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ENTREPRENEUR’S

SURVIVAL GUIDE

A POCKET GUIDE TO START-UP LAW

JAY LANDRUM

THE

THE ENTREPRENEUR’S

SURVIVAL GUIDE

A Pocket Guide to Start-Up Law

_____________________

Jay Landrum

InformaƟon contained in this book is intended to provide general

informaƟon about signicant legal topics and legal developments

and should not be construed as legal advice on any specic facts

and circumstances, nor should this informaƟon be construed as an

adverƟsement for legal services.

TABLE OF CONTENTS

INTRODUCTION ........................................... 9

THE UGLY TRUTHS ABOUT BEING IN

BUSINESS FOR YOURSELF .......................... 13

LEAVING YOUR PRIOR EMPLOYER ............. 19

EMPLOYEE COVENANTS NOT

TO COMPETE ............................................. 25

PLANNING BETWEEN CO-FOUNDERS ........ 29

FICTITIOUS BUSINESS NAMES ................... 33

DO I INCORPORATE? ................................. 37

WHERE DO I FORM? .................................. 43

LLC vs. CORPORATION vs. PARTNERSHIP

vs. SOLE PROPRIETORSHIP ........................ 47

FORMING A BOARD ................................... 65

ADVISORS TO THE BOARD ......................... 69

OFFICERS ................................................... 71

DUTIES OF LOYALTY, GOOD FAITH AND

DUE CARE .................................................. 75

RECORDKEEPING ....................................... 79

PIERCING THE CORPORATE VEIL AND

THE ALTER EGO DOCTRINE ........................ 83

STOCK, PHANTOM STOCK AND SAFES ...... 91

COMMON vs. PREFERRED STOCK .............. 95

VOTING .................................................... 101

SHAREHOLDER AGREEMENT ................... 107

BUY-SELL AGREEMENT ............................ 113

SPOUSAL CONSENTS ................................ 133

STOCK OPTIONS ....................................... 137

VESTING ................................................... 143

409A VALUATIONS ................................... 147

TYPES OF INVESTORS ............................... 151

INVESTOR VALUATIONS ........................... 155

TERM SHEET, LETTER OF INTENT ............. 159

FINANCING YOUR BUSINESS .................... 163

USING FINDERS ........................................ 167

BASIC FORMATION DOCUMENTS ............ 173

OBTAINING AN EIN .................................. 177

SHARE OFFERINGS AND SECURITIES

REGULATIONS .......................................... 179

CORPORATE TRANSPARENCY ACT ........... 187

AN INTELLECTUAL PROPERTY

OVERVIEW ............................................... 203

COPYRIGHTS ............................................ 207

FIVE COPYRIGHT MYTHS .......................... 221

TRADEMARKS ........................................... 225

PATENTS .................................................. 237

TRADE SECRETS ....................................... 243

EMPLOYEES vs. INDEPENDENT

CONTRACTORS ........................................ 249

OFFER LETTERS AND EMPLOYMENT

AGREEMENTS .......................................... 257

PROPRIETARY INFORMATION

AGREEMENTS AND NON-COMPETE

AGREEMENTS .......................................... 261

LABOR CODE 2870 (CALIFORNIA) ............ 267

CONTRACTS AND ARTICLE 2 OF THE

UNIFORM COMMERCIAL CODE ............... 271

DIGITAL SIGNATURES .............................. 275

DATA PRIVACY ......................................... 279

TYPES OF LIABILITY .................................. 283

INSURANCE .............................................. 287

RESOLVING DISPUTES: MEDIATION

AND ARBITRATION .................................. 293

EXIT STRATEGIES ..................................... 299

ABOUT THE AUTHOR

Jay Landrum, a corporate aƩorney, has been working

with entrepreneurs for over 30 years.

He has worked as General Counsel and Vice

President for an NYSE listed company, where he was

part of a management team that grew its business

over 700% in ve years. As a start up entrepreneur,

he has founded several businesses, wriƩen business

plans, raised capital and led operaƟons; as the CEO

of those businesses, he has stood in the same shoes

as entrepreneurs like you.

His corporate legal pracƟce emphasizes business

transacƟons, including enƟty formaƟon, nancing

transacƟons (venture, private and debt), and buy-sell

agreements, as well as day-to-day legal

representaƟon. He frequently serves clients as

counsel on acquisiƟon and merger transacƟons,

asset and stock acquisiƟons, joint ventures, and also

on technology transacƟons, such as development

agreements (website, soŌware development),

manufacturing agreements (OEM, VAR), and

technology-oriented purchase and sale agreements.

Contracts and licensing are also primary pracƟce

areas, including hardware and soŌware licensing

agreements, non-disclosure agreements, distribuƟon

agreements (such as dealer, distributor and

manufacturer representaƟve agreements), and

licensor/agent/licensee representaƟon.

He also has more than 25 years of experience represenƟng

art-based clients, including painters, photographers,

sculptors, songwriters, authors, art publishers and art

agents in areas of general representaƟon, publishing,

distribuƟon, licensing, copyright, and trademark. He is a

recognized expert in the eld of art law, and he has served

as an expert witness for art law disputes.

Outside of his day-to-day legal pracƟce, he has also taught

start-up law at Santa Clara University School of Law and

business law at Jessup University.

Jay’s contact informaƟon is:

Jay Landrum

Berliner Cohen LLP

10 Almaden Blvd., 11th Floor

San Jose, CA 95113

t: 408.286.5800

e: jay.landrum@berliner.com

INTRODUCTION

If you are reading this book because you are about to start

your own business, congratulaons on taking the big leap!

You're in good company -- over 50% of adults have started

a business at some point in their lives. With that

parcipaon level, it's no surprise that small businesses

make up more than half of the U.S. economy!

Of those who make the leap, about a third choose to do so

because they want to be their own boss. Of course, if you

can pursue your passion in the meanme, that's even

beer. As for those who don't start a business (even

though they want to), 40% don’t do so because they

don’t know where to start. Hopefully, this book can solve

some of those mysteries.

Entrepreneurship is a great equalizer. More than 50% of

entrepreneurs do not have a college degree. Almost one

in six entrepreneurs are immigrants, one in six

entrepreneurs are minories, and about 25% are women.

It's esmated that about 30% of small businesses make

money, 30% break even, and 30% lose money. Why do

businesses fail? Oen, because of insucient capital or

poor cash ow. In this book, you'll acquire some tools that

can help you raise capital to keep your business aoat, as

well as informaon that will help you avoid making

common mistakes.

Over my career, I have worked with hundreds of

companies, some as small as one person, others

employing thousands of workers. I have worked in-

house at companies, started businesses, raised

money, run businesses, and have provided legal

advice to thousands of people. I have been in your

shoes…I know what entrepreneurs need to know,

because I have been one. In this book, I’ll do my best

to give you praccal informaon without a lot of

lawyer-speak – with the goal of geng your new

enterprise o to a solid start!

This guide is intended to be an easy-to-read, high-

level view of business law for the entrepreneur. It

covers protecons that are available to you, as well

as the hazards that could impact your eorts. By

taking simple acons to protect yourself and your

rights, and by idenfying potenal pialls, you can

posion your business for long-term success. Note

that there may be some repeon across chapters,

but this is intenonal, in case you are ipping around

to topics/chapters you are specically interested in.

The law can be tricky. Keep in mind that while a

number of general concepts apply, answers to

hypothecal quesons quite oen end up being “it

depends.” In large part, that is because the answer

typically rests on specic factors unique to that

situaon. It will also depend on what law applies;

federal laws may vary within dierent appellate

courts and state laws may vary by state. So, while

this guide does make general statements about the

law, this guide is obviously no subsƟtute for legal

advice. The law is constantly evolving, and if issues

or risks arise (or you are even concerned certain

issues may arise), it’s always important to secure

legal representaƟon.

If this guide achieves its goals, you will walk away

more informed and educated on entrepreneurship

and business law than when you started. If it

really achieves its goals, you will not only be more

informed, but you will also put that knowledge to

use…taking acƟons that beƩer protect you and your

business.

While starƟng a new business may not be for the

faint of heart, the rewards can be great, both

nancially and emoƟonally. But fortune favors the

bold, so read on and prepare yourself for this

exciƟng journey! Best of luck!

Jay Landrum

NOTES

_______________________________________

THE UGLY TRUTHS ABOUT BEING IN

BUSINESS FOR YOURSELF

One of the most common reasons a business fails is

that there is no market for that product or service, or

that you have failed to create one. On one hand, it

seems prey obvious. A business clearly needs to

oer something people want to buy…but since this is

a primary reason that businesses fail, maybe it is not

so obvious aer all.

Entrepreneurs have many reasons why they want to

start their own businesses:

 I want to be my own boss

 When working for someone else, I don't get

to share any of the prots

 I want to work when I want to, and not be

on someone else’s schedule

 I have a great idea – something the world

needs!

 I may not have a new idea, but I can do

beer than those doing it now

 I have something I love doing, and I want to

turn my interest/hobby into a money-

making business

 My friends always say I'm a good cook, and

that I should start my own restaurant

While those are all potenally worthwhile reasons

for you to strike out on your own, self-evaluaƟon is

criƟcal before starƟng a business. You need to be

honest with yourself and ask quesons like the

following:

 Keeping all the prot

sounds great, but do I

understand that “keeping all

the prot” oen means

“geng paid last”? Can I go

without geƫng paid for

some period of Ɵme? For

how long?

 Do I understand that

“working when I want” oen

means “working whenever I can, so I can get

the work done”?

 Do I have the skills necessary to convert my

great idea into a business? (Venture

capitalists will tell you they would rather

invest in a great team with a good idea,

rather than a good team with a great idea…

ideas are important, but the ability to

execute is crical)

 Will my business need start-up capital? How

much? (Hint: it’s probably more than you

think!)

 Can I aord the upfront expenses unl I can

get cash ow posive?

 Will I raise money from friends and family?

Will they be understanding if the business

fails and I lose their money?

 If I need a Small Business Administraon

(“SBA”) loan, will I be willing to risk my

home’s equity and list my house as collateral

Honestly review

your skills and

temperament.

Are you up for

this challenge?

(as will be required)? Will my spouse be OK

with me pung our home at risk?

 While I have an interest in what this business

would oer, does the general market of

consumers have enough interest? Will I be

able to sell enough products or services to

pay my bills, such as rent, employees,

accountants, etc.?

 Do I have the temperament to be able to

deal with all the ups and downs of owning my

own business, including near failure or

growing faster than I can handle?

 Do I have the temperament to be able to deal

with the (somemes unreasonable) demands

of customers and employees?

 Am I considering all aspects of running a

business, and am I able (and interested) to

handle those challenges? (For example,

running a restaurant involves managing

people, markeng, nance, etc.… being a

great cook will not be enough on its own.)

As you evaluate your skill sets, think of people like

horses. There are lots of types of horses, including

show horses, racehorses, and dra/work horses.

While they're all horses, you would never put a work

horse on the track or harness up a racehorse to pull a

heavy load. Each horse may be perfectly suited for

one task, but not at all suited for another.

People are the same way, and every business needs

a variety of “horses" -- you will need someone who

can work the “front of the house,” talking with

customers, making sales, creaƟng markeƟng

campaigns, etc. You will need someone who can

work the “back of the house” as well, keeping the

books, searching for beƩer pricing, managing

contracts, and paying the bills. Which one are you?

Importantly, you need to know what

kind of horse you are! Recognize

where you have weaknesses and hire

people to work in those areas where

you are not as strong. If you love

working with people, and you are not

strong on nances, nd yourself a

strong nancial partner. If you love working with

numbers, but not with people, nd yourself a partner

who can work with the public. Even if you think you

are great at both, you need to recognize you may not

have the Ɵme to do both -- in that case, you may sƟll

need a partner (or employee) to handle the areas

you will not have Ɵme to address.

You should also ask yourself what kind of a life you

are looking to live while you run this business. Are

you willing to shiŌ from a “9 to 5” job into a career

that may require working lots of nights and

weekends? While owning your own company may

eventually allow you to work less and live beƩer, are

you willing to make the sacrices necessary to get

there? Is your family willing to make those same

sacrices?

What

kind of

horse

are you?

This quesƟon is even more important if you start a

business with a partner. Some people start a

company because they want to build a valuable asset

that they can later sell; others go into business for

themselves because they want to be able to work

less and maybe golf every Wednesday. It is criƟcal

that partners have similar objecƟves…when you have

one partner working 70 hours a week while the other

partner works four days a week while he improves

his golf game, issues will

undoubtedly arise. I can tell you

from experience that when

partners are not aligned on their

contribuƟons, the company

immediately has operaƟonal

issues and most frequently does

not survive. Your discussions with

any potenƟal partners should be

blunt… with everyone seƫng out their expectaƟons

for themselves and each other and everyone being

on the same page as to what each partner will be

delivering in their role at the company.

A key to success is idenƟfying obstacles in advance,

and the rst ones you need to idenƟfy are those

resulƟng from your own limitaƟons, and the

limitaƟons of your partners. Once you do that, you

can start to put measures in place to address those

limitaƟons….some of which may be detailed in

wriƟng (and maybe even in a contract), and others

which may just need discussion up front…however,

Make sure

you and any

partners are

aligned on

goals.

since memories oŌen change, puƫng it in wriƟng is

important (and never a bad idea!).

LEAVING YOUR PRIOR EMPLOYER

"Take this job and shove It, I ain't workin' here no

more!"

That’s both a line from a 1977 country music song

wrien by David Allan Coe (and popularized by

Johnny Paycheck) as well as the senment of many

employees across the country. It’s a mindset that

has put many entrepreneurs on the road to self-

employment!

Walking out the door may sound easy, but it may

actually be more dicult than you think.

Before you quit, consider a few things:

Oen, before someone leaves their

job to start their own business, they

want to start pung that new

company together. Depending on

your posion in the company, that

may be dicult. If you are a key

employee, such as an ocer,

director, or manager, or if you are a

skilled employee such as an

engineer, top salesperson, or a specialist in some

area, you may owe a duty of loyalty to the

company, whether or not you have an employment

agreement. If so, that duty of loyalty will prevent

you from doing things that would harm your

employer during the me you are sll working for

Don’t jump

the gun!

Understand

obligaƟons

to your

current

employer!

them. It's important to know your obligaƟons to

your current employer before you start developing

your new business; otherwise, your employer may

claim that your new business belongs to them.

Generally speaking, lower-level employees are

typically not bound by non-compete agreements,

which allows them to develop their new business

during their oﬀ hours and even work for a

compe��ve business on their oﬀ hours.

The higher your posiƟon, the more likely you may

have a duty of loyalty. In many cases, the company

will require that you sign a non-compete agreement

when you are hired…years later, you may not even

remember you signed it, so you may need to ask to

review your le (although, depending on the state,

that non-compete may not be enforceable).

CondenƟality ObligaƟons:

In the course of your employment, it's possible you

may have come across conden�al informa�on

belonging to your employer. Just because you're

leaving doesn't mean you get to use that

informaƟon however you want.

It's possible that when you joined the company, you

signed a non-disclosure agreement which restricts

your use of the company's conden�al informa�on.

Even if you didn't, you s�ll may have restric�ons on

the types of informa�on you can use. Don't be

surprised if your employer asks you to sign

something on your way out stang you're aware of

your condenality obligaons and that you will not

use their condenal informaon in the future.

“AŌer hours” and with no company resources:

Absent some specic restricons you

may have agreed to, you are enƟtled

to develop your own business on

your own hours. If you have specic

work hours and punch a me clock,

it may be more clear that you are

working on your own business “aer

hours”-- of course, if you are a

manager, or someone who does not

have dened hours, it becomes a bit more blurry as

to whether you were working on your own me.

Obviously, if you take two weeks o for vacaon, and

work on your business then, that would be on your

own me, but proving what was done then, versus at

work, may be a challenge.

Not only must you develop your business on your

own hours, but you also must do it with your own

resources. That means you can't use the company

oce, the company phone, company fax machine,

company copier, your company laptop, or anything

else that is owned or supplied by your employer.

Develop

your new

business on

your own

Ɵme with

your own

tools.

Bringing coworkers with you:

You probably work with some people that you like

and think they would be great for your new

company. If leaving your company doesn't already

make your employer upset, taking a few of their best

employees with you will probably do the trick.

SoliciƟng employees is something you should be

very careful about. It's possible, in your employment

documents, you signed something that stated you

would not solicit employees if you leŌ the company.

While it is true that employees are generally “at

will” and can leave at any Ɵme, that does not

always mean that you can lure them away.

The most conservaƟve approach here is to wait unƟl

you have leŌ and started your own company before

you solicit any employees for hire.

When you bring former colleagues into your

company, your employer may be concerned that

they are taking condenƟal informaƟon with them

that you would not have had access to otherwise.

For example, if you are a soŌware engineer who has

decided to start your own company, and you hire the

top three salespeople to now sell your similar

soŌware product, your employer may be concerned

that these salespeople are being hired more for your

employer’s client list than their qualicaƟons as

salespeople. It is very important to get a

commitment from any employees that you hire

away from your current employer (as well as from

any other employer) that your new hires are not

bringing any condenƟal informaƟon over with

them.

I had a client that (prior to my representaƟon) was

sued for copyright infringement. Unbeknownst to the

client, one of his employees had misappropriated a

copy of his prior employer’s source

code and then used that source

code in developing certain code for

my client. Despite the fact my client

did not know this employee had

taken the code, and was “innocent”

under the circumstances, it was

and my client received a judgment

against him for millions of dollars and went into

bankruptcy. In hindsight, the client should have

clearly instructed all employees that they were

forbidden from bringing any prior work product

from any prior employer with them and provided

ongoing training on the same. If the employee had

done so anyway, the client would have been in a

beƩer posiƟon to argue that the employee, not the

company, should be responsible for any

infringement. Later in this book, we will discuss

specics on documents employees should be

required to sign upon hiring, to avoid this risk and

others.

Be careful

about what

informaƟon

others may

bring into

your

business!

NOTES

_______________________________________

EMPLOYEE COVENANTS

NOT TO COMPETE

In the scope of employment, covenants not to

compete are essenƟally agreements where

employees agree not to compete with the employer

during and (someƟmes) aŌer terminaƟon of

employment.

Diﬀerent states have diﬀerent

requirements regarding non-

compete agreements. Generally,

non-compete agreements need to

meet certain condi�ons, such as

being reasonably limited in their

scope (including geography and

dura�on) and the non-compete

must be related to legiƟmate business interests

(such as protec�ng trade secrets, client rela�onships

and conden�al business strategies). The agreement

must also be supported by independent

consideraƟon (typically, some form of addi�onal cash

payment separate from what they would receive as

regular pay).

Agreements that might violate the required

condi�ons would be agreements that would prevent

the employee from working in an en�re industry or

prevent the employee from earning a living in their

chosen profession. The burden will be on the

Enforceability

of a non-

compete

agreement

varies from

state to state.

employer to show the legiƟmate purpose and

reasonable scope. Once you become an employer,

this will be your burden of proof as well.

Some states, such as California, are highly

restricƟve, and only allow non-compete agreements

under very narrow circumstances, such as restricƟng

a company’s owners from compeƟng in connecƟon

with the sale of a business. Other states will allow

non-compete agreements, even for low level,

unskilled workers.

Before you walk out your employer’s door, it is

important that you understand your obligaƟons

under these agreements. When in doubt, you can

always ask for a copy of your employment le and

you will receive anything you have signed; however,

this certainly signals to your employer that you may

be looking for the door.

If you suspect you may have some non-compete

obligaƟons, the most prudent decision may be to

wait unƟl you quit before you start puƫng together

your new business.

If you are entering into business with others, it is

important to understand if they have signed a non-

compete, as their violaƟon of that agreement may

bring claims not only against themselves, but also

against your company.

It is crical that all the documents employees receive

are legal. The penalty for using a non-compete

agreement that is not legally enforceable may not

be limited to the court’s refusal to enforce it…it may

be more costly.

For example, in California, if an employer uses a non-

compete agreement illegally, the employee can

report the company to the California Aorney

General’s oce, which may result in nes and

penalƟes. The company will also be subject to civil

liability, including employee lawsuits for damages,

injuncƟve relief, and aƩorneys’ fees. Further, under

California law, if an employer entered into non-

compete agreement with a California employee aer

January 1, 2022, the company is required to take

further acon and nofy those employees that those

agreements are void under California law, or face

nes for the failure to do so.

NOTES

_______________________________________

PLANNING BETWEEN CO-FOUNDERS

StarƟng a business with a co-founder can be great.

There's someone else to bring other skill sets, help

carry the heavy load of entrepreneurship, and

potenƟally help fund the project. However, it is

important to assess the personal and business

aspects of this collaboraƟon before you make the

leap.

While it may seem obvious, one

oŌen overlooked aspect when

starƟng a business is your plan

around ownership. OŌen, a couple

of people get together and come up

with an idea to form a new venture,

and they start down that path

without considering whether they

have the same goals in mind.

As menƟoned before, one partner may want to start

his own business because he wants more free Ɵme

to pursue his hobbies. His partner may be starƟng

the business with the intent of devoƟng all her Ɵme

to making this business successful, because she

wants to build an empire which will allow her to

reƟre in luxury. Neither is the wrong answer, but it is

important that all partners be on the same page as

to what their expectaƟons are. Being aligned on the

vision of the company, as well as on individual work

AnƟcipate

future

issues so

you can

address

them now!

eorts, will eliminate frustraon and conict in the

future.

Another maer that needs to be decided is who is

going to run the business. Suppose three partners

form a business, and one becomes the CEO, one

becomes the CFO, and one becomes CTO. If a

decision needs to be made as to change in the

direcon of the business, does the CEO have the

authority to make that decision,

or will that require all founders to

have a vote? If a vote, then under

what circumstances is a vote

required (and when is it not

required)?

Does each founder have the right

to spend money as they deem

t? Or is there a nancial

threshold which requires approval? And if approval is

required, who is authorized to give that approval?

In the minds of some founders, Ɵtles are simply

ceremonial, and everyone has equal say. In the

minds of others, those Ɵtles represent the specic

roles and responsibiliƟes of each party. It is

important to clarify under which condions you and

your team will operate.

Obviously, from a praccal standpoint, every

decision cannot be made by group vote. However,

there are strategic decisions which can reasonably

How will the

partners

divide up the

labor? How

are decisions

going to be

made?

require a vote by all. The queson is where those

lines are drawn during everyday management of the

business.

Is everyone going to work in the oce? If someone

chooses to work from home, do they have that

opon? Is vacaon me managed strictly or do

founders take me o whenever they choose?

Not surprisingly, money can oŌen be the most

contenƟous issue between co-founders. There

should also be discussions around how equity will be

held, how prots and losses will be distributed,

whether bonuses will be paid (to some founders and

not to others, based on performance metrics?), and

how disputes will be resolved.

In the event a founder leaves the company, what

happens to that founder’s ownership? Does the

founder retain it or lose it? Is that ownership subject

to vesng over some period of me? Once it has

vested, does the company sll have a right to

purchase it aer they leave? If so, at what price?

Founders oen choose to enter into a buy-sell

agreement (addressed in more detail in a chapter

later) to address a variety of concerns around life

events, including divorce, disability, death, quiƫng

with noƟce, and reƟrement. On the occurrence of

those events, the remaining shareholders and/or the

company have a right (or in some cases, an

obligaon) to purchase ownership from the aected

individual. The benet of a buy-sell agreement is

that the condiƟons are set out in advance, and the

formulas for purchasing the ownership are also

agreed in advance.

The best relaƟonships in business are those that

start with a well thought out arrangement. Co-

founders need to realize this is not negaƟve thinking,

but instead, pracƟcal thinking; anƟcipaƟng the

potholes on your road to success will allow you to

sidestep the damage that may be caused if you

don’t.

FICTITIOUS BUSINESS NAMES

A c��ous business name is a name that is diﬀerent

than the legal name the owner gives to the business.

It's oen called a “trade name” or a name you are

“doing business as” (a “DBA”).

Oen, someone who is operang a

business as a sole proprietor will give

the business a dierent name. If they

do so, they have given it a cous

business name. For example, if I open

a business as a sole proprietor and I

name it “Speedy Cleaners,” then

Speedy Cleaners is my cous

business name and the community

knows my business by that name, not

by my personal name.

Similarly, a corporaon or limited liability company

can also form under one name and operate under a

dierent name. That dierent name would be their

cous business name.

If you are a sole proprietor, one advantage of using a

cous business name is that it provides a level of

privacy, separang your personal name from the

business.

There is no limit to how many cous business

names a business can use, and a business that is in

dierent markets may choose to use dierent names

File for a

DBA when

you are

using a

name other

than the

legal name

of your

business.

in each market. Generally, however, since a business

is trying to build its brand, it may be best to focus on

one name.

In the event you use a cƟƟous business name, you

are required to register that name in the city or

county (or in some cases, the state) in which the

business operates. This gives the public noƟce of the

person or company operaƟng under that name.

The process of registering a cƟƟous business name

is simple. First, you must le an applicaƟon with

your city or county (or state), and it can typically be

led online. There's typically a ling fee, but it is

generally inexpensive.

Next, you are usually required to provide noƟce of

the name to the public, which involves placing the

noƟce in a newspaper of general circulaƟon one or

two days a week for 4 weeks or so.

Newspapers are very familiar with this process, and

provide this service on a at fee, which is usually

inexpensive as well. Since any newspaper of general

circulaƟon will work, you should call around and nd

the best price. All that maƩers is meeƟng the

requirement.

Once the publicaƟon requirement is met, you

provide proof of that publicaƟon to the same

authority where you led your applicaƟon, and the

process is complete.

Once approved, your cƟƟous

business name registraƟon will

remain in place for a certain period

of Ɵme, typically ve years. At that

point, you will need to renew.

It's important to note that ling a

cƟƟous business name does not

provide you with any protecƟon against liability.

While a sole proprietor’s cƟƟous business name

may sound like a corporaƟon, it is not one, and there

is sƟll unlimited liability.

One nal note – your cƟƟous business name

registraƟon may allow you to use that name in the

region where you le, but if you want to have

broader protecƟon (such as exclusivity of that name

in your state or in the U.S.), you will want to look at

ling a trademark.

DBAs will

need to be

renewed.

Don’t miss

your

deadline!

NOTES

_______________________________________

DO I INCORPORATE?

Deciding whether to incorporate your business is a

very important decision to make. Some forms of

business are simple, some forms are more

complicated. Some forms of business provide you

with no liability protecƟon, while others provide

protecƟon of your personal assets.

Decisions around incorpora�on

typically involve two primary

concerns. The rst is liability

protecƟon, meaning protec�ng

your personal assets from

anyone who sues the business.

The second considera�on is

typically taxaƟon, as some

forms of business organiza�on

are taxed diﬀerently than

others.

That being said, there are other factors that will

come into the decision process as well. For example,

are you planning on raising money from investors for

your business? Are you planning on having any co-

owners in the business? Are you planning on having

employees?

In the next few chapters, we will talk in more detail

about the various forms of en��es, but for now, you

should recognize that certain en��es provide you

with limited liability protecƟon. This means that if

LimiƟng your

liability means

protecƟng your

personal assets

from creditors

in the event the

business is

liable.

your business is sued, the assets of the business are

at risk, but your personal assets are not.

CorporaƟons and limited liability companies (and to

some extent, limited partnerships) provide this

limited liability protecƟon.

If you are a sole proprietor, or

you are in a general partnership,

you have no liability protecƟon

by virtue of operaƟng as that

form of enƟty. So, if you are

running a business as a sole

proprietor, and someone is

injured by your business, they

can go aŌer the assets of the

business and your personal

assets, including your home, your savings, and

anything else you have of value.

In a limited partnership, there must be at least one

general partner, and one or more limited partners.

The general partner will have

unlimited liability for all debts

of the partnership and will be

responsible for management of

the partnership. As a limited

partner, you won't lose any

more than your investment in

the partnership, but there are

limitaƟons in terms of your

involvement. For example, as a

limited partner, you are not

A sole

proprietorship

may be easier

to start with,

but it does not

limit your

personal

liability!

Limited

partnerships

only limit the

liability of the

limited partners

– the general

partner sƟll has

unlimited

liability!

allowed to be involved in the operaƟon of the

business and you will have no control over the

business. Limited partners are passive partners, and

if they do more than that, they run the risk of being

recharacterized as general partners (which would

then open those partners up to unlimited liability).

In the event you plan to raise money to fund your

new operaƟon, it is almost guaranteed that you will

need to do so as a corporaƟon or limited liability

company (“LLC”). Investors take comfort in knowing

that the laws governing corporaƟons and LLCs

provide them with clear rights and protecƟons. In

some cases, it's possible you can raise your funding

from limited partners, but that

would put you in the posiƟon of

being a general partner with

unlimited liability, which can be

a big risk. Being a corporaƟon

or LLC provides a level of

legiƟmacy to your business that

investors will appreciate, while

providing you with some

protecƟon for your personal assets.

Of course, a new limited partnership, corporaƟon or

LLC have both an upfront cost for formaƟon as well

as ongoing annual costs, lings and fees, which may

be a few hundred or a few thousand dollars,

depending on the state in which it is formed, and the

size of the enƟty.

The best way to

limit your

personal

liability is to

operate in a

corporaƟon or

LLC.

While the ongoing administra�on of a corpora�on or

LLC can be rela�vely simple, some business owners

prefer to avoid it and remain a sole proprietor. In

that case, it would be recommended that the

business owner look at carrying a much higher level

of insurance to cover the liability risk. Of course,

there will always be the risk that, whatever the

amount of insurance that business has, the insurance

is not suﬃcient to cover the losses for which the

business is responsible.

When deciding what form of business to operate, it

is also worth considering how that business will be

taxed. If you (or you and your spouse) are the sole

owner(s) of an LLC, your taxes might not diﬀer much

from what your taxes would look like as a sole

proprietor -- your business will le on Schedule C of

your personal federal return. In the event you are a

C Corpora�on or partnership, the en�ty will need to

le separate tax returns, which may add some

incremental annual cost and may also impact your

personal taxes. Evalua�ng the tax impact is outside

the scope of this book, and you should always seek

the advice of an accoun�ng professional before you

make a decision as to whether to operate your

business as a sole proprietorship, partnership,

corpora�on or LLC.

Another benet of placing your business in a

corpora�on or LLC is that transferring your business,

in whole or in part, becomes much easier, as you

may be able to simply sell your shares or member

interest. Also, because those enƟƟes are typically

perpetual in nature, your business can easily

conƟnue long aŌer you are gone.

However, here is the boƩom line: when looking at

limited liability protecƟon available by corporaƟons

and LLCs, you should do so recognizing the current

climate in which we live, where everyone sues for

every grievance. Through that lens, it is diﬃcult to

think of many businesses where a sole

proprietorship or partnership would be preferable

to a corpora�on or LLC. While there might be some

upfront costs and some ongoing fees to having a

corporaƟon or LLC, the limitaƟon of liability typically

outweighs those costs.

In the liƟgious world we live in, protect your

personal assets by creaƟng a company structure

that limits your liability.

NOTES

_______________________________________

WHERE DO I FORM?

We have 50 states in the United States, and you can

form an enƟty in any of them. So, which one should

you choose?

Typically, it is best to either form the enƟty in the

state where the company's principal place of

business will be located or in another state with a

large body of corporate law, such as Delaware.

Delaware is popular as a jurisdicƟon in which to

form corporaƟons because its large body of

corporate law provides more predictability in the

event of disputes. It is also

recognized as providing

increased management powers

and giving majority shareholders

more exibility on how to handle

minority shareholders.

Delaware’s Secretary of State is

also known as having very strong

administraƟon, so corporate

lings can be made quickly and

inexpensively. Delaware’s Court

of Chancery is exclusively

dedicated to resolving corporate

law disputes and handles them

more quickly than tradiƟonal

civil courts.

If you form

your

corporaƟon or

LLC in another

state, you will

need someone

living in that

state to be

your registered

agent of

service… if you

don’t know

anyone, you

can hire a

service.

Each corporaƟon or LLC must be registered in the

state in which it operates. If, for example, you

incorporate in Delaware, but your opera�ons are in

California, you will need to le a registra�on of

foreign corpora�on in California; this will result in

your company having to pay fees in two states.

Most states also require you to have a registered

agent in that state. If you do not have someone who

resides in that state and is willing to serve in that

capacity, you will have to hire an independent agent

to act as your registered agent, which will typically

cost $150-200 per year.

Tax consideraƟons are another signicant factor

when deciding where to organize or incorporate

your business. Some states, such as Delaware, Texas,

and Nevada, are known for low or no corporate tax.

However, Delaware charges a franchise tax and

Nevada and Texas charge a gross receipts tax, and

many states require sales tax, so any tax analysis

should encompass all forms of tax, and you should

not assume that simply because a par�cular state

may not have a personal income tax that

incorpora�ng or organizing in that state will save you

money on taxes.

In the event you are seeking privacy, Delaware,

Wyoming, New Mexico, and Nevada oﬀer greater

privacy protec�ons to company owners. Certain

states will not require that the names of owners and

directors be publicly disclosed.

FormaƟon costs and ongoing maintenance costs vary

from state to state, so it is important to factor those

into any decision. For example, California has an

$800 minimum annual franchise fee, and that

minimum fee is unrelated to the number of shares

authorized or issued. By comparison, Delaware has a

minimum annual franchise fee which may be more or

less than California, as the Delaware franchise fee is

the lower of two calculaƟons, the rst being based

on authorized shares and the second being based

total gross assets and total issued shares.

If you intend to raise capital, the

jurisdicƟon you incorporate in may

impact your ability to aƩract

investors. Many investors prefer to

invest in businesses incorporated in

Delaware due to its established

framework and its favorable

governance laws (although California, New York, and

Texas are also popular). AddiƟonally, if the company

is intending to go public, Delaware is preferred

because of its favorable corporate climate.

If you are forming a business that you expect will

perform the majority of its operaƟons within the

state in which you are located, that state will oŌen

be the best choice and the lowest overall cost.

However, it is important to weigh tax benets,

privacy, maintenance costs, and other expenses

before seƩling on any jurisdicƟon in parƟcular.

Where your

incorporate

will usually

maƩer to

investors.

NOTES

_______________________________________

LLC vs. CORPORATION vs.

PARTNERSHIP vs. SOLE

PROPRIETORSHIP

You've decided to start a new business. The next

decision is choosing which type of enƟty you will

operate. There are ve typical forms of business

organizaƟon, and each one has its advantages and

disadvantages.

A business enƟty can be conducted as a:

 sole proprietorship

 general partnership

 limited partnership

 corporaƟon (which for tax purposes can be

treated as either a “C” or “S” corporaƟon

 limited liability company (“LLC”) (which for

tax purposes may be treated as a

disregarded enƟty, as a partnership, or as a

corporaƟon)

Note there are also Professional CorporaƟons and

Limited Liability Partnerships, which may be required

in the event your business falls under certain types of

professional services (aƩorneys, accountants,

physicians, engineers), but in pracƟce, they operate

much like the above- related enƟƟes, so those will

not be addressed separately.

If limiƟng liability is less of a concern, and keeping

costs low is a criƟcal factor, an individual can

proceed as a sole proprietor. A sole proprietorship is

by far the simplest business structure. Any business

that starts with one owner and without formally

incorporaƟng or organizing is automaƟcally a sole

proprietorship. Since there is no legal enƟty being

formed when operaƟng as a sole proprietorship,

these types of businesses may not need to register

with the IRS and may be able to simply use the

owner’s Social Security number as the business tax

ID. Since there is no legal enƟty being formed, taxes

for the business are reported directly on the

owner’s individual Form 1040. This avoids the

double taxaƟon that a C CorporaƟon faces; the

owner reports the income and expenses of the

business on Schedule C of his or her personal federal

income tax return. All earnings of a sole

proprietorship are subject to FICA tax (Federal, State,

Medicare, and Social Security tax), and since the IRS

considers self-employed people as both employer

and employee, sole proprietors are responsible for

paying both halves of the FICA taxes. When a sole

proprietor desires to exit the business, the only

opƟon available to the sole proprietor is to sell the

assets and liabiliƟes of the enƟty. Since the owner’s

personal assets are not protected, this business

structure is not preferable for a business that has

any foreseeable risk.

If there are two or more of you, you can move

forward as a general partnership. A general

partnership is essenƟally a mulƟ-owner version of a

sole proprietorship. Usually, there

is no legal enƟty that has to be

formed when operaƟng as a

general partnership. General

partnerships simply spring into

being when people join forces to

run a business together and divide

the prots from their common

business. Partnerships are

typically used by relaƟvely simple, early-stage

businesses that have not yet achieved signicant

protability. MulƟ-owner companies by their nature

are more complicated than sole proprietorships, so it

is important to have a wriƩen partnership agreement

that controls the operaƟons and ownership of the

enƟty. In partnerships, the income of the enƟty

does not necessarily have to be allocated

proporƟonally to ownership; but, to avoid

misunderstandings later, allocaƟons of prots and

losses should be set out in the partnership

agreement. AddiƟonally, in order to ensure that the

IRS respects those allocaƟons, any partnership that is

not allocaƟng its income proporƟonally to ownership

should make sure their accountant is blessing those

allocaƟons. Partners are not considered employees,

but rather self-employed individuals; they do not

receive wages, but rather receive draws, which are

later reported on each partner’s Schedule K-1. Since

the partners in a partnership are the ones who

report and pay tax on behalf of the partnership, any

enƟty treated as a partnership for tax purposes

General

partnerships

do not

protect the

personal

assets of the

partners!

avoids the double taxaƟon that a C CorporaƟon

faces. A general partnership has the same downsides

as a sole proprietorship, i.e., all earnings are

generally subject to FICA tax and the owners’

personal assets are not protected.

A limited partnership has

elements of a partnership as well

as a corporaƟon. Limited

partnerships are commonly used

for real estate and investment

ventures, in that they are exible

in their operaƟon and provide

investors with limited risk

exposure. In a limited partnership,

there are one or more general

partners who are responsible for managing the day-

to-day opera�ons of the business and who have

unlimited liability, and there are one or more limited

partners who contribute capital but have a passive

role in the operaƟon of the partnership. Based on

that passive role, limited partners have limited

liability. That is a cri�cal trade-oﬀ, as a limited

partner’s liability is limited to the amount of their

investment in the partnership

only so long as they remain in

their passive role. As with a

general partnership, there should

be a wriƩ

en partnership

agreement, with prots and losses

shared between the partners in a

Limited

partnerships

only limit the

liability of

limited

partners, not

the general

partners!

Limited

partners

must remain

as passive

investors!

manner set forth within the partnership agreement.

Also similar to a general partnership, a limited

partnership is taxed on a pass-through basis, with

each partner’s prots and losses reported on their

Schedule K-1, avoiding the double taxaƟon that a C

CorporaƟon faces. While using a limited partnership

structure limits the exposure of the limited partners,

the general partner in a limited partnership remains

personally liable for debts and obligaƟons of the

partnership, and failure of the partnership can put

the general partner at great personal risk. As a

result, those who are operaƟng the limited

partnership will oŌen form an LLC (that they will

manage) to serve as the general partner, in order to

limit those liabiliƟes that would otherwise fall to

them personally.

Since sole proprietorships, general partnerships and

limited partnerships fail to shelter the owners’

personal assets from liability relaƟng to third party

claims against the company, they are not structures

that are preferred when the company has material

risks. To best limit liability, which is generally

preferable in today's liƟgious environment, the most

common soluƟon is to form a corporaƟon or an LLC.

If you have decided to limit liability and form an LLC

or corporaƟon, which one is best? A variety of

factors will inuence the choice.

For tax purposes, there are two basic types of

corporaƟons:

"C CorporaƟon" (standard corporaƟon), and

"S CorporaƟon" -- which is incorporated the same

way as a C CorporaƟon, but has made a tax elecƟon

that allows "pass-through" tax treatment (made

pursuant to "Subchapter S" of the Internal Revenue

Code). Once ling arƟcles of incorporaƟon, the

owners have 75 days to elect "S" status. It is also

possible to change from an "S" to a "C" corporaƟon

(or vice versa) for an upcoming scal year by ling

the appropriate elecƟon papers with the IRS before

the new scal year starts.

However, once "S" status is

terminated, the corporaƟon

generally may not reelect "S"

status for the next ve years.

AddiƟonally, changing from “S”

to “C” (or vice versa) has certain

other tax implicaƟons, so

changing tax elecƟons should be

carefully considered before ling

the elecƟon.

Like a sole proprietorship, partnership, or some types

of LLC, an S CorporaƟon tax elecƟon can eliminate

"double tax." In a C CorporaƟon, the income of the

business is rst taxed at the corporate tax rates,

then the shareholder is again taxed at the

shareholder's individual tax rate when dividends are

An “S

Corpora�on”

is just like a

“C

Corpora�on”

but with a

diﬀerent tax

treatment.

distributed. In contrast, with an S CorporaƟon, net

income and losses are “passed through” and only

taxed at the shareholder level, which oŌen results in

lower overall taxes than with a C CorporaƟon.

As an example of how the “pass

through” vs. “double tax” math

works, let’s assume the

corporate tax rate is 20% and

the individual’s tax rate is 30%:

 Under a C CorporaƟon,

each dollar of net income

eventually becomes

$0.56…rst, the $1.00 is reduced by the 20%

corporate tax (and becomes $0.80); then, that

$0.80 is reduced by the 30% personal tax (and

becomes $0.56).

 Under the S CorporaƟon, each dollar of net

income becomes $0.70…each dollar is only

reduced by the 30% personal tax, so $1.00

becomes $0.70).

To make an S CorporaƟon tax elecƟon, you must also

accept some limitaƟons:

 No shareholders of the

company can be corporaƟons,

partnerships, certain types of

trusts, or non-resident alien

individuals.

S CorporaƟons

can result in

lower taxes,

given its “pass

through”

treatment.

S CorporaƟons

have some

rules about

shareholders.

 No more than 100 shareholders are allowed.

 Only one class of stock is allowed (although

vo�ng and nonvo�ng stock can exist, so long as

other economic rights remain the same).

 All shareholders must consent to the S elec�on

(including spouses of shareholders in states

which follow community property laws).

Alloca�on of income and losses must be made only

in proporƟon to ownership (e.g., if you own 35% of

the shares, you must receive 35% of the prots and

losses).

The shareholders must appoint directors, who in

turn must appoint certain oﬃcers.

Shareholder mee�ngs and upkeep of corporate

records are important, just as with a C Corpora�on.

Even as an S Corpora�on, there s�ll may be separate

state tax on the company’s net income (e.g., in

California, it is the greater of 1.5% of the

corpora�on's net income or $800).

As a business gets larger and more complex, it is

common that it will outgrow the S Corpora�on

structure and move on to become a C Corpora�on.

Similarly, if the business is no longer eligible for S

Corpora�on status, such as if it takes on an

ins�tu�onal investor, its S Corpora�on status will

automa�cally terminate, and it will become a C

Corpora�on.

In addiƟon to C CorporaƟons and S CorporaƟons,

LLCs are also an opƟon to consider. In some ways, an

LLC provides the benets of a corporaƟon, but with

addiƟonal exibility in terms of their operaƟon and

how they are treated for tax purposes.

In general, an LLC allows several opƟons an S

CorporaƟon does not:

CorporaƟons, partnerships, certain types of trusts

and nonresident alien individuals can own interests.

There are no limits on the number of

“members” (the LLC’s equivalent to shareholders).

There are no limits on the types of classes or series

of membership.

The LLC can elect to be taxed as a

partnership, C CorporaƟon, or S

CorporaƟon (or if a single member

LLC, as a disregarded enƟty). If an

LLC chooses to be taxed as an S

CorporaƟon, then it must follow the

same rules that S CorporaƟons must

adhere to, as discussed above.

Gains and losses and voƟng power can be allocated

in a manner that is not proporƟonal to ownership

(e.g., a member can receive 30% of the prots and

losses, own 20% of the LLC member interests, and

have 40% of the voƟng power).

