Legal Discussions and Workshops for Startups
December’s monthly STL Workshop was on Startup “Legal War Stories”. STL’s four presenters led a lively discussion, each presenting one startup case were painful problems could have been avoided by doing it right in the first place. (Cases were appropriately anonymized.)
Subject areas covered:
Held on January 14, 2013, 5:30-8pm.
Tahmina Watson presented on the fundamentals of an H1b visa petition, as well as H1b for the consultancy company and the self-employed entrepreneur at our workshop titled “H1b and the Start-Up.”
Issues covered:
1. H1b basic requirements and time frames.
2. H1b general documentation.
3. H1b for the employer
4. H1b and how it applies to a Start-up company owner
5. H1b for the consulting company.
and other related issues.
With the H1b season about start, this will be important for anyone thinking about filing an H1b on April 1st 2013, whether you are a Start-up founder thinking of an H1b for yourself, or if you are an owner looking to employ people on an H1b visa, or if you are an employee needing to understand more about the H1b process.
For follow-up questions email Tahmina at [email protected].
This is kind of trick question, because LLCs don’t have articles of incorporation or bylaws, they have limited liability agreements, sometimes called operating agreements. An LLC that has elected to be taxed as a corporation is a weird animal. It’s a corporation for federal tax purposes but an LLC under state entity organization law. Even though it is taxed as a corporation, its governing documents must comply with the LLC statute. That means all of the rules that govern organization, issuance of units, relationship of owners, duties of management, requirements for distributions, dissolution and liquidation — they are still found in the LLC act, not the corporation act. For Washington that would be RCW 25.15, rather than RCW 23B. One of the most material differences is that the fiduciary duty of loyalty can be waived with LLCs, something that is sometimes desirable for real estate management firms but would generally not be recommended for a tech startup.
An LLC that has elected to be taxed as a corporation needs a limited liability company agreement designed for its situation. If the company has made an S corp election, it is very important that the LLC agreement have protective language in the document providing, among other things, that investors may not join who would blow the S-election because of their status (e.g., an entity or a foreign citizen). Disclosure and communication to members is critical with this kind of entity, because the distinctions are not widely understood, and investors/members may have incorrect assumptions.
The take away for a startup company is that if you are an LLC and you are being advised to make an S election, or even a C corp election, understand that you will become kind of a hybrid entity that isn’t always well understood. Also, once a corporate election is made, that is what you are in the eyes of the IRS. You can’t switch back to being taxed as a partnership without consequences – you will be treated as liquidating the corporation for tax purposes and may have tax liability as a result.
Since business is usually about numbers, most business documents contain mathematical formulas of one kind or another. Not surprisingly, formulas are often the most critical part of the document and carry the gravest consequences if misinterpreted or incorrectly drafted. In the linked document, I suggest some strategies for drafting formulas so that they are more accessible to the reader and less likely to be misinterpreted by someone tasked later with implementing the agreement. (I attached the Word document so that you can experiment with the formula editor, which is used in the examples.)
The cynical view is that lawyers purposely make legal documents hard-to-read so that lay people have to rely on them to interpret and negotiate the documents. There may be a bit of truth to that, especially in former times, but I don’t think most attorneys intentionally make their documents difficult to read. There are many other valid reasons why legal writing is so obtuse. Here is my List of the Top 10 Reasons Lawyers Produce Hard-to-Read Documents:
Top 10 Reasons Lawyers Produce Hard-to-Read Documents
| 10 | Trade Guild Affectation | Discussed above — I don’t believe most lawyers make things complicated on purpose, but one can see a perverse incentive to do it. |
| 9 | Convention | It’s always been done this way, and lawyers haven’t been exposed to something better. |
| 8 | Esteem of Peers
|
Lawyers want to sound like other lawyers, so they will be respected. This is different from intentionally making the document difficult to read to protect a trade guild’s insularity. I once had a senior attorney reject my draft, not because of its substance, but because he said it sounded “like two people talking on a street corner”. He didn’t mean it as a compliment, but he should have. |
| 7 | Countervailing objectives | Securities disclosure documents and some consumer contracts have countervailing objectives – one purpose is to serve as a marketing document, but the other purpose is to be a record of full disclosure. |
| 6 | Experience | Lawyers get good at parsing long sentences with lots of nested qualifications and with the primary verb well-hidden near the end. (That is to say, they get good at reading bad writing). They also get familiar with the standard provisions in their specialty. |
| 5 | Expense | For efficiency, lawyers rely heavily on prior documents and industry templates as starting points. It would take quite a bit of time to redraft from scratch, and neither they nor their clients want to pay for it. |
