association.  Under that process, one state agency takes the primary role of reviewing and passing on the offering memorandum.  Eleven western states participate in the Western Region (California being the notable exception).  If my memory is correct, only one or two coordinated offerings have been tried in Washington.  But in conversations, member of the DFI staff have been positive towards making coordinated regional offerings work. You can read more about coordinated review on the DFI’s website and on the NASAA’s website.

Merit Review; Promotional Share Escrow

A SCOR offering is actually a registered state offering subject to merit review by the DFI.  In contrast, an offering under  ESHB 2023 is technically an exemption from registration.  In some ways it is a distinction without a difference since the DFI must approve the offering memorandum in both methods.  But under SCOR, the DFI is required to conduct a merit review, meaning that it will judge the proposed offering on the merits and apply several statements of policy regarding corporate equity offerings adopted by the NASAA.  The DFI’s standards are available here, and cover  things like the terms of the securities, financial condition, voting rights, and use of proceeds.  The DFI, for example, can require the issuer to have independent directors if there is a history of affiliated transactions (transactions between shareholders or directors and the company, such as loans or leases)

One thing that may trip up startups is the standard for “promotional shares”.  Shares issued to founders, management, or major owners of the corporation would be considered promotional shares, and DFI will determine whether these shares can be considered “fully paid”.  According to the DFI website, this is determined by dividing the amount of consideration paid in past purchases of the shares by 85% of the proposed public offering price in the offering. Tangible property used as payment in past purchases is counted at its fair value, if that is readily and objectively ascertainable.  Most founder stock in a startup would not pass this standard.

According to the DFI website, there may be an unlimited number of promotional shares in a SCOR offering. However, those in excess of 60% of the shares to be outstanding after the offering must be escrowed for a certain period of time, usually four years, or until the company satisfies other release provisions in the escrow agreement.   In lieu of an escrow, the company may enter into a lock-in agreement that does not involve the expense of a third party escrow agent, and the DFI has a form lock-in agreement  available.

So in other words, the escrowed stock will be similar to vesting restrictions, which most founders are familiar with.  However, unlike unvested stock, which typically vests immediately in the case of a liquidity event, escrowed promotional shares remain in escrow.  While in escrow, payout in the case of a distribution of company assets is according to purchase price paid.  So founders who paid pennies for their restricted stock would not receive a significant distribution until other purchasers received their original purchase price back.  In most cases, this would not be problematic, since it would mimic the results of a typical 1X preferred stock liquidation preference.

Transfer Restrictions.  Securities sold in a SCOR offering are freely transferable (except for transfers designed to thwart the intrastate offering restriction).  HB 2023 offerings are not freely transferable.  Under the Washington rule (WAC 460-99C-170), for the first year they may only be transferred to the issuer, an accredited investor, or family members.  Under federal Rule 147 (the federal exemption HB 2023 relies on), crowdfunded securities  must be held by the purchasers at least nine months, and then any transfers may only be transferred to another resident of Washington.  In either case, transfers will not be likely because there will be no public trading market and most companies will have shareholder covenants imposing restrictions on transfers.

Convertible Debt and Warrants.  Unlike  ESHB 2023 offerings, warrants, debt, and other securities are actually permitted under SCOR offerings.  However, in the case of debt, the issuer must be able to demonstrate an ability to pay back the borrowed money from current earnings.  That is typically not the case with a startup company, so popular convertible debt securities would not be available.

Right to Withdraw.  Though not required by the statute, the DFI created a rule that gives investors the right to cancel their subscription of an ESHB 2023 offering for any reason until the minimum funding amount is reached.  There is no such right in SCOR offerings.  In my comments during the rule making process I objected to the cancellation right since it basically gives investors an option on the company and could make it hard to reach the minimum funding amount.  I recommended that cancellation should only be allowed when there has been a material change in the issuer’s prospects, which they are required to report.  But the DFI, which sees the worst securities law abuses, wasn’t swayed and felt that the cancellation right was important to protect consumers.  In practice, we will see if this becomes a significant problem for issuers.  I am optimistic that it won’t.