An LLC has

a variety of

ways it can

choose to

be taxed!

While one or more managers will manage the LLC, no

oﬃcer posi�ons or board of directors are required,

though those posi�ons can be created if desired.

An LLC is simpler to maintain than a corpora�on,

with no required annual mee�ngs.

However, LLCs also have certain disadvantages

compared to corpora�ons. For example, LLCs must

pay a minimum annual franchise fee (just like

corpora�ons), but LLCs may also have to pay an

addi�onal graduated fee (in California, up to

$11,790) based on gross revenue. This can have

more nega�ve tax implica�ons for a company,

par�cularly if it is selling expensive, but low margin,

products. Also, LLCs are not able to oﬀer certain

fringe benets available to corpora�ons. Finally, if

the business intends to seek funding, many investors

will not invest in an LLC, as they prefer the

protec�ons aﬀorded under the laws governing

corpora�ons.

PERSONAL ASSET PROTECTION

The primary reason for placing a business into a

corporaƟon or LLC is to protect the personal assets

of the owner(s). With some excep�ons, if a business

is not a corpora�on or an LLC, then the owners are

personally liable for any liabili�es, debts, or

judgments of the business; however, with a

corpora�on or LLC, a creditor usually can only collect

against the assets of the business, not against the

personal assets of the owners (for example, the

owners’ houses, investment accounts, etc.).

This protecon of personal assets

may not be allowed if the owners

do not leave the business with

sucient assets to run day-to-day

operaons and cover expected

liabilies, i.e. it is not adequately

capitalized. In that case, the

owners’ personal assets may again

be at risk. If the business has reasonable insurance

coverage, this capitalizaon risk can potenally be

migated. The owners may also be personally liable

(even if a corporaƟon or LLC is in place) if they do

not follow corporate formaliƟes (for example, if the

corporaon fails to have director or shareholder

meengs, or if the enty commingles the owners’

personal funds with the company’s business funds),

or if the owners commit fraud through the business.

If the business is looking for investors, those

investors will almost always want the protecƟon of

a corporaƟon or an LLC. Aer all, they do not want

their assets (beyond their investment) at risk either.

(As menoned above, another way to accomplish

this is to use a limited partnership, but there must be

at least one general partner with unlimited liability).

While the annual cost of maintaining a corporaon

or LLC, including minimum franchise taxes, can be

$1,000 or more annually, these limited liability

Ignore

protecƟon

of your

personal

assets at

your peril!

vehicles may keep you from being personally liable

for debts, liabiliƟes and obligaƟons of the business.

From that perspecƟve, those costs might be the best

investment you can make in your business.

REASONS NOT TO INCORPORATE OR FORM AN LLC

As one might expect, there is a price to be paid for

the privilege of having a corporaƟon or an LLC.

Typically, this takes the form of a minimum annual

tax that applies even if the enƟty is not making any

prot (or even any revenue). With a California

corporaƟon, there is currently a minimum corporate

tax of $800 a year. For a California LLC, there is

currently a minimum tax of $800 per year plus an

annual gross receipts tax based on total income

(which is zero if the total income is less than

$250,000 but can be as high as $11,790 at higher

revenues). For a small business that has good

insurance and is in a eld where the chance of being

sued is very low, it could be argued that it makes

sense to not become a corporaƟon or LLC. However,

even if a business has good insurance, owners may

wish to have the extra layer of protecƟon that a

corporaƟon or LLC provides.

C CORPORATIONS CAN SOMETIMES BE BETTER

THAN AN S CORPORATION OR LLC

If the business needs to carry over money into the

next scal year (such as where the business is

research intensive, for example), a C CorporaƟon

might be the beƩer choice. The reason is that if an S

CorporaƟon or LLC carries money into the next scal

year, the owners will sƟll be taxed as if they had

received that money, even though it was leŌ in the

enƟty. This issue is someƟmes referred to as

“phantom income”, because the owners are required

to pay tax on income where there may not be any

corresponding distribuƟon of cash from the

company. With a C CorporaƟon, the corporaƟon will

pay tax on its net income, but the shareholders will

not personally pay tax related to the corporaƟon if

no dividend was paid to them.

Another advantage is that a C CorporaƟon does not

have restricƟons on types of shareholders. Unlike

an S CorporaƟon, a C CorporaƟon’s shareholders can

include corporaƟons, partnerships, mulƟ-member

LLCs and trusts. An S CorporaƟon may be a drawback

if the business is seeking investors in any of those

prohibited categories.

UlƟmately, the best way to choose a structure in

which to operate your business is to weigh all the

benets and risks of each opƟon, then consult with

legal and tax advisors who can analyze your

individual tax situaƟon.

A SUMMARY OF BASIC ELEMENTS OF

CORPORATIONS AND LLCS

1. Who owns the business?

If C CorporaƟon or S CorporaƟon: Shareholders.

If LLC: Members.

2. Do owners have personal liability for the

company’s debts?

If C CorporaƟon or S CorporaƟon: No.

If LLC: No.

3. Are there restricƟons on what kind of business

can be conducted?

If C CorporaƟon or LLC: some states prohibit

formaƟon of banking, insurance and other special

businesses.

If S CorporaƟon: same as C CorporaƟon, but

excessive passive income (such as from rents,

royalƟes, interest) may jeopardize tax status.

4. Are there restricƟons on the number of owners?

If C CorporaƟon: One or more shareholders are

allowed.

S CorporaƟon: Same as C Corporaon, but no more

than 100 shareholders are permied.

If LLC: One or more members are allowed.

5. Who makes management decisions?

If C CorporaƟon or S CorporaƟon: The board of

directors and the ocers (who report to the board).

If LLC: The member(s) if a member-managed LLC, or

manager(s) if it is a manager-managed LLC.

6. Who can legally bind the business?

If C CorporaƟon or S CorporaƟon: The board of

directors and, if granted authority by the board of

directors, the ocers.

If LLC: The member(s) if a member-managed LLC, or

manager(s) if it is a manager-managed LLC.

7. What happens to the enty when an owner

dies?

If C CorporaƟon or S CorporaƟon: No eect

If LLC: Depending on state law and the operang

agreement, the LLC might dissolve unless remaining

members vote to connue the business.

8. Are there any limits on transferring ownership?

If C CorporaƟon: Transfers of stock may be limited

under securiƟes laws or restricƟons in ArƟcles

(CerƟcate) of IncorporaƟon or under the Bylaws or

a Shareholder Agreement.

If S CorporaƟon: same as C CorporaƟon, except

transfers should be limited to persons and enƟƟes

that qualify as S CorporaƟon shareholders.

If LLC: Unanimous consent of the non-transferring

members may be required under state law or the

LLC’s operaƟng agreement.

9. What ongoing legal formaliƟes are required?

If C CorporaƟon or S CorporaƟon: Annual meeƟngs

of the board of directors and shareholders are

required, and minutes must be taken and maintained

regarding the same.

If LLC: An operaƟng agreement is necessary but

annual meeƟngs are not required.

10. How are business prots taxed?

If C CorporaƟon: Net income is taxed at corporate

rates annually, with shareholders taxed at their

individual tax rates only if dividends are paid.

If S CorporaƟon: Net income is allocated then taxed

at individual tax rates of shareholders annually,

regardless of whether distribuƟons are made.

If LLC: Net income is allocated and taxed at

individual tax rates of members annually, regardless

of whether distribuƟons are made, unless the LLC

elects to be taxed as a C CorporaƟon.

11. What type of business owner would generally

nd each of the following enƟƟes is the best way to

do business?

If C CorporaƟon: Owners who want limited liability

and the ability to split income between themselves

and a separately taxed business, and who may seek

investors that will not meet the S CorporaƟon

shareholder requirements.

If S CorporaƟon: Owners who want limited liability

and individual (pass-though) tax rates to apply to

business income, and are willing to meet the iniƟal

and ongoing S CorporaƟon requirements.

If LLC: Owners who want limited liability and want

either pass-through or corporate taxaƟon,

parƟcularly if they intend on distribuƟng prots in a

non-proporƟonal manner.

NOTES

_______________________________________

FORMING A BOARD

One of the rst steps aŌer forming your corporaƟon

is to appoint a board of directors. If you have

formed an LLC, the creaƟon of a board is opƟonal but

not required.

A well-structured board is criƟcal to the success of

your corporaƟon. IniƟally, the board may be

selected by the incorporator; however, once shares

have been issued, the board should be approved by

a majority vote of the shareholders.

A board of directors has a variety of duƟes, including

strategic oversight of the company, nancial

stewardship (approving budgets, risk management),

ensuring the company abides by all legal and

regulatory requirements, as well as hiring and

managing (and if needed, ring) the President/CEO.

Ideally, the board will have an odd

number of members, so the

company can avoid a situaƟon

where the board is deadlocked.

Boards are generally as small as

three members, or as large as 15+,

but the ideal board is typically ve

members or seven members

depending on the size and

complexity of the company.

However, some states allow as few as one board

member.

Have an

odd

number of

board

members if

possible –

prevent

deadlock!

The ideal board member brings industry experƟse,

nancial experƟse, and/or legal experƟse, and is

willing and able to assist the company in developing

its strategic plans. While it is certainly not unusual to

have shareholders and members of the execuƟve

team parƟcipate on the board, the best pracƟce is to

have a board with independent directors in addiƟon

to directors who are involved in the business on a

day-to-day basis. Independent directors are those

who are not employees or shareholders, and who

can bring a more objecƟve viewpoint.

While it is typical for independent directors to be

paid for their service on the board, directors who

work for the company as exempt employees are

generally not compensated addiƟonally for their

board service. However, even for independent

directors, monetary compensaƟon is normally not

signicant; instead, companies generally

compensate directors with equity, in the form of

stock opƟons or restricted stock grants. By providing

compensaƟon in the form of stock opƟons or stock

grants, the directors’ interests are more aligned with

the shareholders.

When pracƟcal, boards will oŌen form commiƩees

to handle certain tasks, including an audit

commiƩee (to oversee nancial reporƟng and risk

management), a compensaƟon commiƩee (to

oversee execuƟve compensaƟon), and a nominaƟng/

governance commiƩee (to recruit new board

members and ensure good governance pracƟces). A

board should adopt a number of policies to guide

how they will funcƟon, including a code of conduct

and a conict-of-interest policy.

Depending on the size and needs of the company, a

board may meet monthly, quarterly, or annually. The

larger the company, the more likely that the board

will need to meet more frequently.

NOTES

_______________________________________

ADVISORS TO THE BOARD

Advisors to the board of directors are individuals

who will oŌen parƟcipate in board meeƟngs and

provide advice and counsel to the board of directors;

in many ways, they act in a manner similar to the

board of directors, with one signicant excepƟon…

advisors do not have a vote. Advisors provide

insights and recommendaƟons, but they are advisory

opinions only. The board of directors will consider

those recommendaƟons prior to voƟng, but they

have no obligaƟon to incorporate those insights.

Companies someƟmes nd signicant benets in

naming advisors to the board of directors, as it

allows the company to bring in addiƟonal experƟse,

knowledge and skills, without expanding the size of

the board.

Generally speaking, advisors to the

board are outside individuals (i.e.,

they are more similar to

consultants), and are not employees

of the company. Advisors are oŌen

CEOs of other companies,

academics, and industry leaders.

Arguably, the most important

criteria in selecƟng an advisor to the

board is that they are strong analysts of informaƟon

and provide clear and decisive opinions. It is not

unusual to recruit advisors who have specic

Advisors

may aƩend

board

meeƟngs,

but they

don’t get to

vote.

industry experience, as they can speak to best

pracƟces and trends within the industry and provide

a more independent perspecƟve compared to board

members who also are employees of the company.

However, advisors from unrelated industries can also

bring signicant wisdom based on their professional

experiences.

Another benet to appoinƟng advisors is that the

board gets to see these advisors in acƟon before

they are actually appointed to the board, i.e. it allows

the company to “test drive" these individuals before

they are given the full authority of a

board member posiƟon.

Advisors to the board should

generally be excused from board

meeƟngs when the board of

directors is dealing with

condenƟal or sensiƟve maƩers.

From the advisors’ point of view, it

allows them to expand their network, create strong

professional connecƟons, and puts them in a lead

posiƟon once a board seat opens up.

CompensaƟon to advisors is determined by the

board of directors and can take the form of a per

meeƟng fee, a monthly at fee, or an hourly fee.

Most oŌen, advisors are paid on a per meeƟng basis.

Advisors typically serve at the pleasure of the board

and can be terminated at any Ɵme for any reason.

Advisors

are a great

way to

“test drive”

potenƟal

board

members!

OFFICERS

Ocers of a corporaon are high level management

posions, responsible for running the business each

day. They are appointed by, and

report to, the board of directors.

So, while the board is tasked with

seng goals, guiding the business

and dening its strategies, the

ocers are responsible for

execung those decisions of the

board and operang the business on a day-to-day

basis. Ocers are oen also directors, but in large

part, the oﬃcers are the individuals who make

decisions each day to put the strategies and goals

set by the board into ac�on.

Ocers generally fall within 3 classicaons:

execuve, management, and administrave.

Execuve ocers are those responsible for high level

decisions, such as the Chief Execuve Ocer

(“CEO”). The CEO overseas the daily operaons of

the company and delegates tasks to other ocers.

Management ocers are those that oversee the day-

to-day operaons of the company, including the

Chief Financial Ocer (“CFO”). The CFO is

responsible for the nances of the business, and his

or her dues will vary based on company size. In a

smaller company, the CFO may pay the bills and run

payroll; in a larger company, the CFO will manage the

nance department. Finally, the administrave

Oﬃcers serve

at the

direc�on of

the board of

directors.

oﬃcers (such as the Corporate Secretary) are

responsible for managing company records,

coordina�ng shareholder mee�ngs, keeping minutes

of mee�ngs, etc.

The board of directors may, in their discre�on,

create other oﬃcer posi�ons based on the unique

needs of the company. Those posi�ons may include

a Chief Opera�ons Oﬃcer (“COO”), Chief Technology

Oﬃcer (“CTO”), Chief Legal Oﬃcer (“CLO”), Chief Risk

Oﬃcer (“CRO”), Chief Investment Oﬃcer (“CIO”)

and/or Chief Security Oﬃcer (“CSO”). Other oﬃcer

posi�ons may also include Vice-President posi�ons,

such as VP of Sales, VP of Finance, etc.

The number of oﬃcers that are required varies from

state to state. For example, Delaware does not

require any required number of oﬃcers, but since

one par�cular provision of Delaware law provides

that shareholders can require stock cer�cates be

signed by 2 oﬃcers, logic would dictate at least two

are required (and typically, this will be a CEO or

President, and Corporate Secretary). However,

California requires a minimum of three corporate

oﬃcers (CEO or President, CFO, and Corporate

Secretary). Regardless of the minimum number of

oﬃcer posi�ons required by law, one individual can

hold one or more oﬃcer posi�ons. It is not

uncommon in a small corpora�on to have one

person holding the �tles of CEO, CFO, and Corporate

Secretary.

Typically, oﬃcers are appointed by the board on an

annual basis at the board of directors’ annual

meeng. In the event a vacancy is created, the

board of directors will ll that posion during a

regularly scheduled board meeng, a special board

meeng called for that purpose, or by unanimous

wrien consent of the board.

Oﬃcers serve the board of directors, and it is the

directors that must remove them. For example,

Delaware law specically provides that stockholders

are not permied to directly remove corporate

ocers (even though the company’s bylaws provided

for that right) because allowing shareholders to have

such control would interfere with the board of

directors’ management decisions and prevent them

from performing one of their most important

funcons (i.e. the appointment and management of

ocers).

Oﬃcers of a corpora�on are generally also

employees of the company. The one excepon is

where ocers perform no services (or only minor

services) and who are also not receiving (or entled

to receive) any pay based on being an ocer. If an

ocer is not deemed to be an employee, they may

be able to be paid only through prot distribuons.

Given the tax penales associated with misclassifying

such ocers, ocers should be deemed to be

employees unless your CPA or tax aorney feels

otherwise aer evaluang all of the facts and

circumstances.

NOTES

_______________________________________

DUTIES OF LOYALTY, GOOD FAITH

AND DUE CARE

With great power comes great responsibility.

-- Voltaire

As duciaries of the corporaon,

directors and ocers owe a duty of

loyalty and good faith. This

requires directors and ocers to act

honestly and in the best interests

of the company, and to avoid any

appearance of self-dealing.

Directors and ocers must place the interests of the

company ahead of their personal interests, including

their nancial interests.

For example, directors and ocers are not permied

to “usurp corporate opportuni�es,” which means

that directors and ocers are not permied to take

opportunies for themselves when those

opportunies could otherwise be performed within

the company's operaons. In the event there is an

opportunity that a board member or ocer wishes

to take advantage of, that opportunity must be

presented to the board of directors of the company,

and the board of directors must grant permission

before the interested director or oﬃcer pursues

that opportunity. Failure to disclose the corporate

opportunity and secure permission will open the

director or ocer up to personal liability.

Directors

owe a duty

of loyalty

and good

faith.

When possible, the company’s board of directors

should include “independent directors,” meaning

directors who are not employees or shareholders.

By doing so, when the board is seng compensaon

for certain employees, those independent directors

can bring objecvity to the process that otherwise

might be lacking. When it is not possible to have

independent directors as part of the company, the

board has a duty to do its best to ensure fairness, by

making sure all material facts are disclosed,

independent advice is sought where appropriate,

and the transacon in queson is in the best

interests of the corporaon.

Directors and ocers also owe a

duty of care to the corporaon. This

requires directors and ocers to act

in a way that a reasonably prudent

person would act under the same

circumstances. Directors and

ocers are not required to be

perfect in their decision making, but

they are required to exercise the

same care and cauon that a

reasonable person would have

exercised in that same situaon. The duty of care

also includes a duty of oversight, meaning that

directors and ocers must use their best eorts to

make sure that laws and procedures are being

followed, and that eorts have been made to ensure

that no impropriety is occurring within the company.

A duty of

care

requires a

board

member to

act as a

reasonable

person

would.

This duty of care does not turn directors and ocers

into invesgators; it only requires that they stay

engaged with what is happening in the company and

not ignore any impropriety.

Ulmately, the law recognizes that even if the

directors and ocers are properly execung their

dues to the corporaon, not every business

decision will be correct. Oen, decisions must be

made in an environment where informaon is

imperfect, resources are limited, and the future is

unknown. Those decisions are

protected by the business

judgment rule, which essenally

says that so long as the directors

and ocers have acted in a way

that is reasonable, disinterested

and informed, their decisions

will not create liability. Of

course, this assumes that they

have not acted in bad faith or

acted in a manner that was

grossly negligent. In other

words, directors and oﬃcers do

not have to be perfect in their decision making, but

they do need to be diligent in the process of that

decision making.

Managers of an LLC may, depending on the scope of

the operang agreement, have less restricons, as

operang agreements somemes provide that the

managers are permied to engage in compeng

Board members

don’t always

have to be

right…but they

must be

reasonable,

disinterested

and informed

when making

decisions.

ac�vi�es. However, absent very clear wording in the

opera�ng agreement otherwise, managers of an LLC

will be held to similar duciary duƟes. Even if the

opera�ng agreement permits such compe��on,

managers should be careful not to take opportuni�es

that came to them by virtue of their par�cipa�on in

that LLC, unless they have disclosed the opportunity

to the LLC and received permission from the

members to pursue it independent of the LLC.

In some cases, even a majority shareholder may

have duciary obligaƟons to the minority

shareholders. As one California court stated, there is

"strong public interest in assuring that corporate

oﬃcers, directors, majority shareholders and others

are faithful to their duciary obliga�ons to minority

shareholders." The court reasoned that, without

imposing such a duty, a shareholder owning more

than 50% of the company would be able to cause the

company to act in ways benecial only to the

majority shareholder, and based on their minority

percentage, the other shareholders would have no

recourse or protec�on.

Specically, majority shareholders owe duciary

du�es to minority shareholders with regard to any

use to which the majority shareholder puts the

corpora�on or where they use their power to control

the corpora�on, i.e. it generally prevents a majority

shareholder from causing the corpora�on to act in a

manner that benets the majority shareholder at the

expense of minority shareholders.

RECORDKEEPING

Keeping appropriate records is an important part of

running a business. Failure to do so will open the

business up to liability from various direcons.

Generally, each state’s law requires that each

corporaƟon keep adequate and correct books and

records. Generally, it is recommended (at a

minimum) the following records be kept at its

principal oce:

1. a copy of the led arcles (or cercate) of

incorporaon and all amendments to date;

2. the original or a copy of its bylaws, and all

amendments to date;

3. up to date nancial records, including tax

records, and balance sheets and income

statements for the current year and at least

the prior seven scal years;

4. minutes of the meengs of its shareholders,

board, and commiees of the board;

5. a record of all acons taken by shareholders

and/or directors without a meeng,

including wrien consents; and

6. a record of its shareholders, including

names and addresses of all shareholders,

the price paid by any shareholders

purchasing shares from the company, and

the number and class of shares held by each

shareholder.

Those minutes and other books and records can be

kept either in wriƩen form or stored electronically,

provided any electronic form can be converted into

legible, tangible form.

It is best pracƟce for LLCs to maintain similar

documents, such as:

1. a copy of the led arƟcles (or cerƟcate) of

organizaƟon and all amendments to date;

2. the original or a copy of its operaƟng

agreement, and all amendments to date;

3. up to date nancial records, including tax

records, balance sheets, and income

statements for the current year and at least

the prior seven scal years;

4. minutes of the meeƟngs of its members and

managers;

5. a record of all acƟons taken by members

and/or managers without a meeƟng,

including wriƩen consents; and

6. a record of its members, including names

and addresses of all members, the price

paid by any members purchasing member

interests from the company, other cash

contribuƟons of members, and the number

and class of interests held by each member.

Failure to maintain appropriate records will create

liability for the company. First, owners have certain

rights of inspecƟon, and the failure to maintain

records subject to inspecƟon will expose

management to claims that they have breached

their duciary duty by failing to

maintain such records. Second,

failure to maintain appropriate

records may open the enƟty up

to alter ego claims (and if

successful, may also open

management up to potenƟal

personal liability), where those

suing the company may seek to pierce the corporate

veil (discussed further in the next chapter) by

alleging the company failed to adhere to even the

most basic corporate governance procedures.

Keeping good

records is very

important….

don’t ignore

the paperwork.

NOTES

_______________________________________

PIERCING THE CORPORATE VEIL AND

THE ALTER EGO DOCTRINE

One key purpose of creang a business enty is to

limit the liabilies of that business to only that

business, and insulate shareholders, members and

other businesses from liability. The “corporate veil”

is a term used to describe the separaƟon of a

business from its owners for liability purposes. As a

separate enty, a corporaon or an LLC is set up to

shield its owners from personal liability, meaning

liability will generally only aach to the enty, not

the owners. However, somemes a party will sue

the equityholders or related businesses in hopes of

aaching that liability to those pares as well. When

they do so, they are relying on an alter ego theory to

“pierce the corporate veil.”

In order to prevail on an alter

ego claim in hopes of piercing

the corporate veil, a plain in a

lawsuit must rst prove that

there was such a “unity of

interest” and control between

the defendant and the enty

such that it cannot reasonably

be said they are two separate enes. In other

words, the two enes are so intermixed that their

aairs are not readily separable. Oen, this test is

met when the owners and the enty commingle

Alter ego

requires a

nding the two

enƟƟes are

essenƟally

inseparable.

funds (such as using the enƟty’s account to pay an

owner’s personal mortgage).

Second, the plainƟī must show that it would create

an “inequitable result” if the defendant’s act or

omission was treated as that of the defendant alone

(or in some jurisdicƟons, the plainƟī must show

fraudulent intent). Because alter ego is based on

equity, some level of unfairness needs to be found.

To determine if the enƟƟes (note that one of those

enƟƟes can be its owner) are alter egos of each

other, the court will look at a variety of factors, such

as:

• Did the corporaƟon/LLC commingle funds or

assets with the owners or with the other

corporaƟon/LLC?

• Was the corporaƟon/LLC adequately

capitalized? Was ownership properly

issued?

• Did the owners treat assets of the

corporaƟon/LLC as if they were his or her

own personal assets?

• Where required, were minutes and other

corporate records accurately, adequately,

and separately maintained?

• Where required, did the enƟty observe

corporate formaliƟes, such as meeƟngs,

voƟng, etc.?

• If alter ego is sought against two

corporaƟons/LLCs, is the ownership in the

two enes idencal? Do the same owners

control both of those enes?

• If alter ego is sought against two

corporaons/LLCs, are ocers and directors

(or managers) in the two enes idencal?

• Do both corporaons/LLCs employ the same

people?

• Do both corporaons/LLCs share a single

business locaon?

• Is either corporaon/LLC just a shell, used

for a single venture?

• Were related or subsidiary enes treated

as arm's length relaonships as to each

other?

• Did one enty purchase labor, services, or

merchandise for the other?

• Did any enty manipulate its assets and/or

liabilies?

• Was there a siphoning of corporate funds by

the dominant shareholders or members?

• Was either corporaon/LLC formed in order

to transfer exisng liability of another

person or enty to it?

 Was there an aempt to conceal or

misrepresent the identy of responsible

ownership, management, or nancial

interests?

Failing any of these factors is not necessarily fatal in

the alter ego analysis. It is a weighing of all factors

that is ulƟmately determinaƟve.

Both elements of the alter ego

test (unity of interest and an

inequitable result) must be

saƟsed; however, if they are,

that does not mean that the

court must impose alter ego

liability and pierce the corporate

veil. The applica�on of alter ego

liability is fact-based and

reviewed by the trial court on a

case-by-case basis, as each case

is diﬀerent. However, there is a presumpƟon that

liability is limited based on the corporate form, and

the court must nd a basis for rejec�ng that

presump�on.

An alter-ego determina�on does not on its own

prove liability – instead, it is a nding that the

separateness of the en��es is a legal c�on and, as a

result, the court will treat them as one and the same

en�ty.

If an alter ego rela�onship is found, the corpora�on

will con�nue to exist, even though the corporate

form has been disregarded. At that point, if the

court agrees that the corporate veil is pierced, the

obliga�ons or debts of the corpora�on become those

of the shareholder, parent, sister corpora�on, or the

reverse, as applicable.

A nding of

alter ego

requires a

weighing of

mulƟple factors

when

determining if

there is a unity

of interest.

For example,

– A subsidiary corporaon and its parent

corporaon (or other subsidiaries) can each

be held liable for the debts of the other; and

– An individual owner or manager of a

company and the company itself can each

be held liable for the debts of the other.

(note that in “reverse veil piercing,” a third

party is allowed to reach past the owner to

access the assets of the corporaon,

subsidiary, or related corporaon related to

the owner, to sasfy the obligaons of the

owner).

If mulple shareholders are involved, their liability is

joint and several, i.e. they are each 100% responsible

and the plain can pursue any of them for

payment; their individual percentages of ownership

are not considered in determining how they share

the liability (those shareholders will need to work

that out between themselves).

Kinney Shoe Corp. v. Polan is an example of a case

allowing the piercing of the corporate veil. In this

case, Kinney sued the defendant, Mr. Lincoln M.

Polan, to pay money outstanding on a sub-lease by

the Industrial Realty Company. Polan owned

Industrial Realty Company but had never held any

corporate meengs or elected ocers. The court

emphasized that Industrial Realty Company was not

adequately capitalized, there were no corporate

formaliƟes, and it appeared that the company was

deliberately used to carry out transacƟons to benet

another one of Polan’s other companies, which had

assets but would be shielded from liability. Because

Industrial Realty Company was no more than a

transparent shell, the court ruled that if Polan

wanted the protecƟon of a corporaƟon to limit his

liability, he should have followed the simple

formaliƟes of maintaining the corporaƟon, which he

failed to do. The court allowed Kinney to pierce the

corporate veil and hold Polan liable for the unpaid

sublease.

It should be noted that while LLCs and corporaƟons

can both be subject to alter ego liability, LLCs are

generally not required to follow as many corporate

formaliƟes as corporaƟons. As a result, LLCs are

arguably less vulnerable to veil-piercing aƩacks since

veil piercing oŌen focuses on an enƟty’s failure to

maintain corporate formaliƟes (and LLCs have less

formaliƟes to maintain). That being said, LLCs should

observe all formaliƟes required by the state statutes

under which it is organized and avoid other violaƟons

such as commingling funds.

Cases will oŌen state that the alter ego doctrine

should be used sparingly as it is an extreme remedy –

but is it? Recent studies of cases show that acƟons

to pierce the corporate veil have a success rate of

about 30-35%. It’s more frequent where a small

number of owners are involved, as opposed to a

corporaon with many shareholders, i.e. the

likelihood of piercing increases as the number of

shareholders decreases. There is lile doubt that

this is because smaller companies more frequently

fail to observe formaliƟes.

To reduce the risk of a court nding alter ego/veil

piercing, what are best pracces? They include:

Formally issue, in wriƟng, ownership to

shareholders/members, in the form of stock

cercates.

Adopt bylaws or an operaƟng agreement, as

applicable – and have all directors/ocers or

members/managers follow those provisions.

For corporaons, hold inial and annual meengs

of both directors and shareholders, keep minutes of

all meengs, and store them with all other corporate

documents; annual meeƟngs are not generally

required for LLCs, but it is sƟll good pracƟce to do

so.

Document all other major business acons,

including agreements with third pares, and retain

them for at least seven years; all agreements should

be entered into explicitly in the company’s name.

Keep companies separate; this includes separate

leerheads, business cards, signage, phone numbers,

and premises in which they operate.

Don’t commingle funds! Keep the bank accounts

of the owners and the company separate, and do not

use funds from one enƟty for the benet of another

without proper jusƟcaƟon and paperwork.

Make sure the company is adequately

capitalized, whether by requiring owners to make

scheduled contribuƟons or by keeping a minimum

amount of funds in the company’s bank account. It is

a good rule of thumb to keep capital of at least three

months’ worth of anƟcipated costs in the company’s

account, to cover overhead expenses, employee

salaries, contractor fees, etc. Do not fund the

company only when bills need to be paid and never

allow the company to have zero assets. Do not share

workers or advisers, and if you do, each enƟty must

pay them separately.

The more of these factors you can comply with, the

lower the risk that the corporate veil can be pierced.

In summary, the owners of LLCs or corporaƟons

generally have protecƟon from liability, but this

protecƟon is not absolute. The corporate veil may

be pierced when an owner does not treat the

company as a separate business enƟty or uses their

control of the company to commit fraud or an

otherwise illegal act.

Observe corporate formaliƟes to keep the

corporate veil strong.

STOCK, PHANTOM STOCK

AND SAFES

Stock (also commonly referred to as “shares”) are

the ownership units of a corporaƟon. Stock falls

into two categories: common stock and preferred

stock. Within those two general categories,

companies may create various “series” of shares,

and each series may carry diﬀerent rights. Common

stock and preferred stock are discussed in more

detail in the next chapter.

If you work with startups, you will hear phrases such

as “founders’ stock” and “seed stock.” Founders

stock, as the name implies, is typically common

stock granted to the founders of the company and

other early employees and is granted at a very low

price per share. In some instances, the founders will

make the rights of those founders shares

subordinate to other shares. In other instances, they

provide those founders shares with super vo�ng

rights, where each share of founders’ stock might

have ten votes compared to other shares which

carry one vote each. Ul�mately, the rights of the

founders’ stock will vary depending on the leverage

those founders have with the investors they are

seeking. The more the investors want in on the

opportunity, the more leverage the founders have

to set the terms. The more desperate the founders

are for money, the less leverage the founders have.

Seed stock is common or preferred stock that is sold

in a very early round, typically for more money than

the founders shares, but sll at a low price. Shares

sold in this round are also oen referred to as being

part of a “friends and family” round.

Typically, common stock, SAFEs, or converƟble

notes will be granted unƟl a formal investment

round is raised. Investors coming in aer the early

rounds will typically be sold preferred stock. Oen,

the company will create Series A Preferred Stock for

that rst round of investment, then Series B

Preferred Stock for the second round, and so on.

How long each round of funding is open is at the

discreon of the company, but it is typically set out

within the oering documents for that round.

“Phantom Stock,” someƟmes referred to as

syntheƟc equity, is not stock, but acts like it.

Instead, it is a contractual right under an agreement

where the corporaon agrees to treat the phantom

holder (nancially) like a shareholder in the event a

liquidity event occurs; however, absent such an

event, the phantom holder is not treated as a

shareholder, meaning the phantom holder will have

no vong rights and potenally no rights to any

dividends paid prior to liquidity event. Since a

phantom stock agreement is essenƟally a

contractual agreement, the terms are negoable.

For example, phantom stock rights may be subject to

vesng and may be subject to forfeiture if the

phantom holder is no longer an employee of the

corpora�on. Phantom stock can be useful in

scenarios where the owner of a corpora�on might

wish to give an employee some certainty and

“upside,” and treat them as if they are a shareholder

in the event of liquidity, but where that owner is

unwilling to give up any ownership or vo�ng rights in

the interim.

A “SAFE” (Simple Agreement for

Future Equity) is becoming an

increasingly popular instrument.

When the par�es enter into a SAFE,

the investor is buying equity, but

the number (and type) of equity

the investor will receive is not yet

known. Instead, under a SAFE, the

investment will not typically

convert into actual shares unƟl a predened

“funding event” occurs. At that point, the SAFE

converts into the same type of shares sold in the

funding event, but at a discounted price (or

alterna�vely, having the ul�mate price limited by a

valuaƟon cap). This form of investment allows the

company to receive funds as equity, and it allows the

SAFE investor to rely on the exper�se of the next

round of investors (who presumably may have more

investment experience and may conduct more due

diligence), but it also rewards the SAFE holder for

their early investment by giving them a discount oﬀ

the pricing in the next round.

SAFEs oŌen

convert at a

discount, to

account for

the risk of

invesƟng

earlier.

For example, assume the conversion of the SAFE is

triggered when the company raises an investment of

$2,000,000, and also assume SAFE holders were

granted a 20% discount. If the company sold

$2,000,000 of Common Stock at $1.00 a share in its

oﬀering, the SAFE would convert at $0.80 per share.

(I.e., if the SAFE Investor had invested $50,000, the

SAFE investor would receive 62,500 shares of

Common Stock.) If, instead, the company sold

$2,000,000 of Series A Preferred Stock at $1.00 a

share in its oﬀering, the SAFE would s�ll convert at

$0.80 per share, but the SAFE investor would receive

62,500 shares of Series A Preferred Stock in

exchange for the $50,000 investment.

COMMON vs. PREFERRED STOCK

When star�ng a corpora�on, an entrepreneur should

consider what type of stock they want to oﬀer.

Under an S Corpora�on, only one class of stock may

be oﬀered (although vo�ng and non-vo�ng

common stock are allowed if all other rights are the

same), but under a C Corpora�on, there is no

limita�on on how many classes of shares you oﬀer.

Common and preferred stock together make up an

en�ty’s securi�es; they can both be components of

an en�ty’s ownership structure and are provided to

investors in return for their nancial contribu�ons.

The rights of shareholders will vary based on the

rights aﬀorded to each class of stock.

Common stock essen�ally oﬀers

an investor a slice of ownership

in the corpora�on. When people

talk about the stock market,

they are usually referring to

common stock. Some businesses

exclusively issue common stock.

Common stock can be vo�ng or

non-vo�ng, but is typically

vo�ng stock; if so, the

stockholder has the ability to

vote on the nominees to serve

on the board of directors and to

approve any key business

An S

Corporaon

can only have

one class of

stock; some of

that stock can

be vong, and

some non-

vong…. but

that is the only

dierence

permied.

decisions. Opons and other equity-based incenves

are typically exercisable into common stock.

As the name suggests, preferred stock has

preferences over common stock. Preferred stock is

generally higher in priority compared to common

stock when a distribuon is made. Preferred stock

oen receives special rights, which may be an

incenve to investors when choosing to buy either

common or preferred stock.

While common stock is generally “vanilla” in its

rights, preferred stock can come in many avors,

since those rights are oen negoated. The type of

preferred stock preferences that may be oered

include:

 Dividend preference – If a company is

unable to pay dividends to all shareholders,

claims to preferred dividends take

precedence over dividends that are paid on

common shares. This right may be

cumulave or non-cumula

ve. If

cumulaƟve, unpaid annual dividends

accrue; if non-cumulaƟve, a right to annual

dividends is lost if not paid in that year.

 LiquidaƟon Preference – With this

preference, preferred stock will be paid in

full before common stock receives anything.

This can be 1x the preferred investor’s

investment or more, depending on what is

negoated.

 ParƟcipaƟon Rights – This allows a

preferred stockholder to share in the

dividends and prots along with common

stock (aŌer rst receiving their dividend

pursuant to their dividend preference).

 VoƟng Powers – Gives preferred

stockholders the right to vote, oŌen as a

separate class. Preferred stock may also

have what is known as super-vo�ng power;

this gives a preferred stockholder

signicant voƟng power compared to other

shareholders, such as granƟng the

preferred stock more votes per share than

common stock.

 Pre-empƟon Rights – This gives a preferred

stockholder the right to invest in future

oﬀerings so they can maintain their

ownership percentage of the company.

 Conversion Rights – Conversion rights

permit a preferred stockholder to convert

their preferred shares into common shares

at any �me of their choosing (note, there

may also be automaƟc conversion features,

where the preferred stock will

automaƟcally convert into common stock).

 AnƟ-diluƟon ProtecƟon – This preference

is designed to help mi�gate the dilu�ve

eﬀect of future stock issuances, typically

when those later issuances are at a lower

value, i.e. a “down round.” If, for example,

an investor purchases 100,000 shares of

preferred stock at $1.00 per share and then

a subsequent round issues the same stock

for $0.50 per share, the investor who paid

$1.00 per share will receive another

100,000 shares at no addiƟonal cost, so

that their average price per share is also

$0.50.

 Right to Appoint a Board Member – This is

the right of a preferred stockholder to

appoint a board member of their choosing

to the board of directors. OŌen, the

company will retain the ability to reject

that proposed member, but only if there is

a reasonable basis for doing so.

 Put Right – This right gives a preferred

stockholder the ability to sell their

preferred shares back to the company. This

is a less frequent right for the company to

grant, as in many cases, the company may

not be in a nancial posiƟon to repurchase

those shares.

 Tag Along Right – If a stockholder intends

to sell their stake, this preference gives the

preferred holder the opƟon to parƟcipate

in the transacƟon on a pro rata basis. This

essenƟally obligates the selling shareholder

to include some or all the holdings of the

preferred holder in the negoƟaƟons.

 Drag Along Right – This right allows a

majority owner the right to force the

minority owners to parƟcipate in any stock

sale. The purpose of this provision is to

ensure that minority shareholders do not

interfere with potenal sales or other exit

opportunies.

 Right of First Refusal – This preference

gives a preferred holder the right of rst

refusal to buy shares of any shareholders

who intend to sell their shares.

 Warrants in AddiƟon to the Preferred

Shares – in some cases, a preferred

shareholder will require the company to

“sweeten the deal” with warrants. This

would allow the preferred holder to buy

addiƟonal shares (typically common stock)

at the warrant exercise price unl the

warrant’s expiraon date (oen 10 years).

The preferences granted to preferred stock are

negoƟable. While investors will oen seek a wide

variety of rights, the most typical rights granted will

be the dividend preference, the liquidaƟon

preference, the pre-empƟon right, and the right to

convert to common stock. On occasion, the right to

appoint a board seat will also be required by an

investor. The other preferences stated above (such

as put rights, warrants, etc.) will typically not be

granted by a company unless they are in a posion

where they have very lile leverage and desperately

need the funds being oered.

100

NOTES

_______________________________________

101

VOTING

VoƟng is an important aspect of equity ownership

and is an opportunity for equityholders to express

their opinions as to the governance of the company

by voƟng for board members (if a corporaƟon) or

managers (if an LLC).

Equity generally has one of three voƟng rights:

1. Non-voƟng. The holder of that equity has no

right to vote, and as a result, no opportunity

to inuence who is managing the company or

how it is being run.

2. Standard VoƟng. This is the tradiƟonal “one

share, one vote” structure. VoƟng is

proporƟonal to ownership.

3. Super-VoƟng. This is when a class of shares

receives mulƟple votes for each share they

hold. In such a scenario, the holder might have

100 shares, but 200 or 300 votes. Typically, if

this right is provided, it is part of the

preferences provided to preferred stock.

VoƟng can be performed by ballot (such as at a

shareholder meeƟng), by wriƩen consent (in lieu of

a meeƟng), or by proxy (when a shareholder

delegates their voƟng rights to someone else, who

votes on their behalf).

102

CUMULATIVE VOTING

CumulaƟve voƟng is required in some states (such as

California, Arizona, Nebraska and Kentucky), other

states allow it unless the company “opts-out” (by

staƟng so in its charter), and in most states, it is

permiƩed but not required (such as Delaware). The

goal of cumulaƟve voƟng is to give shareholders

(parƟcularly minority shareholders) more inuence

when it comes to voƟng on its board of directors. If

there is no cumulaƟve voƟng, it is referred to as

statutory voƟng or straight voƟng.

Under cumulaƟve voƟng, the votes allocated to a

shareholder are the product of the number of shares

they hold mulƟplied by the number of board seats up

for elecƟon. For example, if a shareholder has 1,000

shares, and three board seats need to be lled, that

shareholder will have 3,000 votes, which can be put

on one board candidate or spread across mulƟple

candidates.

Under statutory voƟng, the votes allocated to a

shareholder are divided by the number of board

seats up for elecƟon. Let’s rst assume the following

shareholders and ownership percentages:

103

*Shareholders A, C and D hold 7,200 shares

combined.

Next, let’s assume there are three board seats that

need to be lled, and each shareholder has proposed

one candidate (i.e., four candidates for three seats).

If we also assume that Shareholders A, C & D are all

aligned on who should be voted onto the board, but

Shareholder B disagrees, what is the result?

Under statutory voƟng, the votes of the

shareholders would be divided by the number of

board seats (i.e. resulƟng in Shareholder A voƟng

1,000 votes on each seat, Shareholder B voƟng 933

votes, Shareholder C voƟng 900 votes and

Shareholder D voƟng 500 votes). Each seat would be

voted on separately, so the aligned shareholders

could combine their votes each Ɵme and win each

seat by a 2,400 to 933 vote, enabling the aligned

shareholders to name all three of their candidates

to the board of directors, and Shareholder B not

Shares Ownership %

Shareholder A* 3,000 30%

Shareholder B 2,800 28%

Shareholder C* 2,700 27%

Shareholder D* 1,500 15%

Total 10,000 100%

104

being able to vote his candidate onto the board,

despite his 28% ownership.

Under cumulaƟve voƟng, again assuming three

board seats are being voted upon, each member

would have votes equal to triple the number of

shares, and those votes can be designated across

one or more board seats. While the aligned

shareholders would have 21,600 shares (i.e. 7,200 X

3) to vote across their three board candidates,

Shareholder B could place all 8,400 (i.e. 2,800 X 3)

votes on his board candidate, enabling Shareholder

B to name one candidate to the board of directors.

The formula to determine how many directors a

shareholder can guarantee to elect under cumulaƟve

voƟng is as follows:

(Shares owned-1) x (Seats to be Elected +1)

(Total Shares Outstanding)

We can use this formula to calculate how many

board members Shareholder B can appoint:

(2,800-1) x (3+1) = 1.196

(10,000)

Assuming there are three directors, Shareholder B is

guaranteed to be able to elect 1 director. If

Shareholders A, C and D put equal votes on each of

their candidates, each would receive 7,200 votes –

not enough to outvote Shareholder B.

105

CumulaƟve voƟng is intended to give minority

shareholders the ability to elect at least one director,

where they otherwise might not have a voice on the

board of directors under statutory voƟng.