| 4 | Fear | A lot of thinking and experience has gone in to prior documents. Lawyers fear that if they re-write a standard document they may miss a detail that matters. |
| 3 | Negotiated document | Because most contracts are negotiated, they are often the work product of multiple authors with different agendas and styles. Lack of coordination and last minute edits all contribute to hard-to-read documents. |
| 2 | Complexity | The subject matter is complicated, full of conditions that are qualified with exceptions that have provisos and further stipulations. |
| 1 | Unit of Truth Problem | The number one cause (in my opinion) of unreadable documents is, as legal drafting Guru Bryan Garner put it, “. . . the fear of qualifying a proposition in a separate sentence, as if an entire idea and all its qualifications had to be fitted into a single sentence.” Another plain English proponent, Howard Darmstadter, calls this the Unit of Truth Problem — lawyers think the unit of truth is the sentence, when in fact it is the whole contract. |
I believe the one thing that would make legal documents more readable is to cure lawyers of the Unit of Truth Problem. As I observed with Reason No. 9, legal matters are full of qualifications and exceptions. I see the following scenario over and over again. After rounds of negotiated changes, another exception or qualification is introduced. The drafter searches for another way to insert a a parenthetical phrase within a long, complicated sentence that already has multiple nested qualifications. It’s poor drafting, and the sentence becomes impossible to read without parsing it carefully. But not putting the exception within the same sentence causes the lawyer real angst. Because in the lawyer’s view, the sentence wouldn’t be true if the qualification doesn’t come before the period. Darmstadter, Garner and other plain English proponents remind us that the “Unit of Truth” is the whole contract. That it is perfectly acceptable for a later sentence to modify an earlier sentence. Of course, it’s poor drafting to bury a qualification in another part of the document, but it is perfectly acceptable to qualify a sentence by the one that immediately follows it, as in this example:
A claim for exemption, which in the case of filers who have reached their 75th birthday may not exceed $4000, must be filed on form AB-34 before July 13th each year.
Rewrite: A claim for exemption must be filed on form AB-34 before July 13th each year. Filers who have reached their 75th birthday may not file a claim for more than $4000.
If you are like me you had to read the first example twice to get its full meaning.
Here are some other ways to attack the Unit of Truth Problem:
The conversion price of the preferred stock will be adjusted for dilutive issuances of new securities according to the rules set forth in this Section.
The whole goal is to produce legal documents that communicate effectively and efficiently. Prose is effective when readers understand the message. It is efficient when readers can understand the message the first time they read it without stopping and re-reading. Efficient writing may sometimes take up more space on the page than less efficient writing.
If legal documents are obtuse, clients simply don’t read them. Or they do their best to plow through them but can’t follow them. The underlying idea of a contract is that both parties reach a “meeting of the minds”. This is less likely to happen if both sides are relying on their lawyers to interpret the contract for them. It also puts the lawyer-client relationship at risk if there is ever a problem.
I aspire to follow the following principals in the documents I draft (you should encourage the same from your lawyer, and consider applying these principals to your writing):
- Keep average sentence length to 20 words, and vary the length (a well-written document should sound like the Gettysburg Address, which adheres to this principle)
- Break up long sentences with bullet points and sub-sentences.
- Use active voice over passive.
- Keep the verb towards the beginning of the sentence.
- Use active, rather than passive, voice.
- Avoid nested modifiers and parentheticals.
- Use if-then construction.
- Use tables if multiple ifs and multiple thens.
- Keep modifiers near the modified word.
- Avoid double negatives.
- Use will, must, and may rather than shall (shall can have at least two, contrary meanings)
- Write numbers one time, not two (2) times. (It seems to be a carryover from the days of handwritten form agreements. It’s not necessary, slows reading way down, and invites error.)
- Minimize definitions, avoid nesting them, and don’t define things away from their common meaning. (Classic example – Rule 506 says you can only sell to 35 “purchasers”. Rule 501(e) excludes “accredited investors,” usually the only purchasers, from the computation of the number of purchasers.)
- Use common language; avoid legalisms and jargon.
- Don’t use any of the following words:
- herein
- therein
- thereof
- such
- provided, however,
- shall
- thereby
- whereas
- therefor (but do use therefore)
Do the documents I produce reflect all of these principals? Unfortunately no, for many of the reasons in my Top 10 List. But I keep trying to improve, and as I get more advanced in my practice I have more control over my starting point when I draft. And I always welcome suggestions for better language in my documents.
So why post this article on a website primarily for clients? Because clients have the power to change legal drafting standards by demanding better from their attorneys. Better documents, faster, more efficient deals with fewer misunderstandings can start with you.