Quarterly Information Requirements.   Quarterly information reports are not required under SCOR offerings, unlike  ESHB 2023, which requires you to make executive compensation, identity of 20% shareholders, and a business summary “publicly accessible” on your website on a quarterly basis as long as the crowdfunded securities are outstanding.  In most circumstances, the crowdfunded securities will be outstanding for a long time, usually until the company is sold or there is a major restructuring.  So this may be a material consideration for some companies or founders, who may be fine with sharing such information with their shareholders but do not want to share it with the general public.

So which offering method is best for your Company,  ESHB 2023 or SCOR?

If you happen to be incorporated in Delaware, want to do a regional offering, need to offer warrants or convertible debt, or don’t want to make your compensation or the identity of your 20% shareholders publicly available on an ongoing basis, a SCOR offering may be your best choice.  Given the 500 shareholder restriction, the lack of investment limits in SCOR offerings may not make a significant difference, unless you believe you will have access to investors who are willing to put in more than $100,000 each (in which case maybe neither type of crowdfunding makes sense for your company?)

On the other hand, the more complicated form, the merit review, and  the promotional shares lock-in of SCOR registrations might sway you in favor of ESHB 2023.  As indicated earlier, the same staff members at the DFI administer both offerings, and they are very willing to help.   Though protective of consumers, they manifest a desire to help responsible small businesses raise capital as efficiently as possible.  Even though the U-7 and 2023 forms ask for similar information, my guess is that getting through the 2023 process will be a bit quicker for three reasons: (1) the 2023 form is actually simpler than the U-7, liberally employing a “check-the-box” format, (2) since they created it, the DFI staff understand their own form, and want it to be used and  accepted, we can assume, and (3) there has been a lot of investment in 2023 by many people around the state who have their eyes on it and want it to work.  DFI knows this and has invested significant resources of their own to make it happen.

How long will it take you to complete the registration process?    Experience with SCOR offerings is limited but six months is not unusual.  But my understanding is that none of these companies were represented by legal counsel, and the DFI staff spent a lot of time helping issuers understand the form and revise it.  DFI director William Beatty suggested in an open meeting that an application prepared with the assistance of a seasoned securities lawyer would be much quicker, perhaps in a few weeks.

Washington Crowdfunding is here!

The Washington Department of Financial Institutions promulgated its final rules today (October 2, 2014) for ESHB 2023, known as the “Washington Jobs Act of 2014″.   You can find the final rules and the final crowdfunding application form here.  This means that Washington intrastate crowdfunding is here and ready to go as of November 1, 2014, when the rules will be effective.

The law was actually passed last March, but the law required the stated Department of Financial Institutions the responsibility of promulgating rules to implement the Act.  The DFI got right on the task, has published both draft and proposed rules and accepted comments on them.  Last week Carter testified at the final public rulemaking hearing and followed up with written comments about one troubling rule in particular, which is the requirement to make financial statements, executive compensation, and large shareholder ownership available to the general public after the offering closes.  You can read Carter’s written comments here.  For some of the things you should consider before doing a Washington crowdfunding, see Carter’s post here.

Washington Crowdfunding – Is it right for your Company?

Crowdfunding is live in Washington state as of November 1, 2014, when the Department of Financial Institutions’ rules become effective for ESHB 2023, the “Washington Jobs Act of 2014″.   You can find the final rules and the final crowdfunding application form here.  

For those who haven’t heard, ESHB 2023 allows an internet offering of up to $1 million to Washington residents.  Issuers (i.e., the company raising the funds) must take steps to ensure that only Washington residents are presented with the actual offering.   Any Washington resident can invest, but the following restrictions apply:

  • For investors with an annual income or net worth of less than $100,000, the greater of either (i) $2,000 or (ii) 5% of the investor’s annual income or net worth (not counting personal residence).
  • For investors with an annual income or net worth of $100,000 or more, 10% of the annual income or net worth of the investor (not counting personal residence), up to $100,000.