SUPER-MAJORITY VOTING AND UNANIMOUS

VOTING

A majority vote is anything larger than 50%... even a

small margin such as 50.000001% is sƟll a majority.

A super-majority vote is a requirement that the vote

be even higher (such as a vote of 65%, 75%, or 80%).

For example, if amending the bylaws requires a super

-majority vote of 75%, then a vote of 51%, or even

74% will not be enough. A unanimous vote requires

100% of the votes.

Requiring a super-majority vote or a unanimous vote

is generally reserved for signicant corporate

changes, where the decision is so impacƞul to the

company that the consensus of most, or all, of the

shareholders is desired. Examples would be

approving a merger, an acquisiƟon, or an

amendment to the number of shares authorized

under the company’s charter documents.

Both cumulaƟve voƟng and super-majority voƟng

play an important role in protecƟng minority

investors, as they both reduce the power of a 51%

shareholder. Obviously, from the perspecƟve of a

shareholder holding a slight majority, cumulaƟve

106

vo�ng and super-majority vo�ng are handcuﬀs

preven�ng his or her full control over the business.

Can you waive or deny cumula�ve vo�ng rights?

No. In California, cumula�ve vo�ng is a statutory

right. It cannot be waived, and it does not need to

be specied in the ar�cles or bylaws. Only publicly

traded corpora�ons can opt out of cumula�ve

vo�ng.

Can you incorporate in a diﬀerent state to avoid

cumula�ve vo�ng rights? No. For example, in

California, cumula�ve vo�ng s�ll applies to foreign

corpora�ons if more than half of their shareholders

live in California, and if they do most of their

business in California.

107

SHAREHOLDER AGREEMENT

There are oen instances when shareholders choose

to enter into a wriƩen agreement that denes how

certain aspects of the business will be managed.

While a shareholder agreement is generally

impraccal or unnecessary in a large private

company or in a public company, such agreements

are oen used in the context of small, privately held

corporaons.

In some cases, the shareholder

agreement provides further detail

as to how certain aspects of the

company will be managed; in other

cases, it grants vong power to

certain shareholders. Consider, for

example, an owner who wants to

bring in a 50% partner, but is

concerned about losing vong

control. In that case, the owner

would sell the new partner 50% of

the shares but retain the right to vote all or some of

those transferred shares under a shareholder

agreement. Those rights would then typically

terminate upon certain events, such as the passage

of me, a sale of a controlling stake in the company,

or a public oering of company shares.

Shareholder

agreements

can be useful

when the

terms do not

impact all

shareholders

equally.

108

Examples of areas somemes covered by

shareholder agreements include:

 maers relang to the management

structure of the company, such as

o the number of members on the

board

o how those board members will be

elected, and how any vacancies

would be lled

o the responsibilies of ocers

o whether there will be a mandatory

rerement age for employees

 maers relang to ownership of the

company, such as

o whether shareholders will have pre

-empve rights

o whether shareholders will have

an-diluon protecon

o whether shareholders will have a

“tag-along” right, which allows

them to parcipate when another

shareholder sells all or part of its

o whether shareholders will have a

“drag-along” right, where the

selling shareholder can choose to

require other shareholders to

parcipate in a sale of shares

o whether shareholders will be

subject to “put” and “call” rights.

Put rights grant the shareholder

109

the right to sell shares to the

company (or other shareholders),

and call rights grant the company

(or other shareholders) the right to

purchase another shareholder’s

o whether shareholders wish to

receive dividends, and if so,

whether those dividends would be

paid on a quarterly or annual basis

o whether shareholders will be

commied to certain restricve

covenants, such as condenality,

non-solicitaon, and non-

compeon provisions

o whether a stock opon plan will be

created, and if so, the number of

shares reserved for issuance under

that plan

o whether each shareholder’s ability

to transfer shares to a third party is

restricted in some manner, and

whether those shares must rst be

oered to the exisng shareholders

o whether each shareholder’s shares

can be repurchased without their

consent, and how the purchase

price would be determined (and

paid) in such an event (and if this

requires material breach by the

shareholder, the condions that

would sasfy such expulsion as a

shareholder)

110

o whether each shareholder’s shares

can (or must) be repurchased upon

reƟrement, and how the purchase

price would be determined (and

paid) in such an event

o whether each shareholder’s shares

can (or must) be repurchased upon

their death, and how the purchase

price would be determined (and

paid) in such an event

 maƩers relaƟng to voƟng, such as

o whether voƟng will be on a

cumulaƟve basis (this is required in

some states such as California, but

not required in others, such as

Delaware)

o whether certain acƟons will require

unanimous or supermajority

approval, such as (i) dissoluƟon of

the company, (ii) sale of all or

substanƟally all of the company’s

assets, (iii) a merger, conversion or

reorganizaƟon, (iv) transacƟons

outside of the ordinary course of

business, (v) amendment of the

charter or bylaws, including a

change in the authorized number

of shares, (vi) the sale of addiƟonal

shares, and (vii) capital

expenditures over a certain

threshold

111

o how deadlock amongst the

shareholders will be resolved

how disputes between the

shareholders will be resolved,

including whether arbitraƟon and/

or mediaƟon will be required

While some of the above can also be enumerated

within the bylaws of the company, shareholder

agreements are useful when the intenƟon of the

parƟes is that those rights will remain in place for a

certain period of Ɵme (or unƟl certain condiƟons

change). For example, certain rights between two

shareholders, each holding 50%, might be intended

to disappear when a third shareholder enters the

company, if deadlock is no longer a concern. In such

a case, the shareholder agreement may be

terminated, along with the rights and obligaƟons

contained in that agreement, and the bylaws can

stand as they were, without amendment.

A majority vote requires more than 50% (i.e.

50.01%); a super-majority vote may require

an even higher vote (i.e. between 51-99%,

but usually 65% or 75%).

112

NOTES

_______________________________________

113

BUY-SELL AGREEMENT

A buy-sell agreement is an agreement between the

company and its shareholders that controls the

purchase and sale of a shareholder’s shares if that

shareholder (i) wishes to sell shares, (ii) leaves the

business, (iii) re�res, (iv) gets divorced, (v) becomes

disabled, or (vi) passes away. This agreement will

provide for an orderly transfer of that ownership in a

manner previously agreed by all par�es.

(Note that these concepts can also be used for an

LLC, but for simplicity, we will address this from a

corpora�on/shareholder perspec�ve in this chapter.)

By planning ahead, the

company can also provide

for how such obliga�ons

will be met. For example,

the company may not have

suﬃcient cash to

repurchase a shareholder’s

shares upon that

shareholder’s death, but the company can provide,

under the buy-sell agreement, that it will take out a

life insurance policy on the shareholder, and that

those funds will be used to saƟsfy all or part of the

purchase obligaƟon upon the shareholder’s death.

Buy-sell agreements

can be used to

address repurchases

of equity under

diﬃcult

circumstances.

114

One oŌen ignored circumstance is the divorce of one

of the shareholders. Especially in a small company,

the remaining shareholders are not interested in

having the hosƟle spouse of its current shareholder

own any porƟon of that owner’s shares. The buy-sell

agreement can provide that those shares will either

be allocated to the shareholder when the marital

property is divided, or if not, those shares would

then be subject to repurchase by the company or

other shareholders.

Because the terms of the buy-sell agreement will

apply to assets jointly held by the shareholder and

his or her spouse, it's important that each buy-sell

agreement includes spousal consents, so the spouse

will be obligated to those same terms.

The following are consideraƟons that a company and

its shareholders should explore as part of the process

of creaƟng a buy-sell agreement:

1. Events which could trigger a buy-out of a

shareholder’s shares

A. A proposed sale of the shares.

· This generally triggers a right of rst refusal

where the corporaƟon, and then the other

115

shareholders have the opƟon to purchase the

· Generally, transfers of shares to or from a

living trust are permiƩed, but the transferred

shares remain subject to the buy-sell agreement

B. Transfers among family members (this is

generally prohibited, except as part of a plan to

transfer ownership rights and/or management

responsibiliƟes to the next generaƟon)

C. TerminaƟon of an employee-shareholder's

employment by the corporaƟon

D. For licensed professionals, any acƟon that

terminates their license to pracƟce the profession

E. The death of a shareholder

F. An employee-shareholder's disability

G. Divorce

· Divorce generally triggers a buy-out if any

shares are awarded to the non-employee

spouse

· The employee-spouse generally has an

opƟon to purchase the shares of the other

spouse

· If the employee-spouse doesn't purchase

116

all the available shares, the corporaƟon and

then the other shareholders generally have

opƟons to purchase the shares which remain

available

H. Death of a spouse

· Generally, this triggers a buy-out if any

shares go to someone who does not already

own shares of the company

· The employee-spouse generally has an

opƟon to purchase the shares of the deceased

spouse

· If the employee-spouse doesn't purchase

all of the available shares, the corporaƟon and

then the other shareholders generally have the

opƟon to purchase the shares

2. Who will be enƟtled (or required) to buy the

shares?

A. The corporaƟon

B. The person who sold or transferred the shares to

the selling shareholder (for example, if the

shareholder giŌed shares to his children, but one

child wants out, that giŌing shareholder might have

a rst opƟon to buy the shares back)

117

C. The other shareholders

· OŌen a goal is to allow each shareholder an

opportunity to retain his or her ownership

posiƟon in relaƟon to the other remaining

shareholders

3. Will the purchase be opƟonal or mandatory?

(This can depend on the type of triggering event)

A. The corporaƟon can have an opƟon and, if it is

not exercised in full, the other shareholders can:

· Have an opƟon to purchase the balance of

the available shares or

· They can be required to purchase any

shares which the corporaƟon does not

purchase

· Note: The selling shareholder is always

required to sell his shares if the opƟon is

exercised

B. If neither the corporaƟon nor the other

shareholders are required to buy the shares, are

there circumstances in which a shareholder should

have a right to require them to buy his shares?

Examples:

 Death

118

 Complete disability

 ReƟrement aŌer a parƟcular age or period of

service

4. How will the value of the shares be determined?

The three principal methods of valuing the shares

are (i) an appraisal of the shares when a triggering

event occurs, (ii) a formula wriƩen into the buy-sell

agreement, or (iii) an agreed value that is reviewed

periodically by the shareholders

A. Appraisal Method

An appraisal of the business is performed by an

independent third party cerƟed to conduct business

appraisals.

· Advantages of the Appraisal method

- RelaƟvely objecƟve and can consider any

developments that were not anƟcipated

when the agreement was signed

- Leaves much less room for tacƟcal

maneuvers to reduce or increase the value of

the shares. A formula or agreed value price

invites such maneuvers, which can lead to

liƟgaƟon and bad feelings

· Disadvantages of the Appraisal method

- An appraisal can be expensive ($10,000 to

119

$15,000 per appraiser is not unusual).

- Appraisals take �me to prepare.

- The value might be a surprise to the

shareholders. This risk can be reduced by

appraising the business now.

B. Formula Method

 A formula price is

usually based on book

value, earnings, or a

combina�on of both.

Formulas can be simple or

quite complex. For

example, a mature

manufacturing business

with appreciated real

property might use book value (subs�tu�ng the

appraised value of the real estate) plus ve

�mes the most recent year's earnings. If

earnings are an important measure of value,

several years of earnings can be considered,

with the most recent years weighted more

heavily

 Formula Examples for Calcula�ng Per Share

Price:

· Book Value Formula: A corpora�on’s book

value is the diﬀerence between the total assets

and the total liabili�es, divided by the number

of shares outstanding as of the date the book

value is determined.

Many formulas

are available.

You need to

nd the best

one best for

your business.

120

· MulƟple of Book Value Formula: The sum of

the book value of the corporaƟon and an

amount equal to [number] Ɵmes the average

annual net earnings of the corporaƟon, divided

by the number of shares outstanding as of the

date the book value is determined.

· Average Annual Net Earnings MulƟple

Formula: Dividing by ve the aggregate net

earnings or losses of the corporaƟon, aŌer

federal and state income taxes, for the ve

scal years of the corporaƟon immediately

preceding the date of the event causing the

purchase and sale, then divided by the number

of shares outstanding as of the date the value is

determined.

· Prot MulƟple Formula: An amount equal

to [number] Ɵmes (i) the aggregate of the

corporaƟon’s losses and net prots aŌer taxes

for the ve complete scal years preceding the

date of the event causing purchase and sale

under this Agreement, (ii) divided by ve then

(iii) divided by the number of shares

outstanding as of the date the value is

determined.

· Weighted Average Prot MulƟple Formula:

The quoƟent determined by dividing, by 15, the

121

sum of the following products: ve Ɵmes the

net prot of the most recent scal year; four

Ɵmes the net prot of the second most recent

scal year; three Ɵmes the net prot of the

third most recent scal year; twice the net

prot of the fourth most recent scal year; and

the net prot of the Ōh most recent scal

year, divided by the number of shares

outstanding as of the last day of the ve-year

period.

· Book Value + Goodwill Formula: (i)

CalculaƟng goodwill by mulƟplying by [number]

the excess of (a) the average annual net

earnings for the ve complete scal years

immediately preceding the date of the event

over (b) [number] percent of the average book

value as of the end of each of the same ve

scal years, then (ii) adding book value, then

(iii) dividing by the number of shares

outstanding as of the date of the event.

· Advantages of the Formula method

- Less expensive and faster than an appraisal.

- No surprises, since the parƟes can

determine the formula value at any Ɵme.

122

· Disadvantages of the Formula method

- The formula looks backward at past

opera�ng results and does not consider future

events such as a recently obtained favorable

contract, a promising new customer or the

loss of an important account.

- Over �me, the variance between the

formula value and the perceived actual value

may increase.

C. Agreed Value Method

The par�es can agree to value the shares annually

or at some other interval.

· Advantages of the Agreed Value method

- Reects the par�es' subjec�ve

expecta�ons concerning the prospects of the

business.

- Can consider economic trends and the sale

price of comparable businesses.

- If you are using insurance to fund the

eventual purchase of shares, you probably

have a specic value of the shares in mind

when you purchase the insurance. That can

serve as the ini�al agreed value. If you intend

to review periodically whether the insurance

coverage is suﬃcient, you should plan to

update the agreed value at those intervals.

123

· Disadvantages of the Agreed Value method

- Requires unanimous consent to change. So,

if one party becomes seriously ill, the others

may be unwilling to update the value to

increase the purchase price.

- Shareholders oŌen are too busy to

consider valuaƟon, which may become

controversial and tangled with other sensiƟve

issues. An agreement that uses an agreed

value should always include a formula or

appraisal value as a backup. The backup

method would apply if no agreed value had

been determined for a period of Ɵme (oŌen 18

to 24 months).

5. How will the purchase price be funded and paid?

The principal ways to fund the purchase price are

advance funding in the form of insurance or corporate

reserves, future funding in the form of installment

payments of the purchase price, or some combinaƟon

of these. ParƟcularly with the death buy-out,

insurance is oŌen a preferred method as it will ensure

the funds are available when the buy-out is required.

Note: It is always possible that the business will be

sold or the corporaƟon liquidated before any

triggering event occurs. In that event, or if the stock

becomes publicly traded, no buy-out under the

agreement would ever occur.

124

A. Lump Sum Payment

This method is most oŌen used for shareholders with

a small percentage interest in the business.

If the value of the stock is low (as it might be for an S

CorporaƟon with few valuable assets or for a

shareholder with a small interest in the business) or

the corporaƟon has reserved substanƟal liquid assets

to fund the buy-out, it might be best to require

payment for the stock to be made all at once.

If the corporaƟon or the other shareholders needed

addiƟonal cash to fund the purchase, they would

borrow from a lending insƟtuƟon at that Ɵme.

However, the lender might be reluctant to make a

loan for this purpose.

· Advantages of Lump Sum Payment

- The selling shareholder (or the surviving

family) is not dependent on the future success

of the business (as they would be under an

installment payment arrangement)

- Avoids the necessity of ne-tuning a payment

plan in advance

· Disadvantages of Lump Sum Payment

- For many companies, this is not realisƟc for the

purchase of a large block of shares because the

purchase price will be too high in comparison to

both the corporaƟon's anƟcipated liquid assets

125

and the likely borrowing capacity of the

corporaƟon and its shareholders

B. Life Insurance

The corporaƟon could purchase life insurance on its

shareholders to fund the eventual purchase of their

shares.

· Advantages of Life Insurance

- Life insurance shiŌs the

risk of an early death and

buy-out obligaƟon to the

insurance company

- Assures that at a

shareholder's death the

funds to purchase that

owner’s shares will be

available and can be

distributed to the decedent

shareholder's family. The

payment to the decedent's

family does not depend on the future success of

the business

- The owners of a whole life policy can benet

from the tax-free "inside build-up" of the funds

invested in the policy

- If a shareholder-employee terminates

employment before death, a policy of permanent

insurance can serve as a down payment for the

shares. The terminaƟng shareholder-employee

then has several aƩracƟve alternaƟves: use the

policy for reƟrement or estate planning, borrow

Insurance can

be a great way

of guaranteeing

the funds will be

available to

repurchase

shares in the

event an owner

passes away.

126

against it, or surrender it to the insurance

company for its cash value

· Disadvantages of Life Insurance

- Uses current funds to purchase insurance to

pay for a future buy-out. If the business needs

capital, this use of funds might slow the growth of

the business, parƟcularly if the funds in the

business generate a higher aŌer-tax return than

funds in the insurance policy. If this is a concern,

consider a leveraged life insurance purchase to

leave the funds at work in the business but

achieve the risk-shiŌing benets of insurance

- If a shareholder terminates employment for a

reason other than death, the life insurance

provides funds only to the extent of its cash

surrender value, which may be low in the rst few

years aŌer the policy is acquired. (If this is a

concern, consider a no-load or low-load policy)

- Note: Separate policies are usually necessary to

cover terminaƟon of employment resulƟng from

disability.

C. Installment Payments

Generally, the corporaƟon should be required to

make as large a down payment as it anƟcipates will

be feasible, and the balance should be paid over a

number of years. (Life insurance can be used to fund

127

just the down payment, rather than the enƟre

purchase price.)

· Interest

- How oŌen should interest be paid?

- Generally, for the sake of simplicity, the

interest rate should at least equal the Applicable

Federal Rate (the minimum rate necessary to

avoid imputed interest for tax purposes). The rate

can be xed at the buy-out date based on the

prime rate or the corporaƟon's cost of borrowed

funds at that Ɵme, or it can oat with the prime

rate or another interest rate.

· Security and OperaƟng restricƟons

- The selling shareholder can have a security

interest in the shares sold or in other assets.

- The corporaƟon could be prevented from using

its cash for any unusual purpose unƟl all of the

installment payments are made, unless the note

holder consents to the extraordinary expenditure.

Financial raƟo requirements may be imposed,

requiring the company to maintain certain

nancial metrics.

 Note: If the restricƟ

ons constrain

management too much, they could harm the

business and increase the risk to the recipient

of the payments.

128

· AcceleraƟon events

- Generally, the enƟre unpaid purchase price for

the shares would be due if the corporaƟon

dissolved, merged into another corporaƟon, sold

its business or entered into bankruptcy.

 Promissory notes made by the remaining

shareholders could accelerate if they sold their

stock in the corporaƟon or became bankrupt.

· Advantages of Installment Payments

- Compared to insurance funding, an installment

payment arrangement frees current cash for

investment in the business.

- Matches future payments with funds earned in

the future

- Both insurance funding and installment

payments are complex. Installment payments

defer most of the complexity unƟl a buy-out

occurs

· Disadvantages of Installment Payments

- The payment to the selling shareholder (or the

family) depends on the success of the business. If

the business does poorly, they may never receive

full payment or payments may be delayed. This

risk is aggravated if the only security is the shares

of the other shareholders.

129

6. Will all community property interests in shares be

covered?

· If stock is held in the name of a husband and

wife, the agreement should specify which one of

them has the right to vote and to sell the shares

· The agreement should provide a way to recover

shares from a non-employee spouse at divorce or

at the spouse's death

· The spouse of each shareholder should sign the

agreement

· If an employee-shareholder marries, the law

might permit the new spouse to acquire a

community property interest in the shares – but

the new spouse might not be bound by the

agreement unless the new spouse signs it.

Accordingly, the new spouse should be required to

sign the agreement

7. Should the buy-out arrangement aﬀect related

businesses?

· If the same people own more than one acƟve

business together, should a triggering event in one

business also trigger a mandatory or opƟonal buy-

out in the other businesses?

· OŌen a corporaƟon rents real estate and

130

equipment from a partnership formed by the

shareholders. They do not usually require a buyout

of the partnership interest at the same �me that

the shares are repurchased. (The exis�ng

partnership agreement should exclude or create

an excep�on to the "business opportunity" rule so

that the remaining shareholders can form a new

partnership and acquire new property in the new

partnership, not the old one)

8. Should a depar�ng shareholder agree not to

compete with the corpora�on?

· If a shareholder with a substan�al interest in

the corpora�on agrees not to compete with the

corpora�on within a reasonable geographic area

and for a limited �me, California courts generally

will only enforce the agreement if it is ac�vated by

a sale of the shareholder's stock of the

corpora�on. The agreement generally would

remain in eﬀect for three to seven years.

9. Will the agreement aﬀect anyone else?

· Are the shares currently pledged?

· Is an exis�ng buy-sell agreement or

shareholders agreement in eﬀect? Do the

incorpora�on documents or the bylaws restrict the

transfer of shares?

131

10. Is the corporaƟon an S CorporaƟon for tax

purposes?

· Because certain issuances or transfers of shares

can terminate the S Corporaon status, a buy-sell

agreement can help to retain the valuable S status

by prohibing such transacons.

· Will the S Corporaon be required to make

distribuons in an amount sucient to enable the

shareholders to pay their taxes on their shares of

the corporaon's income?

Once the above issues are thoroughly considered,

the buy-sell agreement process should include a

corporate aorney as well as a CPA, so all legal and

tax issues can be thoroughly veed. These

agreements are typically complex, and because

certain events such as divorce, disability, and death

make modicaon dicult or impossible, it is crical

that the agreement be correct from the beginning.

132

NOTES

_______________________________________

133

SPOUSAL CONSENTS

For those living in “community property” states

(currently Arizona, California, Idaho, Louisiana,

Nevada, New Mexico, Texas, Washington, and

Wisconsin), the enƟty and the individual may want to

consider requiring a spousal consent when certain

documents are being executed. This stems from the

fact that the spouse may have certain rights that

might later be asserted in a manner contrary to their

spouse.

For example, when a person purchases equity in a

corporaƟon or LLC, that equity may be deemed a

community property asset. If one spouse agrees to

sell the ownership in conjuncƟon with a transacƟon

proposed by the company, what will be the result if

the other spouse refuses to consent to that

transacƟon? Under community property laws, each

spouse may have equal say on that asset, and even

more drasƟcally, nonconsenƟng spouses may have

the right to void certain transacƟons.

A spousal consent is a document signed by the

spouse of an equity investor, under which the

spouse consents to the terms of the agreement.

Assume a Restricted Stock Purchase Agreement is

entered into between the company and Mrs. Smith.

When Mr. Smith signs a spousal consent, Mr. Smith is

agreeing to all of the terms of the Restricted Stock

Purchase Agreement, even though he is not a direct

134

signer on the Restricted Stock Purchase Agreement.

The same concept extends to LLC operaƟng

agreements, shareholder agreements, voƟng

agreements, leases, real estate transacƟons,

beneciary designaƟons, guarantees, and any other

agreements for which the spousal consent applies.

By having a spousal consent in place, the company

and/or other equity owners can enforce, against the

equityholder's spouse, the transfer and voƟng

restricƟons and other obligaƟons contained in those

agreements.

In some cases, an individual is

reluctant to bring their spouse

into the discussion and secure

the spousal consent. This

should be a warning sign for

several reasons. One might

quesƟon the integrity of

someone who acƟvely keeps

informaƟon from their spouse;

however, the larger issue from

the company’s standpoint is that this refusal to

secure the spouse’s consent creates potenƟal risk to

the company. If the company agrees to proceed

without the spousal consent, it takes the risk that

those spouses will be at odds in the future, and the

company’s ability to move forward with shareholder

consent may be compromised.

Failure to secure

spousal

consents may

mean the

spouse is not

bound to the

terms of the

agreement.

135

In draŌing a spousal consent, it is important that the

spousal consent specically references the applicable

agreement(s). Failure to do so will likely result in a

spousal consent that is unenforceable.

A spousal consent must clearly specify the

agreement to which they are consenƟng.

136

NOTES

_______________________________________

137

STOCK OPTIONS

At the early stage of the company, shortly aŌer

formaƟon, it is typically preferable to issue founders

shares to all of the owners. However, as the value of

the company increases, granƟng shares can create

signicant tax consequences, as the receipt of shares

will be taxed at the fair market value of those shares.

As a result, employee stock opƟons are typically

used as a tool to incenƟvize employees by providing

them with the opportunity to parƟcipate in the

upside growth of the business without having to

make a cash investment (or incur tax) at the Ɵme of

grant.

A stock opƟon is an agreement that provides the

holder (the “opƟonee”) a right to purchase a specic

type of stock (usually common stock) at a

predetermined price (the “exercise price”). Stock

opƟons are non-transferable, and if the employee

fails to exercise the opƟon, the opƟon terminates.

Most companies will adopt a stock opƟon plan which

establishes the opƟon pool, i.e., the number of

shares reserved for distribuƟon as opƟons. The stock

opƟon plan should be approved by the shareholders,

aŌer which Ɵme the board of directors can grant

opƟons from the pool of shares.

The size of the stock opƟon pool varies, but generally

in start-ups it will range between 15% and 20% of the

company’s fully diluted shares. When calculaƟng the

138

fully diluted shares, the issued shares are added to

any converƟble securiƟes along with the number of

shares allocated to the stock opƟon plan itself.

The exercise price is calculated on a per share basis

and is typically set at 100% of the fair market value

of one share at the Ɵme of grant. While the exercise

price can be higher, pricing the opƟon at a per share

price below 100% of the fair market value can result

in tax consequences to the opƟonee, accounƟng

charges to the company, and potenƟal violaƟons of

securiƟes laws.

PenalƟes relaƟng to the issuance of opƟons below

fair market value can be avoided by securing a 409A

valuaƟon (discussed in more detail in a separate

chapter). ValuaƟons performed pursuant to SecƟon

409A of the Internal Revenue Code provide a “safe

harbor” so long as the valuaƟon has been conducted

in the last 12 months and there have not been

material changes in the business that would be

expected to signicantly change the value of the

shares.

There are two types of opƟons that can be granted:

IncenƟve stock opƟons (“ISOs”) and nonstatutory

stock opƟons (also referred to as “nonqualied

stock opƟons” or “NSOs”).

IncenƟve stock opƟons may be granted only to

employees, and cannot be granted to non-employee

directors, advisors, consultants, and other service

139

providers. The exercise price of an

ISO must be 100% of the fair

market value as of the date of

grant; if the ISO is granted to

someone who owns more than 10%

of the equity of the company, then

the exercise price of the ISO must

be 110% of the fair market value as of the date of

grant. ISOs have addi�onal requirements which

must be sa�sed for them to retain their preferen�al

tax treatment.

Any op�on that does not meet the requirements of

an ISO will be treated as an NSO. NSOs are used

typically to incenƟvize non-employees, including non-

employee directors, independent contractors,

advisors, consultants, vendors, and other service

providers.

ISOs and NSOs receive diﬀerent tax treatments.

When an ISO is exercised, no tax is due for regular

income tax purposes (although tax may be due for

AlternaƟve Minimum Tax purposes); tax on any gain

(i.e. the amount by which the sale price exceeds the

exercise price) will be assessed at the �me the shares

acquired via the op�on are sold. For example, if the

op�on is exercised at an exercise price of $1 and fair

market value on the date of sale is $10, tax will be

assessed on the $9 gain. Keep in mind that the rate

of tax an op�on holder pays on the sale of stock

received from an ISO exercise depends on how long

ISOs can

only be

given to

employees.

140

the stock has been held and whether it was sold as a

“qualifying” or “disqualifying” disposiƟon.

When a NSO is exercised, the oponee will be

required to pay tax at ordinary income rates on the

amount by which the fair market value of the stock

on the date of exercise exceeds the exercise price

paid; when the stock acquired through that exercise

is sold, addiƟonal capital gains tax will be due on the

amount that the sale price exceeds the fair market

value on the date of exercise. For example, if the

opon is exercised at an exercise price of $1, and the

fair market value at the date of exercise is $4, tax will

be assessed in that tax year on the $3 gain; if the fair

market value is $10 on the date of sale, addional

tax will be assessed on the $6 gain realized between

the date of exercise and the date of sale. While

these are general guidelines, anyone exercising

opons should conrm the tax consequences with

their CPA prior to any exercise of opons.

There are three scenarios where stock opƟons will

not be exercisable. The rst scenario is when the

opƟon is “under water,” meaning the current fair

market value is below the exercise price (this would

be equivalent of buying $1 for $1.10). If you wanted

to acquire shares, you would be beer o purchasing

shares directly from the company if the fair market

value is less than the opon price.

The second scenario is where the opƟon expires. An

ISO must not be granted with a term longer than 10

141

years, and if granted to someone owning 10% or

more of the company, the term must not be longer

than ve years. While there is no limit on the term

of an NSO, it is typical that the stock opƟon plan will

limit that term to 10 years as well.

The third scenario is where the opƟon terminates.

Most stock opƟon plans provide that when an

employee or service provider is no longer providing

services, that individual has a limited amount of Ɵme

to exercise the opƟon. This exercise is generally 30 to

90 days following the terminaƟon of services date.

The stock opƟon plan will typically permit this period

to be extended by 12 months for the opƟonee’s

disability, or 18 months in the event of death of the

opƟonee.

Stock opƟon grants are typically subject to vesƟng.

The most common vesƟng period is four years, with

25% of the shares vesƟng aŌer one year, and the

remaining shares vesƟng 1/36 per month over the

next three years. As discussed in the VesƟng

chapter, these opƟons may be subject to

acceleraƟon in certain circumstances.

Some stock opƟon plans will also provide for “early

exercise” of the opƟon, allowing the opƟonee to

exercise unvested shares. The benet of doing so is

that the opƟonee will begin their holding period on

those shares, which will allow them to receive a

preferred tax treatment; of course, by doing so, the

142

opƟonee has put their money at risk, as the stock

could decline in value, even below the exercise price.

Even in the case of an early exercise, the shares

remain subject to the vesƟng schedule and the

company will retain a right to repurchase (at the

exercise price) any shares that remain unvested.

Because the shares are sƟll subject to repurchase by

the company, the opƟonee is not permiƩed to

transfer any shares that are sƟll subject to the

vesƟng schedule. In the event an opƟonee chooses

to avail themselves of the early exercise opportunity,

the opƟonee must le an 83(b) elecƟon with the IRS

within 30 days of the early exercise.

143

VESTING

Ves�ng is a contractual concept that provides

someone with the opportunity to earn a payment,

asset or benet upon the sa�sfac�on of certain

condi�ons.

Vesng can take place within a number of dierent

agreements, such as stock purchase agreements,

shareholder agreements, and phantom stock

agreements; however, most oen, we see vesng

used in the employer-employee relaonship, such as

in the granng of stock opons. Stock op�ons,

when granted, are typically subject to a ves�ng

schedule, and upon the employee’s sasfacon of

that schedule (typically by remaining as an employee

for the required period of me) those opons are

vested and the employee can, if they choose to do

so, exercise those opons.

In the context of stock opons, those opons are

typically vested over a four-year period. Most

commonly, 25% of the shares vest aer one year of

employment, with the remaining 75% vesng equally

over the subsequent 36 months. If the employee’s

employment terminates, vesng immediately stops.

“Cliﬀ ves�ng” is when some or all of the vesng

occurs in one large chunk. In the example above, the

rst 25% would be considered cli vesng, because if

the employee le at 11 months, they would not vest

into any opons. However, if that same employee

144

le aer 13 months, the employee would have

vested into 13/48ths of the stock opon grant.

Vesng which occurs evenly over me, i.e. years 2-4

in the above example, is referred to as “graded

vesƟng.”

It is not unusual for companies

to use a combinaon of cli

vesng and graded vesng.

Cli vesng provides the

company with several benets:

it is simple to manage, it is cost

eecve, it delays certain

payments that otherwise might already vest, and it

creates an incenve for employees to remain for at

least that cli period since all benets will otherwise

be lost. On the other hand, if cli vesng is spread

over too long of a period, it fails to movate

employees, as they have not earned anything unl

they survive the cli period. As a result, companies

oen use a combinaon (such as that used in the

example above). By doing so, employees who last

less than a year do not receive a benet, but those

that have passed the one-year mark will start to see

their commitment reected on the vesng schedule

in the form of vested shares that they can choose to

exercise.

While vesƟng is oŌen based on a certain period of

Ɵme passing, vesƟng can also be aƩached to other

milestones (instead of, or in addion to, the me-

based milestones), such as funding milestones, R&D

Most stock

op�on grants

u�lize both cliﬀ

ves�ng and

graded ves�ng.

145

milestones, revenue milestones, or individual

milestones (such as a sales

representaƟve’s performance).

UlƟmately, vesƟng is intended to

delay the granƟng of that

payment, asset or benet unƟl

certain performance has been

received by the company.

VesƟng can be subject to acceleraƟon upon certain

events, but it is not always the case. For example, a

company might provide that all vesƟng on stock

opƟons accelerates if the company is sold or merged;

in other cases, those stock opƟons do not accelerate

so long as the acquiring company assumes the stock

opƟons. In other cases, they do not accelerate in any

event, and in the event of a sale or merger, any

unvested opƟons are simply lost.

As a recipient of a stock opƟon or other payment,

asset, or benet that is subject to vesƟng, it is

important that you understand the condiƟons on

which that benet is granted. Similarly, it is

important that the company be very clear as to the

vesƟng condiƟons -- failure to do so can result in an

employee suing for what they feel they earned. In

the event the company is poised for sale, it can cause

a potenƟal buyer to reconsider a purchase or

merger, or at the very least, demand addiƟonal

nancial assurances from the company and its

shareholders for any liability that might arise due to

the uncertainty of the vesƟng program.

Most stock

opƟon grants

vest over

four years.

146

NOTES

_______________________________________

147

409A VALUATIONS

A 409A valuaƟon is an independent appraisal of the

fair market value (“FMV”) of a private company’s

stock. The valuaƟon is made as of the date of

issuance and is used to set the exercise price for

stock opƟons and stock grants issued to employees.

SecƟon 409A of the Internal Revenue Code provides

a framework for valuing stock for compensaƟon

purposes. Performed by an independent, third-party

appraiser, a 409A valuaƟon is used to determine the

proper value of stock opƟons and stock grants. A

properly performed valuaƟon provides a “safe

harbor,” protecƟng the company and its employees

from IRS penalƟes that may arise if

the FMV has not been determined

appropriately. The safe harbor

concept assumes that because it

was performed by a qualied third

party, the calculated FMV is a

reasonable fair market value of the

company’s stock and can be relied

upon by the company.

There is no universal formula for determining the

FMV of a company. The determinaƟon of the

company’s FMV requires the judgment of the

appraiser, who may use a variety of methods in

determining FMV. The following three methods are

409As lower

your risk that

the stock

opƟon value

is later found

to be

incorrect.

148

most common, and may be combined in the

discre�on of the valua�on company:

 Income Approach - this approach focuses

on the income producing capabili�es of the

company by es�ma�ng future income and

cash ows.

 Market Approach -- this approach values

the assets, revenue and earnings of the

business compared to other companies. If

the company has had a recent nancing

event, and those investments have been

nego�ated on an arms length basis, those

investments will provide addi�onal

guidance as to the company’s FMV.

 Asset approach-- this approach is used in

early-stage companies that have not had a

funding event and do not yet produce

revenues, and focuses on the net asset

value of the company (based in part on the

cost to replace such assets).

Independent appraisers have an obliga�on to ensure

that the 409A and the FMV resul�ng from it are

“fair.”

A 409A valua�on is ideally conducted before any

op�ons or shares are granted to any employees or

advisors, and then refreshed every 12 months, or

upon a material event occurring. Material events are

any events that might signicantly aﬀect the

company’s stock price, but will certainly include

events such as:

149

 a successful funding round

 the comple�on of a major milestone of

the company

 the acquisi�on, or loss, of a major

contract that will signicantly aﬀect

revenue

 receipt of a term sheet from a poten�al

acquirer, or

 changes in market condi�ons that will

aﬀect the company’s prot margins

It is not unusual for early-stage companies to elect

not to hire a third-party appraiser to perform a 409A

analysis, as the cost for an ini�al 409A might be

$3000-5000. However, choosing not to have a

properly formed 409A can expose the company and

its employees to signicant risk in the event the value

the company chooses to use is later deemed

inappropriate.

If the 409A valua�on is not performed using one of

the IRS-approved methods, penal�es can be

signicant, including (i) all deferred compensa�on

becoming immediately taxable, (ii) interest being

charged on that taxable amount, and (iii) an

addi�onal 20% penalty.

150

NOTES

_______________________________________

151

TYPES OF INVESTORS

When a business starts seeking investment, there are

a number of types of investors that might be

approached.

Friends and Family are usually the rst stop. This

group is typically approached when very small

amounts of money are being requested. Their

investments are oŌen in the form of SAFEs (Simple

Agreement for Future Equity) or, alternaƟvely,

common stock. Unfortunately, if the business

opportunity does not work out, this is the most

uncomfortable money to lose, as you may be talking

about it next Thanksgiving. Friends and family oŌen

don't invest much, but they may also have a very low

tolerance for risk on the money they have invested.

They may not be sophisƟcated and may not fully

appreciate the fact they might lose their complete

investment (no maƩer how oŌen you tell them

otherwise). For that reason, it is very important to

make sure that even though they are friends and

family, the business has provided proper

documentaƟon relaƟng to the nancing, which

clearly spells out all the risk

factors.

Angel Investors, typically high

net worth individuals, will

generally make investments in

very early-stage companies.

The earlier the

investment, the

higher the

returns the

investor expects.

152

Angels will typically invest between $25,000 and

$500,000 in a “seed round” (commonly in either

converble notes or preferred stock) and their

investment usually also includes oering advice and

mentorship, as well as their connecons. They

typically will not require a board seat or other

approval rights, and they are generally not involved

in day-to-day acvies of the company. Angel

investors have a higher risk tolerance, choosing to

invest in high-risk ventures because they are looking

for high rewards.

Venture Capitalists, or VCs, typically manage funds

which in turn make investments in high growth

companies. Their investments are larger than angel

investors and usually come in aŌer the startup phase

when businesses need substanƟal capital in order to

grow. VCs will typically invest $2,000,000 or more, in

a Series A, Series B, or later rounds, and will typically

receive preferred stock. It is not unusual for the VC

to require a board seat as part of their investment.

Their investments are sƟll considered high risk, as

they expect many investments to fail with a few

yielding signicant returns. VC's will typically look for

a 10X return over ve to seven years.

Private Equity investors typically invest capital in

companies that have matured. They will oen

require signicant ownership stakes in exchange for

their investment -- in many cases, they will require a

controlling interest in the company. Investments can

be anywhere from $10 million to $100+ million.

153

Because of these late-stage investments, they have a

more moderate risk tolerance, and they are looking

for a steady return on investment over ve to seven

years, at which me they're looking for the company

to either sell or le for a public oering.

Corporate Investors and Strategic Investors are

larger companies that invest in smaller companies to

diversify their porolios or ll a niche need in their

business. Because these investments are typically

strategic, they are also seeking ways to collaborate.

For example, an investment might be placed in a

smaller company beer situated to research and

develop new products, with the strategic investor

providing access to cash and technology. While this

type of investor is aracve in the sense that they

typically have deep pockets, it is not uncommon to

nd that there are work-culture gaps between small,

nimble, early-stage companies and large, slow

moving, instuonal companies.

154

NOTES

_______________________________________

155

INVESTOR VALUATIONS

Before talking about diﬀerent methods to value your

business for purposes of investment, it is important

to understand the terminology investors use.

“Pre-money” and “post-money”

terms relate to value. Pre-money is

the term used to state the value of

the company before the

investment is made. Post- money

is the term used to state the value

of the company aŌer the

investment is made. For example,

if the company is worth $4 million

prior to the investment (i.e. the pre

-money value) and the investor is

inves�ng $2 million, then the company will have a

post-money value of $6 million. Assuming there is a

single class of stock, and the company has 8 million

shares outstanding prior to the investment, it will

need to issue another 4 million shares to the investor

for his $2 million investment.

The earlier stage the business is in, the harder it is to

answer the ques�on “What is the value of my

company?"

Value will vary based on a number of factors:

Learn the

terminology

and how to

calculate

company

value before

you start

asking for

money.

156

 Is the company protable? Companies can

have no prot but sƟll be valuable (but

protability doesn’t hurt!).

 What are its annual prots? Obviously, the

higher the prots, the higher the valuaƟon.

 Are prots dependent upon a small number

of customers rather a large number of

customers? A lack of client diversicaƟon

may result in a potenƟally lower value.

 Are prots trending up or down? Are prots

climbing up rapidly or slowly? Prots that

are trending up at a quick pace will jusƟfy a

higher valuaƟon than prots that are

climbing slowly.

 Are distribuƟon channels for its products

broad or narrow? The more distribuƟon

channels that are in place, the beƩer.

 Does the company own intellectual

property (“IP”)? Are patents registered?

Are trademarks registered? Have copyrights

been registered? Have all employees and

contractors signed condenƟality and

invenƟon assignment documents? It is

criƟcal to have all IP rights protected, and

registraƟon is a very important step in that

process. Patents and trademarks which

have not achieved registraƟon run a risk of

not ever being approved, which results in a

discounted IP value.

 Is it expected that employees will remain

with the company for the foreseeable

future?

157

 What are the most signicant risks of the

company moving forward?

UlƟmately, investors will be looking to receive a

substanƟal return in an early-stage company, but

smaller returns on more mature companies. For

example, an investor might be looking for the value

of their investment to mulƟply by 5X in three years

with an early-stage company, where they might be

seeking a substanƟally smaller return from a well-

established company.

UlƟmately, when seeking money from investors, it is

important not only to evaluate the price they are

willing to pay but also consider the value they can

bring in the form of non-cash contribuƟons. For

example, an investor with a lot of market experƟse

and connecƟons (oŌen referred to as “smart

money”) might be a beƩer partner than one willing

to pay more cash but who is not bringing any

strategic value (referred to as “dumb money”).

158

NOTES

_______________________________________

159

TERM SHEET, LETTER OF INTENT

A term sheet is a non-binding agreement that

idenes the basic terms and condions of a

transacon. A term sheet is also referred to as a

leƩer of intent or “LOI.” Term sheets are used in a

variety of transacons.

Companies raising money will

oen provide a term sheet to

potenal investors that states

all the material terms of the

investment. In those

circumstances, the term sheet

will outline rights, preferences,

and protecons aorded to the investor, as well as

provide informaon about the oering itself, such as

any minimum investment required. In the case of

small investors, the term sheet is generally not open

to much negoaon; however, it is very common for

the lead investor to negoate nancial terms,

including valuaon and an-diluon protecons, as

well as non-monetary terms such as their ability to

appoint a board member, informaon rights, vong

rights, the size of the stock opon pool, and other

rights and protecons that may or may not extend to

other holders of the same shares.

When companies seek to enter into a transacon to

acquire/sell a substanal amount of assets, or if two

companies are ancipang a merger, the transacon

Term sheets are

non-binding,

except for a few

terms, such as

condenƟality.

160

will typically be spelled out on a term sheet prior to

moving to nal documentaon. Likewise, if a

company intends to purchase the shares of another

company from that company’s shareholders, those

terms will generally be rst idened on a term

sheet.