If you are the indemnified party, an indemnification clause is simply a promise by the other party to cover your losses if they do something that causes you harm or causes a third party to sue you. The key words are “indemnify”, “hold harmless”, and “defend”. Indemnify and hold harmless mean the same thing — to make whole after causing a loss. The word defend relates to responsibility for defending from law suits, and isn’t present in an indemnification provision if the indemnified party prefers to defend its own lawsuits (although the indemnifying party may be required to pay for it).
Often, the indemnified party would ultimately be able to recover on the loss under another legal theory, such as breach of contract or tort. So the primary effect of indemnification in most cases is to shift the cost of defending third party claims to the indemnifying party. Even so, the indemnification provision is very useful for explicitly setting out the responsibilities of the indemnifying party. And if the indemnification clause provides that it is the exclusive way to recover against the indemnifying party, it is very useful for setting parameters around such things as the scope, maximum liability, and time periods when a claim may be brought. Indemnification provisions go hand-in-hand with insurance covenants.
Here is an indemnification clause from an Independent Contractor Agreement, with explanations in bold:
Contractor will, at its expense if Company requests, defend any of the following types of third party claims brought against Company or its directors, officers, or agents (collectively, “Indemnitees”): [If you are sued by anyone for any of the following reasons, the contractor will be responsible for defending you in court.]
(i) any claim that, if true, would constitute a breach of the Agreement by Contractor; [Since the claim is regarded as true, the contractor must defend you based on whether the allegations in the complaint would constitute a breach of the contractor’s agreement.]
(ii) any claim related to injury to or death of any person (e.g., worker claims) or damage to any property arising out of or related to performance of any Work; [If the contractor’s work causes anyone to by physically injured or killed, the contractor must defend the suit.] or
(iii) any claim that otherwise arises from the acts or failures to act of Contractor or its agents (including any claim that the Work Product infringes upon the rights of any third party) [If the contractor copies someone else’s code or the work infringes someone elses IP, and you get sued for it, the contractor would be responsible for defending the suit and making you whole.].
Contractor will indemnify and hold harmless the Indemnitees from any costs, damages, and fees (e.g., attorney fees and the fees of other professionals) reasonably incurred by any of them that are attributable to any such claim. Should the Work Product, in whole or in part, constitute an infringement and any use of it be enjoined or threatened to be enjoined, Contractor will notify Company and, upon Company’s request and at Contractor’s expense: (i) procure for Company the right to continue use of the Work Product, or portion of it, as applicable; or (ii) replace or modify the Work Product, or any portion of it, with a non-infringing version, provided that the replacement or modification meets all Specifications to Company’s satisfaction. If (i) or (ii) of the previous sentence are not available to Contractor, in addition to any damages or other remedies to which Company may be entitled, Contractor will refund to Company all amounts paid to Contractor for the applicable Work Product.
Incentive stock options, or “ISOs”, are options that are entitled to potentially favorable federal tax treatment. Stock options that are not ISOs are usually referred to as nonqualified stock options or “NQOs”. The acronym “NSO” is also used. These do not qualify for special tax treatment. The primary benefit of ISOs to employees is the favorable tax treatment — no recognition of income at the time of exercise, and long-term capital gains versus ordinary income at the time the stock is sold. But in the typical exit by acquisition scenario, employees exercise their stock options and are cashed out at the time of the acquisition. In that scenario, since they sell immediately, they do not qualify for the special tax rates, and their stock options default to NQOs. So in practice, there tends not to be a material difference in the end between NQOs and ISOs. If emplyees are in a situation where it makes sense to exercise and hold (for example, if the company goes public), then the benefits of ISOs may be realized.
The discussion below is not comprehensive. Please consult your own tax adviser for application to your situation.
| Incentive Stock Options | Non-Qualified Stock Options | |
| Who can receive? | Employees only. | Anyone. |
| Requirements: | Must be issued pursuant to a shareholder- and board-approved stock option plan. | Should be approved by the board of directors and pursuant to a written agreement. |
| The exercise price must be no lower than fair market value at the time of grant. | If the exercise price is less than the fair market value of the stock at the time of grant, the employee may be subject to significant penalties under Section 409A, including taxation on vesting. | |
| The option must be nontransferable, and the exercise period (from date of grant) must be no more than 10 years. | ||
| Options must be exercised within three months of termination of employment (extended to one year for disability, no time limit for death). | ||
| For 10% (or more) shareholders, the exercise price must equal 110% or more of the fair market value at time of grant. | ||
| For 10% (or more) shareholders, the value of options received in any one year, cannot yield stock valued at more than $100,000 if exercised (value is determined at the time of the grant). Any amount in excess of the limit will be treated as an NQO. | No limit on value of granted options. | |
| Tax effect to Company: |
The company is generally not entitled to a deduction for federal income tax purposes with respect to the grant unless the employee sells the stock before the end of the requisite holding periods. |
Company receives deduction in year recipient recognizes income, as long as, in the case of an employee, the company satisfies withholding obligations. |
| Tax effect to Employee: | No tax at the time of grant or at exercise. Long term capital gain (or loss) recognized only upon sale of stock if employee holds stock acquired by exercise a year or more from exercise and at least two years from date of grant. | The recipient receives ordinary income (or loss) upon exercise equal to the difference between the exercise price and the fair market value of the stock at date of exercise. |
| But the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax. | The income recognized on exercise is subject to income tax withholding and to employment taxes. | |
| Gain or loss when the stock is sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). | When the stock is sold, the gain is long term capital gain if held more than one year from exercise. The gain will be the difference between the sales price and tax basis, which is equal to exercise price plus the income recognized at exercise. | |
This workshop, held on June 7, was well-attended. If you were there and have follow-up questions, feel free to post in the comments section.