If you are interested in pursuing a crowdfunding offering.  Joe Wallin has written an excellent summary of the steps to take now which you can find here.  Joe is the attorney who originally proposed the idea for a Washington Crowdfunding law last year to representative Cyrus Habib, who was instrumental in getting it through the Washington legislature.  These two should be commended for making Crowdfunding a reality in Washington.

There are many ramifications to consider before launching into a Washington crowdfunding campaign, Before you do it, consider the following: 

Investor limits and integration.  Remember that if you use the Washington law you cannot take funds from investors who don’t live in Washington.  The maximum individual investment limits apply to every investor for one year, including wealthy individuals who are limited to $100,000. You might think that you could split up the offering, say for example by doing  a separate accredited investor private offering in another state.  But there is a concept called integration which means basically all of your fundraising for one year will be lumped into the same offering, unless two offerings are sufficiently different (e.g., a different type of security offered) to quality as a separate offering under the rules.  For example, if you sold $500,000of series A Preferred Stock in your crowdfunding campaign, and then a few months later find a wealthy investor or fund that is willing to invest $2 million, you may be prevented from accepting the investment unless the type and price of the security are sufficiently distinguishable.   Another thing to be careful about is any previous offerings of the same class.  Integration works both ways (back and forward).  The applicable time period is six months.  Under WAC 460-99C-200, non-crowdfund offerings that are six months before the crowdfund offering or six months after it will not be considered integrated with the crowdfund offering if no similar securities are offered or sold during those time periods.  WAC 460-99C-200 also lists the other standards for determining whether two offerings are similar enough to be considered integrated.  So, before you launch a crowdfunding campaign, you need to wait at least six months since your last offering of any similar securities, and you need to have a plan for how you will accomplish second and third financing rounds as you grow. 

Ongoing public disclosure.  The rules require you to make executive compensation, identity of 20% shareholders, and a business summary “publically accessible” on your website on a quarterly basis as long as the crowdfunded securities are outstanding.  In most circumstances, the crowdfunded securities will be outstanding for a long time, usually until the company is sold or there is a major restructuring.  So the public disclosure requirements are likely to extend long after the crowdfunded securities are sold.  During the rule formation process, there was disagreement about the meaning of “publicly accessible”.  The same wording is used in the statue, and many of those involved in getting the law passed understood it to mean available to directors and shareholders on the public website, but not necessarily available to every member of the public.  I testified about this at the public hearing and submitted written comments when it became apparent that the DFI was sticking by its interpretation that publically accessible means available to all members of the public.  Given the many original supporters of the law who think quarterly information should be available to investors, but not the general public, there is a good chance that the DFI will change its interpretation or that the law will be amended to clarify this next year.  In the meantime, this is something that you need to take into account when considering whether to use HB2023.  In particular consider 

  • whether as a founder, you are okay with making your compensation and that of your other executives and directors available to the general public;
  • whether you have any concerns about competitors having this information; and
  • whether there is any risk that the requirement to publicly disclose ownership will dissuade a large shareholder from participating in a subsequent equity offering.

GAAP Financials.  To do a crowdfunded offering, you must submit GAAP financials, including any required footnotes.  Depending on your past operations, preparing GAAP financial statements may be somewhat expensive.  Make sure you have discussed this with your accountant so you can plan for the cost.  

Type of Security.  Convertible debt, though typical for many initial financing rounds, is not allowed under the rules.  Basically your choice will be common stock  or preferred stock or the LLC equivalents.

Minimum Amount; Escrow Agent; Right to Cancel.  The rules require you to set a minimum amount of subscriptions that you must have received before you can close the offering.   The minimum amount must be large enough so that the company can execute its business plan if it only raises that amount.  This is a good rule and is typical in most private offerings.  The reason for a minimum amount is that it protects against the situation where the company takes funds from people who commit early but doesn’t raise enough to execute its business plan and fails for that reason.  The early investors get a raw deal in that case.  To make the rule effective you are required to hire an escrow agent to hold funds until the minimum amount is reached.  So you need to calculate the cost of an escrow agent when considering whether to do a crowdfunded offering.  Also, another thing to be aware of is that until the minimum amount is reached, investors have the right to cancel their subscription.  This would be an unusual provision in a private offering but something the DFI added to protect consumers.