While a term sheet is generally non-binding, it is also

possible to have certain binding provisions within the

term sheet. Most oen, those binding provisions

relate to condenality and “no-shop” clauses. The

condenƟality provision will state that while the

pares are not obligated to enter into a transacon,

they will keep the existence of the transacon

condenal as well as any informaon that they may

learn from the other party during the process. The

no-shop provision is oen a part of a term sheet

when the purchase of a business is being

contemplated. The no-shop provision states that, for

a period of me, the seller will not seek or entertain

any other oers; the purpose of this is to give the

buyer and seller me to complete the transacon,

and to prohibit the seller from using the buyer’s oer

as a “stalking horse” to negoate a beer deal with a

third party. The length of the no-shop period will

vary, but is typically a period of me long enough to

allow the pares to complete the ancipated

transacon.

The intent of a term sheet is to allow the pares to

negoate and nalize all material deal points before

they incur the me and expense of draing deal

161

documentaon. If the pares cannot reach an

agreement on the material terms within a term

sheet, there is no reason to proceed to document

draing.

In circumstances where documentaon is being

draed by legal counsel, using a term sheet is even

more important, as it will provide a clear road map as

to which terms need to be included in the nal deal

documentaon. This will make the draing faster,

and by extension, less expensive.

It is important to note that while a

term sheet is non-binding, making

changes aer it is agreed to will be

dicult. It is non-binding in the

sense that the pares are not

obligated to enter into the deal

that is laid out in the term sheet.

However, once the term sheet is agreed upon, it will

be very dicult for either party to go back to the

other party with any material changes; once the term

sheet is agreed upon, those terms are considered

“the deal” and “re-trading” is viewed negavely.

Based on that, negoang a very clear and

acceptable term sheet is crical; failing to do so can

potenally jeopardize the transacon if one party

proposes changes post-signing.

While term sheets are not required to be executed,

as they are non-binding, it is good pracce to have

them executed so that each party is clearly agreeing

The more

thorough the

term sheet,

the smoother

the deal.

162

to the terms contained within the term sheet. Of

course, if the term sheet includes any binding

provisions, such as a condenƟality provision or a no-

shop provision, then without quesƟon the term

sheet should be executed by all parƟes intended to

be bound by those provisions.

163

FINANCING YOUR BUSINESS

There are mulƟple ways to nance your business.

Equity - When you sell equity in a business, you are

selling ownership. Examples of equity include SAFEs

(Simple Agreement for Future Equity), common

stock, preferred stock, member interests and

partnership interests.

Debt – When you nance your business with debt,

you are issuing promissory notes in exchange for

loans. For early-stage companies, it is quite common

that these loans be secured with the assets of the

business and/or by a personal guarantee from the

founders. When loans are obtained through the

Small Business AdministraƟon program, a personal

guarantee will be required.

For a company to qualify for a tradiƟonal bank

business loan, the business will need to have stable

cash ow; without stable cash ow, the company

may need to resort to other non-bank debt nancing

strategies.

The benet of issuing equity is that there is nothing

to repay. If the company fails, the investor loses their

investment. Their only hope to recoup any of their

investment is if there is residual value leŌ in the

company aŌer it is liquidated and all creditors have

been paid rst. Because of that risk, selling equity at

164

a very early stage is oen more dicult, and an

investor may prefer a converƟble note.

When an investment comes in on a converble note,

the investor holds the note and collects interest, but

also has the opon to convert that note to equity. In

that sense, the investor has the best of both worlds,

being secured while holding the note and having the

upside of equity once they convert. The converble

note will dictate when the note converts at the

investor’s discreon and when it converts

automacally.

Increasingly, SAFEs are being used instead of

converƟble notes. With a SAFE, the investor is

receiving an equity interest, but the value and nature

of that interest is determined in the future. For

example, a SAFE might provide that the SAFE will

convert into whatever equity is raised in the next

round, but at a discount. If the next round raised is

preferred stock at $1.00 per share, the SAFE holder

might receive their shares of preferred stock at a

20% discount (i.e. $0.80 per share). This discount

rewards the SAFE investor for placing their money

into the company at an earlier me when the risk

was higher.

Factoring of Receivables. If the company has an

acve ow of accounts receivables, it may be able to

nance its business by factoring those receivables.

In this approach, the company sells its unpaid

invoices, i.e. accounts receivable, to a third-party

165

company referred to as a "factor.” The factor

provides cash immediately on those receivables,

taking a percentage of the invoice values as their

transacƟon fee. While the company sacrices a

percentage of its receivables, it is able to access

funds quickly instead of waing for those receivables

to be paid over me. In “recourse factoring,” the

business is responsible in the event the customer

does not ulmately pay; in “non-recourse factoring,”

the business risk of non- payment is shied to the

factor. If non-recourse, the factor will require a

larger percentage of the receivables as their fee, to

oset some of their collecon risk.

See the chapter on “Types of Investors” to learn

more about the dierent proles of investors and

how they typically parcipate in funding businesses.

166

NOTES

_______________________________________

167

USING FINDERS

Raising funds to get your business o the ground (or

to the next level) is one of the most signicant

challenges an entrepreneur can encounter.

Entrepreneurs oen reach out to people they know

to try to tap into those networks and will oen agree

to pay those people (“nders”) a percentage of funds

raised, oen termed a “nders fee.” It's clear why

entrepreneurs would want to do this; however,

unless certain specic requirements are complied

with, these individuals may not be permied by law

to earn success fees when raising capital.

Unfortunately, many nders do not live up to

expectaons; they oen require a lot of informaon

from the company, then fail to deliver any

meaningful connecons.

Finders typically have not

registered as broker-dealers

with the Securies and

Exchange Commission (the

“SEC”), and generally are not in

compliance with state laws

applicable to broker-dealers

either. Finders have generally

been under the impression

(incorrectly) that they are exempt from those

requirements. While the SEC has proposed an

exempon that might provide nders some relief

Using a nder

may not be

legal in your

state…if it is,

there may be

compliance

requirements.

168

from the broker-dealer registraƟon requirement,

such exempƟve relief is not yet nalized and does

not appear to be on the SEC’s list of prioriƟes.

For now, if a nder acts in a manner that requires it

to be registered as a broker-dealer, and no

exempƟon applies, the nder must be registered

with the SEC and the Financial Industry Regulatory

Authority (“FINRA“). It is important to note that

state laws sƟll need to be complied with as well.

While some nders are familiar with the legal

requirements but ignore them, many others are

completely unaware that what they are doing is in

violaƟon of the law – but unfortunately, as the adage

goes, ignorance of the law is no excuse.

There is a signicant risk to the company when the

company engages a nder who is an unlicensed

broker-dealer. Agreements with new investors can

become void, and an investor potenƟally will be

granted rescission rights. These rescission rights will

essenƟally let the investor reverse their posiƟon and

receive a refund of their investment, which

essenƟally provides the investor a guarantee against

losing any money… if the investment works out, the

investor does not complain, but if the investment

does not succeed, the investor seeks rescission and a

refund of the failed investment.

Technically, the exempƟon which provides nders

relief from general broker-dealer licensing

requirements is not a statutory exempƟon, but

169

originates from a no-acƟon leƩer, where the SEC

stated it would not recommend enforcement acƟons

against nders where the nder was providing a

potenƟal list of investors in exchange for a

commission. However, the SEC claried that this was

based on the assumpƟon that (i) the nder had a

very limited role in negoƟaƟons, (ii) the business

introduced by the nder was a going concern (not a

shell company), (iii) the nder gave no opinion as to

the value of the securiƟes, or whether the company

should issue the securiƟes, (iv) the nder did not

assist anyone in obtaining any nancing, (v) the

nder did not prepare or

distribute materials about the

transacƟon, and (vi) the nder

was not engaged in due

diligence or any analysis

regarding the transacƟon. In

short, the nder is expected to

make the introducƟon and

then step out of the way. If

this is all the nder does, the

nder may be able to avoid registering as a broker-

dealer.

California has passed its own regulaƟons on this

topic. AŌer earlier legislaƟon had barred nders

completely, the state revised the law to permit

nders to operate in very limited circumstances.

A nder needs to

make the

introducƟon

then withdraw

from further

conversaƟon

with the

prospect.

170

In California, a nder must be a natural person and

must NOT take any of the following acƟons:

1. Provide services to an issuer for a

transacon or a series of related

transacons for the oer or sale of

securies of the issuer that exceeds a

securies purchase price of een million

dollars ($15,000,000) in the aggregate.

2. Parcipate in negoang any of the terms

of the oer or sale of the securies.

3. Advise any party to the transacon

regarding the value of the securies or the

advisability of invesng in, purchasing, or

selling the securies.

4. Conduct any due diligence on the part of

any party to the transacon.

5. Sell or oer for sale in connecon with the

issuer transacon any securies of the

issuer that are owned, directly or

indirectly, by the nder.

6. Receive, directly or indirectly, possession

or custody of any funds in connecon with

the issuer transacon.

7. Knowingly receive compensaon in

connecon with any oer or sale of

securies unless the sale is qualied under

California law or unless the security or the

transacon is exempt or not otherwise

subject to qualicaon.

8. Make any disclosure to a potenal

purchaser other than the following: (A) the

name, address, and contact informaon of

171

the issuer, (B) the name, type, price, and

aggregate amount of any securies being

oered in the issuer transacon, and (C)

the issuer’s industry, locaon, and years in

business.

In addion to complying with the above restricons

by California, the nder must also

1. At the same me as making the

introducon, provide each person the nder

introduces with a wrien agreement

disclosing (i) the nder’s compensaon, (ii)

the fact that the nder is not providing any

advice, (iii) disclosing whether the nder

owns any securies of the company, (iv)

disclosing any conicts of interest, and (v)

advising the party that they have the right

to pursue remedies at law for any breach of

the nder agreement.

2. Register with the State of California and pay

the ling fee (currently $300.00) to the

Department of Financial Protecon and

Innovaon, along with a statement of

informaon which includes the name and

address of the nder. Once registered, the

nder will be required to make annual

lings and pay annual renewal fees, at

which me the nder will need to disclose

any transacon-based compensaon

received in the prior 12 months.

172

The law regarding nders remains very unseƩled,

and companies choosing to use nders should

proceed very carefully. It is recommended that

companies using nders rst engage appropriate

legal counsel who can review the acƟviƟes of the

nder and provide guidance to help ensure that the

corporaƟon has not hired an individual who should

have registered with the SEC and FINRA as a broker-

dealer.

173

BASIC FORMATION DOCUMENTS

The core documentaƟon required to set up a

corporaƟon includes the following:

1. FormaƟon document – Depending on the

state of formaon, the document led with

the applicable Secretary of State for

purposes of forming a corporaon will be

Arcles of Incorporaon or a Cercate of

Incorporaon;

2. Bylaws – this document sets forth detailed

provisions governing the responsibilies of

the directors, shareholders and ocers of

the corporaon, the manner of calling and

holding meengs of the shareholders and

board of directors, and requirements for

reports to shareholders, maintenance of

corporate records, execuon of contracts,

and other miscellaneous maers pertaining

to the operang procedures and

governance of the corporaon. Essenally,

it serves as the “rules of the road” for how

the corporaon will operate. Each

corporaon is required by law to have

Bylaws adopted;

3. WriƩen Consents and/or OrganizaƟonal

Minutes – this group of documents will

cover the appointment/elecon of the

Board of Directors, appointment of ocers,

issuance of shares, and other inial and

ongoing operang maers;

174

4. Ownership Transfer Ledger (also called a

Stock Ledger)– this document sets forth the

shareholders, their addresses, number and

type of shares held, the purchase date of

the shares, the cercate numbers, and

price paid to the company for such shares;

5. Statement of InformaƟon (if California) or

other informaonal lings – in California,

this ling is due within 90 days aer

formaon, and states the company’s

principal place of business, its ocers and

directors, its agent of service, and type of

business (other states require similar lings,

e.g. annual reports);

6. SecuriƟes ling -due based on the sale(s) of

shares by the corporaon. In California, for

example, this is known as a 25102(f) ling;

7. Employer IdenƟcaƟon Number (“EIN”) of

the corporaon (this can be obtained online

at www.irs.gov);

8. If applicable, the corporaon’s Subchapter S

ElecƟon (Form 2553); and

9. Stock CerƟcates.

175

The core documentaƟon required to set up a limited

liability company includes the following:

1. FormaƟon document – Depending on the

state of formaƟon, the document led with

the applicable Secretary of State for

purposes of forming a corporaƟon will be

ArƟcles of OrganizaƟon or a CerƟcate of

OrganizaƟon;

2. OperaƟng Agreement – Every member of a

limited liability company must be a party to

the operaƟng agreement. It is the primary

document that denes the characterisƟcs of

the LLC, the relaƟonship of its members and

the duƟes of its members and managers (if

manager-managed). An operaƟng

agreement is required by law. While

statutes of states will vary, those rules and

procedures will apply to the LLC unless the

operaƟng agreement indicates otherwise;

3. WriƩen Consents and/or OrganizaƟonal

Minutes – this group of documents will

cover the appointment of the Manager (if

the LLC is manager-managed), issuance of

member interests, and other iniƟal

operaƟng and ongoing maƩers;

4. Ownership Transfer Ledger (also called a

Member Interest Ledger)– this document

ets forth the members, their addresses,

number and type of units held, date of

purchase, and price paid to the company for

such shares;

176

5. Statement of InformaƟon (if California) or

other informaƟonal lings – in California,

this ling is due within 90 days aŌer

formaƟon, and states the company’s

principal place of business, its members or

managers, its agent of service, and type of

business (other states require similar lings,

e.g. annual reports);

6. SecuriƟes ling - due based on the sale(s) of

units by the LLC. In California, for example,

this is known as a 25102(f) ling;

7. EIN (this can be obtained online at

www.irs.gov);

8. If applicable, the LLC’s Subchapter S ElecƟon

(Form 2553); and

9. Member Interest CerƟcates.

177

OBTAINING AN EIN

An employer idenƟcaƟon number, or “EIN" is a

unique nine-digit number that idenƟes your

business for tax purposes. You will need an EIN in

order to open your business bank account, apply for

business licenses, and le tax returns. An EIN is

required when a business has employees. However,

even a business without employees is required to

have an EIN if it operates as a corporaƟon or a

partnership; if they have no employees, a sole

proprietor or single-member LLC can use his or her

Social Security number or apply for an EIN. Many

sole proprietors and single-member LLCs choose to

secure an EIN for privacy reasons; with an EIN, they

do not have to provide their Social Security number

to other parƟes (such as when they need to

complete a W-9 for a client).

An EIN can be obtained online,

through a simple applicaƟon on the

IRS website (www.irs.gov).

Typically, you will be provided with

the EIN immediately at the end of

the EIN applicaƟon process. The applicaƟon process

takes about 10 minutes to complete, but make sure

that the applicaƟon is led out correctly before

submiƫng it electronically.

You can only apply for an EIN aŌer the corporaƟon,

LLC, or partnership is in existence. If formed as a

corporaƟon, prior to compleƟng the applicaƟon, you

Geƫng an

EIN is quick

and easy.

178

should seek advice from your CPA as to whether the

corpora�on will elect to be taxed as an “S

Corpora�on.” If formed as an LLC, then prior to

comple�ng the applica�on, you should seek advice

from your CPA as to whether the LLC will elect to be

taxed as a C Corpora�on, S Corpora�on, or

partnership (or a disregarded en�ty if the LLC has

only a single member).

On your applica�on, you will need to iden�fy a

“responsible party” and you will need to list the

responsible party’s Taxpayer Iden�ca�on Number

(i.e. social security number). A responsible party is

the person who ul�mately owns or controls the

en�ty or who exercises ul�mate eﬀec�ve control

over the en�ty. The responsible party must be an

individual (i.e. a natural person), not a legal en�ty

such as a corpora�on or LLC.

179

SHARE OFFERINGS AND SECURITIES

REGULATIONS

When you sell (“issue”) securi�es, a series of state

and federal regula�ons kick in. “SecuriƟes” are

nancial instruments which typically fall under the

broad categories of equity (such as stock and

member interests), debt (such as promissory notes),

derivaƟves (such as op�ons and warrants) and

hybrids (having equity-like and debt-like features,

such as conver�ble notes).

In addi�on to the federal

Securi�es Act of 1933 (the “1933

Act”), most states have enacted

their own securi�es laws as well,

referred to as “blue sky laws.” Any

issuance of securi�es must sa�sfy

both federal and state requirements, including the

registra�on of oﬀered securi�es, unless the security

is exempt from registra�on. Unless the security is

registered or qualies under an exemp�on, no

security may be transferred to another party.

In the event you fail to comply with federal and state

regula�ons, any purchaser who purchases a non-

exempt, non-registered security is en�tled to rescind

(void) the purchase and collect back any funds that

were paid for the security (and possibly, addi�onal

damages).

“Blue sky

laws” are the

securiƟes

laws of each

state.

180

Even if the security qualies as exempt from

registra�on, the company s�ll has “an�-fraud”

obliga�ons regarding the securi�es, such as the

obliga�on not to make untrue statements of material

fact or, conversely, omit material facts…what you

say in the course of oﬀering the securi�es must be

true, and you can’t leave out any informa�on that

would be material to an investor evalua�ng the

investment.

For purposes of this chapter, the focus will be on

private oﬀerings, where the securi�es are oﬀered by

the company to a small number of qualied investors

who understand and accept the risks of the

investment. Oﬀerings of securi�es by early-stage

companies are most commonly made under

Regula�on D which contains exemp�ons under Rule

504, Rule 506(b) and Rule 506(c).

Before discussing the exemp�ons, it is important to

understand the concept of an “accredited investor.”

An accredited investor is an investor who, because of

their wealth or experience, is deemed by the

government to be sophis�cated enough to fend for

themselves in investment opportuni�es. For those

who do not meet those qualica�ons, i.e. the non-

accredited investors, the securi�es laws impose

certain requirements if a company wishes to sell

securi�es to them, in order to provide some

addi�onal protec�ons for those non-accredited

investors.

181

How can individuals qualify as an accredited

investor?

Most oen, individuals qualify as an accredited

investor by having

 Net worth over $1 million, excluding their

primary residence (individually or with spouse

or partner), OR

 Income over $200,000 (individually) or

$300,000 (with spouse or partner) in each of

the prior two years, and they reasonably expect

the same for the current year

While it happens less frequently, individuals can also

qualify as accredited if they are

 Investment professionals in good standing

holding the general securies representave

license (Series 7), the investment adviser

representave license (Series 65), or the

private securies oerings representave

license (Series 82)

 Directors, execuve ocers, or general

partners (GP) of the company selling the

securies (or of a GP of that company)

 A “family client” of a “family oce” that

qualies as an accredited investor

 For investments in a private fund,

“knowledgeable employees” of the fund

182

How can enƟƟes qualify as an accredited investor?

En��es can qualify as an accredited investor by

 Owning investments in excess of $5 million

 Being a corpora�on, partnership, LLC, trust, 501

(c)(3) organiza�on, employee benet plan,

“family oﬃce” or any “family client” of that

oﬃce, any of the forgoing having assets in

excess of $5 million

 Being an en�ty in which all equity owners

individually meet the accredited investor test

 Being an investment adviser (SEC- or state-

registered or exempt repor�ng advisers) or a

SEC-registered broker-dealer

 Being a bank, savings and loan associa�on,

insurance company, registered investment

company, business development company,

small business investment company or rural

business investment company

With the knowledge of what

cons�tutes an accredited investor,

the next step is evaluaƟng which

exempƟon would be most

appropriate for your oﬀering. For

this analysis, we will focus on exemp�ons under Rule

504, 506(b) and 506(c).

How much can be raised from the sale of securiƟes?

Under Rule 504: Up to $10 million within a 12-month

period

Knowing

whether an

investor is

“accredited”

is criƟcal.

183

Under Rule 506(b) and 506(c): There is no limit

Who can invest in the securiƟes?

Under Rule 504: Anyone

Under Rule 506(b): An unlimited

number of accredited investors,

and up to 35 non-accredited

investors

Under Rule 506(c): An unlimited

number of accredited investors, but NO non-

accredited investors

What informaƟon needs to be provided to

investors ?

Under Rule 504: No specic informa�on is required,

but best pracƟce is to provide informaƟon about the

investment, the risk factors, and that the investment

is a high-risk investment that may result in complete

loss of capital. InformaƟon provided must be free of

any material misstatements, and there must be no

omissions of material fact.

Under Rule 506(b): No specic informa�on is

required to be provided to accredited investors, but

best pracƟce is to provide informaƟon about the

investment, the risk factors, and that the investment

is a high-risk investment that may result in complete

loss of capital. Non-accredited investors must

receive extensive disclosure, similar to registering an

oﬀering with the SEC. All informaƟon provided must

Only

accredited

investors are

allowed under

Rule 506(c).

184

be free of any material misstatements, and there

must be no omissions of material fact.

Under Rule 506(c): No specic informaƟon is

required, but best pracƟce is to provide informaƟon

about the investment, the risk factors, and that the

investment is a high-risk investment that may result

in complete loss of capital. InformaƟon provided

must be free of any material misstatements, and

there must be no omissions of material fact.

How do you demonstrate the investor is accredited?

Under Rule 504: It's not required

Under Rule 506(b): The investor

provides a statement with

informaƟon supporƟng their

accredited status, and the

company can reasonably rely on

that statement

Under Rule 506(c): The company

must ac�vely verify the investor

is accredited, by using third party

resources or by reviewing

investor nancial informaƟon

Can you adver�se the oﬀering?

Under Rule 504: No general solicitaƟon or general

adverƟsing is allowed

Under Rule

506(b), you

can rely on

the

statements as

to accredited

status….under

Rule 506(c),

you need to

verify that

informaƟon.

185

Under Rule 506(b): No general solicitaƟon or general

adverƟsing is allowed; sales are

permiƩed only to investors with

whom there is a pre-exisƟng

relaƟonship

Under Rule 506(c): The are no

limitaƟons on adverƟsing

Does the oering also need to comply with state

blue sky laws?

Under Rule 504: Yes. Depending on the jurisdicƟon,

compliance with Rule 504 alone may not saƟsfy state

law requirements.

Under Rule 506(b): No. Compliance with Rule 506(b)

saƟses state law requirements, although a noƟce

that securiƟes have been sold may be required by

the state.

Under Rule 506(c): No. Compliance with Rule 506(c)

saƟses state law requirements, although a noƟce

that securiƟes have been sold may be required by

the state.

As a praccal maer, any securies oered under

Rule 506 should be oered only to accredited

investors. While Rule 506(b) does allow sales to non-

accredited investors, the burden of the informaƟon

disclosure requirements outweighs the benets of

selling to non-accredited investors. Another factor

to consider is that non-accredited investors will

Only Rule 506(c)

allows for

general

adverƟsing.

186

typically invest less, will be less able to aﬀord the

loss of their investment, and will most typically be

the par�es who sue if the investment does not work

out as hoped. Non-accredited investors should only

be accepted under a Rule 504 oﬀering, and even in

that case, it is generally not advisable.

Rule 504 Rule 506(b) Rule 506(c)

Limit of

oﬀering

size?

$10MM in a

12 month

period

No limit No limit

Who can

invest?

Anyone 35 or less non-

accredited,

unlimited ac-

credited

Only accredit-

Info to

provide to

investors?

No require-

ment

No requirement

for accredited,

extensive for

non-accredited

No require-

ment

Conrm

investor is

accredited?

No require-

ment

Can rely on

investor state-

ments

Need to ac-

�vely verify

General

Adver�s-

ing?

No No Yes

S�ll need

to comply

with blue

sky laws?

Yes No, but no�ce

may be required

No, but no�ce

may be re-

quired

187

CORPORATE TRANSPARENCY ACT

The Corporate Transparency Act (“CTA”), eecve

January 1, 2024, is recent federal legislaon enacted

to combat money laundering and terrorism nancing

through United States enes. The CTA requires

certain business enes to le Benecial Ownership

Informaon (“BOI”) and Reporng Company

Informaon with the U.S. Department of the

Treasury’s Financial Crimes Enforcement Network

(“FinCEN”). Benecial ownership informaon refers

to idenfying informaon about the individuals who

directly or indirectly own or control a company.

Reports must be submied electronically. FinCEN has

developed an online system to submit the

informaon, named the “Benecial Ownership

Secure System (BOSS).” Only “Reporng Companies”

are required to report

A BOI ling integrates three classes of parcipants:

Repor�ng Companies, Benecial Owners, and

Applicants.

Only companies falling under the denion of

Reporng Companies are required to report BOI and

enty informaon to FinCEN. A “Repor�ng

Company” is a domes�c or foreign en�ty that is (i) a

corpora�on, (ii) a limited liability company, or (iii)

any en�ty created (or a foreign en�ty registered in

the U.S.) by the ling of a document with a

secretary of state, or any similar oﬃce under the

188

law of a state or Indian tribe. It does not maer

how long ago the enty was formed.

Generally, trusts are exempted from reporng, as are

23 categories of exempt enes. The 23 exempted

enƟƟes include (i) securies reporng issuers, (ii)

governmental authories, (iii) banks, (iv) credit

unions, (v) depository instuon holding companies,

(vi) money services businesses, (vii) brokers or

dealers in securies, (viii) securies exchanges or

clearing agencies, (ix) other Exchange Act registered

enes, (x) investment companies or investment

advisers, (xi) venture capital fund advisers, (xii)

insurance companies, (xiii) state-licensed insurance

producers, (xiv) Commodity Exchange Act registered

enes, (xv) accounng rms, (xvi) public ulies,

(xvii) nancial market ulies, (xviii) pooled

investment vehicles, (xix) tax-exempt enes (e.g.

organizaons formed under 501(c), 527(e)(1) or 4947

(a)), (xx) enes assisng tax-exempt enes, (xxi)

large operang companies, (xxii) subsidiaries of

certain exempt enes, and (xxiii) inacve enes.

For a company to qualify for the “large operaƟng

company” exempƟon, the company must have (i)

more than 20 full-me employees in the U.S., (ii)

more than $5 million in gross receipts or sales from

U.S. sources, as evidenced from the federal income

tax return led in the previous year, AND (iii)

operaons in a physical oce located in the U.S. All

of these condiƟons must be met to qualify for this

exempƟon. The large operang company exempon

189

requires that the enƟty itself employ more than 20

full-Ɵme employees in the United States;

consolidaƟon of this employee count across mulƟple

enƟƟes is not permiƩed.

To qualify for the “inacƟve enƟty” exempƟon, the

enƟty must (i) have been formed prior to January 1,

2020, (ii) not have engaged in any business acƟvity,

(iii) not be owned by a foreign person and not have

had a change of control in the prior 12 months; (iv)

not have paid or received funds in an amount greater

than $1,000 in the prior 12 months; and (v) hold no

assets or interests in any other enƟty (i.e. not a shell

company). Again, all of these condiƟons must be met

to qualify for this exempƟon.

To qualify for the “tax-exempt enƟty” exempƟon,

any of the following four criteria must apply: (a) the

enƟty is an organizaƟon that is described in secƟon

501(c) of the Internal Revenue Code (“Code”) and

exempt from tax under 501(a) of the Internal

Revenue Code, (b) the enƟty is an organizaƟon that

is described in secƟon 501(c) of the Internal Revenue

Code, but lost its tax-exempt status less than 180

days ago, (c) the enƟty is a poliƟcal organizaƟon, as

dened in 527(e)(1) of the Code or (4) the enƟty is a

trust described in paragraph (1) or (2) of secƟon

4947(a) of the Code.

190

Who are Benecial Owners?

A “Benecial Owner” is any individual who owns or

controls 25% or more of the ownership interest in

the ReporƟng Company and/or any individual who

exercises “substanƟal control” over the ReporƟng

Company.

It is important to note that all

Bene

cial Owners are

individuals. In the event an

owner is an enƟty (such as a

corporaƟon or LLC), the

reporƟng Company must look

through the enƟty to its

individual owners.

For example, assume the

ReporƟng Company has three

owners: Individual A at 50% ownership, Individual B

at 40% ownership, and Individual C at 10%

ownership, as well as a President who owns no

equity. In such a case, BOI lings must include

Individual A and Individual B (based on ownership of

25% or more) and the President (based on

substanƟal control).

If we assume the same scenario, but assume the

owners are Individual A at 50% ownership, EnƟty B at

40% ownership (EnƟty B being held 50% each by

Individual X and Individual Y), and Individual C at 10%

ownership, then the ling obligaƟons will change.

Benecial

owners are

people…if a

company is the

owner, you need

to drill down to

the individual

owner level.

191

Individual X and Individual Y, by virtue of each owing

50% of EnƟty B, are each deemed to own 20% of the

ReporƟng Company (i.e. EnƟty B’s 40% of ReporƟng

Company mulƟplied by their 50% interest in EnƟty B

= 20%). Thus, under this revised set of facts, only

Individual A will be deemed to exceed the 25%

ownership threshold.

For purposes of LLCs and other enƟƟes issuing capital

or prot interests (including enƟƟes treated as

partnerships for federal income tax purposes),

ownership interests are based on the individual's

capital and prot interests in the enƟty…a right to

receive 25% or more of distribuƟons will trigger a BOI

ling requirement, even if ownership is less.

For example, if ve members of an LLC each hold a

20% ownership interest in the LLC, but the prots are

split 30%, 30%, 30%, 5%, 5%, then the company will

need to make BOI lings on the three members

receiving 30% prot distribuƟons. If either of the 5%

owners is in a substanƟal control posiƟon, such as a

manager, a BOI ling will need to be led for that

individual as well.

The deniƟon of “ownership interest” is very broad,

including any ownership of (i) stock, (ii) capital or

prots interest (“units”) in an LLC or partnership, (iii)

any converƟble instrument (e.g., converƟble debt,

SAFEs), (iv) any puts, calls, opƟons, and warrants,

and (v) anything else used to establish ownership.

192

There are no excep�ons for future/con�ngent

conversion rights.

Individuals having “substanƟal control” include (i)

senior oﬃcers, (ii) those with authority to appoint or

remove certain oﬃcers or a majority of directors,

and (iii) other important decision-makers, including

any individuals with any other form of signicant

inuence over the Repor�ng Company. In short, the

deni�on requires a BOI ling for anyone who is able

to make important decisions on behalf of the

Repor�ng Company.

Examples of direct ways to exercise substanƟal

control over a repor�ng company include: being

represented on the board, ownership or control of a

majority of the vo�ng power, or rights that are

associated with nancing or interest. Examples of

indirect ways to exercise substanƟal control over a

repor�ng company include: controlling one or more

intermediary en��es that separately or collec�vely

exercise substan�al control over a Repor�ng

Company, or exer�ng control through arrangements

or nancial or business rela�onships with other

individuals ac�ng as agents.

Benecial owners can own or control a Repor�ng

Company through trusts. They can do so by either

exercising substan�al control over a Repor�ng

Company through a trust arrangement or by owning

or controlling the ownership interests of a Repor�ng

Company that are held in a trust. If the trust is a

193

benecial owner, the trustees are to be reported.

The registraon of a trust with a court of law merely

to establish the court’s jurisdicon over any disputes

involving the trust does not make the trust a

reporng company.

Filing ExempƟons

Individuals who are exempted from the reporng

requirements are (1) minor children (2) nominees,

intermediaries, custodians or agents (3) employees,

(4) inheritors, and (5) creditors.

An individual qualies for a minor child excepon if

they are a minor child residing in the state in which

the Reporng Company was rst created, and where

a parent or legal guardian’s informaon is being

reported in lieu of the minor child’s informaon.

An individual qualies for the nominees,

intermediaries, custodians or agents excepon if

they are performing ordinary advisory or other

contractual services (such as tax professionals or

aorneys) to the Reporng Company.

Employees are exempt from ling if (i) any

substanal control is derived solely from their

employment status and (2) that employee is not a

senior ocer of the reporng company.

If an individual’s only interest in the reporng

company is a future interest through a right of

194

inheritance, they qualify for the inheritor’s

excep�on.

An individual qualies for the creditor excep�on if

the individual is en�tled to payment from the

Repor�ng Company to sa�sfy a loan or a debt, so

long as this en�tlement is the only ownership

interest that the individual has in the Repor�ng

Company.

Homeowners’ associa�ons (HOAs) may be required

to report if they are not recognized by the IRS as a

sec�on(c)(4) organiza�on and are incorporated by

ling documents with a secretary of state or a similar

oﬃce.

Who are Company Applicants?

An “Applicant” is the individual (i) who directly les

the document that rst forms or registers the

enƟty, or (ii) who is primarily responsible for

direcƟng or controlling the ling of the relevant

document by another. A Repor�ng Company may

not have more than two (2) Applicants.

Applicants of preexis�ng en��es that were formed

prior to January 1, 2024, are exempt from any ling

requirement.

What are the ReporƟng requirements?

As to the company itself, the Repor�ng Company

must report the following informa�on:

195

Full legal name & any trade name;

Principal place of business address;

JurisdicƟon of formaƟon / registraƟon; and

Tax IdenƟcaƟon Number or EIN.

As to the Benecial Owners and Applicants, the

ReporƟng Company must report the following

informaƟon:

Required Applicant/Benecial Owners

InformaƟon:

Full Legal Name;

Date of Birth;

Current ResidenƟal Address; and

Non-Expired U.S. IdenƟcaƟon Document,

or a Foreign Passport (including an image of

the idenƟcaƟon document).

When is the ReporƟng due?

For those ReporƟng Companies that were formed or

registered before January 1,2024, the CTA iniƟally

required they report BOI for their Benecial Owners

(but not any Applicants) no later than January 1,

2025.

Generally, ReporƟng Companies must report BOI for

both their Benecial Owners and Company

196

Applicants within 30 days aer formaon or

registraon.

If there are any changes in the idenes of Benecial

Owners or to any BOI informaon (including change

of address, passport numbers, etc.), a Reporng

Company will be required to le an updated report

with FinCEN within 30 days of the change, regardless

of when the Reporng Company learns of it.

FinCEN IdenƟers

Reporng Companies, Benecial Owners and

Applicants can each obtain a numerical “FinCEN

Idener” which may be supplied to the ler instead

of the detailed informaon. For example, an

aorney ling the enty (and who, by doing so,

becomes an Applicant), may choose (for privacy or

security reasons) to provide the Reporng Company

with his or her FinCEN Idener, instead of providing

the Reporng Company with his or her date of birth,

passport, and residence.

In the event someone is a

Benecial Owner of mulple

Reporng Companies, a FinCEN

Idener will be a more

ecient way of providing

informaon. Further, if any

changes need to be made, the

change can be made to the FinCEN Idener, instead

of having to update each Reporng Company ling.

If you will be

part of mulƟple

lings, consider

geƫng a FinCEN

IdenƟer.

197

Foreign EnƟƟes

In addiƟon to companies that are in the 50 states

and the District of Columbia, a company that is

created or registered to do business in a U.S.

territory will be required under the CTA to report

benecial ownership informaƟon to FinCEN. U.S.

territories include the Commonwealth of Puerto

Rico, the Commonwealth of the Northern Mariana

Islands, American Samoa, Guam, and the U.S. Virgin

Islands.

A foreign enƟty needs to report benecial ownership

informaƟon to FinCEN if they have registered to do

business in the United States by ling a document

with a government agency to obtain (1) an IRS

employer idenƟcaƟon number (2) a cƟƟous

business name, or (3) a professional or occupaƟonal

license that does not create a new enƟty.

Who can use BOI informaƟon?

The informaƟon collected pursuant to CTA lings is

collected on a secure, non-public database. While

the informaƟon will not be made public, it would be

available to federal, state, local, and trusted foreign

agencies for law enforcement purposes. The

informaƟon is not subject to requests under the

Freedom of InformaƟon Act.

198

Those who could access the CTA informa�on include:

Federal agencies, if engaged in na�onal

security, intelligence, and civil and criminal

law enforcement

State, local, and tribal law enforcement

agencies, if “a court of competent

jurisdic�on” rules that those agencies

should be allowed access to that

informa�on

“Trusted” foreign law enforcement, if

obtained via an intermediary U.S. federal

agency

The Department of the Treasury, if in

connec�on with its oﬃcial du�es, including

tax administra�on

Financial insƟtuƟons, in order to meet

customer due diligence requirements

under applicable law, but only if the

Repor�ng Company consents to the search

Benecial ownership informa�on reported to FinCEN

will be stored using rigorous informa�on security

methods and controls typically used in the federal

government to protect non-classied yet sensi�ve

informa�on systems at the highest security level.

FinCEN will work closely with those authorized to

access benecial ownership informa�on to ensure

199

that they understand their roles and responsibiliƟes

in using the reported informaƟon only for authorized

purposes and handling in a way that protects its

security and condenƟality.

What if a ReporƟng Company fails to report?

PenalƟes may be assessed when there is a failure to

report, or a failure to report accurately. It is unlawful

for any person to willfully provide false or fraudulent

BOI, or to willfully fail to report a complete BOI and

update that BOI when informaƟon changes.

However, no penalƟes will trigger in the event an

individual who provides inaccurate informaƟon (i)

did not know about the inaccuracy, (ii) was not

aƩempƟng to evade reporƟng requirements; and (iii)

corrects inaccurate informaƟon “voluntarily and

promptly,” but no more than 90 days aŌer

submission of the inaccurate ling.

FinCEN will consider all facts relevant to a

determinaƟon of willfulness when deciding whether

to pursue enforcement acƟons. Civil reporƟng

penalƟes are currently $500 per day for each day of

an outstanding violaƟon, up to $10,000. Criminal

penalƟes are currently up to a maximum of 2 years

imprisonment.

If an individual misuses the CTA ling informaƟon, it

can result in criminal nes up to $250,000 and 5

years imprisonment.

200

What if previously reported informaƟon changes?

If there are any changes to the required informaon

about the Reporng Company or its benecial

owners, your company will be required to le an

updated BOI report no later than 30 days aer the

date on which the change occurred. The same 30-day

meline applies to changes in informaon submied

by an individual in order to obtain a FinCEN

idener.

The following are examples of changes that would

require an updated BOI report: (i) any change to the

informaon reported for a reporng company, such

as registering a new DBA, (ii) a change in benecial

owners, such as a new Chief Execuve Ocer (or

another person now having substanal control) or

upon a sale that changes the ownership interest

threshold of 25% ownership (iii) or any change to a

benecial owner’s name, address, or unique

idenfying number provided in a BOI report.

Further, when a benecial owner that was a minor

child reaches the age of majority (18 to 21 years old,

depending on the state), you must le an updated

BOI report, idenfying the individual as a benecial

owner.

Updated BOI reports should be led electronically

though the secure ling system. There is no

requirement to report a company’s terminaon or

dissoluon.

201

Senior Oﬃcer Liability

Importantly, senior oﬃcers of a

Repor�ng Company that fail to

le a required BOI report may

be held personally accountable

for that failure. For example,

should the Repor�ng Company

fail to le, and then a $10,000

ne be assessed, the senior oﬃcers may be

responsible for paying the ne in the event the

Repor�ng Company lacks the means to do so.

Failing to le a

BOI report can

create liability

for the oﬃcers

of the company.

202

NOTES

_______________________________________

203

AN INTELLECTUAL PROPERTY

OVERVIEW

The Four Pillars of Intellectual Property

Intellectual property refers to those intangible

crea�ons of the human mind…those ideas, designs,

methods, sayings, and so forth that have value…but

unlike tangible property, intellectual property can’t

be protected by locking it in a safe.

Intellectual property falls into one of four categories:

1. Copyrights

2. Trademarks

3. Patents

4. Trade Secrets

Each of these will be discussed in detail, but in

general:

Copyrights are used to protect original works of

authorship xed in any tangible medium of

expression, including wri�

ngs, artwork,

choreography, songs, movies, etc. Copyrights are

exclusively governed by federal law (specically, the

U.S. Copyright Oﬃce).

Trademarks are words, phrases, logos and symbols

used in conjuncƟon with certain goods or services.

Shapes, sounds, fragrances and colors may also be

You may have

mulƟple ways to

protect your IP…

consider all of

them!

204

registered as trademarks. Trademarks are issued and

monitored by the federal government (the Patent

and Trademark Oﬃce), but they may also be

regulated by state law.

Patents grant a patent holder

the exclusive right to make,

use, import and sell the

patented innova�

on, in

exchange for disclosing all

details about the inven�on.

Patents are exclusively

governed by federal law (the Patent and Trademark

Oﬃce).

Trade secrets can be viewed as the opposite of a

patent. With a patent, a patent holder is granted

exclusive use for a period of �me in exchange for full

disclosure about the inven�on. Trade secret law

allows a party to keep the idea a secret, and prevent

others from using it, so long as the secrecy is

maintained (note that in some limited scenarios,

such as where there is addi�onal informa�on related

to your patent which is not required to be disclosed,

your patented inven�on might also have aspects that

qualify as a trade secret). The Uniform Trade Secrets

Act, adopted by most states, provides protec�ons in

regard to trade secrets. However, unlike patents, if

someone obtains the same trade secret by lawful

means (such as independently discovering the same

idea later), the second party cannot be prevented

With a patent,

you reveal all…

with a trade

secret, you

reveal nothing.

205

from using the trade secret or from revealing it to

others.

Which method of intellectual property protecon is

best will depend on the facts and circumstances. For

example, suppose a sculptor has discovered a

process in which she treats the molds in a certain

manner, allowing her to accelerate producon of

sculptures. Even though that process might qualify as

a patentable process, she may decide, based on the

cost of securing a patent and the cost and diculty

of enforcing the patent, that it might be best to keep

that process as a trade secret, rather than revealing

it to the world.

Creators, whether an arst, designer, or a

mechanical engineer, may oen nd that they can

employ mulple forms of intellectual property

protecon:

 the work itself may be copyrighted

(painngs, soware code, non-funconal

design elements, etc.);

 the product’s brand, or the creator’s brand

(e.g. Ralph Lauren®) may be trademarked;

 a customer list may be protected by trade

secret; and

 the product itself and/or the processes to

create it may be the subject of a trade

secret or patent.

206

Knowing your opƟons will help you decide the best

way to protect the creaƟons of you and your

company…every creator, and every company, has

intellectual property to protect, so read on, and

let’s learn how to protect it!

207

COPYRIGHTS

What can be protected by copyright?

such as literary works, musical works, dramaƟc

works, pictorial and sculptural works, moƟon

pictures, audiovisual works and architectural works.

The type of arƟsƟc expression protected by copyright

law is broad, ranging from the familiar to the less

expected, including artwork,

soŌware code, cartoons,

posters, fabric designs, games,

puzzles, collages, toys, bumper

sƟckers, jewelry designs,

sculpture, stained glass designs,

technical drawings, architectural

drawings, weaving designs,

plays, movies, choreography,

and even pantomime.

What is not protected?

Ideas cannot be protected

under copyright law. Neither can

discoveries, principles, formulas,

procedures, processes, systems,

methods of operaƟon, and

concepts. Also, words, symbols,

Ɵtles, slogans and short phrases

Authorship vs.

idea:

J.K. Rowling

can copyright a

Harry PoƩer

book (a work),

but she can’t

keep someone

else from

wriƟng a book

about a young

boy who goes

to a school to

learn magic (a

concept or

idea).

208

cannot be copyrighted (but as discussed later, can

potenƟally be protected under trademark law).

Under copyright law, the copyright owner has the

exclusive right to make copies, prepare derivaƟve

works, sell or distribute copies, and display the work

in public. Anyone else doing so, without permission,

will infringe upon those intellectual property rights.

How is a copyright created? Do I need to le

something?

Prior to March 1, 1989, it was required that the

works that were published. Omiƫng the noƟce on a

work published before that date would mean the

work lost copyright protecƟon (unless the omission

was cured within ve years following publicaƟon).

 The word “Copyright” or the © symbol;

 The date of publicaƟon; and

 The copyright owner’s name.

2013 John Smith.”

For works created on or aŌer March 1, 1989, use of

the copyright noƟce is opƟonal. So, are you required

to put the copyright noƟce on your works? No. Is it a

good idea to do it anyway? Yes.