This workshop is for entrepreneurs who are thinking about forming a start-up, or have recently started a business, and want greater insight on how to avoid the typical legal problems encountered by new businesses. Four professionals – a securities lawyer, an intellectual property (IP) lawyer, an immigration lawyer, and an international tax CPA – will discuss the most important legal issues to consider in the early stages of your business. Their presentations will provide information on how to protect your intellectual property rights, avoid tax surprises, handle immigration issues and ensure a smooth growth and exit.
Our Top 10 Legal Missteps List:
Caution: The discussion below is not comprehensive. You need to consult your own attorney as to the specifics of Section 409A and as it applies to your situation.
These days anyone involved with equity compensation will hear a reference to “Section 409A”. It is a reference to Section 409A of the Internal Revenue Code, part of the American Jobs Creation Act of 2004.
Employees and independent contractors participating in a nonqualified deferred compensation arrangement which fails to comply with Section 409A will be subject to:
Incentive stock options (“ISOs”) are exempt from Section 409A. However, one requirement of ISOs is that the exercise price at the time of grant is no higher than the market value of the common stock. So, if it is determined that the fair market value of common stock is greater than the exercise price at the date of grant, the option will not be exempted from 409A. Therefore, the steps necessary for valuing a nonqualified stock option are also applicable to incentive stock options.
The company may protect itself and its option recipients from the negative consequences of Section 409A by doing the following: (1) make sure that the exercise price is no less than fair market value on the date of grant, and (2) insure that the option does not include any other feature for the deferral of compensation other than deferral of recognition until the exercise or disposition of the option or, if the stock received on exercise is restricted, until the vesting of that stock. An example of a deferred compensation feature would be an option that allowed the employee at the time of exercise to elect to take cash amount equal to the option spread as deferred compensation over time. This would render the option subject to Section 409A.
With respect to setting the exercise price at fair market value, it is important to keep in mind that the board’s determination of fair market value must be defendable to the IRS (and in the event the company goes public, to the SEC, as discussed below). A simple board resolution stating the fair market value of the company is insufficient. The fair market value of private company stock or equity unit must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.
The factors to be considered under a reasonable valuation method:
These days, boards of directors of many venture-backed companies are relying on periodic formal valuations done by financial firms. That may not be a realistic solution for an early stage company. In such cases, the company can minimize its risk under Section 409A if it can find an adviser, CFO, or someone else who can qualify as someone with “significant knowledge and experience or training in performing similar valuations”. Often very early stage companies have developed some software code but have no sales, sales contracts, or significant value in their trademark. In such cases the reasonable replacement cost of the software code is one metric that might form the primary basis for the valuation.
A stock option is a commitment from the company to allow the grantee (usually an employee) to purchase a certain amount of stock from the company at a fixed price (called the “exercise price”) for a certain period (typically up to 10 years from the date of grant). Shareholders own a piece of the company. Optionholders are not shareholders (yet). They own the right to purchase the stock at a given price by a certain time. Options are usually intended as an incentive to build the value of the company going forward. The exercise price does not change as the value of the company increases. So (hopefully) as the value of the company increases, the value to the employee will grow. If the value of the company remains dormant while the employee holds the option, then there is no significant benefit to the employee. Employee stock options are usually issued pursuant to a stock option plan approved by the board of directors and the shareholders. This is primarily because “incentive stock options” — stock options that are eligible for certain favorable tax treatment, must be issued pursuant to a shareholder approved plan. See What is the difference between incentive stock options and non-qualified stock options.
The grant and exercise of of stock options are subject United States and local laws, including tax and securities laws.
Copyright © 2021 · News Child Theme on Genesis Framework · WordPress · Log in