Risks of encouraging competitors.  Consider the stage of your company.  Crowdfunding can be great exposure to the public if that’s what you need right now.  On the other hand, for some companies it makes sense to operate in stealth mode while you are developing your product.  If you are at this stage, it might not make sense to make potential competitors aware of your company and its progress.

Managing Shareholders.   A typical privately financed startup would have less than 30 shareholders.  A crowdfunded company may have hundreds, which significantly increases the organizational work and paper flow.   Your company needs to have a method for restricting its offering online to Washington residents only, an efficient way to exchange residency information, signatures, and other information from investors, processes for coordinating the exchange of all of that information and investment funds with the escrow agent.  You need an efficient way to provide quarterly informational updates meeting notices to shareholders, and receive back shareholder votes.   Most of the models for handling these tasks will be taken from public company precedents.  If you are going to be an early mover on crowdfunding, expect to spend some extra time and money breaking new ground.

500 Shareholder Limit.  Under Section 12(g) of the federal Securities and Exchange Act of 1934, a company must register with the SEC if it has more than $10,000,000 in assets and a class of securities held by more than 2000 shareholders or more than 500 non-accredited shareholders.  Most shareholders in a crowdfunded campaign will probably be non-accredited investors.  So while the whole idea behind crowdfunding is to raise small amounts from many people (thereby spreading the risk in a certain way) the effect of Section 12(g) is to put downward pressure on the number of shareholders and upward pressure on the minimum investment that you can accept.  To put some numbers on it, you can raise $1 million if 500 investors invest $2,000, each, the maximum amount for those earning less than $100,000 a year.   So a company that wants to accept smaller subscriptions would be limiting itself to raising $500,000 if minimum investments are $1,000, $250,000 if minimum investments are $500, etc.  This of course doesn’t leave any breathing room for subsequent  financing and stock option and warrant exercises, all of which could throw the company over the threshold, triggering expensive SEC reporting requirements.  The take away is that you should not be expecting to do a fund raising where you take donations of $100, $50, or less.  Depending on on your target raise, $500 or $1,000 minimum investments will probably be your practical limit.

So how can you manage the 500 shareholder issue?  Here are some suggestions:

  • Set a minimum investment amount that will make it hard to go over the shareholder limit.
  • Carefully monitor subscriptions and include in your offering documents a right to close the offering if the number of subscriptions goes over a certain level.
  • Obtain shareholder agreements to notify of accredited investor status, and track it.
  • Consider including in your articles of incorporation a company right to redeem shares for a certain price if the number of shares and/or the value of the company’s assets goes over a certain level. 
  • Consider provisions in your employee stock option plan that allow the Board of Directors to delay exercise until just prior to a liquidity event if the company is at risk of going over the threshold.

New regulatory landscape; DFI Oversight.  This is new for Washington.  No one knows exactly how it is going to work in practice.  Whereas most private placements have no practical oversight from regulatory authorities, Washington crowdfunded offerings will be reviewed and must be approved by the DFI.  You company will be subject to the DFI’s ongoing oversight as long as crowdfunded securities are outstanding.   You are submitting your company to this oversight when you launch a crowdfunding campaign.  The DFI has a responsibility to protect consumers, and as the rule enactment process demonstrated, they don’t always draw the line where advocates for issuers might have them.   But the DFI has gone out of its way to help small unsophisticated companies accomplish SCOR offerings, which are similar to offerings under ESHB 2023, and we can expect them to do the same here.  We also know that DFI has shown remarkable professionalism in the speed at which they have promulgated draft rules, accepted, summarized and responded to comments, and published the final rules, all well within the deadline set forth by the statute.  All of this represents a lot of work and they should be commended for their job.  So I think that responsible companies with solid business opportunities will find the DFI to be a good partner.  But be prepared to be flexible when they ask you to make changes to your disclosure. 