209

At the very least, placing the copyright line may

prevent your copyrighted material from being used

by someone else who does not understand you hold

a copyright to that work. For maximum protecon

and ability to collect damages, you should also le

the created work with the Copyright Oce.

PublicaƟon is achieved when there is distribuon of

copies of the work, by sale, rental, lease or lending.

Even the oering of copies for distribuon or display

constutes publicaon; however, when only a single

work exists, such as an original painng or a unique

sculpture, public display does not constute

publicaon. Publicaon is an important concept, as it

will impact the type and number of copies that will

need to be submied when copyright registraon is

applied for.

How long does a copyright last? What happens aŌer

that?

The simple answer is that, for any qualifying work

created on or aŌer January 1, 1978, copyright

protecon for individuals lasts for the life of the

author (i.e. the creator) plus an addiƟonal 70 years;

if created by an enty (such as by Disney arsts), it

will last for 120 years aŌer creaƟon or 95 years aŌer

publicaƟon, whichever is less.

If you are looking to use someone else’s creave

work in any way, determining when a copyright

expires can be important; once a copyright expires,

210

the work is in the public domain and anyone can

freely use it. However, depending on when a work

was created, calcula�ng the dura�on of the copyright

is not as easy as it might seem. To answer it, you may

need to explore mul�ple versions of the U.S.

and the 1998 Sonny Bono Copyright Term Extension

Act, looking at when each copyright period started

and when it expired.

For works created before January 1, 1978, each work

was protected by a common law copyright when it

was created, which ran un�l the work was published.

Upon publica�on, the owner had to comply with the

1909 Act requirements (including aﬃxing a copyright

no�ce to the work); if not, the work entered the

public domain. If federal copyright protec�on was

secured, the copyright ran for 28 years, with a

poten�al renewal of another 28 years (with another

possible extension under a later Act).

The Copyright Act of 1976, which is now the basis for

U.S. copyright law, changed the star�ng point of

date of creaƟon. Under the 1976 Act, copyright

protec�on generally lasted for the life of the author

plus an addi�onal 50 years, or 75 years from crea�on

for corporate authorship (such as Disney).

As if that wasn’t complex enough, the 1998

extending protec�on of the author to life plus 70

211

years, and for works of corporate authorship to 120

years aŌer creaƟon or 95 years aŌer publicaƟon,

whichever is earlier.

At some point, however, copyrights expire…and

when they do, they cannot be renewed. At that

point, the work enters the public domain and is

available for use by anyone, anyƟme, anywhere,

without restricƟon.

So, what is the boƩom line when calculaƟng the life

of a copyright? Generally speaking,

 For works created on or aŌer January 1,

1978, copyright protecƟon lasts for the life

of the author plus an addiƟonal 70 years (or

for corporate authorship, 120 years aŌer

creaƟon or 95 years aŌer publicaƟon).

 As of 2024, any work published before

January 1, 1929 would have now entered

the public domain.

 Works which fall in between these dates

need to be reviewed on a case-by-case

basis, as numerous factors will inuence

whether the work has entered the public

domain, including whether it was published,

and if so, when it was published.

 How do you nd the relevant dates? In a

book, the publicaƟon date should be right

inside the cover. For other works, searching

212

the Library of Congress website

(www.loc.gov) and the Copyright Oﬃce

website (www.copyright.gov) can help you

determine the publica�on dates of many

crea�ons.

One nal point to keep in mind regarding public

domain works…although certain works may now be

in the public domain, new works incorpora�ng the

public domain work into new treatments may s�ll be

protectable under copyright law, such as Andy

Warhol’s contemporary images of the Mona Lisa.

Before you use a work you think is now in the public

domain, it is important to conrm whether it is (or is

not). Otherwise, your ac�ons may cons�tute

What is registraƟon? How expensive is it? Do I need

a lawyer to do it?

when you 

le your

receive a registra�on

number, and that ling will

serve as evidence of the fact

that you created the work

on or before your ling

date. The process is fairly

simple, does not require a

lawyer, and is denitely something you can learn to

A basic registraƟon

can be done online

for as low as $45!

At that price,

it’s easy to register

the creaƟve works

you think most

important to

protect.

213

do on your own; if you don’t feel comfortable with it

(or if you have a more complicated ling), it might be

worth hiring a lawyer to help on the rst ling or

two, and then maybe you’ll be able to y solo from

there.

What is infringement?

As a copyright holder, those who violate your

Infringement ul�mately rests on a nding of

substanƟal similarity from an ordinary observer’s

point of view. This “audience test” is a subjec�ve test

and has been used by many courts and modied

many ways, but it essen�ally asks whether someone

who was not trying to determine the ways in which

two works diﬀered would generally overlook those

diﬀerences and regard the two works as the same.

Put another way, it asks whether the defendant

wrongfully copied so much of the plain�ﬀ’s work to

cause the average person to immediately see the

two works as similar, without anyone sugges�ng to

that person how the works are similar.

Hopefully, before your work is infringed upon, you

have already completed two things:

1. Your work already has a copyright noƟce

on it (i.e. © John Doe 2017). While not

required for copyright protec�on, it is the

214

rst step in proving the infringement was

intenonal; and

2. You have already led your copyright with

the U.S. Copyright Oﬃce. If you have not,

you should do so immediately upon learning

of the infringement; however, you won’t be

entled to certain benets if this is done

aer the infringement occurs. For example,

if you register your copyright prior to the

infringement, even if you can’t prove actual

damages, you can obtain statutory damages

that range between $750 and $150,000 per

act of infringement.

The next step is to serve the party with a cease-and-

desist le�er. This warning leer idenes your work,

states that you own the copyright to the work,

idenes the infringing acts they have taken, and

orders that all infringement cease immediately or

else you will le legal acon against them. If you

have led your copyright already and have the

cercate back from the U.S. Copyright Oce, you

should aach that to your leer as well. If the

infringing product is being sold online, you should

also send a takedown noce to the Internet host

service, which informs them of your rights to the

copyrights and noes them of the links which have

infringing products.

The next step will be to le a lawsuit in Federal

Court, where you’ll have several remedies:

215

 requesng restraining orders and

injuncƟons

, to prevent further

infringement;

 requesng monetary damages; and

 in some cases, being awarded aƩorney’s

fees.

Damages against innocent infringers (i.e. those who

honestly believed their use was “fair use”) are

typically less steep than willful infringers. While

innocent infringers have to stop infringing and may

have to pay a reasonable royalty rate for their use of

the image, that may be the extent of their liability.

Intenonal infringement carries much steeper

penales. As menoned, statutory damages can

range between $750 and $150,000 per act of

infringement.

Addionally, if you believe the infringement rises to

the level of a criminal oense, you may be able to le

a criminal complaint with the FBI’s Intellectual

Property Fraud Unit. Criminal prosecuon typically

requires that the wrongdoer connued infringement

aer your warning leer and commied those

infringements for nancial gain. Penales can range

from ve years in prison to a $500,000 ne.

The Fair Use Doctrine

Fair use is a concept under copyright law that allows

someone who is not the copyright owner to sll use

216

the copyrighted materials for certain limited

purposes. This includes using copyrighted works for

purposes such as cri�cism, comment, news

repor�ng, teaching, scholarship and research.

Sec�on 107 of the U.S. Copyright Act addresses four

factors for evalua�ng whether a use falls under the

fair use excep�on:

1. The purpose and character of the use, including

whether the use is of a commercial nature or is for

nonprot educaƟonal purposes

Is the purpose of the use to make money?

Courts are more likely to nd non-commercial uses

to be fair use, such as nonprot educa�onal use.

However, in some cases, non-commercial use can be

found to not be fair use, where certain commercial

use is found to be fair use.

Is the use transforma�ve?

If the use creates something new or has a much

diﬀerent purpose or character, the use is more likely

to be considered fair.

While this commercial nature component is an

important factor, the balancing test looks at the

purpose and character of use along with the other

factors below.

217

2. The nature of the copyrighted work

How creaƟve is the work?

The more creaƟve, the less likely that fair use claims

will prevail. Use of creaƟve works, such as songs,

books and poems are less likely to be considered fair

use, as opposed to works that are more factual in

nature (such as news reports and technical manuals).

Has the work been published? If not, it is less likely

that a fair use excepƟon will apply.

3. The amount and substanƟality

of the porƟon used in relaƟon to

the copyrighted work as a whole

How much of the work was

used?

The greater the amount of the

work that is used, the less likely fair use will be

found. Contrary to a common belief that you can use

a certain percentage without violaƟng a copyrighted

work, there is no percentage of use that creates a

safe harbor.

If a small part of the work was used, how “core” to

the work is that part?

Using a very small part of the work can be found to

not be fair use if it is the “heart” of the work, such as

a summary of a biography which excerpts the most

unique and interesƟng stories.

What is used,

not how much

is used, is more

of the focus in

fair use review.

218

Since it is only one factor in the four-part test, it is

possible that using the en�re work can s�ll be found

to be fair use under some scenarios.

4. The eﬀect of the use upon the poten�al market

for or value of the copyrighted work

Does the use impact the value of the underlying

When the current or future market value of the

copyrighted work is negaƟvely impacted, fair use is

less likely to be found. For example, if the use of a

video by a news outlet impacts the ability of the

videographer to sell the video to other news outlets,

fair use is less likely to be found.

Because fair use is determined by weighing the

above four factors, and potenƟally other factors, it is

always a case-by-case analysis. There are no bright-

line rules; but the rst and fourth factors (purpose

and character of the use, and the eﬀect on the

poten�al market) are usually the most inuenƟal.

Keep in mind that images posted on social media,

whether on TwiƩer, Facebook or other social

networking plaƞorms, are protected by copyright

just as much as those printed in a book. While social

media plaƞorms are built for “sharing” and are less

formal, use of images from such sites must sƟll meet

the same fair use excepƟons. Similarly, just because

you nd an image on a website, that does not mean

it is available to grab and use…even the use of

219

somewhat innocuous items like photos of furniture

or signs can later be found to be an infringing use.

Finally, remember that just because use is related to

one of the general excepƟons, such as criƟcism or

news reporƟng, nding fair use is not automaƟc. For

example, use of someone else’s photograph in your

news story may not be permiƩed under the news

reporƟng excepƟon unless the photograph itself is

the news story. Use of an image on a t-shirt

distributed to students at a school may not fall under

the “teaching” excepƟon.

The fair use excepƟon essenƟally grants the right to

use someone else’s copyrighted, creaƟve expression

without their permission, but the excepƟon is

narrow. If you intend to be an unlicensed user of

someone else’s copyright, your use should be

evaluated very carefully before you move ahead with

it.

Use of Someone Else’s Copyrights in Your Work

Let’s assume you have found a photograph taken by

someone else that you wish to use as a “source

work” in your work. Assuming there’s no quesƟon

that the photograph is sƟll protected by copyright,

are you allowed to use it? UlƟmately, the answer to

this quesƟon revolves around fair use, discussed

earlier in detail.

You are permiƩed to use other copyrighted works

within your own work provided your own work is

220

suciently transformaƟve. For example, creang a

sculpture from a photograph where every eort is

made to make the sculpture a three-dimensional

representaon of that photograph will not be

suciently transformave. However, the use of a

poron of the copyrighted work in a collage may

avoid a copyright infringement claim.

People are oen inspired by the work of others, and

it is not unusual to then rely on someone else’s work

as “source materials” when creang their own

works. The key when using these copyrighted

materials is to avoid over-reliance; the less reliance

on the source materials, the more likely your work

will be transformave. When creang certain wrien

and musical materials, reuse of copyright protected

materials belonging to someone else can somemes

be unconscious, so if something “sounds too

familiar,” you may want to check your research. It’s

important to note that copyright protecon aaches

to a number of materials you might rely on as source

materials for your own creaons. A cast iron car you

use as a model for the car in your painng may

already be copyrighted. Photographs, parcularly

those within books and websites, are somemes

overlooked as copyrighted properes. For example, if

you paint a photograph from a book, it’s highly likely

that work will be infringing, unless the arsc

imagery you add suciently transforms that

underlying work.

221

FIVE COPYRIGHT MYTHS

There are a number of myths that exist about

outdated law, or maybe they were just made up by

conduct—either way, these myths are widely held

and are wrong. So, let’s clear up a few of them:

Myth #1: If I don’t make any money from it, it’s not

While not making any money may decrease the

amount of monetary damages awarded to the

righul copyright owner, it won’t eliminate them.

Damage has sll been done by your infringement.

Imagine that you copied your favorite Bruce

Springsteen album for all your friends. While you

might have meant well (and made your friends

happy), the result is that none of your friends need

to buy the album any more…so Bruce and his E-

Street Band just lost out on all of those sales. Bruce is

unhappy, and you have a problem.

Truth #1: Infringement is the act of copying it, not

only the selling of it.

222

Myth #2: If I copy 20% or less, it’s not copyright

infringement.

This is the “it’s not stealing if I only steal a lile bit”

defense. Unfortunately, there’s no clear-cut rule

about exactly how much of the prior work you can

use before it becomes infringement.

Whether it’s 5%, 10%, 5 notes, 1 sentence, or making

it in a diﬀerent size, the real test is if a “reasonable

person” would nd your work to be “substan�ally

similar” to the original. Since “reasonable person”

and “substan�ally similar” tests are decided based

on the unique facts of the case, relying on the “I only

used a lile bit” defense requires some real

unbiased evalua�on rst.

Truth #2: There’s no standard measurement for how

much is “safe” to use vs. how much equals

infringement—it all depends on the facts.

Myth #3: If there’s no copyright noƟce, there’s no

If the work was created in the last 35 years or so,

even if the creator leaves oﬀ the © line, the creator

s�ll has a copyright on her original content from the

�me of crea�on…automa�cally.

Truth #3: No copyright noce may be required.

Never assume the work is public domain…do your

research!

223

Myth #4: If I give credit to the copyright owner, it’s

not copyright infringement.

Sorry — just iden�fying who you stole it from doesn’t

make it right. Controlling the use of the original work

is exactly what the owner has a right to do. What

kind of law would it be if you could get around it

simply by referencing the original creator? If you

need to use part of someone else’s work, get

permission.

Truth #4: Giving credit is nice, but it’s not enough.

Myth #5: If I hire someone to create an original

work, I own the copyright.

Maybe. In the case of your employee…yes. But it’s

not necessarily true if you hired an independent

contractor for the same exact project. This ques�on

is a very tricky one, and we have covered it in more

detail in another chapter.

Let’s assume you hired an ar�st to paint a portrait of

your cat. Who owns it? Without a contract

otherwise, you may own the actual pain�ng, but the

painter owns the copyright. Can the painter do

anything with the image he wants (such as making

and selling posters)? Most likely.

224

The same may apply if you hire someone to design a

logo or a website…the designer may have the right to

repurpose that logo or website for other clients,

unless your contract provides otherwise.

One more note for those of you familiar with the

independent contractor “work made for hire”

concept…it is only opera�ve in certain circumstances,

so without other language clearly assigning

ownership of all copyrights to you, it s�ll may not be

enough, even if you specify that the work is “work

made for hire.”

Instead, every contract with an independent

contractor should be in wri�ng and explicitly provide

that (a) the company owns all works created under

the agreement, (b) the independent contractor

assigns to the company any and all copyright rights

(in the event that any residual rights may remain

with the independent contractor), and (c) the

independent contractor will execute all

documenta�on required to make such assignments

eﬀec�ve.

Truth #5: He who pays for the creaƟon and he who

owns the copyright are not necessarily the same

person.

225

TRADEMARKS

Trademarks are authorized under federal law (the

Lanham Act) and are also governed by laws of each

State. Registra�on of trademarks can also be

accomplished interna�onally under diﬀerent

interna�onal trea�es.

Trademarks can be obtained by use (which provides

the user with common law rights) or by federal

registra�on with the U.S. Patent and Trademark

Oﬃce or with individual states.

In order to apply for a

federal registra�on, the

applicant must establish

either actual use of, or an

intenƟon to use, the Mark in

interstate commerce. To

receive registra�on, you

must ul�mately show use in

interstate commerce.

Interstate commerce

requires that goods or

services be oﬀered across

state lines. For example, a restaurant located in

California which does not adver�se, or render

services to anyone, in any other state would likely

not qualify for a federal trademark (although it could

poten�ally qualify for a state trademark).

While you can le

for a trademark

with only an

intenƟon to use it,

the mark will not

provide evidence

of actual use in

interstate

commerce.

226

What is the benet of a federal registraƟon?

 NaƟonwide protecƟon of the mark

 The right to sue in Federal Court

 Use of the symbol

 Incontestability aŌer ve years of proven

conƟnuous use

 Priority of use is established from the date

of the applicaƟon



Greater recovery of damages for

infringement, including aƩorney fees and

statutory damages

 The right to claim priority for registering

internaƟonally

The right to stop the imporƟng of goods

which infringe upon the mark

In the United States, the rst party to use the

trademark, not the rst to le an applicaƟon, has

superior rights to that trademark. For example, if I

open “Dandy Jay’s Dry Cleaners” in San Jose,

California, and never le for a trademark, I sƟll have

common law rights relaƟng to that trademark. If,

several years later, someone applies for a federal

registraƟon of “Dandy Jay’s Dry Cleaners,” they will

not be able to prevent my use of that trademark in

San Jose, even if they are granted a federal

227

registraƟon. However, the federal registrant will be

able to prevent me from using it elsewhere.

“Marks” can take several forms:

1. Trade name: idenƟes a company or

business (Verizon®)

2. Trademark: idenƟes certain goods of a

copany (Life Savers®)

3. Service Mark: idenƟes the services of a

company (Roto-RooterSM)

Marks that idenƟfy and

disƟnguish a specic product

from others in the market

can take many forms, such as

a word (Adidas), name

(Smith’s Food and Drug

Stores), logo/symbol (Nike

swoosh), slogan (Melts in

your mouth, Not in your

hands), domain name (www.google.com), design

(Pepsi logo), device (Coca-Cola contour boƩle),

sound (NBC’s chimes), or color (pink Owens Corning

berglass).

The primary purpose of a trademark is to indicate the

source of origin of the goods or services. In other

words, it is to ensure that when you buy a product

such as a pair of shoes with the Nike swoosh, you can

Trademarks can

be words, names,

logos, symbols,

slogans, domain

names, designs,

devices, sounds,

and even colors.

228

be condent that those shoes were manufactured by

Nike and not from some other source.

Trademarks help guarantee the quality of goods

carrying the mark, and as the trademark develops

more recognion, it can carry a high monetary value

to a company. Products carrying the mark eventually

create a demand for those products, such as with

Gucci sunglasses or a Louis Vuion bag.

When a trademark is applied for, the mark must

idenfy a parcular class of goods or services to

which it belongs. There are currently 45 internaonal

classes of goods and services, and your mark must

fall within one of these classes. For example, you

might think “art products” is one class; however,

paint is in one class, chalk is in a dierent class,

coloring books are in a third class, etc. Depending on

your products or services, applying for trademarks in

several classes may be necessary if you wish to fully

protect your mark.

Before a trademark can be registered with the

United States Patent and Trademark oce, the

trademark must be reviewed by a

trademark examiner for

disncveness. Marks cannot be

generic, and the more “fanciful”

the mark is, the more likely

registraon will be granted.

The more

unique the

word, the

stronger the

trademark.

229

The disƟncƟveness of a trademark follows the

following spectrum:

 Fanciful, meaning the word has essenƟally

been created by the applicant (such as

Kodak, Exxon, or Zappos)

 Arbitrary, meaning the word exists in our

vocabulary but is not typically associated

with those types of goods (such as Apple

computers, Tide detergent or Camel

cigareƩes)

 SuggesƟve, where the word suggests

properƟes of the product (such as Caress

soap, Coppertone sunscreen, or Sweet’N

Low sweetener)

 DescripƟve, where the word describes the

product aƩributes (such as Spray ‘n Wash or

Hamburger Helper)

 Generic, where the product is named for

exactly what it is (such as bleach or gas)

Certain words, such as aspirin, became generic based

on their use. As a result, companies try to take

acƟons limiƟng the use of their trademarks in a

generic form. Xerox would like you to say you are

making photocopies, not xeroxes, and Kleenex would

prefer you call it a facial Ɵssue instead of a kleenex.

230

Trademarks should be used as adjecƟves, not nouns.

For example, it would be proper to adver�se that

consumers should “Use Kleenex facial �ssues when

you have a stuﬀy nose” but it would be incorrect to

adver�se “Use a Kleenex when you have a stuﬀy

nose.”

Trademark conicts generally revolve around

“likelihood of confusion.” When a trademark is

applied for, it will be compared to other exis�ng

registered marks, and if a similar mark is used in

conjunc�on with a similar type of goods or services,

the registra�on will be denied.

When reviewing whether a likelihood of confusion

exists, the trademark examiner will look at several

factors, including:

 whether the goods/services compete with

each other

 how similar the marks are, in spelling,

sound, appearance, and meaning (including

transla�ons)

 how strong each mark is (on the fanciful to

generic scale)

 whether the two marks share the same

customers

The same mark can exist with diﬀerent trademark

holders where no likelihood of confusion exists. For

231

example, Delta Faucets is allowed for plumbing

xtures at the same me as Delta Air Lines is allowed

for air transportaon—since there is no likelihood

of a consumer thinking an airline is also making

faucets, or that a faucet maker is also ying

passengers around, both marks can coexist.

Before using a mark or ling an applicaon for

registraon, at the very minimum, be sure to take

some me to surf the Internet to see if anyone is

using a similar mark in similar goods or services—it

will save you money and heartache when you avoid

using a mark that someone else has already invested

me and treasure to develop.

Prior to trademark registraon, you are permied to

use the symbol. Once a trademark registraon is

granted, you are permied to use the symbol. In

both cases, the purpose is to put others on noce

that you are claiming trademark rights for that mark.

Trademarks achieving registraon are registered for

10 years (although there is a “Secon 8” ling

required between years 5 & 6, declaring the mark is

sll in use or there is

excusable non-use). Aer the

mark is registered for 5 years,

and the mark is sll in use in

commerce, you can also le a

“Secon 15” declaraon of

incontestability, which will

protect you from challenges

A trademark can

be renewed every

10 years for as

long as you wish,

as long as you

keep using it!

232

that your mark is not disncve and lacks secondary

meaning, is confusingly similar to a mark that

predates your registraon, or that it is a “funconal”

mark which simply describes a product feature. A

trademark can be renewed every 10 years,

indenitely, so long as there is connuous use of the

mark (unless the mark becomes generic).

Once your trademark is granted, you must:

 Use the trademark exactly as it is registered

 Use the trademark as an adjecƟve and not

as a noun

 Use the symbol (if using it in text, such as

markeng literature, use of the symbol in

the rst instance where the trademark is

used is typically sucient)

Where possible you should also highlight the

trademarked word, either by using bold, italics, all

capital leers, underlining, or using a combinaon of

these.

Enforcing Trademark Infringement

If you have a trademark worth protecng from

infringement, hopefully you have taken steps to le

your federal registraon on that trademark already.

Depending on the trademark, your lawsuit will need

to be led either in a state court or a federal court;

usually, it will be the laer.

233

To prevail in a trademark acƟon, you will need to

show there was unauthorized use of a trademark or

service mark on or in connecƟon with goods or

services, in a manner that is likely to cause

confusion, decepƟon, or mistake about the source of

the goods or services.

Likelihood of confusion is found when the origin of

the goods is uncertain, meaning a buyer believes he

is buying it from the company that holds the

trademark, but in fact, the buyer is buying it from

someone else.

In response, the sued party will raise defenses, such

as the fact there is no likelihood of confusion. When

considering likelihood of confusion, criteria include

looking at the strength of the mark, the similarity of

the marks, similarity of markeƟng channels,

evidence of confusion in the marketplace, and the

defendant’s intent. To support your case for

confusion in the marketplace, surveys can be

performed, but they can be expensive and need to

meet the court’s standards.

Other defenses include challenging the claimed

trademark, denying infringement occurred, or

asserƟng a defense against the allegaƟons, such as a

statute of limitaƟons defense.

234

If you prove trademark infringement, you have

several remedies available to you:

 restraining orders and injuncƟons, to

prevent further use of the mark

 an order requiring destrucƟon of goods

containing the infringing mark

 monetary damages

 in some cases, you can be awarded

aƩorney’s fees

If you are awarded statutory damages (which are

calculated by law and used when actual damages are

dicult to calculate), the court will determine your

judgment and order the defendant to pay it. Before

actual damages (damages based on your actual

harm) are awarded, the court may rst require that

you present evidence from a forensic accountant

explaining to the court the extent to which you have

suered nancial damage.

Whether you are the party whose trademark has

been infringed upon, or the party being sued for

infringement, it’s important to seriously consider the

costs of ligaon. When balancing the costs of taking

the maer to court, negoang a selement of the

lawsuit may leave more money in the pockets of all

pares (except the lawyers).

235

However, someƟmes liƟgaƟon cannot be avoided; in

that case, seek legal counsel early in the process so

you can be informed about your opƟons and the

strength of your case. If you sue for infringement,

can you win? If you win, what is the likelihood the

defendant will have the money to pay the judgment?

Keep in mind that suing for trademark infringement

is very expensive, oŌen running well over $100,000.

It is unlikely a law rm will take an infringement case

on a conƟngency basis, so you will have to pay your

aƩorney’s fees while your case is going on.

236

NOTES

_______________________________________

237

PATENTS

Patents grant you, as the patent holder, the exclusive

right to make, use, import and sell the patented

innovaƟon in exchange for disclosing all the details of

the invenƟon. It’s essenƟally a trade: you have an

idea, and in return for sharing it with the world, you

get an exclusive period to exploit the invenƟon –

typically 20 years from the earliest ling date of your

applicaƟon.

First, be sure your idea qualies for a patent. For

patentability, it will need to meet ve requirements:

1. It must be a patentable subject maƩer,

which falls within four general categories:

 a process or method (way of doing

something)

 a machine (a “thing” that has xed or

moving parts, or a combinaƟon of devices)

 a manufacture (a “thing” that is

manufactured from a variety of materials

which take on a new form, made by a

human or by a machine, as opposed to

something found in nature)

 a compound (something that is composed

of two or more substances that are

combined, such as mulƟple gases, powders,

uids, or solids)

238

2. It must have uƟlity (meaning it must have

usefulness)

3. The idea must be novel (i.e. a new idea, not

something that has been thought of

previously)

4. The idea must be nonobvious (not

something that would be easy for anyone to

come up with), and

5. The applicaƟon must provide the

enablement (a clear descripƟon of how to

make and use the invenƟon).

Types of patents include:

1. UƟlity patents are by far the

most typical, covering any new

and useful process, machine,

arƟcle of manufacture, or

composiƟons of maƩers, or any

new useful improvements to

those categories

2. Design patents cover new, original, and

ornamental design for an arƟcle of

manufacture

3. Plant patents are granted to those who

invent or discover and asexually reproduce

any disƟnct and new variety of plant

UƟlity patents

are the most

common form

of patent.

239

So, let’s assume you have a patentable idea. Beware!

There have been some criƟcal changes to U.S.

patent law since 2013—these changes, which went

into eect as of March 2013, are very signicant.

Following previous strategies as to when to le a

patent can result in you losing the opportunity to

ever patent your invenon (so be careful about

relying on what your friends think they know about

patents).

Old laws don’t count…

Previously, U.S. patent law operated on a “rst-to-

invent” basis, meaning that even if you led your

patent applicaon aŌer someone else led on the

same invenon, your applicaon could sll prevail

provided you could prove that you invented the

claimed invenon rst. This concept is now

inapplicable.

On March 16, 2013, the “rst-inventor-to-le”

provisions went into eect. Under 35 U.S.C. § 102(a)

(2), an applicant is not entled to

a patent if the claimed invenon

was described in a U.S. patent or

in a published U.S. patent

applicaon which names another

inventor and has an eecve

ling date preceding the eecve

ling date of the claimed invenon. In simple terms,

this means that the inventor who les rst wins. In

contrast to the prior law, it no longer maers if you

In the land of

patents, the

rst to le

beats the rst

to invent.

240

invented the claimed invenon rst. This rst-to-le

policy places the U.S. patent law in line with that of

many other countries in the world, which generally

reward the rst person who les a patent

applicaon.

Some inventors want to be able

to test market demand for the

invenon before spending

money to le their patent. If the

claimed invenon is described

in a printed publicaon, or put

in public use, on sale, oered

for sale, or otherwise made

available to the public before

the eecve ling date of the

claimed invenon, the inventor has twelve months

from that disclosure date to le the patent

applicaon; however, disclosing prior to ling the

patent applicaon may put your internaonal patent

rights at risk. Note that if the disclosure is made

under a wrien nondisclosure agreement, it will not

be considered a disclosure that starts the twelve-

month clock and is also not considered a disclosure

with regards to foreign rights.

What does all this mean? Inventors need to move

more quickly than ever to establish some level of

patent protecon over their invenons. This means

geng a patent applicaon on le as soon as

possible.

AŌer ling a

provisional

applicaƟon,

you have 12

months to le

your full

patent

applicaƟon.

241

Patents are exclusively governed by federal law (the

Patent and Trademark Oce), so your applicaon for

a patent will be led with the Patent Oce and

assigned to a patent examiner. This examiner will

work with you during the applicaon process and

nofy you of any deciencies in your applicaon.

If you are sll rening your idea, or you need to get

the money together for ling your patent, you might

consider ling a provisional applicaƟon. A

provisional applicaon is sll a patent applicaon but

has less burdensome requirements than a non-

provisional applicaon. Cheaper and faster to dra

than a full-edged patent applicaon, this step can

buy you some me to test the market and cra

language for your non-provisional applicaon.

A provisional applicaon sll establishes an ocial

United States patent applicaon ling date for the

invenon and permits you to use the term “Patent

Pending” in connecon with the invenon. However,

aer ling a provisional applicaon, you must le the

non-provisional applicaƟon within the following 12

months. While the language in provisional patents

can be very general or very specic, you should sll

try to describe the invenon in as much detail as

possible, to prevent a dispute later as to the scope of

your invenon.

Be aware that while you can le patent applicaons

on your own, this is an area where a do-it-yourself

approach can lead to disastrous results if you have

242

no experience doing so. Failing to properly state your

claims within the patent may result in a patent that

does not cover important aspects of your idea…

meaning those novel ideas will not be protected.

243

TRADE SECRETS

Virtually every company has intellectual property

assets, including trade secrets. Is there something

that you think gives your company an advantage

because other companies do not have that

informaƟon? If so, you may have a trade secret.

Trade secrets can take a variety of forms, but

generally involve informaƟon that is not publicly

available. Examples can include customer lists,

manufacturing methodologies and other business

“know how” that are valuable

because the informaƟon is

closely held by the company.

Unlike patents, trade secrets do

not have a specic term. They

are a trade secret so long as

they are properly maintained as

a secret.

Trade secrets are governed by both state and federal

law, depending on the violaƟon. The Uniform Trade

Secrets Act (“UTSA”) has been adopted by at least 40

states.

The UTSA denes a “trade secret” as:

 informaƟon, including a formula, paƩern,

compilaƟon, program, device, method,

technique, or process

Don’t overlook

trade secrets

—chances are

you have

some!

244

 that derives independent economic value,

actual or poten�al, from not being generally

known (or readily ascertainable through

appropriate means) by others who might

obtain economic value from its disclosure or

use, and

 there are eﬀorts taken that are reasonable

under the circumstances to maintain the

secrecy of that informa�on

Obviously, a trade secret must be a “secret” to begin

with. But how is that decided? Several factors help

determine whether certain informa�on rises to the

level of a trade secret:

 the extent to which the informa�on is

known outside of that par�cular business

 the extent to which it is known by

employees and others involved in that

par�cular business

 the extent of the measures taken by the

business to guard the secrecy of the

informa�on

 the value of the informa�on to that

par�cular business and to its compe�tors

 the amount of eﬀort or money expended by

the business in developing the informa�on

245

 the ease or diﬃculty with which the

informa�on could be properly acquired or

duplicated by others

Require that your employees

sign condenƟality agreements,

and remind them regularly

about the assets that the

company considers to be trade

secrets. This goes a long way in

protec�ng valuable trade secret

informa�on.

If a trade secret exists, someone

who discloses or uses it without

a right to do so may be liable, if:

 they discovered the

secret by improper means,

 their disclosure or use cons�tutes a breach

of condence placed in them by the other in

disclosing the secret to them,

 they learned the secret from a third person

with no�ce of the facts that it was a secret

and that the third person discovered it by

improper means or that the third person’s

disclosure of it was otherwise a breach of

his duty to the other, or

Every

employee

should sign a

condenƟality

agreement;

aŌer that,

frequent

training of

employees will

help keep your

secrets safe.

246

 they learned the secret with noƟce of the

facts that it was a secret and that its

disclosure was made by mistake

In the event there is a misappropriaƟon of your

trade secrets, you may be enƟtled to injuncƟve relief

(where the court orders the other party to stop using

the trade secrets), damages (where the court orders

the other party to pay you money) and possibly even

repayment of your aƩorney’s fees (when the court

nds that the misappropriaƟon was willful or

malicious).

However, not all uses of your trade secrets by

someone else are illegal. Trade secrets can be

obtained by lawful means, such as independent

discovery, reverse engineering, or disclosure that

results from the trade secret holder’s failure to

properly protect the trade secret.

Assuming that ling a patent is an opƟon, is there

ever a scenario when you would not le for

one? Compared to patents, maintaining informaƟon

as a trade secret can be less expensive (no

registraƟon costs) and provides an unlimited term of

use. However, unlike patents, if someone legally

discovers (or reverse engineers) the same process

later, you will not be able to prevent them from

using that process (while you would have the right to

do so if it was patented). Also, as the holder of a

patent, you can license that know-how to another

247

party; doing so with a trade secret is much more

diﬃcult.

Don’t underes�mate the value of your trade secret

assets. You would most likely never turn over your

customer list to a compe�tor, so don’t overlook

protec�ng the trade secrets of your business.

248

NOTES

_______________________________________

249

EMPLOYEES vs. INDEPENDENT

CONTRACTORS

In our modern-day workforce, many businesses use a

combinaƟon of employees and independent

contractors in their operaƟons. While both are

important contributors to the workforce, there are

legal and nancial implicaƟons if those workers are

misclassied. Classifying workers incorrectly can

impact employers and workers alike and correct

classicaƟon is necessary to make sure that the

business can properly comply with tax laws and labor

regulaƟons.

While standards used to classify

employees and independent

contractors may vary between

federal and various states laws,

there are some factors that

apply universally. Those factors

include the level of control of

the worker, the nature of the

work being performed, and the relaƟonship

between the business and the worker.

UlƟmately, the disƟncƟon lies in the working

relaƟonship that the business has with the individual.

1. Does the worker have control over how,

when, and where the work is performed?

Does the worker work independently

without supervision?

Classifying

workers as

employees vs.

contractors is

a fact-based

decision.

250

2. Does worker provide their own tools and

materials, such as their own computer and

telephone? Is the worker responsible for

their own business expenses?

3. Is the worker performing a “high skills” form

of services?

4. Is the worker performing services that

would not be considered a regular or

integral part of the business?

5. Is the worker’s work arrangement

temporary rather than permanent? Is the

work project based? Does the assignment

have an end date aŌer which the worker

will no longer be employed?

6. Is the worker paid by the job or upon

achieving certain milestones, as opposed to

payment based on hours worked?

7. Can the worker hire their own employees,

and assign them part of the work

responsibility?

8. Has the worker secured their own liability

insurance? Is the worker responsible for his

or her own health insurance and other

benets? Has the company disclaimed any

obligaƟon to pay vacaƟon, sick leave and

PTO to the worker?

9. If the worker is terminated, does it give rise

to an acƟon for breach of contract (i.e.

cannot be terminated at will)?

The more condently the above quesƟons can be

answered “yes,” the more likely the worker may

qualify as an independent contractor.

251

To further enable this analysis, California has put in

place the “ABC test.” In the event the ABC test does

not apply for some reason, the courts would then

apply a test based on the totality of the factors, such

as those menƟoned above.

If the ABC test does apply, a worker is deemed to be

an employee rather than an independent contractor

unless all three of the following condiƟons are met.

Those three condiƟons are:

A. The worker is free from the control and

direcƟon of the hiring enƟty in connecƟon

with the performance of the work, both

under the contract for the performance of

the work and in fact

B. The worker performs work that is outside

the usual course of the hiring enƟty’s

business (by way of example, if a retail

clothing store hires an outside plumber to

x a leak, those plumbing services are not

part of the company's usual business;

however, if a bakery hires cake decorators

to work on a regular basis on its custom-

designed cakes, that would be considered in

the usual course of business), and

C. The worker is customarily engaged in an

independently esta

blished trade,

occupaƟon, or business of the same nature

as that involved in the work performed.

252

Note that the third prong of this test not only

requires that the worker be able to perform these

services elsewhere, but also that they are acƟvely

engaged in doing so. Another indicaƟon of an

independent contractor relaƟonship is that the

worker has formed an independent business, has

other clients, is adverƟsing that business, and holds

appropriate licenses to run that business.

If the company determines someone does qualify as

an independent contractor, the engagement of that

independent contractor should be set out in a wriƩen

independent contractor agreement which clearly

states the scope of work and the compensaƟon.

As an independent contractor, those workers are

responsible for their own tax obligaƟons, including

paying income tax, Social Security, Medicare and self

-employment tax. Independent contractors should

le quarterly taxes to avoid any penalƟes.

In the event your business misclassies an employee

as an independent contractor, the IRS may impose

signicant penalƟes based on your failure to properly

withhold the correct taxes. Even worse, if the

employee who was wrongly classied as an

independent contractor fails to pay their taxes, and

now has no money to do so, the taxing authoriƟes

will hold your business responsible for those taxes

on the basis that those taxes would have been paid if

you had properly classied the worker.

253

By misclassifying an employee

as an independent contractor,

that worker has also lost certain

employee-related benets such

as sick me, workers

compensaon, unemployment

benets and the right to

unionize. The denial of these

benets can potenally lead to

an acon by the employee

against the company.

Oen, a worker desires to be an

independent contractor so that they can take

advantage of certain write-os and potenally

reduce the amount of taxes that they pay. Unless

they truly qualify as an independent contractor, the

company cannot allow this, even if the worker prefers

it. Just because the worker agrees with the

classicaon, that does not shelter the company

from liability.

Proper classicaon of employees is crical. Failing

to do so opens the business up to a number of

liabilies, from employment lawsuits and other legal

acons to tax penales. If in doubt, the best pracce

is to classify the worker as an employee.

If a worker

needs to be

classied as an

employee,

don’t classify

them as a

contractor,

even if they

are agreeable

to it!

254

Ownership of Intellectual Property Created by a

Worker

ClassicaƟon of employees and

independent contractors is also

criƟcal in the area of ownership of

intellectual property. All creaƟve

works which an employee creates

for the company, and all copyrights

associated with those works, will

be owned by the company.

However, absent a wriƩen

agreement to the contrary, an

independent contractor may very likely be the

on the company’s behalf. Many companies are

surprised to hear that even though they paid the

independent contract for the work, the company may

not own the rights to it; although the company may

have the right to a royalty free license, it may not be

able to prevent the independent contractor from

using that work product elsewhere.

The company’s typical expectaƟon is that it has the

exclusive right to exploit those copyrights, create

derivaƟve works, and license works to others. No

company wants to nd out later that the

independent contractor actually has those rights

instead.

One example of where this issue arises is with

website development. A company hires someone to

Make sure

your

agreement is

clear that

you own the

IP your

contractor

develops!

255

develop a unique look and feel for their website, and

pays signicant sums to do so, only to later see the

same template used on another site. Without the

proper agreements, the independent contractor has

the right to use that design with others, and the

hiring party has no right to stop it. This same

example could apply to a myriad of other scenarios,

such as to soware the independent contractor

develops, a logo they developed, or a song they

wrote for your commercial.

When using an independent contractor, the

company should not rely solely on the employee

versus independent contractor test or on the “works

made for hire” doctrine (which is limited to nine

categories of works and requires a wrien

agreement between the pares specifying that the

work is a work made for hire).

Instead, every contract with an

independent contractor should

be in wriƟng and explicitly

provide that the company owns

all works created under the

agreement, the independent

contractor assigns any and all

that any residual rights may remain with the

independent contractor), and that the independent

contractor will execute all documentaon required

to make such assignments eecve.

All independent

contractor

agreements

should be in

wriƟng.

256

NOTES

_______________________________________

257

OFFER LETTERS AND EMPLOYMENT

AGREEMENTS

It is crical to document every employee’s hiring

condions in wring. This typically takes the form of

either an oer leer or an employment agreement.

An oer leer typically states the

job descripon, compensaon

and benets the employee will

receive and (importantly) claries

that the engagement of the

employee is on an “at-will” basis.

When employed on an at-will

basis, both the employee and the employer have the

right to terminate the working relaonship at any

me, with or without noce. Of course, even at-will

employees cannot be terminated for reasons that

violate law or public policy. For example, an

employer cannot terminate an employee based upon

their race and then claim the terminaon was

allowed under the at-will provision.

Employment agreements are oen used when hiring

execuves, to provide that execuve with some

certainty around their employment (oen because

they may have le a good paying job in order to

come to the company, and don’t want to be red a

few months later for no reason). In addion to

detailing the job descripon, compensaon, and

benets that would be included, employment

Your oer

leer should

always state

the employee

is “at-will.”

258

agreements oen have a requirement that the

employer will only terminate the employee upon

“good cause” during the term of the agreement.

Denions of good cause may vary slightly, but

generally speaking, good cause can be found where

an employee engages in serious

misconduct, performs poorly, fails

to show up to work on a repeated

basis, violates company policies,

violates laws, harasses or

threatens employees or customers,

uses alcohol or drugs at work, or

generally fails to perform duƟes

that someone in their posiƟon

would perform, aŌer being given

noƟce of non-performance.

In the event an employment agreement is

terminated without good cause, the company may

sll be permied to do so under the terms of the

agreement so long as they pay a predetermined

severance payment.

Employment agreements can be for an indenite

term, but the best pracce is to have a start and end

date with the possibility to renew if appropriate.

That way, if the event the employer believes their

basis for terminang for good cause may be later

deemed insucient, the employer can instead wait

unl the stated end date and then choose not to

renew. In the event the company has terminated the

employee and the employee objects, believing the

“Good cause”

deniƟons

can vary…

clearly state

in all

employment

contracts

what your

deniƟon is.

259

employer failed to meet the good cause standard,

having an end date will also allow the company to

minimize damages, as lost wages should not extend

past the end date of the contract.

Employment agreements may also include provisions

(i) protecng the company’s condenal

informaon, (ii) prohibing the employee from

performing services for any other company during

the course of their employment, (iii) prohibing the

employee from bringing third party informaon into

the company, and (iv) prohibing the employee from

solicing customers and employees for a limited

period of me aer leaving the business (if allowed

under state law).

In the event an employee is creang intellectual

property as part of their employment, the oer leer

or employment agreement should specify that all

work created during such employment belongs to

the company.

260

NOTES

_______________________________________

261

PROPRIETARY INFORMATION

AGREEMENTS AND NON-COMPETE

AGREEMENTS

Given the substanƟal amount of Ɵme and treasure

businesses devote to developing their proprietary

informaƟon, it's important that companies do their

best to ensure that employees and contractors do

not use that informaƟon once they leave the

company.

Two common legal tools for protecƟng that valuable

informaƟon are Proprietary InformaƟon and

InvenƟons Agreements (“PIIAs”) and Non-Compete

Agreements (“NCAs”).

Proprietary InformaƟon and InvenƟons

Agreements.

When a business uses a PIIA, the

agreement serves mulƟple

purposes. The rst purpose is to

protect condenƟal and sensiƟve

business informaƟon, making it

clear to the employee that they

are legally bound to protect the

company’s proprietary informaƟon during their

employment and even aŌer their employment

terminates. “Proprietary informaƟon” is generally

all informaƟon that (a) is not known by actual or

potenƟal compeƟtors of the company or is generally

Every

employee

should sign a

PIIA!

