A. Formation Of Entity

The decision about what kind of entity a new business should be is made by the business owners, with input from an attorney and accountant. The exact choice requires consideration of many individual factors respecting the business and its owners.

A Limited Liability Company is a relatively new entity which is taxed like a partnership (there is one level of tax at the owner level). It allows for flexibility with regard to both management structure and profit allocations.

A C Corporation is usually preferred by venture capitalists as a prelude to an IPO. The main disadvantage is that it is taxed separately from its shareholders. Income is taxed twice, once at the corporate level and again when the income is distributed to the shareholders. This double taxation is particularly a problem if the company is sold in an asset transaction.

An S Corporation is not subject to double taxation for federal purposes. It is rarely used when the company intends to raise funds because of certain unfavorable technical requirements. There are limits on who can be shareholders (no nonresident aliens and no corporations). There can only be one class of shares, so there can be no preferred stock, which limits the flexibility of profit allocations.

A Limited Partnership is now rarely used due to the existence of LLCs.

One disadvantage of a limited liability company, S corporation and limited partnership is that income is taxed to the owners whether or not it is in fact distributed.

Internal structure of entity

A company should consider whether a shareholders’ agreement (corporation) or an operating agreement (LLC) would be appropriate. The agreement provides for restrictions on the transfer of shares, buy-sell provisions and any agreements related to management of the company.

B. Securities Law Highlights

No matter what form of entity, ownership interests are "securities" under federal and California law. Many forms of debt are also considered securities.

Offering of securities for sale is highly regulated and a mistake can subject a business and its owners to civil and criminal penalties.

Securities must either be a) registered with the SEC and qualified with the state of California or b) issued pursuant to an exemption under both statutory schemes.

Registration and qualification are very expensive.

The typical exemption relied upon by a start-up business is a "limited offering" or "private placement" --- limited number of offerees, all of whom have a pre-existing relationship with the company, and who are sophisticated and able to fend for themselves in the investment.

The "limited offering" or "private placement" exemptions are also referred to as Regulation D (federal) and Section 25102 (f) (California). If shares are offered and sold to residents in any other state, the company must comply with the laws of that state and a separate exemption must be found under each state’s statutory scheme. The more states involved, the higher the legal fees incurred.

In offering securities for sale in successive or multiple offerings, a company must be cognizant of the "integration" concept under federal and state securities laws where those offerings will be considered to be one large public offering rather than a series of limited offerings.

Whether or not exempted from registration, "anti-fraud" provisions of the securities laws apply to any and all offerings. Anyone acting on behalf of the company cannot make any false statements or omit any material facts in connection with the offer or sale of the securities. The anti-fraud provisions apply to the business plan (see section D below) and any other written or oral statements.

C. Documents Needed To Raise Capital

Offeree Questionnaire, which is drafted by an attorney, allows the company to rely on statements made by a prospective offeree that he or she meets the requirements for the exemption. It should be distributed and returned before entering into further discussions or providing any other documents.

Business Plan or Private Placement Memorandum which is usually drafted by the founders or a consultant and then reviewed by the attorney for compliance with securities laws. The attorney can draft it but usually this is prohibitively expensive.

Subscription Agreement, which is drafted by an attorney, is the contract entered into between the issuer and the company. Typical provisions are an acknowledgment by the investor that private placement shares are not freely transferable, a minimum investment amount (to limit the number of investors), and a clause that the company will return the investment if the round of financing is not completed.

D. The Business Plan

The business plan is the primary method of distributing information about the company to potential investors. It should cover all aspects of the projected business, including a description of the business idea; the market; background on the company’s management; and analysis of competition or projected competition.

The primary failure of most business plans is to omit or understate the risks.

Business plans for technology companies should fully disclose the fast-changing nature of the field. A statement such as "no competitor has established dominance in this area" may be true when written but completely misleading at the time of the investment.

For technology companies, business plans should contain possible exit strategies, such as an IPO or sale to a larger entity. However, no guarantees or warranties of success should be made.

E. Using The Web To Distribute Offering Materials

While the SEC is currently reviewing its regulations and may change them in the near future, currently "general solicitation" of investors is not allowed under the exemption provided by Regulation D. Using the Web to post offering documents and/or to raise money can easily be viewed as a general solicitation and thus a violation of the securities laws.

F. Need For Qualified Legal Advice

This outline highlights some of the legal issues faced by a start-up business. The issues addressed are not comprehensibly addressed, nor have all issues which might typically be faced by a start-up business been addressed. It is critical that a start-up business obtain qualified legal advice at its inception and on an ongoing basis so as to maximize its potential for success.

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