Consider Other Methods to Raise Equity.  Lastly, before you launch a 2023 offering, consider whether other options are better for your company, such as a private placement to angel investors in the traditional way, through a new 506(c) offering that allows internet advertising to accredited investors, or a Washington or regional SCOR offering that also allows internet advertising to accredited or non-accredited investors.  See my post comparing SCOR offerings to 2023 offerings.

Washington Crowdfunding CLE Lecture

On October 9th Carter will be giving a lecture on the new Washington Crowdfunding law to Washington Small Business Development Center Advisers.  The meeting qualifies for CLE credit for Washington lawyers, who are invited.  If you are a lawyer and interested in attending the CLE, please contact Carter through this website.

The Exploratory Phase – When should you incorporate?

“When should we incorporate?”  It’s a question we startup attorneys hear all the time.   Everyone knows that you want to run your startup business through a corporation or LLC to have the limited liability protections afforded by those entities.   But before any business gets going there is always an exploratory phase.  During this period business plans are developed and tested, market research may be conducted, and software code might be written.

Many times it turns out the idea isn’t worth pursuing, so it doesn’t always make sense to incur the time and expense of incorporating, not to mention having to get a tax ID, a business license, and incurring reporting obligations with federal, state and local governments. On the other hand, problems result if you wait too long.  Software, the business plan, contact lists, perhaps trademarks – all of these things are or should be assets of the business.  If you don’t have agreements among your collaborators, there can be confusion or disagreement about the ownership of these assets when the business gets going.  Frequently collaborators haven’t decided yet or they don’t take time to work out the percentage ownership of the business.  Often emails or other writings are exchanged that may be ambiguous or contradictory.  I’ve seen at least one case where an early collaborator who did very little made a successful claim against the company when it had an exit a few years later.  She received a healthy, and unearned, portion of the company sale price.

Another very serious issue is your potential personal liability if you collaborate with others during the exploration phase.  In an adequately capitalized corporation or LLC, an entrepreneur’s risk is normally limited to the amount of his or her investment.  A creditor suing the company could not reach, for example, the entrepreneur’s personal assets such as car, home, or bank accounts.  That liability limitation does not apply for partnerships.  Partners are personally liable for the debts of the partnership.  See RCW 25.05.120.  And individual partners have the authority, absent an agreement otherwise, to incur debt and other obligations for the partnership.

Now take those two rules of law and couple it with a third principle – by just working on the project together you may have formed a de facto partnership.  The explicit rule for Washington can be found at RCW 25.05.055:

“The association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.”

So, if you are not careful, you might think you are just helping out a friend on his business idea and later discover you formed a de facto partnership and are personally liable for a debt that one of your partners took on in behalf of the business.    

So the takeaway is don’t wait too long to incorporate.  You should definitely  incorporate before:

  • earning any revenues
  • entering into any material contracts
  • hiring any employees
  • receiving any funding

During the exploratory phase, if after considering the above factors you feel it is still early to incorporate, take precautions to maintain ownership of your business and assets.  Make sure that anyone who works creates or works with any of your intellectual property signs an intellectual property assignment agreement.  This includes volunteers and contractors, as well as all collaborators/partners.   If you decide to hold off on incorporating, it is a really good idea to put in place a simple agreement between you and your collaborators.  At a minimum this agreement should have the following elements:

  • statement of the partners’ percentage ownership
  • contributions of individuals, including time, money, and assets (e.g., software, equipment)
  • limitation on authority of partners to sign contracts or incur debt without approval of other partners
  • assignment of all related intellectual property
  • agreement as to what happens to IP and other assets if the partnership dissolves

You can find a simple template agreement  on my resource page that covers these elements.   It is no substitute for legal counsel and you use it at your own risk.  So please, before you or your collaborators have risked significant time or money, consult an attorney.