262

unavailable to the public, (b) has been created,

discovered, developed, or otherwise become known

to the company or in which property rights have

been assigned or otherwise conveyed to the

company, and (c) has material economic value or

potenƟal material economic value to the company's

present or future business. This will include trade

secrets, but also all other discoveries, developments,

designs, invenƟons, formulas, soŌware programs,

processes, techniques, know-how, negaƟve know-

how, data research, techniques, technical data,

purchasing informaƟon, customer and supplier lists,

business plans and other informaƟon valuable to the

company.

It will also include an obligaƟon that the employee

keep any third party proprietary informaƟon

condenƟal as well, as it is common for businesses to

acquire condenƟal informaƟon of other parƟes as

they work together.

The second purpose is to make clear that any

invenƟons developed by the employee during the

course of their employment are the sole property of

the company, and that the employee has no rights to

those invenƟons while they are at the company and

aŌer they leave the company. The PIIA will also

contain provisions requiring the employee to assign

those rights to the company.

While it is clear that invenƟons conceived of, or

developed, during working hours using company

263

equipment, supplies, faciliƟes and other company

informaƟon are owned by the company, many states

will carve an excepƟon out for invenƟons the

employee creates outside of work hours using their

own resources. An example of such an exclusion is

California's Labor Code sec�on 2870, which allows

employees to own any invenƟons they create on

their own Ɵme; this is discussed in more detail in the

next chapter.

The best pracƟce is to have every

employee sign a PIIA, even those

that might not be thought of as

likely to invent anything. Any

employee may see a need of the

company and come up with an

invenƟve soluƟon for solving that problem, including

your minimum wage workers. Don't underesƟmate

the ability of your employees to nd soluƟons! Have

everyone sign a PIIA.

Non-Compete Agreements.

NCAs agreements prevent employees, contractors,

and owners from engaging in acƟviƟes that would be

compeƟƟve with the business of the company.

NCAs are diﬃcult to enforce and should not be used

unless they are clearly allowed in your jurisdicƟon.

In California, for example, it is unlawful for employers

to use non-compeƟƟon agreements with employees

(unless they meet a statutory excepƟon) and

PIIAs need to

comply with

state law.

264

employees are now able to seek damages, injuncve

relief and reasonable aorney fees when employers

try to enforce unlawful non-compete agreements.

California’s law (California Business and Professions

Code secons 16600.1 and 16600.5) extends its

protecon to workers even in circumstances where

the contract was signed, or the employment was

maintained, outside of California.

In fact, in California, if an employer uses a non-

compete agreement illegally, the employee can

report you to the California Aorney General’s oce,

which may result in nes and penalƟes. The

company will also be subject to civil liability,

including employee lawsuits for damages, injuncƟve

relief, and aƩorneys’ fees. Further, under California

law, if an employer entered into non-compete

agreement with a California employee aer January

1, 2022, the company is required to take further

acon and nofy those employees that those

agreements are void under California law, or face

nes for the failure to do so.

Despite California’s restricons, in

other jurisdic

ons, such

agreements are more enforceable.

The rst rule for using NCAs is to

proceed with care and conrm

your jurisdicon permits NCAs.

In the event your jurisdicon allows NCAs, then the

second rule for using NCAs is that they should be

Use NCAs

carefully and

strategically.

265

reasonable in scope, meaning of a reasonably short

duraƟon, a reasonably limited geographic scope, and

a dened business interest that is reasonably narrow

in scope. If the restricƟons are found to be overly

broad or overly burdensome, the agreement may be

unenforceable.

The third rule for using NCAs is that they should be

used strategically. While a court might nd it is

reasonable to have an NCA for a soŌware engineer

who has access to proprietary informaƟon, they are

less likely to enforce the same agreement against an

administraƟve assistant or someone working in the

warehouse.

266

NOTES

_______________________________________

267

LABOR CODE 2870 (CALIFORNIA)

Intellectual property assets are the lifeblood of many

businesses today. If you are star�ng a business, you

would not want to see a former employee walk out

the door with your intellectual property. As

discussed in the previous chapter, the Proprietary

InformaƟon and InvenƟons Agreement (“PIIA”) is

one crucial tool for protec�ng intellectual property.

However, at least nine states have enacted statutes

governing employee inven�

on assignment

agreements, so any PIIA will need to comply with

those applicable state laws. For example, in

California, the statute is codied under California

Labor Code sec�on 2870. The California statute and

others like it require the employer to no�fy the

employee that the PIIA does not apply to an

inven�on that does not qualify as the employer’s

inven�on under the state’s statute.

Employers want to make sure that the results of their

employees’ eﬀorts made on company �me belong to

the company. California Labor Code Sec�on 2870

qualies that right of the company, and states that

inven�ons of an employee are not assigned to the

employer if they are wholly developed on the

employee’s own Ɵme and if they are developed

without the uses of employer’s equipment,

supplies, faciliƟes, or trade secret informaƟon.

268

Labor Code 2870 does not, however, apply to

invenƟons that relate (at the Ɵme of concepƟon or

reducƟon to pracƟce of the invenƟon) to the

employers’ business or anƟcipated research or the

employer, or invenƟons that result from work done

by the employee in his or her capacity as an

employee of the company. If a California employee is

required, under their PIIA, to assign an invenƟon,

then the employer must provide a wriƩen noƟce to

the employee staƟng that this agreement does not

include invenƟons that qualify under SecƟon 2870.

That noƟce is usually provided as a secƟon within the

PIIA itself.

As an employee, if you develop a variaƟon of a

product or concept of your employer, you must

assume that the employer will aƩempt to claim

ownership rights unless the idea is in an unrelated

eld and is not part of a larger project to which you

are (or were) assigned. Working from home and

using your own equipment is not enough; if the

concept is derived from trade secrets or is a variaƟon

of an exisƟng project assigned by the employer, then

the employer can claim ownership of the invenƟon.

California’s SecƟon 2870 reads as follows:

(a) Any provision in an employment agreement

which provides that an employee shall assign, or oﬀer

to assign, any of his or her rights in an inven�on to

his or her employer shall not apply to an inven�on

that the employee developed en�rely on his or her

269

own �me without using the employer's equipment,

supplies, facili�es, or trade secret informa�on except

for those inven�ons that either:

(1) Relate at the �me of concep�on or reduc�on to

prac�ce of the inven�on to the employer's business,

or actual or demonstrably an�cipated research or

development of the employer; or

(2) Result from any work performed by the

employee for the employer.

(b) To the extent a provision in an employment

agreement purports to require an employee to assign

an inven�on otherwise excluded from being required

to be assigned under subdivision (a), the provision is

against the public policy of this state and is

unenforceable.

As menƟoned, while this chapter focuses primarily

on the California limitaƟons impacƟng a company’s

ownership of employee invenƟons, it is important to

understand if your jurisdicƟon has a similar

provision, as you will need to comply with that

state’s requirements.

270

NOTES

_______________________________________

271

CONTRACTS AND ARTICLE 2 OF THE

UNIFORM COMMERCIAL CODE

Hold on to your hats, because it’s Ɵme to cover some

somewhat boring (but important) contract terms!

Sales, no maƩer how informal or miniscule, are all

governed by contract law. Generally, common law is

the law that applies, but special rules have been

developed for the sale of goods.

These special contract rules are contained in ArƟcle 2

of the Uniform Commercial Code, typically referred

to as the “UCC.” The UCC has been adopted by most

states to some degree.

ArƟcle 2 of the UCC applies to the sale of any

“goods,” which includes all things that are movable,

so the rules will generally apply to all tangible,

personal property.

ApplicaƟon of the UCC is an all or nothing deal, so

when a contract includes both goods and services,

you need to decide whether the goods or the

services are the most important aspect of the

contract. To make that determinaƟon, use the

primary purpose test and look to see whether the

goods or services are the primary purpose for the

contract. For example, if you are commissioned to

create a sculpture, the UCC would apply to the

contract because, while you will perform the service

of sculpƟng, ulƟmately the sculpture itself is the

272

main reason for the contract. Therefore, in the

context of all types of sales, you will need to keep

the UCC in mind.

Transac�ons between two private, non-merchant

par�es will not be subject to UCC requirements, such

as when two private par�es engage in the sale of an

automobile. However, if one of those par�es is in the

business of selling automobiles, the UCC will need to

be addressed.

Now, before determining whether the UCC applies,

you rst need to conrm there is a contract for the

sale of goods, which starts at forma�on — was there

a contract to begin with? A contract, plain and

simple, is a legally enforceable agreement. A legally

enforceable contract requires an oﬀer, acceptance

and considera�on.

An oﬀer is a proposal by a party to another party,

indica�ng a willingness to enter into an agreement

based on certain terms.

When determining if there was an oﬀer, the UCC

does not require that an exact price was discussed; a

court can assume a reasonable price, e.g. the fair

market value. However, if there were vague or

ambiguous material terms, there was no oﬀer. For

example, in the context of the goods, if it is unclear

what is being purchased, the terms are too

ambiguous.

273

Acceptance is an unequivocal agreement to the

terms of the oﬀer (without any modica�on). It can

be verbal, in wri�ng, or implied though conduct. Any

change to the oﬀer creates a counteroﬀer, which

would then be available for either acceptance or the

crea�on of another counteroﬀer.

ConsideraƟon is something of value that is

exchanged by the par�es pursuant to the contract.

Considera�on can be money, a promise to do (or not

do) something, the performance of an act, or a

promise to perform an exchange (if you x my sink, I

will give you my NFL �ckets).

The ideal way to form a contract is for one party to

clearly oﬀer the item and the other to accept that

oﬀer by performing some act. For example, you oﬀer

to sell a product for a price and the buyer accepts the

oﬀer by making the required payment.

There may be instances in which

the contract exists but is not

enforceable. One important rule to

consider is the Statute of Frauds.

The Statute of Frauds requires

par�es to memorialize and sign

their agreements to prevent

conicts and reduce fraud (by

requiring evidence beyond just someone’s word).

Under the UCC, sales of goods over $500 must

comply with the Statute of Frauds.

The Statute

of Frauds

applies to

sales of

goods over

$500.

274

The easiest way to saƟsfy the Statute of Frauds is

with a wriƩen document. The UCC requires two

things in this document—(i) it must specify the

quanty you are agreeing to sell, and (ii) it must be

signed by the buyer. A standard sales receipt that

lists the quanty of the item and is signed by the

buyer suces for Statute of Fraud purposes. Having

a buyer sign a sales receipt should always be part of

your sales process, but when the sale is over $500,

it’s required!

There are a few excepons to the requirement that

there be a wrien document. For instance, when an

order is for customized goods that have already been

produced, or where goods have already been

accepted by the buyer, or where there is clearly a

contract that has already been completed in whole

or in part (such as where paral payment has been

made).

If the UCC requirements are not followed, one party

may be able to avoid his or her contract obligaons,

meaning the sale you thought you had made is

cancelled, and you now have no recourse. Be mindful

of the requirements, so you can keep the deal you

made.

275

DIGITAL SIGNATURES

In our increasingly electronic age, digital signatures

are frequently replacing tradional paper-based

methods of signing documents. These electronic

signatures bring transacon benets, including

increasing the speed and eciency of transacons,

as well as increased security, reduced paperwork,

and lower costs. However, as with most things,

digital signatures must meet certain requirements

to be enforceable.

A digital signature uses a

cryptographic method to verify the

authencity and integrity of a

digital message or document.

Unlike a simple electronic

signature, such as a scanned image

of a handwrien signature, a

digital signature uses public key

infrastructure (“PKI”) to create a

secure, unique idener for the

signer. This PKI is important, as it

serves as the cryptographic keys that are part of the

encrypon process needed to authencate dierent

people and devices.

A digital signature has three basic steps: creaƟon,

vericaƟon, and security. First, sender's computer

generates a unique hash value for the document's

contents. Next, the sender applies a private key

Digital

signatures are

as legally

binding as

hand

signatures…so

long as they

meet the

requirements.

276

(known only to the sender) to that hash. AŌer the

document and digital signature are sent, the

recipient can verify the signature by using the

sender’s public key to decrypt the signature. AŌer

generaƟng its own hash of the document, the

recipient compares it to the hash of the sender’s

document. If they match, that conrms that the

document hasn’t been altered since it was signed.

EncrypƟon and cryptography techniques create an

extremely secure process that resists forgery and

tampering.

In 1999, the United States passed the Uniform

Electronic TransacƟons Act (“UETA”), with a goal of

regulaƟng the use of electronic signatures and

records in commerce across state borders. Since

then, UETA has been adopted by most states. Under

UETA, electronic signatures are valid if there is an

intent to sign, there is consent to conduct business

electronically, there is an associaƟon of the

signature with the record, and there is proper

record retenƟon.

In 2000, the United States passed the Electronic

Signatures in Global and NaƟonal Commerce Act

(“ESIGN Act”). The ESIGN Act states that digital

signatures carry the same legal weight as

handwriƩen signatures, so long as those digital

signatures meet certain requirements (similar criteria

to UETA), i.e. an intent to sign, consent to conduct

business electronically, an associaƟon of the

277

signature with the record, and proper record

retenƟon.

To saƟsfy those criteria:

Intent to sign. Both parƟes intend to sign the

document.

Consent to do business electronically. Both parƟes

must agree to do business electronically, whether

they do so explicitly or implicitly.

Associa�on of signature with the record. There must

be some form of a mark (either graphical or textual)

on the document that can be associated with the

record.

Record reten�on. Each party must be able to access

and print and save the signed document.

How are UETA and the ESIGN Act diﬀerent?

EssenƟally, it is a maƩer of scope. While each state

in the United States may accept or reject guidelines

in the UETA, each state must have laws that validate

electronic signatures, i.e. because of the ESIGN Act,

no state has the power to deny the authenƟcity of e-

signatures.

Not all documents can be signed electronically,

which may vary by jurisdicƟon. Digital signatures

cannot be used for documents such as

 Wills, codicils, and testamentary trusts

278

 No�ces of default, foreclosure, evic�on, or

the cancella�on or termina�on of u�li�es

 Health proxies and “do not resuscitate”

orders

In the European Union, digital signatures are

governed by the Electronic IdenƟcaƟon and Trust

Services (“eIDAS”) Regula�on, which came into

eﬀect in 2016, with a goal to create a consistent

digital signing procedure across countries. Digital

signatures are also governed by interna�onal

standards, including ISO/IEC 27001 (informa�on

security management) and ISO/IEC 14888 (digital

signatures).

These standards provide guidance for the crea�on,

use, and valida�on of digital signatures across

diﬀerent jurisdic�ons, ensuring interoperability and

legal recogni�on globally.

The enforceability of digital signatures can also be

aﬀected by the laws and regula�ons in diﬀerent

jurisdic�ons. The ESIGN Act, UETA and eIDAS provide

broad recogni�on of digital signatures in the U.S. and

E.U., but varia�ons in na�onal laws can create a

scenario where a digital signature that is legally

binding in one country may not be enforceable in

another country; if you are using digital signatures

interna�onally, it’s crucial to stay informed about

evolving laws to ensure enforceability in those

jurisdic�ons.

279

DATA PRIVACY

In today’s digital world, businesses collect, process,

and store vast amounts of data, ranging from

customer informa�on to nancial records and

employee details. Doing so creates privacy concerns,

as we all become increasingly concerned with what

businesses can do with the data they collect.

Data privacy laws in the United

States are passed by the states,

such as the California Privacy Rights

Act (“CPRA”), which is generally

seen as the most comprehensive

(and restricƟve) of state privacy

laws.

In the European Union, they have adopted the

General Data ProtecƟon RegulaƟon (“GDPR”), which

denes strict guidelines about how data can be

collected, stored, used and processed. Fines for

viola�ng the GDPR can be severe.

Other countries have adopted their own data privacy

laws, so it is important to understand the

jurisdic�ons of the laws related to your business.

Otherwise, you may end up with signicant nes.

While nes are certainly something every business

wants to avoid, an equally important consequence is

a loss of customer trust. Data breaches and data

abuse are diﬃcult events from which to recover. As

Data

privacy is

based on

state law.

280

the frequency of cyberaƩacks increases and phishing

scams and ransomware climb, failing to protect

against data breaches can result in wrongdoers

gaining access to sensiƟve informaƟon of your

customers and employees, such as their names,

contact informaƟon, credit card numbers, or

employment records. The loss of trust and the

reputaƟonal damage related to a breach may

ulƟmately be a greater nancial consequence than

the direct nancial losses (ransom costs and nes).

To avoid the costs of data breach,

businesses should adopt a policy

that stresses data minimizaƟon. In

other words, a business should

collect and store no more data

than absolutely necessary for its

business purposes.

Do your customers pay by credit card? If so, is it

necessary to store that credit card informaƟon in

your system? If not, do not do it. Whenever it is no

longer necessary to retain any data, that is the Ɵme

to remove it from your system.

Consider uƟlizing well-established third-party

payment processors and cloud-based storage

vendors. This will alleviate some of the burden on

your business to be a data privacy expert; you will

sƟll need to ensure that those vendors adhere to the

same data protecƟon standards, but so long as they

Don’t keep

any personal

informaƟon

unless you

must!

281

are a respected provider, they are probably doing so

already.

If you decide to hold the customer data yourself

because it is important for business objecƟves,

consider anonymizaƟon and pseudonymizaƟon of

that data, so the privacy of your customers is

improved by reducing the risk that the accessed data

can be used to idenƟfy them.

Inside your business, employees are your rst line of

defense against data privacy threats. Human error,

such as clicking on phishing emails or mishandling

data, is a leading cause of data breaches. Train your

employees regularly on best pracƟces in data

privacy, such as requiring a phone call to conrm any

changes to any exisƟng payment instrucƟons.

As privacy laws conƟnue to develop, consumers are

receiving increased protecƟon, including

 The right to access their data

 The right to correct inaccuracies

 The right to delete data (i.e. the "right to be

forgoƩen")

 The right to transfer data to another service

 The right to object to processing their data

Having procedures in place to deal with the

consumers’ demands regarding their data is crucial

for any business that collects and retains that data.

282

ProtecƟng collected data is not an opƟon, but a

necessity. Businesses must take proacƟve steps to

protect sensiƟve data, as your business may survive

or fail based on the nancial and reputaƟonal costs

of any data privacy failures.

283

TYPES OF LIABILITY

In today’s liƟgious society, entrepreneurs and

business owners need to be aware of all forms of

liabiliƟes the business may encounter. Below are

some common types of liabiliƟes, but it is certainly

not a compete list.

Contract Liability. Contract liability arises when a

business fails to fulll the terms and condiƟons of a

contract. This might include contract breaches such

as a failure to deliver products or services, a failure

to make payments due, breaches of condenƟality,

and failure to honor warranƟes or guarantees.

Tort Liability. Tort liability arises when a business is

negligent, or its acƟons (or omissions) cause damage

to another party. Negligence is dened as a failure

to use reasonable care, which leads to injuries. Tort

liability, in the form of product liability, can also

arise when the products that are manufactured or

sold by the business end up harming the consumers

of those products. Tort liability can also extend to

defamaƟon (which includes libel and slander) if the

business spreads false informaƟon that harms

another party. Invasion of privacy is also an

intenƟonal tort, giving individuals a cause of acƟon

when the company publicly discloses private

informaƟon of an individual.

Employment Liability. When employees of the

company take certain acƟons, the company can be

284

responsible for those acƟons under a legal principle

known as vicarious liability. For example, if one of

your drivers causes an accident while driving on the

job, the company may be held liable for damages,

because that employee was acƟng within the scope

of their employment at the Ɵme the injury was

caused. AddiƟonally, your business will be liable

when employees sustain injuries while on the job.

It seems obvious that if your business is found to be

knowingly permiƫng systemaƟc discriminaƟon or

harassment of employees based on race, gender,

age, disability, etc., your business will be responsible.

If an employee is wrongfully terminated in violaƟon

of law or in violaƟon of their employment

agreement, the business will have liability related to

those claims as well. However, companies are

someƟmes surprised to hear that even if only one

manager is found to have discriminated against or

harassed an employee, your business may also be

responsible for that manager's acƟons, parƟcularly if

the company failed to take immediate acƟon once

learning of that conduct.

Intellectual Property Liability. Claims of patent

infringement arise when the business uses someone

else's patents without a license or other form of

permission. Similarly, copyright infringement can

arise when copyrighted content (or new content

substanƟally similar to copyrighted content) is used

without permission. This frequently occurs when the

company incorporates images found on the internet

285

into the company website (since those images

contain metadata that can make them traceable by

the copyright owner). Trademark infringement

arises when the company uses a name or logo that is

confusingly similar to another company’s trademark.

Companies must train employees on how to avoid

intellectual property infringement. For example, an

employee or contractor could potenally incorporate

proprietary code of another product into your

company’s soware, and no one may become aware

of that infringement unl it is too late. The company

should stress the importance of original content and

make it clear that no other content is permied

unless it is clearly in the public domain or properly

licensed.

Product Liability. Product liability claims can be

made against a company based on defecƟve design,

defecƟve manufacturing, or failure to warn

consumers by including sucient instrucons and

warnings that could have prevented injury.

Professional Liability. Professional liability, or errors

and omissions liability, can be incurred when the

professional services that were provided are either

incorrect or misleading in nature, or otherwise fail to

meet industry standards, and that failure caused a

nancial loss or other injury. For example, aorney

and doctor malpracce claims fall under this

category.

286

While it is not pracƟcal to list every form of liability a

company may encounter, it is imperaƟve that every

business take stock of where its most signicant risks

are and then put in place appropriate training and

insurance to miƟgate those risks.

287

INSURANCE

When operaƟng a business, it is important to limit

risks and personal liability as much as possible.

Forming your business as a limited liability enƟty,

such as a corporaƟon or LLC, is the rst step in doing

so.

The next step is securing insurance for your

operaƟon. Business insurance comes in a variety of

avors, and it’s important to pick those forms of

insurance appropriate to your business.

General Liability Insurance. General Liability

Insurance (or “GLI”) protects your business from

liabiliƟes related to accidents, injuries, or negligence

that occur on your premises or as a result of your

business operaƟons. This is a fundamental

requirement for businesses, especially if the

company has a physical locaƟon or has direct

interacƟon with clients. GLI can cover the following

types of injuries:

 Bodily injury claims, such as if a customer

slips and falls on your property

 Property damage claims

 Personal injury (e.g., slander or libel)

 AdverƟsing injury (e.g., allegaƟons of

intellectual property infringement)

288

Property Insurance. Property insurance will protect

your business’s physical assets (such as your building,

equipment, inventory, and furniture) against damage

or loss due to re, theŌ, vandalism, and certain

natural disasters. With the proceeds from this

insurance, the company can repair or replace those

assets, minimizing business disrupƟon. Having

property insurance is criƟcal if your business has a

signicant investment in physical inventory or real

estate.

Workers’ CompensaƟon Insurance. Workers'

CompensaƟon insurance provides benets to

employees who are injured or become ill while on the

job. It helps cover medical expenses, lost wages, and

other costs associated with work-related injuries or

illnesses. This insurance is mandatory in most

jurisdicƟons and having it will help the company

avoid costly lawsuits and nes.

Commercial Auto Insurance. If your business uses

vehicles as part of your operaƟons (whether a eet

of delivery trucks or a single vehicle used by

employees for business purposes), commercial auto

insurance will be necessary to cover vehicle damage

(collision and non-collision related) and auto accident

-related injuries to employees and third parƟes, as

well as losses resulƟng from vandalism and theŌ.

Professional Liability Insurance (Errors and

Omissions Insurance).

Professional Liability

Insurance, oŌen called Errors and Omissions (or

289

“E&O”) insurance, is important for businesses that

provide services or advice. It protects against claims

of negligence, errors, or omissions made by

professionals while providing their services. In the

event you are sued by a client who claims you

provided substandard services or advice, E&O

insurance will help cover any claims against you

related to professional mistakes or negligence,

including any defense costs (even if you are not

ulmately liable for the underlying claim).

Directors and Oﬃcers (“D&O”) Insurance. D&O

Insurance is oponal, but it is oen required once

investors or non-founders join the Board of

Directors. Also, if your company makes a strategic

hire as an ocer of the organizaon, that individual

may require D&O coverage to be in place before they

join. D&O insurance will protect the personal assets

of corporate directors and ocers in the event they

are sued for acons they have taken within the scope

of their ocial dues. The company is also covered

by D&O insurance in the event the board members

are sued. Coverage maers may include claims

related to mismanagement, breach of duciary duty,

or failure to comply with regulaons. D&O insurance

will cover the legal defense costs, as well as any

resulng selement or judgment.

Business Interrup�on Insurance. If your business is

forced to temporarily close or reduce operaons due

to a re, natural disaster, or equipment failure,

business interrupon insurance will compensate your

290

business for any lost income related to those events.

It will also pay for any operaƟonal expenses (such as

rent, uƟliƟes, and payroll) during any pause of your

business operaƟons. Business interrupƟon insurance

will allow the company to conƟnue paying bills and

employees, even though operaƟons have halted.

Cyber Liability Insurance. Cyber Liability insurance

protects against risks such as cyberaƩacks, data

breaches, and other technology-related threats. As

businesses become more dependent on digital

plaƞorms, more businesses are insuring for those

related risks. Cyber Liability insurance will cover data

breaches (and the costs of noƟfying clients about

those breaches), costs of data recovery, legal fees,

and any ransomware or other cyber extorƟon.

Product Liability Insurance. If your business

manufactures, distributes, or sells products, you may

want to consider product liability insurance. This

kind of insurance specically covers injuries or

damages (whether personal or property related)

caused by defects in your products, which may not

only include those stemming from operaƟng defects,

but also those related to design aws, manufacturing

defects, and improper labeling. Product liability

insurance will cover any damages assessed against

the company as well as the legal fees to defend the

claims.

291

Umbrella Insurance. Umbrella Insurance serves as

an extra layer of liability coverage, in case there are

claims that exceed the limits of other liability policies

like GLI or commercial auto insurance. Because it is

second in line, umbrella insurance is typically a cost-

eﬀec�ve approach to cover catastrophic claims.

Businesses are all diﬀerent, so while insurance is an

essen�al tool for managing risk, the right type and

amount of coverage will depend on your business’s

specic needs, size, and industry, as well as other risk

management considera�ons. In any event, the right

insurance package should enable you to grow your

company without undue worry about how it may be

impacted by unforeseen events.

292

NOTES

_______________________________________

293

RESOLVING DISPUTES:

MEDIATION AND ARBITRATION

Because running a business means working with

other people, disputes are inevitable. Of course, the

rst step is to try to resolve maers amicably

without lawyers, but somemes that is just not

possible.

Once ligaon is led, both sides of the dispute will

incur signicant costs as the maer moves through

the court system and the pares engage in discovery,

moons and other pretrial maneuvers.

MediaƟon and arbitraƟon are two methods of

alternave dispute resoluon, and they may allow

the pares to reach a conclusion faster and more

cost eecvely than taking the maer to trial in a

courtroom. In fact, prior to the maer going to trial,

the court will compel the pares to engage in either

mediaon or arbitraon, in hopes that one of those

processes will bring the pares to a resoluon.

In some cases, mediaƟon and arbitraƟon are

voluntary dispute resoluon opons available to the

pares. In other cases, mediaƟon and/or

arbitraƟon are required pursuant to the terms of the

contract between the pares (or because it is

ordered by the court).

MediaƟon is a nonbinding, collaboraƟve process

where both sides of the dispute mutually agree on a

294

neutral party, who will serve as

the mediator. This neutral party

will typically be a rered judge or

a very experienced aorney.

Prior to the day of mediaon,

each side will submit a mediaon

brief to the mediator, outlining its posions and any

selement eorts made to date. On the day of

mediaon, the pares may sit together briey at the

beginning, but in many cases, the pares never see

each other during the enre session. At some point,

the pares will be in separate rooms, and the

mediator will move back and forth between the

rooms, talking to each side about the strengths and

weaknesses of their posions. Mediaon is a less

formal proceeding than arbitraon.

All discussions that take place in the mediaon are

condenal and cannot be used as evidence in

subsequent legal proceedings. This includes any

selement oers made during mediaon.

Along the way, the mediator will try to get the

pares to reach a selement. Mediaon is

somemes very valuable (and eye opening) to the

clients as it provides a third party opinion as to the

strength of their case (as they may not always be

geng the full picture from their legal counsel,

either because counsel does not want to deliver bad

news or because counsel is too enamored with their

own arguments). With a good mediator, a selement

can be reached even if neither party expected to

MediaƟon is

collaboraƟve…

arbitraƟon is

adversarial.

295

seƩle when they arrived that day. If a seƩlement is

reached, a seƩlement agreement is draŌed that day

and signed by the parƟes. As menƟoned above,

mediaƟon is a non-binding process; the mediator

does not make a decision as to a winner and loser,

and either party can walk away from the mediaƟon

at any Ɵme. The mediator is simply there to

facilitate discussions and hopefully help the parƟes

reach a compromise they can all live with. As the

saying goes, the most successful mediaƟon is one

where everyone leaves unhappy – this means that

each side gave more than they wanted so they could

reach a compromise.

ArbitraƟon. ArbitraƟon is a

binding, adversarial process,

and is much more formal and

structured than mediaƟon, but

less rigid than the court process.

First, the parƟes will agree on a

neutral third party, called an

arbitrator. In the event the

parƟes are unable to agree on an

arbitrator, the court may choose

to appoint one. OŌen, the

arbitrator is either a reƟred judge or an aƩorney that

has experience with the subject maƩer at issue.

Once engaged, the arbitrator will set a preliminary

hearing where the parƟes can discuss procedural

maƩers, a schedule for discovery and any other early

-stage issues. The arbitrator may also begin ruling on

Mediators

facilitate

discussion and

negoƟaƟon;

arbitrators

make awards,

picking

winners and

losers.

296

any moons of the pares, such as discovery

challenges.

Prior to the day of arbitraon, each side will submit

an arbitraon brief. At the arbitraon, the arbitrator

will review presented evidence, listen to witness

tesmony, and make rulings as to the admissibility of

evidence.

Unlike mediaƟon, aŌer the arbitraƟon is completed,

the arbitrator will make a decision, known as an

“award,” and that decision will be legally binding on

the pares and enforceable in a court of law. In that

respect, it is very similar to a judge issuing a ruling.

Unlike a ruling from a court proceeding, awards are

generally not subject to appeal. The only excepons

are when there is misconduct by the arbitrator or

other procedural irregularies that jusfy review by a

court. However, pares cannot appeal simply

because they did not think the arbitrator reached the

right conclusion.

Mediaon is oen a quick and inexpensive way to try

to resolve a dispute. It is parcularly useful when the

pares wish to preserve their relaonship on a going

forward basis, as the process is more cooperave

than arbitraon or a court trial. Arbitraon and

court trials can create a “scorched earth” mentality

and can oen put the pares in an “all or nothing”

frame of mind, which does not encourage selement

eorts.

297

ArbitraƟon is beƩer suited to situaƟons where the

parƟes need a nal, binding decision, and where they

would like that faster than they might be able to

achieve with a full court trial. While arbitraƟon is

generally faster than a court trial, it is much more

expensive than mediaƟon. In fact, depending on the

case, the cost savings from arbitraƟon compared to a

court trial may be negligible (parƟcularly if a high-

prole arbitrator is used… unlike a court trial, the

parƟes will be paying the arbitrator an hourly rate for

his or her Ɵme).

298

NOTES

_______________________________________

299

EXIT STRATEGIES

Many entrepreneurs, when starng a business, are

already thinking about how they will be able to exit

that business and rere. Whether that is your

mindset now, or won’t be for some me to come,

business owners have a variety of ways to exit from a

successful company.

Ini�al Public Oﬀering. An inial public oering

(“IPO”) is an event where a private company oers

its shares to the public for the rst me, i.e. it

becomes a publicly traded company on a stock

exchange. It involves ling an S-1 registraon ling,

which is just part of a complicated, lengthy and

expensive registraon process (count on $1.0-$1.5

million dollars in legal and accounng fees). An IPO

has many benets, including

 Valuaon mulple -- public companies can

oen enjoy a higher price to earnings

mulple than a private company can

 Access to capital -- Raising substanal

capital is easier in a public company

 Liquidity -- because of public trading,

owners, investors, and other shareholders

have an available market in which they can

sell shares

 Awareness-- public companies get a boost in

credibility, allowing them to aract top

talent and market the company more

successfully

300

Many entrepreneurs see an IPO as being the

“ulƟmate success,” but IPOs are not right for every

company. Ongoing legal and accounƟng fees can be

quite signicant (from several hundred thousand

dollars to millions of dollars annually), and

inconsistent revenue streams can severely impact

value. Also, there will need to be a strong market for

the shares; otherwise, the share volaƟlity may be so

great that very few shares can be sold before the

share price goes into a tailspin, severely impacƟng

shareholder value and liquidity. For that reason,

companies typically need to achieve a certain level of

success before they go public; otherwise, they may

be siƫng with a public company (along with all the

costs of being public) without signicant market

interest to create a stock that has liquidity.

While an IPO is an event many business owners

dream of, it is a relaƟvely uncommon way to exit

your business. It is more common for a company to

merge or sell.

Mergers. A merger occurs when

two companies combine, with

one company surviving and the

other company disappearing. In

a direct or forward merger, the

company geƫng acquired (the

“target”) merges into the

acquirer, with the acquirer surviving and the target

disappearing. In the case of a forward triangular

merger, the target merges into a subsidiary of the

In a merger,

one enƟty

survives, the

other

disappears.

301

acquirer, with the subsidiary surviving and the target

disappearing. In the case of a reverse triangular

merger, the target merges with a subsidiary of the

acquirer, the subsidiary disappears, and the target

survives as a wholly owned subsidiary of the

acquirer.

Unlike an IPO, which can take a year or more to

complete, mergers can occur in the span of a few

months, providing owners with a faster path to

liquidity. Also, where the buyer is a compeƟtor or in

a complementary channel, synergies between the

two companies can make both enƟƟes more

successful going forward. In a merger, it is quite

common for employees to conƟnue with the new

enterprise, oŌen with retenƟon bonuses or stock

opƟons in the surviving enƟty.

One signicant advantage of a merger over a stock

purchase (which will be discussed below) is that a

merger typically does not require unanimous

approval by the company's shareholders. While it will

require a majority (or someƟmes, super-majority)

vote, uncooperaƟve minority shareholders have less

opportunity to obstruct the transacƟon. Note that if

there are mulƟple classes of stock, each class may be

required to vote separately, which means each class

must then vote a majority of votes in favor of the

merger before the transacƟon can be completed.

One factor to consider in a merger is what happens

to the target company’s exisƟng contracts with other

302

parƟes. In a merger where the target does not

survive, all assets and liabiliƟes will be assumed by

the acquirer or the subsidiary of the acquirer, and

third-party contracts will be deemed to have been

assigned or transferred to the acquirer. As a result,

third party consents are typically required. However,

in a reverse triangular merger, where the target

ulƟmately survives as a wholly owned subsidiary,

third party consents are not typically required, unless

there is a “change of control” provision in that

contract. A change of control provision states that in

the event of (i) a merger, (ii) a change in ownership

of more than 50%, or (iii) a sale of all or substanƟally

all of its assets, the other party must consent to the

transacƟon or otherwise have the right to terminate

the contract.

Stock Sales. Another method of

selling a business is the sale of

stock held by the shareholders.

This sale of stock might be to a

compeƟtor, a private equity

fund, a private investor, or even

through an employee stock

ownership plan.

From the seller's perspecƟve,

one benet of a stock sale is that all liabiliƟes (unless

specically excluded) are transferred to the acquiring

party. Of course, this is less favorable from a buyer’s

standpoint.

A stock sale

transfers all

assets and

liabiliƟes,

except

specically

excluded

liabiliƟes.

303

Another benet is that not all shareholders

technically need to parƟcipate. In a stock sale, the

parƟes to the transacƟon include the individual

shareholders. Assuming the buyer accepts something

less than full parƟcipaƟon, any shareholders who

choose not to sell can conƟnue as shareholders, post

-transacƟon.

Finally, in a stock sale, there can be tax benets to

both the buyer and the seller, depending on the

circumstances. The buyer may be able to take

advantage of seller’s net operaƟng loss carry

forward, and selling shareholders may enjoy certain

tax benets as well, as the stock purchase

transacƟon results in a single layer of tax at the

shareholder level; under an asset purchase from a C

CorporaƟon, tax would trigger at both the company

level (on sale) and shareholder level (upon

distribuƟon of proceeds).

However, if the buyer does not accept anything less

than full parƟcipaƟon, unanimous consent of the

shareholders will be required, since all shareholders

each need to agree to sell their shares. As a result, in

companies with many shareholders, the buyer will

typically use a merger approach; in companies with a

small number of cooperaƟve shareholders, a stock

sale is preferable as it is a liƩle less complicated.

304

Asset Sales. An asset sale, in the

context of an exit, is the sale by

the company of all or

substanƟ

ally all of the

company’s assets related to the

business operaƟon (except those

assets specically excluded).

However, no liabiliƟes are

transferred to the buyer unless

the buyer specically assumes

those liabiliƟes. As a result, the seller must then use

the sales proceeds to pay all liabiliƟes prior to

making any distribuƟon of sale proceeds to

shareholders.

Shareholder consent (typically, by majority vote) will

be required in order to complete the sale of all or

substanƟally all of the assets of the company.

In general, a stock sale is typically preferable to a

seller (because liabiliƟes transfer), while an asset

sale is typically preferable to a buyer (because

liabiliƟes do not transfer).

Generally, in the case of a distressed business being

put up for sale, the buyer will require an asset sale so

it can be condent that no liabiliƟes will be deemed

transferred to the buyer.

UlƟmately, all business owners want a successful

nancial exit. However, the best exit strategy will

depend on the business, its structure, and its goals

An asset sale

transfers

assets but no

liabiliƟes,

except

specically

included

liabiliƟes.

305

for the future. It will also obviously depend on deal

pricing and the tax impact of the deal structure, as

well as the willingness of shareholders to approve or

parƟcipate in the proposed transacƟon. Having

experienced legal and accounƟng advice will be

criƟcal as you make decisions on deal structure.

306

NOTES:

_______________________________________

307

NOTES

_______________________________________

308

NOTES

_______________________________________

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ENTREPRENEUR’S

SURVIVAL GUIDE

A POCKET GUIDE TO START-UP LAW

JAY LANDRUM

THE

THE ENTREPRENEUR’S

SURVIVAL GUIDE

A Pocket Guide to Start-Up Law

_____________________

Jay Landrum

InformaƟon contained in this book is intended to provide general

informaƟon about signicant legal topics and legal developments

and should not be construed as legal advice on any specic facts

and circumstances, nor should this informaƟon be construed as an

adverƟsement for legal services.

TABLE OF CONTENTS

INTRODUCTION ........................................... 9

THE UGLY TRUTHS ABOUT BEING IN

BUSINESS FOR YOURSELF .......................... 13

LEAVING YOUR PRIOR EMPLOYER ............. 19

EMPLOYEE COVENANTS NOT

TO COMPETE ............................................. 25

PLANNING BETWEEN CO-FOUNDERS ........ 29

FICTITIOUS BUSINESS NAMES ................... 33

DO I INCORPORATE? ................................. 37

WHERE DO I FORM? .................................. 43

LLC vs. CORPORATION vs. PARTNERSHIP

vs. SOLE PROPRIETORSHIP ........................ 47

FORMING A BOARD ................................... 65

ADVISORS TO THE BOARD ......................... 69

OFFICERS ................................................... 71

DUTIES OF LOYALTY, GOOD FAITH AND

DUE CARE .................................................. 75

RECORDKEEPING ....................................... 79

PIERCING THE CORPORATE VEIL AND

THE ALTER EGO DOCTRINE ........................ 83

STOCK, PHANTOM STOCK AND SAFES ...... 91

COMMON vs. PREFERRED STOCK .............. 95

VOTING .................................................... 101

SHAREHOLDER AGREEMENT ................... 107

BUY-SELL AGREEMENT ............................ 113

SPOUSAL CONSENTS ................................ 133

STOCK OPTIONS ....................................... 137

VESTING ................................................... 143

409A VALUATIONS ................................... 147

TYPES OF INVESTORS ............................... 151

INVESTOR VALUATIONS ........................... 155

TERM SHEET, LETTER OF INTENT ............. 159

FINANCING YOUR BUSINESS .................... 163

USING FINDERS ........................................ 167

BASIC FORMATION DOCUMENTS ............ 173

OBTAINING AN EIN .................................. 177

SHARE OFFERINGS AND SECURITIES

REGULATIONS .......................................... 179

CORPORATE TRANSPARENCY ACT ........... 187

AN INTELLECTUAL PROPERTY

OVERVIEW ............................................... 203

COPYRIGHTS ............................................ 207

FIVE COPYRIGHT MYTHS .......................... 221

TRADEMARKS ........................................... 225

PATENTS .................................................. 237

TRADE SECRETS ....................................... 243

EMPLOYEES vs. INDEPENDENT

CONTRACTORS ........................................ 249

OFFER LETTERS AND EMPLOYMENT

AGREEMENTS .......................................... 257

PROPRIETARY INFORMATION

AGREEMENTS AND NON-COMPETE

AGREEMENTS .......................................... 261

LABOR CODE 2870 (CALIFORNIA) ............ 267

CONTRACTS AND ARTICLE 2 OF THE

UNIFORM COMMERCIAL CODE ............... 271

DIGITAL SIGNATURES .............................. 275

DATA PRIVACY ......................................... 279

TYPES OF LIABILITY .................................. 283

INSURANCE .............................................. 287

RESOLVING DISPUTES: MEDIATION

AND ARBITRATION .................................. 293

EXIT STRATEGIES ..................................... 299

ABOUT THE AUTHOR

Jay Landrum, a corporate aƩorney, has been working

with entrepreneurs for over 30 years.

He has worked as General Counsel and Vice

President for an NYSE listed company, where he was

part of a management team that grew its business

over 700% in ve years. As a start up entrepreneur,

he has founded several businesses, wriƩen business

plans, raised capital and led operaƟons; as the CEO

of those businesses, he has stood in the same shoes

as entrepreneurs like you.

His corporate legal pracƟce emphasizes business

transacƟons, including enƟty formaƟon, nancing

transacƟons (venture, private and debt), and buy-sell

agreements, as well as day-to-day legal

representaƟon. He frequently serves clients as

counsel on acquisiƟon and merger transacƟons,

asset and stock acquisiƟons, joint ventures, and also

on technology transacƟons, such as development

agreements (website, soŌware development),

manufacturing agreements (OEM, VAR), and

technology-oriented purchase and sale agreements.

Contracts and licensing are also primary pracƟce

areas, including hardware and soŌware licensing

agreements, non-disclosure agreements, distribuƟon

agreements (such as dealer, distributor and

manufacturer representaƟve agreements), and

licensor/agent/licensee representaƟon.

He also has more than 25 years of experience represenƟng

art-based clients, including painters, photographers,

sculptors, songwriters, authors, art publishers and art

agents in areas of general representaƟon, publishing,

distribuƟon, licensing, copyright, and trademark. He is a

recognized expert in the eld of art law, and he has served

as an expert witness for art law disputes.

Outside of his day-to-day legal pracƟce, he has also taught

start-up law at Santa Clara University School of Law and

business law at Jessup University.

Jay’s contact informaƟon is:

Jay Landrum

Berliner Cohen LLP

10 Almaden Blvd., 11th Floor

San Jose, CA 95113

t: 408.286.5800

e: jay.landrum@berliner.com

INTRODUCTION

If you are reading this book because you are about to start

your own business, congratulaons on taking the big leap!

You're in good company -- over 50% of adults have started

a business at some point in their lives. With that

parcipaon level, it's no surprise that small businesses

make up more than half of the U.S. economy!

Of those who make the leap, about a third choose to do so

because they want to be their own boss. Of course, if you

can pursue your passion in the meanme, that's even

beer. As for those who don't start a business (even

though they want to), 40% don’t do so because they

don’t know where to start. Hopefully, this book can solve

some of those mysteries.

Entrepreneurship is a great equalizer. More than 50% of

entrepreneurs do not have a college degree. Almost one

in six entrepreneurs are immigrants, one in six

entrepreneurs are minories, and about 25% are women.

It's esmated that about 30% of small businesses make

money, 30% break even, and 30% lose money. Why do

businesses fail? Oen, because of insucient capital or

poor cash ow. In this book, you'll acquire some tools that

can help you raise capital to keep your business aoat, as

well as informaon that will help you avoid making

common mistakes.

Over my career, I have worked with hundreds of

companies, some as small as one person, others

employing thousands of workers. I have worked in-

house at companies, started businesses, raised

money, run businesses, and have provided legal

advice to thousands of people. I have been in your

shoes…I know what entrepreneurs need to know,

because I have been one. In this book, I’ll do my best

to give you praccal informaon without a lot of

lawyer-speak – with the goal of geng your new

enterprise o to a solid start!

This guide is intended to be an easy-to-read, high-

level view of business law for the entrepreneur. It

covers protecons that are available to you, as well

as the hazards that could impact your eorts. By

taking simple acons to protect yourself and your

rights, and by idenfying potenal pialls, you can

posion your business for long-term success. Note

that there may be some repeon across chapters,

but this is intenonal, in case you are ipping around

to topics/chapters you are specically interested in.

The law can be tricky. Keep in mind that while a

number of general concepts apply, answers to

hypothecal quesons quite oen end up being “it

depends.” In large part, that is because the answer

typically rests on specic factors unique to that

situaon. It will also depend on what law applies;

federal laws may vary within dierent appellate

courts and state laws may vary by state. So, while

this guide does make general statements about the

law, this guide is obviously no subsƟtute for legal

advice. The law is constantly evolving, and if issues

or risks arise (or you are even concerned certain

issues may arise), it’s always important to secure

legal representaƟon.

If this guide achieves its goals, you will walk away

more informed and educated on entrepreneurship

and business law than when you started. If it

really achieves its goals, you will not only be more

informed, but you will also put that knowledge to

use…taking acƟons that beƩer protect you and your

business.

While starƟng a new business may not be for the

faint of heart, the rewards can be great, both

nancially and emoƟonally. But fortune favors the

bold, so read on and prepare yourself for this

exciƟng journey! Best of luck!

Jay Landrum

NOTES

_______________________________________

THE UGLY TRUTHS ABOUT BEING IN

BUSINESS FOR YOURSELF

One of the most common reasons a business fails is

that there is no market for that product or service, or

that you have failed to create one. On one hand, it

seems prey obvious. A business clearly needs to

oer something people want to buy…but since this is

a primary reason that businesses fail, maybe it is not

so obvious aer all.

Entrepreneurs have many reasons why they want to

start their own businesses:

 I want to be my own boss

 When working for someone else, I don't get

to share any of the prots

 I want to work when I want to, and not be

on someone else’s schedule

 I have a great idea – something the world

needs!

 I may not have a new idea, but I can do

beer than those doing it now

 I have something I love doing, and I want to

turn my interest/hobby into a money-

making business

 My friends always say I'm a good cook, and

that I should start my own restaurant

While those are all potenally worthwhile reasons

for you to strike out on your own, self-evaluaƟon is

criƟcal before starƟng a business. You need to be

honest with yourself and ask quesons like the

following:

 Keeping all the prot

sounds great, but do I

understand that “keeping all

the prot” oen means

“geng paid last”? Can I go

without geƫng paid for

some period of Ɵme? For

how long?

 Do I understand that

“working when I want” oen

means “working whenever I can, so I can get

the work done”?

 Do I have the skills necessary to convert my

great idea into a business? (Venture

capitalists will tell you they would rather

invest in a great team with a good idea,

rather than a good team with a great idea…

ideas are important, but the ability to

execute is crical)

 Will my business need start-up capital? How

much? (Hint: it’s probably more than you

think!)

 Can I aord the upfront expenses unl I can

get cash ow posive?

 Will I raise money from friends and family?

Will they be understanding if the business

fails and I lose their money?

 If I need a Small Business Administraon

(“SBA”) loan, will I be willing to risk my

home’s equity and list my house as collateral

Honestly review

your skills and

temperament.

Are you up for

this challenge?

(as will be required)? Will my spouse be OK

with me pung our home at risk?

 While I have an interest in what this business

would oer, does the general market of

consumers have enough interest? Will I be

able to sell enough products or services to

pay my bills, such as rent, employees,

accountants, etc.?

 Do I have the temperament to be able to

deal with all the ups and downs of owning my

own business, including near failure or

growing faster than I can handle?

 Do I have the temperament to be able to deal

with the (somemes unreasonable) demands

of customers and employees?

 Am I considering all aspects of running a

business, and am I able (and interested) to

handle those challenges? (For example,

running a restaurant involves managing

people, markeng, nance, etc.… being a

great cook will not be enough on its own.)

As you evaluate your skill sets, think of people like

horses. There are lots of types of horses, including

show horses, racehorses, and dra/work horses.

While they're all horses, you would never put a work

horse on the track or harness up a racehorse to pull a

heavy load. Each horse may be perfectly suited for

one task, but not at all suited for another.

People are the same way, and every business needs

a variety of “horses" -- you will need someone who

can work the “front of the house,” talking with

customers, making sales, creaƟng markeƟng

campaigns, etc. You will need someone who can

work the “back of the house” as well, keeping the

books, searching for beƩer pricing, managing

contracts, and paying the bills. Which one are you?

Importantly, you need to know what

kind of horse you are! Recognize

where you have weaknesses and hire

people to work in those areas where

you are not as strong. If you love

working with people, and you are not

strong on nances, nd yourself a

strong nancial partner. If you love working with

numbers, but not with people, nd yourself a partner

who can work with the public. Even if you think you

are great at both, you need to recognize you may not

have the Ɵme to do both -- in that case, you may sƟll

need a partner (or employee) to handle the areas

you will not have Ɵme to address.

You should also ask yourself what kind of a life you

are looking to live while you run this business. Are

you willing to shiŌ from a “9 to 5” job into a career

that may require working lots of nights and

weekends? While owning your own company may

eventually allow you to work less and live beƩer, are

you willing to make the sacrices necessary to get

there? Is your family willing to make those same

sacrices?

What

kind of

horse

are you?

This quesƟon is even more important if you start a

business with a partner. Some people start a

company because they want to build a valuable asset

that they can later sell; others go into business for

themselves because they want to be able to work

less and maybe golf every Wednesday. It is criƟcal

that partners have similar objecƟves…when you have

one partner working 70 hours a week while the other

partner works four days a week while he improves

his golf game, issues will

undoubtedly arise. I can tell you

from experience that when

partners are not aligned on their

contribuƟons, the company

immediately has operaƟonal

issues and most frequently does

not survive. Your discussions with

any potenƟal partners should be

blunt… with everyone seƫng out their expectaƟons

for themselves and each other and everyone being

on the same page as to what each partner will be

delivering in their role at the company.

A key to success is idenƟfying obstacles in advance,

and the rst ones you need to idenƟfy are those

resulƟng from your own limitaƟons, and the

limitaƟons of your partners. Once you do that, you

can start to put measures in place to address those

limitaƟons….some of which may be detailed in

wriƟng (and maybe even in a contract), and others

which may just need discussion up front…however,

Make sure

you and any

partners are

aligned on

goals.

since memories oŌen change, puƫng it in wriƟng is

important (and never a bad idea!).

LEAVING YOUR PRIOR EMPLOYER

"Take this job and shove It, I ain't workin' here no

more!"

That’s both a line from a 1977 country music song

wrien by David Allan Coe (and popularized by

Johnny Paycheck) as well as the senment of many

employees across the country. It’s a mindset that

has put many entrepreneurs on the road to self-

employment!

Walking out the door may sound easy, but it may

actually be more dicult than you think.

Before you quit, consider a few things:

Oen, before someone leaves their

job to start their own business, they

want to start pung that new

company together. Depending on

your posion in the company, that

may be dicult. If you are a key

employee, such as an ocer,

director, or manager, or if you are a

skilled employee such as an

engineer, top salesperson, or a specialist in some

area, you may owe a duty of loyalty to the

company, whether or not you have an employment

agreement. If so, that duty of loyalty will prevent

you from doing things that would harm your

employer during the me you are sll working for

Don’t jump

the gun!

Understand

obligaƟons

to your

current

employer!

them. It's important to know your obligaƟons to

your current employer before you start developing

your new business; otherwise, your employer may

claim that your new business belongs to them.

Generally speaking, lower-level employees are

typically not bound by non-compete agreements,

which allows them to develop their new business

during their oﬀ hours and even work for a

compe��ve business on their oﬀ hours.

The higher your posiƟon, the more likely you may

have a duty of loyalty. In many cases, the company

will require that you sign a non-compete agreement

when you are hired…years later, you may not even

remember you signed it, so you may need to ask to

review your le (although, depending on the state,

that non-compete may not be enforceable).

CondenƟality ObligaƟons:

In the course of your employment, it's possible you

may have come across conden�al informa�on

belonging to your employer. Just because you're

leaving doesn't mean you get to use that

informaƟon however you want.

It's possible that when you joined the company, you

signed a non-disclosure agreement which restricts

your use of the company's conden�al informa�on.

Even if you didn't, you s�ll may have restric�ons on

the types of informa�on you can use. Don't be

surprised if your employer asks you to sign

something on your way out stang you're aware of

your condenality obligaons and that you will not

use their condenal informaon in the future.

“AŌer hours” and with no company resources:

Absent some specic restricons you

may have agreed to, you are enƟtled

to develop your own business on

your own hours. If you have specic

work hours and punch a me clock,

it may be more clear that you are

working on your own business “aer

hours”-- of course, if you are a

manager, or someone who does not

have dened hours, it becomes a bit more blurry as

to whether you were working on your own me.

Obviously, if you take two weeks o for vacaon, and

work on your business then, that would be on your

own me, but proving what was done then, versus at

work, may be a challenge.

Not only must you develop your business on your

own hours, but you also must do it with your own

resources. That means you can't use the company

oce, the company phone, company fax machine,

company copier, your company laptop, or anything

else that is owned or supplied by your employer.

Develop

your new

business on

your own

Ɵme with

your own

tools.

Bringing coworkers with you:

You probably work with some people that you like

and think they would be great for your new

company. If leaving your company doesn't already

make your employer upset, taking a few of their best

employees with you will probably do the trick.

SoliciƟng employees is something you should be

very careful about. It's possible, in your employment

documents, you signed something that stated you

would not solicit employees if you leŌ the company.

While it is true that employees are generally “at

will” and can leave at any Ɵme, that does not

always mean that you can lure them away.

The most conservaƟve approach here is to wait unƟl

you have leŌ and started your own company before

you solicit any employees for hire.

When you bring former colleagues into your

company, your employer may be concerned that

they are taking condenƟal informaƟon with them

that you would not have had access to otherwise.

For example, if you are a soŌware engineer who has

decided to start your own company, and you hire the

top three salespeople to now sell your similar

soŌware product, your employer may be concerned

that these salespeople are being hired more for your

employer’s client list than their qualicaƟons as

salespeople. It is very important to get a

commitment from any employees that you hire

away from your current employer (as well as from

any other employer) that your new hires are not

bringing any condenƟal informaƟon over with

them.

I had a client that (prior to my representaƟon) was

sued for copyright infringement. Unbeknownst to the

client, one of his employees had misappropriated a

copy of his prior employer’s source

code and then used that source

code in developing certain code for

my client. Despite the fact my client

did not know this employee had

taken the code, and was “innocent”

under the circumstances, it was

and my client received a judgment

against him for millions of dollars and went into

bankruptcy. In hindsight, the client should have

clearly instructed all employees that they were

forbidden from bringing any prior work product

from any prior employer with them and provided

ongoing training on the same. If the employee had

done so anyway, the client would have been in a

beƩer posiƟon to argue that the employee, not the

company, should be responsible for any

infringement. Later in this book, we will discuss

specics on documents employees should be

required to sign upon hiring, to avoid this risk and

others.

Be careful

about what

informaƟon

others may

bring into

your

business!

NOTES

_______________________________________

EMPLOYEE COVENANTS

NOT TO COMPETE

In the scope of employment, covenants not to

compete are essenƟally agreements where

employees agree not to compete with the employer

during and (someƟmes) aŌer terminaƟon of

employment.

Diﬀerent states have diﬀerent

requirements regarding non-

compete agreements. Generally,

non-compete agreements need to

meet certain condi�ons, such as

being reasonably limited in their

scope (including geography and

dura�on) and the non-compete

must be related to legiƟmate business interests

(such as protec�ng trade secrets, client rela�onships

and conden�al business strategies). The agreement

must also be supported by independent

consideraƟon (typically, some form of addi�onal cash

payment separate from what they would receive as

regular pay).

Agreements that might violate the required

condi�ons would be agreements that would prevent

the employee from working in an en�re industry or

prevent the employee from earning a living in their

chosen profession. The burden will be on the

Enforceability

of a non-

compete

agreement

varies from

state to state.

employer to show the legiƟmate purpose and

reasonable scope. Once you become an employer,

this will be your burden of proof as well.

Some states, such as California, are highly

restricƟve, and only allow non-compete agreements

under very narrow circumstances, such as restricƟng

a company’s owners from compeƟng in connecƟon

with the sale of a business. Other states will allow

non-compete agreements, even for low level,

unskilled workers.

Before you walk out your employer’s door, it is

important that you understand your obligaƟons

under these agreements. When in doubt, you can

always ask for a copy of your employment le and

you will receive anything you have signed; however,

this certainly signals to your employer that you may

be looking for the door.

If you suspect you may have some non-compete

obligaƟons, the most prudent decision may be to

wait unƟl you quit before you start puƫng together

your new business.

If you are entering into business with others, it is

important to understand if they have signed a non-

compete, as their violaƟon of that agreement may

bring claims not only against themselves, but also

against your company.

It is crical that all the documents employees receive

are legal. The penalty for using a non-compete

agreement that is not legally enforceable may not

be limited to the court’s refusal to enforce it…it may

be more costly.

For example, in California, if an employer uses a non-

compete agreement illegally, the employee can

report the company to the California Aorney

General’s oce, which may result in nes and

penalƟes. The company will also be subject to civil

liability, including employee lawsuits for damages,

injuncƟve relief, and aƩorneys’ fees. Further, under

California law, if an employer entered into non-

compete agreement with a California employee aer

January 1, 2022, the company is required to take

further acon and nofy those employees that those

agreements are void under California law, or face

nes for the failure to do so.

NOTES

_______________________________________

PLANNING BETWEEN CO-FOUNDERS

StarƟng a business with a co-founder can be great.

There's someone else to bring other skill sets, help

carry the heavy load of entrepreneurship, and

potenƟally help fund the project. However, it is

important to assess the personal and business

aspects of this collaboraƟon before you make the

leap.

While it may seem obvious, one

oŌen overlooked aspect when

starƟng a business is your plan

around ownership. OŌen, a couple

of people get together and come up

with an idea to form a new venture,

and they start down that path

without considering whether they

have the same goals in mind.

As menƟoned before, one partner may want to start

his own business because he wants more free Ɵme

to pursue his hobbies. His partner may be starƟng

the business with the intent of devoƟng all her Ɵme

to making this business successful, because she

wants to build an empire which will allow her to

reƟre in luxury. Neither is the wrong answer, but it is

important that all partners be on the same page as

to what their expectaƟons are. Being aligned on the

vision of the company, as well as on individual work

AnƟcipate

future

issues so

you can

address

them now!

eorts, will eliminate frustraon and conict in the

future.

Another maer that needs to be decided is who is

going to run the business. Suppose three partners

form a business, and one becomes the CEO, one

becomes the CFO, and one becomes CTO. If a

decision needs to be made as to change in the

direcon of the business, does the CEO have the

authority to make that decision,

or will that require all founders to

have a vote? If a vote, then under

what circumstances is a vote

required (and when is it not

required)?

Does each founder have the right

to spend money as they deem

t? Or is there a nancial

threshold which requires approval? And if approval is

required, who is authorized to give that approval?

In the minds of some founders, Ɵtles are simply

ceremonial, and everyone has equal say. In the

minds of others, those Ɵtles represent the specic

roles and responsibiliƟes of each party. It is

important to clarify under which condions you and

your team will operate.

Obviously, from a praccal standpoint, every

decision cannot be made by group vote. However,

there are strategic decisions which can reasonably

How will the

partners

divide up the

labor? How

are decisions

going to be

made?

require a vote by all. The queson is where those

lines are drawn during everyday management of the

business.

Is everyone going to work in the oce? If someone

chooses to work from home, do they have that

opon? Is vacaon me managed strictly or do

founders take me o whenever they choose?

Not surprisingly, money can oŌen be the most

contenƟous issue between co-founders. There

should also be discussions around how equity will be

held, how prots and losses will be distributed,

whether bonuses will be paid (to some founders and

not to others, based on performance metrics?), and

how disputes will be resolved.

In the event a founder leaves the company, what

happens to that founder’s ownership? Does the

founder retain it or lose it? Is that ownership subject

to vesng over some period of me? Once it has

vested, does the company sll have a right to

purchase it aer they leave? If so, at what price?

Founders oen choose to enter into a buy-sell

agreement (addressed in more detail in a chapter

later) to address a variety of concerns around life

events, including divorce, disability, death, quiƫng

with noƟce, and reƟrement. On the occurrence of

those events, the remaining shareholders and/or the

company have a right (or in some cases, an

obligaon) to purchase ownership from the aected

individual. The benet of a buy-sell agreement is

that the condiƟons are set out in advance, and the

formulas for purchasing the ownership are also

agreed in advance.

The best relaƟonships in business are those that

start with a well thought out arrangement. Co-

founders need to realize this is not negaƟve thinking,

but instead, pracƟcal thinking; anƟcipaƟng the

potholes on your road to success will allow you to

sidestep the damage that may be caused if you

don’t.

FICTITIOUS BUSINESS NAMES

A c��ous business name is a name that is diﬀerent

than the legal name the owner gives to the business.

It's oen called a “trade name” or a name you are

“doing business as” (a “DBA”).

Oen, someone who is operang a

business as a sole proprietor will give

the business a dierent name. If they

do so, they have given it a cous

business name. For example, if I open

a business as a sole proprietor and I

name it “Speedy Cleaners,” then

Speedy Cleaners is my cous

business name and the community

knows my business by that name, not

by my personal name.

Similarly, a corporaon or limited liability company

can also form under one name and operate under a

dierent name. That dierent name would be their

cous business name.

If you are a sole proprietor, one advantage of using a

cous business name is that it provides a level of

privacy, separang your personal name from the

business.

There is no limit to how many cous business

names a business can use, and a business that is in

dierent markets may choose to use dierent names

File for a

DBA when

you are

using a

name other

than the

legal name

of your

business.

in each market. Generally, however, since a business

is trying to build its brand, it may be best to focus on

one name.

In the event you use a cƟƟous business name, you

are required to register that name in the city or

county (or in some cases, the state) in which the

business operates. This gives the public noƟce of the

person or company operaƟng under that name.

The process of registering a cƟƟous business name

is simple. First, you must le an applicaƟon with

your city or county (or state), and it can typically be

led online. There's typically a ling fee, but it is

generally inexpensive.

Next, you are usually required to provide noƟce of

the name to the public, which involves placing the

noƟce in a newspaper of general circulaƟon one or

two days a week for 4 weeks or so.

Newspapers are very familiar with this process, and

provide this service on a at fee, which is usually

inexpensive as well. Since any newspaper of general

circulaƟon will work, you should call around and nd

the best price. All that maƩers is meeƟng the

requirement.

Once the publicaƟon requirement is met, you

provide proof of that publicaƟon to the same

authority where you led your applicaƟon, and the

process is complete.

Once approved, your cƟƟous

business name registraƟon will

remain in place for a certain period

of Ɵme, typically ve years. At that

point, you will need to renew.

It's important to note that ling a

cƟƟous business name does not

provide you with any protecƟon against liability.

While a sole proprietor’s cƟƟous business name

may sound like a corporaƟon, it is not one, and there

is sƟll unlimited liability.

One nal note – your cƟƟous business name

registraƟon may allow you to use that name in the

region where you le, but if you want to have

broader protecƟon (such as exclusivity of that name

in your state or in the U.S.), you will want to look at

ling a trademark.

DBAs will

need to be

renewed.

Don’t miss

your

deadline!

NOTES

_______________________________________

DO I INCORPORATE?

Deciding whether to incorporate your business is a

very important decision to make. Some forms of

business are simple, some forms are more

complicated. Some forms of business provide you

with no liability protecƟon, while others provide

protecƟon of your personal assets.

Decisions around incorpora�on

typically involve two primary

concerns. The rst is liability

protecƟon, meaning protec�ng

your personal assets from

anyone who sues the business.

The second considera�on is

typically taxaƟon, as some

forms of business organiza�on

are taxed diﬀerently than

others.

That being said, there are other factors that will

come into the decision process as well. For example,

are you planning on raising money from investors for

your business? Are you planning on having any co-

owners in the business? Are you planning on having

employees?

In the next few chapters, we will talk in more detail

about the various forms of en��es, but for now, you

should recognize that certain en��es provide you

with limited liability protecƟon. This means that if

LimiƟng your

liability means

protecƟng your

personal assets

from creditors

in the event the

business is

liable.

your business is sued, the assets of the business are

at risk, but your personal assets are not.

CorporaƟons and limited liability companies (and to

some extent, limited partnerships) provide this

limited liability protecƟon.

If you are a sole proprietor, or

you are in a general partnership,

you have no liability protecƟon

by virtue of operaƟng as that

form of enƟty. So, if you are

running a business as a sole

proprietor, and someone is

injured by your business, they

can go aŌer the assets of the

business and your personal

assets, including your home, your savings, and

anything else you have of value.

In a limited partnership, there must be at least one

general partner, and one or more limited partners.

The general partner will have

unlimited liability for all debts

of the partnership and will be

responsible for management of

the partnership. As a limited

partner, you won't lose any

more than your investment in

the partnership, but there are

limitaƟons in terms of your

involvement. For example, as a

limited partner, you are not

A sole

proprietorship

may be easier

to start with,

but it does not

limit your

personal

liability!

Limited

partnerships

only limit the

liability of the

limited partners

– the general

partner sƟll has

unlimited

liability!

allowed to be involved in the operaƟon of the

business and you will have no control over the

business. Limited partners are passive partners, and

if they do more than that, they run the risk of being

recharacterized as general partners (which would

then open those partners up to unlimited liability).

In the event you plan to raise money to fund your

new operaƟon, it is almost guaranteed that you will

need to do so as a corporaƟon or limited liability

company (“LLC”). Investors take comfort in knowing

that the laws governing corporaƟons and LLCs

provide them with clear rights and protecƟons. In

some cases, it's possible you can raise your funding

from limited partners, but that

would put you in the posiƟon of

being a general partner with

unlimited liability, which can be

a big risk. Being a corporaƟon

or LLC provides a level of

legiƟmacy to your business that

investors will appreciate, while

providing you with some

protecƟon for your personal assets.

Of course, a new limited partnership, corporaƟon or

LLC have both an upfront cost for formaƟon as well

as ongoing annual costs, lings and fees, which may

be a few hundred or a few thousand dollars,

depending on the state in which it is formed, and the

size of the enƟty.

The best way to

limit your

personal

liability is to

operate in a

corporaƟon or

LLC.

While the ongoing administra�on of a corpora�on or

LLC can be rela�vely simple, some business owners

prefer to avoid it and remain a sole proprietor. In

that case, it would be recommended that the

business owner look at carrying a much higher level

of insurance to cover the liability risk. Of course,

there will always be the risk that, whatever the

amount of insurance that business has, the insurance

is not suﬃcient to cover the losses for which the

business is responsible.

When deciding what form of business to operate, it

is also worth considering how that business will be

taxed. If you (or you and your spouse) are the sole

owner(s) of an LLC, your taxes might not diﬀer much

from what your taxes would look like as a sole

proprietor -- your business will le on Schedule C of

your personal federal return. In the event you are a

C Corpora�on or partnership, the en�ty will need to

le separate tax returns, which may add some

incremental annual cost and may also impact your

personal taxes. Evalua�ng the tax impact is outside

the scope of this book, and you should always seek

the advice of an accoun�ng professional before you

make a decision as to whether to operate your

business as a sole proprietorship, partnership,

corpora�on or LLC.

Another benet of placing your business in a

corpora�on or LLC is that transferring your business,

in whole or in part, becomes much easier, as you

may be able to simply sell your shares or member

interest. Also, because those enƟƟes are typically

perpetual in nature, your business can easily

conƟnue long aŌer you are gone.

However, here is the boƩom line: when looking at

limited liability protecƟon available by corporaƟons

and LLCs, you should do so recognizing the current

climate in which we live, where everyone sues for

every grievance. Through that lens, it is diﬃcult to

think of many businesses where a sole

proprietorship or partnership would be preferable

to a corpora�on or LLC. While there might be some

upfront costs and some ongoing fees to having a

corporaƟon or LLC, the limitaƟon of liability typically

outweighs those costs.

In the liƟgious world we live in, protect your

personal assets by creaƟng a company structure

that limits your liability.

NOTES

_______________________________________

WHERE DO I FORM?

We have 50 states in the United States, and you can

form an enƟty in any of them. So, which one should

you choose?

Typically, it is best to either form the enƟty in the

state where the company's principal place of

business will be located or in another state with a

large body of corporate law, such as Delaware.

Delaware is popular as a jurisdicƟon in which to

form corporaƟons because its large body of

corporate law provides more predictability in the

event of disputes. It is also

recognized as providing

increased management powers

and giving majority shareholders

more exibility on how to handle

minority shareholders.

Delaware’s Secretary of State is

also known as having very strong

administraƟon, so corporate

lings can be made quickly and

inexpensively. Delaware’s Court

of Chancery is exclusively

dedicated to resolving corporate

law disputes and handles them

more quickly than tradiƟonal

civil courts.

If you form

your

corporaƟon or

LLC in another

state, you will

need someone

living in that

state to be

your registered

agent of

service… if you

don’t know

anyone, you

can hire a

service.

Each corporaƟon or LLC must be registered in the

state in which it operates. If, for example, you

incorporate in Delaware, but your opera�ons are in

California, you will need to le a registra�on of

foreign corpora�on in California; this will result in

your company having to pay fees in two states.

Most states also require you to have a registered

agent in that state. If you do not have someone who

resides in that state and is willing to serve in that

capacity, you will have to hire an independent agent

to act as your registered agent, which will typically

cost $150-200 per year.

Tax consideraƟons are another signicant factor

when deciding where to organize or incorporate

your business. Some states, such as Delaware, Texas,

and Nevada, are known for low or no corporate tax.

However, Delaware charges a franchise tax and

Nevada and Texas charge a gross receipts tax, and

many states require sales tax, so any tax analysis

should encompass all forms of tax, and you should

not assume that simply because a par�cular state

may not have a personal income tax that

incorpora�ng or organizing in that state will save you

money on taxes.

In the event you are seeking privacy, Delaware,

Wyoming, New Mexico, and Nevada oﬀer greater

privacy protec�ons to company owners. Certain

states will not require that the names of owners and

directors be publicly disclosed.

FormaƟon costs and ongoing maintenance costs vary

from state to state, so it is important to factor those

into any decision. For example, California has an

$800 minimum annual franchise fee, and that

minimum fee is unrelated to the number of shares

authorized or issued. By comparison, Delaware has a

minimum annual franchise fee which may be more or

less than California, as the Delaware franchise fee is

the lower of two calculaƟons, the rst being based

on authorized shares and the second being based

total gross assets and total issued shares.

If you intend to raise capital, the

jurisdicƟon you incorporate in may

impact your ability to aƩract

investors. Many investors prefer to

invest in businesses incorporated in

Delaware due to its established

framework and its favorable

governance laws (although California, New York, and

Texas are also popular). AddiƟonally, if the company

is intending to go public, Delaware is preferred

because of its favorable corporate climate.

If you are forming a business that you expect will

perform the majority of its operaƟons within the

state in which you are located, that state will oŌen

be the best choice and the lowest overall cost.

However, it is important to weigh tax benets,

privacy, maintenance costs, and other expenses

before seƩling on any jurisdicƟon in parƟcular.

Where your

incorporate

will usually

maƩer to

investors.

NOTES

_______________________________________

LLC vs. CORPORATION vs.

PARTNERSHIP vs. SOLE

PROPRIETORSHIP

You've decided to start a new business. The next

decision is choosing which type of enƟty you will

operate. There are ve typical forms of business

organizaƟon, and each one has its advantages and

disadvantages.

A business enƟty can be conducted as a:

 sole proprietorship

 general partnership

 limited partnership

 corporaƟon (which for tax purposes can be

treated as either a “C” or “S” corporaƟon

 limited liability company (“LLC”) (which for

tax purposes may be treated as a

disregarded enƟty, as a partnership, or as a

corporaƟon)

Note there are also Professional CorporaƟons and

Limited Liability Partnerships, which may be required

in the event your business falls under certain types of

professional services (aƩorneys, accountants,

physicians, engineers), but in pracƟce, they operate

much like the above- related enƟƟes, so those will

not be addressed separately.

If limiƟng liability is less of a concern, and keeping

costs low is a criƟcal factor, an individual can

proceed as a sole proprietor. A sole proprietorship is

by far the simplest business structure. Any business

that starts with one owner and without formally

incorporaƟng or organizing is automaƟcally a sole

proprietorship. Since there is no legal enƟty being

formed when operaƟng as a sole proprietorship,

these types of businesses may not need to register

with the IRS and may be able to simply use the

owner’s Social Security number as the business tax

ID. Since there is no legal enƟty being formed, taxes

for the business are reported directly on the

owner’s individual Form 1040. This avoids the

double taxaƟon that a C CorporaƟon faces; the

owner reports the income and expenses of the

business on Schedule C of his or her personal federal

income tax return. All earnings of a sole

proprietorship are subject to FICA tax (Federal, State,

Medicare, and Social Security tax), and since the IRS

considers self-employed people as both employer

and employee, sole proprietors are responsible for

paying both halves of the FICA taxes. When a sole

proprietor desires to exit the business, the only

opƟon available to the sole proprietor is to sell the

assets and liabiliƟes of the enƟty. Since the owner’s

personal assets are not protected, this business

structure is not preferable for a business that has

any foreseeable risk.

If there are two or more of you, you can move

forward as a general partnership. A general

partnership is essenƟally a mulƟ-owner version of a

sole proprietorship. Usually, there

is no legal enƟty that has to be

formed when operaƟng as a

general partnership. General

partnerships simply spring into

being when people join forces to

run a business together and divide

the prots from their common

business. Partnerships are

typically used by relaƟvely simple, early-stage

businesses that have not yet achieved signicant

protability. MulƟ-owner companies by their nature

are more complicated than sole proprietorships, so it

is important to have a wriƩen partnership agreement

that controls the operaƟons and ownership of the

enƟty. In partnerships, the income of the enƟty

does not necessarily have to be allocated

proporƟonally to ownership; but, to avoid

misunderstandings later, allocaƟons of prots and

losses should be set out in the partnership

agreement. AddiƟonally, in order to ensure that the

IRS respects those allocaƟons, any partnership that is

not allocaƟng its income proporƟonally to ownership

should make sure their accountant is blessing those

allocaƟons. Partners are not considered employees,

but rather self-employed individuals; they do not

receive wages, but rather receive draws, which are

later reported on each partner’s Schedule K-1. Since

the partners in a partnership are the ones who

report and pay tax on behalf of the partnership, any

enƟty treated as a partnership for tax purposes

General

partnerships

do not

protect the

personal

assets of the

partners!

avoids the double taxaƟon that a C CorporaƟon

faces. A general partnership has the same downsides

as a sole proprietorship, i.e., all earnings are

generally subject to FICA tax and the owners’

personal assets are not protected.

A limited partnership has

elements of a partnership as well

as a corporaƟon. Limited

partnerships are commonly used

for real estate and investment

ventures, in that they are exible

in their operaƟon and provide

investors with limited risk

exposure. In a limited partnership,

there are one or more general

partners who are responsible for managing the day-

to-day opera�ons of the business and who have

unlimited liability, and there are one or more limited

partners who contribute capital but have a passive

role in the operaƟon of the partnership. Based on

that passive role, limited partners have limited

liability. That is a cri�cal trade-oﬀ, as a limited

partner’s liability is limited to the amount of their

investment in the partnership

only so long as they remain in

their passive role. As with a

general partnership, there should

be a wriƩ

en partnership

agreement, with prots and losses

shared between the partners in a

Limited

partnerships

only limit the

liability of

limited

partners, not

the general

partners!

Limited

partners

must remain

as passive

investors!

manner set forth within the partnership agreement.

Also similar to a general partnership, a limited

partnership is taxed on a pass-through basis, with

each partner’s prots and losses reported on their

Schedule K-1, avoiding the double taxaƟon that a C

CorporaƟon faces. While using a limited partnership

structure limits the exposure of the limited partners,

the general partner in a limited partnership remains

personally liable for debts and obligaƟons of the

partnership, and failure of the partnership can put

the general partner at great personal risk. As a

result, those who are operaƟng the limited

partnership will oŌen form an LLC (that they will

manage) to serve as the general partner, in order to

limit those liabiliƟes that would otherwise fall to

them personally.

Since sole proprietorships, general partnerships and

limited partnerships fail to shelter the owners’

personal assets from liability relaƟng to third party

claims against the company, they are not structures

that are preferred when the company has material

risks. To best limit liability, which is generally

preferable in today's liƟgious environment, the most

common soluƟon is to form a corporaƟon or an LLC.

If you have decided to limit liability and form an LLC

or corporaƟon, which one is best? A variety of

factors will inuence the choice.

For tax purposes, there are two basic types of

corporaƟons:

"C CorporaƟon" (standard corporaƟon), and

"S CorporaƟon" -- which is incorporated the same

way as a C CorporaƟon, but has made a tax elecƟon

that allows "pass-through" tax treatment (made

pursuant to "Subchapter S" of the Internal Revenue

Code). Once ling arƟcles of incorporaƟon, the

owners have 75 days to elect "S" status. It is also

possible to change from an "S" to a "C" corporaƟon

(or vice versa) for an upcoming scal year by ling

the appropriate elecƟon papers with the IRS before

the new scal year starts.

However, once "S" status is

terminated, the corporaƟon

generally may not reelect "S"

status for the next ve years.

AddiƟonally, changing from “S”

to “C” (or vice versa) has certain

other tax implicaƟons, so

changing tax elecƟons should be

carefully considered before ling

the elecƟon.

Like a sole proprietorship, partnership, or some types

of LLC, an S CorporaƟon tax elecƟon can eliminate

"double tax." In a C CorporaƟon, the income of the

business is rst taxed at the corporate tax rates,

then the shareholder is again taxed at the

shareholder's individual tax rate when dividends are

An “S

Corpora�on”

is just like a

“C

Corpora�on”

but with a

diﬀerent tax

treatment.

distributed. In contrast, with an S CorporaƟon, net

income and losses are “passed through” and only

taxed at the shareholder level, which oŌen results in

lower overall taxes than with a C CorporaƟon.

As an example of how the “pass

through” vs. “double tax” math

works, let’s assume the

corporate tax rate is 20% and

the individual’s tax rate is 30%:

 Under a C CorporaƟon,

each dollar of net income

eventually becomes

$0.56…rst, the $1.00 is reduced by the 20%

corporate tax (and becomes $0.80); then, that

$0.80 is reduced by the 30% personal tax (and

becomes $0.56).

 Under the S CorporaƟon, each dollar of net

income becomes $0.70…each dollar is only

reduced by the 30% personal tax, so $1.00

becomes $0.70).

To make an S CorporaƟon tax elecƟon, you must also

accept some limitaƟons:

 No shareholders of the

company can be corporaƟons,

partnerships, certain types of

trusts, or non-resident alien

individuals.

S CorporaƟons

can result in

lower taxes,

given its “pass

through”

treatment.

S CorporaƟons

have some

rules about

shareholders.

 No more than 100 shareholders are allowed.

 Only one class of stock is allowed (although

vo�ng and nonvo�ng stock can exist, so long as

other economic rights remain the same).

 All shareholders must consent to the S elec�on

(including spouses of shareholders in states

which follow community property laws).

Alloca�on of income and losses must be made only

in proporƟon to ownership (e.g., if you own 35% of

the shares, you must receive 35% of the prots and

losses).

The shareholders must appoint directors, who in

turn must appoint certain oﬃcers.

Shareholder mee�ngs and upkeep of corporate

records are important, just as with a C Corpora�on.

Even as an S Corpora�on, there s�ll may be separate

state tax on the company’s net income (e.g., in

California, it is the greater of 1.5% of the

corpora�on's net income or $800).

As a business gets larger and more complex, it is

common that it will outgrow the S Corpora�on

structure and move on to become a C Corpora�on.

Similarly, if the business is no longer eligible for S

Corpora�on status, such as if it takes on an

ins�tu�onal investor, its S Corpora�on status will

automa�cally terminate, and it will become a C

Corpora�on.

In addiƟon to C CorporaƟons and S CorporaƟons,

LLCs are also an opƟon to consider. In some ways, an

LLC provides the benets of a corporaƟon, but with

addiƟonal exibility in terms of their operaƟon and

how they are treated for tax purposes.

In general, an LLC allows several opƟons an S

CorporaƟon does not:

CorporaƟons, partnerships, certain types of trusts

and nonresident alien individuals can own interests.

There are no limits on the number of

“members” (the LLC’s equivalent to shareholders).

There are no limits on the types of classes or series

of membership.

The LLC can elect to be taxed as a

partnership, C CorporaƟon, or S

CorporaƟon (or if a single member

LLC, as a disregarded enƟty). If an

LLC chooses to be taxed as an S

CorporaƟon, then it must follow the

same rules that S CorporaƟons must

adhere to, as discussed above.

Gains and losses and voƟng power can be allocated

in a manner that is not proporƟonal to ownership

(e.g., a member can receive 30% of the prots and

losses, own 20% of the LLC member interests, and

have 40% of the voƟng power).

An LLC has

a variety of

ways it can

choose to

be taxed!

While one or more managers will manage the LLC, no

oﬃcer posi�ons or board of directors are required,

though those posi�ons can be created if desired.

An LLC is simpler to maintain than a corpora�on,

with no required annual mee�ngs.

However, LLCs also have certain disadvantages

compared to corpora�ons. For example, LLCs must

pay a minimum annual franchise fee (just like

corpora�ons), but LLCs may also have to pay an

addi�onal graduated fee (in California, up to

$11,790) based on gross revenue. This can have

more nega�ve tax implica�ons for a company,

par�cularly if it is selling expensive, but low margin,

products. Also, LLCs are not able to oﬀer certain

fringe benets available to corpora�ons. Finally, if

the business intends to seek funding, many investors

will not invest in an LLC, as they prefer the

protec�ons aﬀorded under the laws governing

corpora�ons.

PERSONAL ASSET PROTECTION

The primary reason for placing a business into a

corporaƟon or LLC is to protect the personal assets

of the owner(s). With some excep�ons, if a business

is not a corpora�on or an LLC, then the owners are

personally liable for any liabili�es, debts, or

judgments of the business; however, with a

corpora�on or LLC, a creditor usually can only collect

against the assets of the business, not against the

personal assets of the owners (for example, the

owners’ houses, investment accounts, etc.).

This protecon of personal assets

may not be allowed if the owners

do not leave the business with

sucient assets to run day-to-day

operaons and cover expected

liabilies, i.e. it is not adequately

capitalized. In that case, the

owners’ personal assets may again

be at risk. If the business has reasonable insurance

coverage, this capitalizaon risk can potenally be

migated. The owners may also be personally liable

(even if a corporaƟon or LLC is in place) if they do

not follow corporate formaliƟes (for example, if the

corporaon fails to have director or shareholder

meengs, or if the enty commingles the owners’

personal funds with the company’s business funds),

or if the owners commit fraud through the business.

If the business is looking for investors, those

investors will almost always want the protecƟon of

a corporaƟon or an LLC. Aer all, they do not want

their assets (beyond their investment) at risk either.

(As menoned above, another way to accomplish

this is to use a limited partnership, but there must be

at least one general partner with unlimited liability).

While the annual cost of maintaining a corporaon

or LLC, including minimum franchise taxes, can be

$1,000 or more annually, these limited liability

Ignore

protecƟon

of your

personal

assets at

your peril!

vehicles may keep you from being personally liable

for debts, liabiliƟes and obligaƟons of the business.

From that perspecƟve, those costs might be the best

investment you can make in your business.

REASONS NOT TO INCORPORATE OR FORM AN LLC

As one might expect, there is a price to be paid for

the privilege of having a corporaƟon or an LLC.

Typically, this takes the form of a minimum annual

tax that applies even if the enƟty is not making any

prot (or even any revenue). With a California

corporaƟon, there is currently a minimum corporate

tax of $800 a year. For a California LLC, there is

currently a minimum tax of $800 per year plus an

annual gross receipts tax based on total income

(which is zero if the total income is less than

$250,000 but can be as high as $11,790 at higher

revenues). For a small business that has good

insurance and is in a eld where the chance of being

sued is very low, it could be argued that it makes

sense to not become a corporaƟon or LLC. However,

even if a business has good insurance, owners may

wish to have the extra layer of protecƟon that a

corporaƟon or LLC provides.

C CORPORATIONS CAN SOMETIMES BE BETTER

THAN AN S CORPORATION OR LLC

If the business needs to carry over money into the

next scal year (such as where the business is

research intensive, for example), a C CorporaƟon

might be the beƩer choice. The reason is that if an S

CorporaƟon or LLC carries money into the next scal

year, the owners will sƟll be taxed as if they had

received that money, even though it was leŌ in the

enƟty. This issue is someƟmes referred to as

“phantom income”, because the owners are required

to pay tax on income where there may not be any

corresponding distribuƟon of cash from the

company. With a C CorporaƟon, the corporaƟon will

pay tax on its net income, but the shareholders will

not personally pay tax related to the corporaƟon if

no dividend was paid to them.

Another advantage is that a C CorporaƟon does not

have restricƟons on types of shareholders. Unlike

an S CorporaƟon, a C CorporaƟon’s shareholders can

include corporaƟons, partnerships, mulƟ-member

LLCs and trusts. An S CorporaƟon may be a drawback

if the business is seeking investors in any of those

prohibited categories.

UlƟmately, the best way to choose a structure in

which to operate your business is to weigh all the

benets and risks of each opƟon, then consult with

legal and tax advisors who can analyze your

individual tax situaƟon.

A SUMMARY OF BASIC ELEMENTS OF

CORPORATIONS AND LLCS

1. Who owns the business?

If C CorporaƟon or S CorporaƟon: Shareholders.

If LLC: Members.

2. Do owners have personal liability for the

company’s debts?

If C CorporaƟon or S CorporaƟon: No.

If LLC: No.

3. Are there restricƟons on what kind of business

can be conducted?

If C CorporaƟon or LLC: some states prohibit

formaƟon of banking, insurance and other special

businesses.

If S CorporaƟon: same as C CorporaƟon, but

excessive passive income (such as from rents,

royalƟes, interest) may jeopardize tax status.

4. Are there restricƟons on the number of owners?

If C CorporaƟon: One or more shareholders are

allowed.

S CorporaƟon: Same as C Corporaon, but no more

than 100 shareholders are permied.

If LLC: One or more members are allowed.

5. Who makes management decisions?

If C CorporaƟon or S CorporaƟon: The board of

directors and the ocers (who report to the board).

If LLC: The member(s) if a member-managed LLC, or

manager(s) if it is a manager-managed LLC.

6. Who can legally bind the business?

If C CorporaƟon or S CorporaƟon: The board of

directors and, if granted authority by the board of

directors, the ocers.

If LLC: The member(s) if a member-managed LLC, or

manager(s) if it is a manager-managed LLC.

7. What happens to the enty when an owner

dies?

If C CorporaƟon or S CorporaƟon: No eect

If LLC: Depending on state law and the operang

agreement, the LLC might dissolve unless remaining

members vote to connue the business.

8. Are there any limits on transferring ownership?

If C CorporaƟon: Transfers of stock may be limited

under securiƟes laws or restricƟons in ArƟcles

(CerƟcate) of IncorporaƟon or under the Bylaws or

a Shareholder Agreement.

If S CorporaƟon: same as C CorporaƟon, except

transfers should be limited to persons and enƟƟes

that qualify as S CorporaƟon shareholders.

If LLC: Unanimous consent of the non-transferring

members may be required under state law or the

LLC’s operaƟng agreement.

9. What ongoing legal formaliƟes are required?

If C CorporaƟon or S CorporaƟon: Annual meeƟngs

of the board of directors and shareholders are

required, and minutes must be taken and maintained

regarding the same.

If LLC: An operaƟng agreement is necessary but

annual meeƟngs are not required.

10. How are business prots taxed?

If C CorporaƟon: Net income is taxed at corporate

rates annually, with shareholders taxed at their

individual tax rates only if dividends are paid.

If S CorporaƟon: Net income is allocated then taxed

at individual tax rates of shareholders annually,

regardless of whether distribuƟons are made.

If LLC: Net income is allocated and taxed at

individual tax rates of members annually, regardless

of whether distribuƟons are made, unless the LLC

elects to be taxed as a C CorporaƟon.

11. What type of business owner would generally

nd each of the following enƟƟes is the best way to

do business?

If C CorporaƟon: Owners who want limited liability

and the ability to split income between themselves

and a separately taxed business, and who may seek

investors that will not meet the S CorporaƟon

shareholder requirements.

If S CorporaƟon: Owners who want limited liability

and individual (pass-though) tax rates to apply to

business income, and are willing to meet the iniƟal

and ongoing S CorporaƟon requirements.

If LLC: Owners who want limited liability and want

either pass-through or corporate taxaƟon,

parƟcularly if they intend on distribuƟng prots in a

non-proporƟonal manner.

NOTES

_______________________________________

FORMING A BOARD

One of the rst steps aŌer forming your corporaƟon

is to appoint a board of directors. If you have

formed an LLC, the creaƟon of a board is opƟonal but

not required.

A well-structured board is criƟcal to the success of

your corporaƟon. IniƟally, the board may be

selected by the incorporator; however, once shares

have been issued, the board should be approved by

a majority vote of the shareholders.

A board of directors has a variety of duƟes, including

strategic oversight of the company, nancial

stewardship (approving budgets, risk management),

ensuring the company abides by all legal and

regulatory requirements, as well as hiring and

managing (and if needed, ring) the President/CEO.

Ideally, the board will have an odd

number of members, so the

company can avoid a situaƟon

where the board is deadlocked.

Boards are generally as small as

three members, or as large as 15+,

but the ideal board is typically ve

members or seven members

depending on the size and

complexity of the company.

However, some states allow as few as one board

member.

Have an

odd

number of

board

members if

possible –

prevent

deadlock!

The ideal board member brings industry experƟse,

nancial experƟse, and/or legal experƟse, and is

willing and able to assist the company in developing

its strategic plans. While it is certainly not unusual to

have shareholders and members of the execuƟve

team parƟcipate on the board, the best pracƟce is to

have a board with independent directors in addiƟon

to directors who are involved in the business on a

day-to-day basis. Independent directors are those

who are not employees or shareholders, and who

can bring a more objecƟve viewpoint.

While it is typical for independent directors to be

paid for their service on the board, directors who

work for the company as exempt employees are

generally not compensated addiƟonally for their

board service. However, even for independent

directors, monetary compensaƟon is normally not

signicant; instead, companies generally

compensate directors with equity, in the form of

stock opƟons or restricted stock grants. By providing

compensaƟon in the form of stock opƟons or stock

grants, the directors’ interests are more aligned with

the shareholders.

When pracƟcal, boards will oŌen form commiƩees

to handle certain tasks, including an audit

commiƩee (to oversee nancial reporƟng and risk

management), a compensaƟon commiƩee (to

oversee execuƟve compensaƟon), and a nominaƟng/

governance commiƩee (to recruit new board

members and ensure good governance pracƟces). A

board should adopt a number of policies to guide

how they will funcƟon, including a code of conduct

and a conict-of-interest policy.

Depending on the size and needs of the company, a

board may meet monthly, quarterly, or annually. The

larger the company, the more likely that the board

will need to meet more frequently.

NOTES

_______________________________________

ADVISORS TO THE BOARD

Advisors to the board of directors are individuals

who will oŌen parƟcipate in board meeƟngs and

provide advice and counsel to the board of directors;

in many ways, they act in a manner similar to the

board of directors, with one signicant excepƟon…

advisors do not have a vote. Advisors provide

insights and recommendaƟons, but they are advisory

opinions only. The board of directors will consider

those recommendaƟons prior to voƟng, but they

have no obligaƟon to incorporate those insights.

Companies someƟmes nd signicant benets in

naming advisors to the board of directors, as it

allows the company to bring in addiƟonal experƟse,

knowledge and skills, without expanding the size of

the board.

Generally speaking, advisors to the

board are outside individuals (i.e.,

they are more similar to

consultants), and are not employees

of the company. Advisors are oŌen

CEOs of other companies,

academics, and industry leaders.

Arguably, the most important

criteria in selecƟng an advisor to the

board is that they are strong analysts of informaƟon

and provide clear and decisive opinions. It is not

unusual to recruit advisors who have specic

Advisors

may aƩend

board

meeƟngs,

but they

don’t get to

vote.

industry experience, as they can speak to best

pracƟces and trends within the industry and provide

a more independent perspecƟve compared to board

members who also are employees of the company.

However, advisors from unrelated industries can also

bring signicant wisdom based on their professional

experiences.

Another benet to appoinƟng advisors is that the

board gets to see these advisors in acƟon before

they are actually appointed to the board, i.e. it allows

the company to “test drive" these individuals before

they are given the full authority of a

board member posiƟon.

Advisors to the board should

generally be excused from board

meeƟngs when the board of

directors is dealing with

condenƟal or sensiƟve maƩers.

From the advisors’ point of view, it

allows them to expand their network, create strong

professional connecƟons, and puts them in a lead

posiƟon once a board seat opens up.

CompensaƟon to advisors is determined by the

board of directors and can take the form of a per

meeƟng fee, a monthly at fee, or an hourly fee.

Most oŌen, advisors are paid on a per meeƟng basis.

Advisors typically serve at the pleasure of the board

and can be terminated at any Ɵme for any reason.

Advisors

are a great

way to

“test drive”

potenƟal

board

members!

OFFICERS

Ocers of a corporaon are high level management

posions, responsible for running the business each

day. They are appointed by, and

report to, the board of directors.

So, while the board is tasked with

seng goals, guiding the business

and dening its strategies, the

ocers are responsible for

execung those decisions of the

board and operang the business on a day-to-day

basis. Ocers are oen also directors, but in large

part, the oﬃcers are the individuals who make

decisions each day to put the strategies and goals

set by the board into ac�on.

Ocers generally fall within 3 classicaons:

execuve, management, and administrave.

Execuve ocers are those responsible for high level

decisions, such as the Chief Execuve Ocer

(“CEO”). The CEO overseas the daily operaons of

the company and delegates tasks to other ocers.

Management ocers are those that oversee the day-

to-day operaons of the company, including the

Chief Financial Ocer (“CFO”). The CFO is

responsible for the nances of the business, and his

or her dues will vary based on company size. In a

smaller company, the CFO may pay the bills and run

payroll; in a larger company, the CFO will manage the

nance department. Finally, the administrave

Oﬃcers serve

at the

direc�on of

the board of

directors.

oﬃcers (such as the Corporate Secretary) are

responsible for managing company records,

coordina�ng shareholder mee�ngs, keeping minutes

of mee�ngs, etc.

The board of directors may, in their discre�on,

create other oﬃcer posi�ons based on the unique

needs of the company. Those posi�ons may include

a Chief Opera�ons Oﬃcer (“COO”), Chief Technology

Oﬃcer (“CTO”), Chief Legal Oﬃcer (“CLO”), Chief Risk

Oﬃcer (“CRO”), Chief Investment Oﬃcer (“CIO”)

and/or Chief Security Oﬃcer (“CSO”). Other oﬃcer

posi�ons may also include Vice-President posi�ons,

such as VP of Sales, VP of Finance, etc.

The number of oﬃcers that are required varies from

state to state. For example, Delaware does not

require any required number of oﬃcers, but since

one par�cular provision of Delaware law provides

that shareholders can require stock cer�cates be

signed by 2 oﬃcers, logic would dictate at least two

are required (and typically, this will be a CEO or

President, and Corporate Secretary). However,

California requires a minimum of three corporate

oﬃcers (CEO or President, CFO, and Corporate

Secretary). Regardless of the minimum number of

oﬃcer posi�ons required by law, one individual can

hold one or more oﬃcer posi�ons. It is not

uncommon in a small corpora�on to have one

person holding the �tles of CEO, CFO, and Corporate

Secretary.

Typically, oﬃcers are appointed by the board on an

annual basis at the board of directors’ annual

meeng. In the event a vacancy is created, the

board of directors will ll that posion during a

regularly scheduled board meeng, a special board

meeng called for that purpose, or by unanimous

wrien consent of the board.

Oﬃcers serve the board of directors, and it is the

directors that must remove them. For example,

Delaware law specically provides that stockholders

are not permied to directly remove corporate

ocers (even though the company’s bylaws provided

for that right) because allowing shareholders to have

such control would interfere with the board of

directors’ management decisions and prevent them

from performing one of their most important

funcons (i.e. the appointment and management of

ocers).

Oﬃcers of a corpora�on are generally also

employees of the company. The one excepon is

where ocers perform no services (or only minor

services) and who are also not receiving (or entled

to receive) any pay based on being an ocer. If an

ocer is not deemed to be an employee, they may

be able to be paid only through prot distribuons.

Given the tax penales associated with misclassifying

such ocers, ocers should be deemed to be

employees unless your CPA or tax aorney feels

otherwise aer evaluang all of the facts and

circumstances.

NOTES

_______________________________________

DUTIES OF LOYALTY, GOOD FAITH

AND DUE CARE

With great power comes great responsibility.

-- Voltaire

As duciaries of the corporaon,

directors and ocers owe a duty of

loyalty and good faith. This

requires directors and ocers to act

honestly and in the best interests

of the company, and to avoid any

appearance of self-dealing.

Directors and ocers must place the interests of the

company ahead of their personal interests, including

their nancial interests.

For example, directors and ocers are not permied

to “usurp corporate opportuni�es,” which means

that directors and ocers are not permied to take

opportunies for themselves when those

opportunies could otherwise be performed within

the company's operaons. In the event there is an

opportunity that a board member or ocer wishes

to take advantage of, that opportunity must be

presented to the board of directors of the company,

and the board of directors must grant permission

before the interested director or oﬃcer pursues

that opportunity. Failure to disclose the corporate

opportunity and secure permission will open the

director or ocer up to personal liability.

Directors

owe a duty

of loyalty

and good

faith.

When possible, the company’s board of directors

should include “independent directors,” meaning

directors who are not employees or shareholders.

By doing so, when the board is seng compensaon

for certain employees, those independent directors

can bring objecvity to the process that otherwise

might be lacking. When it is not possible to have

independent directors as part of the company, the

board has a duty to do its best to ensure fairness, by

making sure all material facts are disclosed,

independent advice is sought where appropriate,

and the transacon in queson is in the best

interests of the corporaon.

Directors and ocers also owe a

duty of care to the corporaon. This

requires directors and ocers to act

in a way that a reasonably prudent

person would act under the same

circumstances. Directors and

ocers are not required to be

perfect in their decision making, but

they are required to exercise the

same care and cauon that a

reasonable person would have

exercised in that same situaon. The duty of care

also includes a duty of oversight, meaning that

directors and ocers must use their best eorts to

make sure that laws and procedures are being

followed, and that eorts have been made to ensure

that no impropriety is occurring within the company.

A duty of

care

requires a

board

member to

act as a

reasonable

person

would.

This duty of care does not turn directors and ocers

into invesgators; it only requires that they stay

engaged with what is happening in the company and

not ignore any impropriety.

Ulmately, the law recognizes that even if the

directors and ocers are properly execung their

dues to the corporaon, not every business

decision will be correct. Oen, decisions must be

made in an environment where informaon is

imperfect, resources are limited, and the future is

unknown. Those decisions are

protected by the business

judgment rule, which essenally

says that so long as the directors

and ocers have acted in a way

that is reasonable, disinterested

and informed, their decisions

will not create liability. Of

course, this assumes that they

have not acted in bad faith or

acted in a manner that was

grossly negligent. In other

words, directors and oﬃcers do

not have to be perfect in their decision making, but

they do need to be diligent in the process of that

decision making.

Managers of an LLC may, depending on the scope of

the operang agreement, have less restricons, as

operang agreements somemes provide that the

managers are permied to engage in compeng

Board members

don’t always

have to be

right…but they

must be

reasonable,

disinterested

and informed

when making

decisions.

ac�vi�es. However, absent very clear wording in the

opera�ng agreement otherwise, managers of an LLC

will be held to similar duciary duƟes. Even if the

opera�ng agreement permits such compe��on,

managers should be careful not to take opportuni�es

that came to them by virtue of their par�cipa�on in

that LLC, unless they have disclosed the opportunity

to the LLC and received permission from the

members to pursue it independent of the LLC.

In some cases, even a majority shareholder may

have duciary obligaƟons to the minority

shareholders. As one California court stated, there is

"strong public interest in assuring that corporate

oﬃcers, directors, majority shareholders and others

are faithful to their duciary obliga�ons to minority

shareholders." The court reasoned that, without

imposing such a duty, a shareholder owning more

than 50% of the company would be able to cause the

company to act in ways benecial only to the

majority shareholder, and based on their minority

percentage, the other shareholders would have no

recourse or protec�on.

Specically, majority shareholders owe duciary

du�es to minority shareholders with regard to any

use to which the majority shareholder puts the

corpora�on or where they use their power to control

the corpora�on, i.e. it generally prevents a majority

shareholder from causing the corpora�on to act in a

manner that benets the majority shareholder at the

expense of minority shareholders.

RECORDKEEPING

Keeping appropriate records is an important part of

running a business. Failure to do so will open the

business up to liability from various direcons.

Generally, each state’s law requires that each

corporaƟon keep adequate and correct books and

records. Generally, it is recommended (at a

minimum) the following records be kept at its

principal oce:

1. a copy of the led arcles (or cercate) of

incorporaon and all amendments to date;

2. the original or a copy of its bylaws, and all

amendments to date;

3. up to date nancial records, including tax

records, and balance sheets and income

statements for the current year and at least

the prior seven scal years;

4. minutes of the meengs of its shareholders,

board, and commiees of the board;

5. a record of all acons taken by shareholders

and/or directors without a meeng,

including wrien consents; and

6. a record of its shareholders, including

names and addresses of all shareholders,

the price paid by any shareholders

purchasing shares from the company, and

the number and class of shares held by each

shareholder.

Those minutes and other books and records can be

kept either in wriƩen form or stored electronically,

provided any electronic form can be converted into

legible, tangible form.

It is best pracƟce for LLCs to maintain similar

documents, such as:

1. a copy of the led arƟcles (or cerƟcate) of

organizaƟon and all amendments to date;

2. the original or a copy of its operaƟng

agreement, and all amendments to date;

3. up to date nancial records, including tax

records, balance sheets, and income

statements for the current year and at least

the prior seven scal years;

4. minutes of the meeƟngs of its members and

managers;

5. a record of all acƟons taken by members

and/or managers without a meeƟng,

including wriƩen consents; and

6. a record of its members, including names

and addresses of all members, the price

paid by any members purchasing member

interests from the company, other cash

contribuƟons of members, and the number

and class of interests held by each member.

Failure to maintain appropriate records will create

liability for the company. First, owners have certain

rights of inspecƟon, and the failure to maintain

records subject to inspecƟon will expose

management to claims that they have breached

their duciary duty by failing to

maintain such records. Second,

failure to maintain appropriate

records may open the enƟty up

to alter ego claims (and if

successful, may also open

management up to potenƟal

personal liability), where those

suing the company may seek to pierce the corporate

veil (discussed further in the next chapter) by

alleging the company failed to adhere to even the

most basic corporate governance procedures.

Keeping good

records is very

important….

don’t ignore

the paperwork.

NOTES

_______________________________________

PIERCING THE CORPORATE VEIL AND

THE ALTER EGO DOCTRINE

One key purpose of creang a business enty is to

limit the liabilies of that business to only that

business, and insulate shareholders, members and

other businesses from liability. The “corporate veil”

is a term used to describe the separaƟon of a

business from its owners for liability purposes. As a

separate enty, a corporaon or an LLC is set up to

shield its owners from personal liability, meaning

liability will generally only aach to the enty, not

the owners. However, somemes a party will sue

the equityholders or related businesses in hopes of

aaching that liability to those pares as well. When

they do so, they are relying on an alter ego theory to

“pierce the corporate veil.”

In order to prevail on an alter

ego claim in hopes of piercing

the corporate veil, a plain in a

lawsuit must rst prove that

there was such a “unity of

interest” and control between

the defendant and the enty

such that it cannot reasonably

be said they are two separate enes. In other

words, the two enes are so intermixed that their

aairs are not readily separable. Oen, this test is

met when the owners and the enty commingle

Alter ego

requires a

nding the two

enƟƟes are

essenƟally

inseparable.

funds (such as using the enƟty’s account to pay an

owner’s personal mortgage).

Second, the plainƟī must show that it would create

an “inequitable result” if the defendant’s act or

omission was treated as that of the defendant alone

(or in some jurisdicƟons, the plainƟī must show

fraudulent intent). Because alter ego is based on

equity, some level of unfairness needs to be found.

To determine if the enƟƟes (note that one of those

enƟƟes can be its owner) are alter egos of each

other, the court will look at a variety of factors, such

as:

• Did the corporaƟon/LLC commingle funds or

assets with the owners or with the other

corporaƟon/LLC?

• Was the corporaƟon/LLC adequately

capitalized? Was ownership properly

issued?

• Did the owners treat assets of the

corporaƟon/LLC as if they were his or her

own personal assets?

• Where required, were minutes and other

corporate records accurately, adequately,

and separately maintained?

• Where required, did the enƟty observe

corporate formaliƟes, such as meeƟngs,

voƟng, etc.?

• If alter ego is sought against two

corporaƟons/LLCs, is the ownership in the

two enes idencal? Do the same owners

control both of those enes?

• If alter ego is sought against two

corporaons/LLCs, are ocers and directors

(or managers) in the two enes idencal?

• Do both corporaons/LLCs employ the same

people?

• Do both corporaons/LLCs share a single

business locaon?

• Is either corporaon/LLC just a shell, used

for a single venture?

• Were related or subsidiary enes treated

as arm's length relaonships as to each

other?

• Did one enty purchase labor, services, or

merchandise for the other?

• Did any enty manipulate its assets and/or

liabilies?

• Was there a siphoning of corporate funds by

the dominant shareholders or members?

• Was either corporaon/LLC formed in order

to transfer exisng liability of another

person or enty to it?

 Was there an aempt to conceal or

misrepresent the identy of responsible

ownership, management, or nancial

interests?

Failing any of these factors is not necessarily fatal in

the alter ego analysis. It is a weighing of all factors

that is ulƟmately determinaƟve.

Both elements of the alter ego

test (unity of interest and an

inequitable result) must be

saƟsed; however, if they are,

that does not mean that the

court must impose alter ego

liability and pierce the corporate

veil. The applica�on of alter ego

liability is fact-based and

reviewed by the trial court on a

case-by-case basis, as each case

is diﬀerent. However, there is a presumpƟon that

liability is limited based on the corporate form, and

the court must nd a basis for rejec�ng that

presump�on.

An alter-ego determina�on does not on its own

prove liability – instead, it is a nding that the

separateness of the en��es is a legal c�on and, as a

result, the court will treat them as one and the same

en�ty.

If an alter ego rela�onship is found, the corpora�on

will con�nue to exist, even though the corporate

form has been disregarded. At that point, if the

court agrees that the corporate veil is pierced, the

obliga�ons or debts of the corpora�on become those

of the shareholder, parent, sister corpora�on, or the

reverse, as applicable.

A nding of

alter ego

requires a

weighing of

mulƟple factors

when

determining if

there is a unity

of interest.

For example,

– A subsidiary corporaon and its parent

corporaon (or other subsidiaries) can each

be held liable for the debts of the other; and

– An individual owner or manager of a

company and the company itself can each

be held liable for the debts of the other.

(note that in “reverse veil piercing,” a third

party is allowed to reach past the owner to

access the assets of the corporaon,

subsidiary, or related corporaon related to

the owner, to sasfy the obligaons of the

owner).

If mulple shareholders are involved, their liability is

joint and several, i.e. they are each 100% responsible

and the plain can pursue any of them for

payment; their individual percentages of ownership

are not considered in determining how they share

the liability (those shareholders will need to work

that out between themselves).

Kinney Shoe Corp. v. Polan is an example of a case

allowing the piercing of the corporate veil. In this

case, Kinney sued the defendant, Mr. Lincoln M.

Polan, to pay money outstanding on a sub-lease by

the Industrial Realty Company. Polan owned

Industrial Realty Company but had never held any

corporate meengs or elected ocers. The court

emphasized that Industrial Realty Company was not

adequately capitalized, there were no corporate

formaliƟes, and it appeared that the company was

deliberately used to carry out transacƟons to benet

another one of Polan’s other companies, which had

assets but would be shielded from liability. Because

Industrial Realty Company was no more than a

transparent shell, the court ruled that if Polan

wanted the protecƟon of a corporaƟon to limit his

liability, he should have followed the simple

formaliƟes of maintaining the corporaƟon, which he

failed to do. The court allowed Kinney to pierce the

corporate veil and hold Polan liable for the unpaid

sublease.

It should be noted that while LLCs and corporaƟons

can both be subject to alter ego liability, LLCs are

generally not required to follow as many corporate

formaliƟes as corporaƟons. As a result, LLCs are

arguably less vulnerable to veil-piercing aƩacks since

veil piercing oŌen focuses on an enƟty’s failure to

maintain corporate formaliƟes (and LLCs have less

formaliƟes to maintain). That being said, LLCs should

observe all formaliƟes required by the state statutes

under which it is organized and avoid other violaƟons

such as commingling funds.

Cases will oŌen state that the alter ego doctrine

should be used sparingly as it is an extreme remedy –

but is it? Recent studies of cases show that acƟons

to pierce the corporate veil have a success rate of

about 30-35%. It’s more frequent where a small

number of owners are involved, as opposed to a

corporaon with many shareholders, i.e. the

likelihood of piercing increases as the number of

shareholders decreases. There is lile doubt that

this is because smaller companies more frequently

fail to observe formaliƟes.

To reduce the risk of a court nding alter ego/veil

piercing, what are best pracces? They include:

Formally issue, in wriƟng, ownership to

shareholders/members, in the form of stock

cercates.

Adopt bylaws or an operaƟng agreement, as

applicable – and have all directors/ocers or

members/managers follow those provisions.

For corporaons, hold inial and annual meengs

of both directors and shareholders, keep minutes of

all meengs, and store them with all other corporate

documents; annual meeƟngs are not generally

required for LLCs, but it is sƟll good pracƟce to do

so.

Document all other major business acons,

including agreements with third pares, and retain

them for at least seven years; all agreements should

be entered into explicitly in the company’s name.

Keep companies separate; this includes separate

leerheads, business cards, signage, phone numbers,

and premises in which they operate.

Don’t commingle funds! Keep the bank accounts

of the owners and the company separate, and do not

use funds from one enƟty for the benet of another

without proper jusƟcaƟon and paperwork.

Make sure the company is adequately

capitalized, whether by requiring owners to make

scheduled contribuƟons or by keeping a minimum

amount of funds in the company’s bank account. It is

a good rule of thumb to keep capital of at least three

months’ worth of anƟcipated costs in the company’s

account, to cover overhead expenses, employee

salaries, contractor fees, etc. Do not fund the

company only when bills need to be paid and never

allow the company to have zero assets. Do not share

workers or advisers, and if you do, each enƟty must

pay them separately.

The more of these factors you can comply with, the

lower the risk that the corporate veil can be pierced.

In summary, the owners of LLCs or corporaƟons

generally have protecƟon from liability, but this

protecƟon is not absolute. The corporate veil may

be pierced when an owner does not treat the

company as a separate business enƟty or uses their

control of the company to commit fraud or an

otherwise illegal act.

Observe corporate formaliƟes to keep the

corporate veil strong.

STOCK, PHANTOM STOCK

AND SAFES

Stock (also commonly referred to as “shares”) are

the ownership units of a corporaƟon. Stock falls

into two categories: common stock and preferred

stock. Within those two general categories,

companies may create various “series” of shares,

and each series may carry diﬀerent rights. Common

stock and preferred stock are discussed in more

detail in the next chapter.

If you work with startups, you will hear phrases such

as “founders’ stock” and “seed stock.” Founders

stock, as the name implies, is typically common

stock granted to the founders of the company and

other early employees and is granted at a very low

price per share. In some instances, the founders will

make the rights of those founders shares

subordinate to other shares. In other instances, they

provide those founders shares with super vo�ng

rights, where each share of founders’ stock might

have ten votes compared to other shares which

carry one vote each. Ul�mately, the rights of the

founders’ stock will vary depending on the leverage

those founders have with the investors they are

seeking. The more the investors want in on the

opportunity, the more leverage the founders have

to set the terms. The more desperate the founders

are for money, the less leverage the founders have.

Seed stock is common or preferred stock that is sold

in a very early round, typically for more money than

the founders shares, but sll at a low price. Shares

sold in this round are also oen referred to as being

part of a “friends and family” round.

Typically, common stock, SAFEs, or converƟble

notes will be granted unƟl a formal investment

round is raised. Investors coming in aer the early

rounds will typically be sold preferred stock. Oen,

the company will create Series A Preferred Stock for

that rst round of investment, then Series B

Preferred Stock for the second round, and so on.

How long each round of funding is open is at the

discreon of the company, but it is typically set out

within the oering documents for that round.

“Phantom Stock,” someƟmes referred to as

syntheƟc equity, is not stock, but acts like it.

Instead, it is a contractual right under an agreement

where the corporaon agrees to treat the phantom

holder (nancially) like a shareholder in the event a

liquidity event occurs; however, absent such an

event, the phantom holder is not treated as a

shareholder, meaning the phantom holder will have

no vong rights and potenally no rights to any

dividends paid prior to liquidity event. Since a

phantom stock agreement is essenƟally a

contractual agreement, the terms are negoable.

For example, phantom stock rights may be subject to

vesng and may be subject to forfeiture if the

phantom holder is no longer an employee of the

corpora�on. Phantom stock can be useful in

scenarios where the owner of a corpora�on might

wish to give an employee some certainty and

“upside,” and treat them as if they are a shareholder

in the event of liquidity, but where that owner is

unwilling to give up any ownership or vo�ng rights in

the interim.

A “SAFE” (Simple Agreement for

Future Equity) is becoming an

increasingly popular instrument.

When the par�es enter into a SAFE,

the investor is buying equity, but

the number (and type) of equity

the investor will receive is not yet

known. Instead, under a SAFE, the

investment will not typically

convert into actual shares unƟl a predened

“funding event” occurs. At that point, the SAFE

converts into the same type of shares sold in the

funding event, but at a discounted price (or

alterna�vely, having the ul�mate price limited by a

valuaƟon cap). This form of investment allows the

company to receive funds as equity, and it allows the

SAFE investor to rely on the exper�se of the next

round of investors (who presumably may have more

investment experience and may conduct more due

diligence), but it also rewards the SAFE holder for

their early investment by giving them a discount oﬀ

the pricing in the next round.

SAFEs oŌen

convert at a

discount, to

account for

the risk of

invesƟng

earlier.

For example, assume the conversion of the SAFE is

triggered when the company raises an investment of

$2,000,000, and also assume SAFE holders were

granted a 20% discount. If the company sold

$2,000,000 of Common Stock at $1.00 a share in its

oﬀering, the SAFE would convert at $0.80 per share.

(I.e., if the SAFE Investor had invested $50,000, the

SAFE investor would receive 62,500 shares of

Common Stock.) If, instead, the company sold

$2,000,000 of Series A Preferred Stock at $1.00 a

share in its oﬀering, the SAFE would s�ll convert at

$0.80 per share, but the SAFE investor would receive

62,500 shares of Series A Preferred Stock in

exchange for the $50,000 investment.

COMMON vs. PREFERRED STOCK

When star�ng a corpora�on, an entrepreneur should

consider what type of stock they want to oﬀer.

Under an S Corpora�on, only one class of stock may

be oﬀered (although vo�ng and non-vo�ng

common stock are allowed if all other rights are the

same), but under a C Corpora�on, there is no

limita�on on how many classes of shares you oﬀer.

Common and preferred stock together make up an

en�ty’s securi�es; they can both be components of

an en�ty’s ownership structure and are provided to

investors in return for their nancial contribu�ons.

The rights of shareholders will vary based on the

rights aﬀorded to each class of stock.

Common stock essen�ally oﬀers

an investor a slice of ownership

in the corpora�on. When people

talk about the stock market,

they are usually referring to

common stock. Some businesses

exclusively issue common stock.

Common stock can be vo�ng or

non-vo�ng, but is typically

vo�ng stock; if so, the

stockholder has the ability to

vote on the nominees to serve

on the board of directors and to

approve any key business

An S

Corporaon

can only have

one class of

stock; some of

that stock can

be vong, and

some non-

vong…. but

that is the only

dierence

permied.

decisions. Opons and other equity-based incenves

are typically exercisable into common stock.

As the name suggests, preferred stock has

preferences over common stock. Preferred stock is

generally higher in priority compared to common

stock when a distribuon is made. Preferred stock

oen receives special rights, which may be an

incenve to investors when choosing to buy either

common or preferred stock.

While common stock is generally “vanilla” in its

rights, preferred stock can come in many avors,

since those rights are oen negoated. The type of

preferred stock preferences that may be oered

include:

 Dividend preference – If a company is

unable to pay dividends to all shareholders,

claims to preferred dividends take

precedence over dividends that are paid on

common shares. This right may be

cumulave or non-cumula

ve. If

cumulaƟve, unpaid annual dividends

accrue; if non-cumulaƟve, a right to annual

dividends is lost if not paid in that year.

 LiquidaƟon Preference – With this

preference, preferred stock will be paid in

full before common stock receives anything.

This can be 1x the preferred investor’s

investment or more, depending on what is

negoated.

 ParƟcipaƟon Rights – This allows a

preferred stockholder to share in the

dividends and prots along with common

stock (aŌer rst receiving their dividend

pursuant to their dividend preference).

 VoƟng Powers – Gives preferred

stockholders the right to vote, oŌen as a

separate class. Preferred stock may also

have what is known as super-vo�ng power;

this gives a preferred stockholder

signicant voƟng power compared to other

shareholders, such as granƟng the

preferred stock more votes per share than

common stock.

 Pre-empƟon Rights – This gives a preferred

stockholder the right to invest in future

oﬀerings so they can maintain their

ownership percentage of the company.

 Conversion Rights – Conversion rights

permit a preferred stockholder to convert

their preferred shares into common shares

at any �me of their choosing (note, there

may also be automaƟc conversion features,

where the preferred stock will

automaƟcally convert into common stock).

 AnƟ-diluƟon ProtecƟon – This preference

is designed to help mi�gate the dilu�ve

eﬀect of future stock issuances, typically

when those later issuances are at a lower

value, i.e. a “down round.” If, for example,

an investor purchases 100,000 shares of

preferred stock at $1.00 per share and then

a subsequent round issues the same stock

for $0.50 per share, the investor who paid

$1.00 per share will receive another

100,000 shares at no addiƟonal cost, so

that their average price per share is also

$0.50.

 Right to Appoint a Board Member – This is

the right of a preferred stockholder to

appoint a board member of their choosing

to the board of directors. OŌen, the

company will retain the ability to reject

that proposed member, but only if there is

a reasonable basis for doing so.

 Put Right – This right gives a preferred

stockholder the ability to sell their

preferred shares back to the company. This

is a less frequent right for the company to

grant, as in many cases, the company may

not be in a nancial posiƟon to repurchase

those shares.

 Tag Along Right – If a stockholder intends

to sell their stake, this preference gives the

preferred holder the opƟon to parƟcipate

in the transacƟon on a pro rata basis. This

essenƟally obligates the selling shareholder

to include some or all the holdings of the

preferred holder in the negoƟaƟons.

 Drag Along Right – This right allows a

majority owner the right to force the

minority owners to parƟcipate in any stock

sale. The purpose of this provision is to

ensure that minority shareholders do not

interfere with potenal sales or other exit

opportunies.

 Right of First Refusal – This preference

gives a preferred holder the right of rst

refusal to buy shares of any shareholders

who intend to sell their shares.

 Warrants in AddiƟon to the Preferred

Shares – in some cases, a preferred

shareholder will require the company to

“sweeten the deal” with warrants. This

would allow the preferred holder to buy

addiƟonal shares (typically common stock)

at the warrant exercise price unl the

warrant’s expiraon date (oen 10 years).

The preferences granted to preferred stock are

negoƟable. While investors will oen seek a wide

variety of rights, the most typical rights granted will

be the dividend preference, the liquidaƟon

preference, the pre-empƟon right, and the right to

convert to common stock. On occasion, the right to

appoint a board seat will also be required by an

investor. The other preferences stated above (such

as put rights, warrants, etc.) will typically not be

granted by a company unless they are in a posion

where they have very lile leverage and desperately

need the funds being oered.

100

NOTES

_______________________________________

101

VOTING

VoƟng is an important aspect of equity ownership

and is an opportunity for equityholders to express

their opinions as to the governance of the company

by voƟng for board members (if a corporaƟon) or

managers (if an LLC).

Equity generally has one of three voƟng rights:

1. Non-voƟng. The holder of that equity has no

right to vote, and as a result, no opportunity

to inuence who is managing the company or

how it is being run.

2. Standard VoƟng. This is the tradiƟonal “one

share, one vote” structure. VoƟng is

proporƟonal to ownership.

3. Super-VoƟng. This is when a class of shares

receives mulƟple votes for each share they

hold. In such a scenario, the holder might have

100 shares, but 200 or 300 votes. Typically, if

this right is provided, it is part of the

preferences provided to preferred stock.

VoƟng can be performed by ballot (such as at a

shareholder meeƟng), by wriƩen consent (in lieu of

a meeƟng), or by proxy (when a shareholder

delegates their voƟng rights to someone else, who

votes on their behalf).

102

CUMULATIVE VOTING

CumulaƟve voƟng is required in some states (such as

California, Arizona, Nebraska and Kentucky), other

states allow it unless the company “opts-out” (by

staƟng so in its charter), and in most states, it is

permiƩed but not required (such as Delaware). The

goal of cumulaƟve voƟng is to give shareholders

(parƟcularly minority shareholders) more inuence

when it comes to voƟng on its board of directors. If

there is no cumulaƟve voƟng, it is referred to as

statutory voƟng or straight voƟng.

Under cumulaƟve voƟng, the votes allocated to a

shareholder are the product of the number of shares

they hold mulƟplied by the number of board seats up

for elecƟon. For example, if a shareholder has 1,000

shares, and three board seats need to be lled, that

shareholder will have 3,000 votes, which can be put

on one board candidate or spread across mulƟple

candidates.

Under statutory voƟng, the votes allocated to a

shareholder are divided by the number of board

seats up for elecƟon. Let’s rst assume the following

shareholders and ownership percentages:

103

*Shareholders A, C and D hold 7,200 shares

combined.

Next, let’s assume there are three board seats that

need to be lled, and each shareholder has proposed

one candidate (i.e., four candidates for three seats).

If we also assume that Shareholders A, C & D are all

aligned on who should be voted onto the board, but

Shareholder B disagrees, what is the result?

Under statutory voƟng, the votes of the

shareholders would be divided by the number of

board seats (i.e. resulƟng in Shareholder A voƟng

1,000 votes on each seat, Shareholder B voƟng 933

votes, Shareholder C voƟng 900 votes and

Shareholder D voƟng 500 votes). Each seat would be

voted on separately, so the aligned shareholders

could combine their votes each Ɵme and win each

seat by a 2,400 to 933 vote, enabling the aligned

shareholders to name all three of their candidates

to the board of directors, and Shareholder B not

Shares Ownership %

Shareholder A* 3,000 30%

Shareholder B 2,800 28%

Shareholder C* 2,700 27%

Shareholder D* 1,500 15%

Total 10,000 100%

104

being able to vote his candidate onto the board,

despite his 28% ownership.

Under cumulaƟve voƟng, again assuming three

board seats are being voted upon, each member

would have votes equal to triple the number of

shares, and those votes can be designated across

one or more board seats. While the aligned

shareholders would have 21,600 shares (i.e. 7,200 X

3) to vote across their three board candidates,

Shareholder B could place all 8,400 (i.e. 2,800 X 3)

votes on his board candidate, enabling Shareholder

B to name one candidate to the board of directors.

The formula to determine how many directors a

shareholder can guarantee to elect under cumulaƟve

voƟng is as follows:

(Shares owned-1) x (Seats to be Elected +1)

(Total Shares Outstanding)

We can use this formula to calculate how many

board members Shareholder B can appoint:

(2,800-1) x (3+1) = 1.196

(10,000)

Assuming there are three directors, Shareholder B is

guaranteed to be able to elect 1 director. If

Shareholders A, C and D put equal votes on each of

their candidates, each would receive 7,200 votes –

not enough to outvote Shareholder B.

105

CumulaƟve voƟng is intended to give minority

shareholders the ability to elect at least one director,

where they otherwise might not have a voice on the

board of directors under statutory voƟng.

SUPER-MAJORITY VOTING AND UNANIMOUS

VOTING

A majority vote is anything larger than 50%... even a

small margin such as 50.000001% is sƟll a majority.

A super-majority vote is a requirement that the vote

be even higher (such as a vote of 65%, 75%, or 80%).

For example, if amending the bylaws requires a super

-majority vote of 75%, then a vote of 51%, or even

74% will not be enough. A unanimous vote requires

100% of the votes.

Requiring a super-majority vote or a unanimous vote

is generally reserved for signicant corporate

changes, where the decision is so impacƞul to the

company that the consensus of most, or all, of the

shareholders is desired. Examples would be

approving a merger, an acquisiƟon, or an

amendment to the number of shares authorized

under the company’s charter documents.

Both cumulaƟve voƟng and super-majority voƟng

play an important role in protecƟng minority

investors, as they both reduce the power of a 51%

shareholder. Obviously, from the perspecƟve of a

shareholder holding a slight majority, cumulaƟve

106

vo�ng and super-majority vo�ng are handcuﬀs

preven�ng his or her full control over the business.

Can you waive or deny cumula�ve vo�ng rights?

No. In California, cumula�ve vo�ng is a statutory

right. It cannot be waived, and it does not need to

be specied in the ar�cles or bylaws. Only publicly

traded corpora�ons can opt out of cumula�ve

vo�ng.

Can you incorporate in a diﬀerent state to avoid

cumula�ve vo�ng rights? No. For example, in

California, cumula�ve vo�ng s�ll applies to foreign

corpora�ons if more than half of their shareholders

live in California, and if they do most of their

business in California.

107

SHAREHOLDER AGREEMENT

There are oen instances when shareholders choose

to enter into a wriƩen agreement that denes how

certain aspects of the business will be managed.

While a shareholder agreement is generally

impraccal or unnecessary in a large private

company or in a public company, such agreements

are oen used in the context of small, privately held

corporaons.

In some cases, the shareholder

agreement provides further detail

as to how certain aspects of the

company will be managed; in other

cases, it grants vong power to

certain shareholders. Consider, for

example, an owner who wants to

bring in a 50% partner, but is

concerned about losing vong

control. In that case, the owner

would sell the new partner 50% of

the shares but retain the right to vote all or some of

those transferred shares under a shareholder

agreement. Those rights would then typically

terminate upon certain events, such as the passage

of me, a sale of a controlling stake in the company,

or a public oering of company shares.

Shareholder

agreements

can be useful

when the

terms do not

impact all

shareholders

equally.

108

Examples of areas somemes covered by

shareholder agreements include:

 maers relang to the management

structure of the company, such as

o the number of members on the

board

o how those board members will be

elected, and how any vacancies

would be lled

o the responsibilies of ocers

o whether there will be a mandatory

rerement age for employees

 maers relang to ownership of the

company, such as

o whether shareholders will have pre

-empve rights

o whether shareholders will have

an-diluon protecon

o whether shareholders will have a

“tag-along” right, which allows

them to parcipate when another

shareholder sells all or part of its

o whether shareholders will have a

“drag-along” right, where the

selling shareholder can choose to

require other shareholders to

parcipate in a sale of shares

o whether shareholders will be

subject to “put” and “call” rights.

Put rights grant the shareholder

109

the right to sell shares to the

company (or other shareholders),

and call rights grant the company

(or other shareholders) the right to

purchase another shareholder’s

o whether shareholders wish to

receive dividends, and if so,

whether those dividends would be

paid on a quarterly or annual basis

o whether shareholders will be

commied to certain restricve

covenants, such as condenality,

non-solicitaon, and non-

compeon provisions

o whether a stock opon plan will be

created, and if so, the number of

shares reserved for issuance under

that plan

o whether each shareholder’s ability

to transfer shares to a third party is

restricted in some manner, and

whether those shares must rst be

oered to the exisng shareholders

o whether each shareholder’s shares

can be repurchased without their

consent, and how the purchase

price would be determined (and

paid) in such an event (and if this

requires material breach by the

shareholder, the condions that

would sasfy such expulsion as a

shareholder)

110

o whether each shareholder’s shares

can (or must) be repurchased upon

reƟrement, and how the purchase

price would be determined (and

paid) in such an event

o whether each shareholder’s shares

can (or must) be repurchased upon

their death, and how the purchase

price would be determined (and

paid) in such an event

 maƩers relaƟng to voƟng, such as

o whether voƟng will be on a

cumulaƟve basis (this is required in

some states such as California, but

not required in others, such as

Delaware)

o whether certain acƟons will require

unanimous or supermajority

approval, such as (i) dissoluƟon of

the company, (ii) sale of all or

substanƟally all of the company’s

assets, (iii) a merger, conversion or

reorganizaƟon, (iv) transacƟons

outside of the ordinary course of

business, (v) amendment of the

charter or bylaws, including a

change in the authorized number

of shares, (vi) the sale of addiƟonal

shares, and (vii) capital

expenditures over a certain

threshold

111

o how deadlock amongst the

shareholders will be resolved

how disputes between the

shareholders will be resolved,

including whether arbitraƟon and/

or mediaƟon will be required

While some of the above can also be enumerated

within the bylaws of the company, shareholder

agreements are useful when the intenƟon of the

parƟes is that those rights will remain in place for a

certain period of Ɵme (or unƟl certain condiƟons

change). For example, certain rights between two

shareholders, each holding 50%, might be intended

to disappear when a third shareholder enters the

company, if deadlock is no longer a concern. In such

a case, the shareholder agreement may be

terminated, along with the rights and obligaƟons

contained in that agreement, and the bylaws can

stand as they were, without amendment.

A majority vote requires more than 50% (i.e.

50.01%); a super-majority vote may require

an even higher vote (i.e. between 51-99%,

but usually 65% or 75%).

112

NOTES

_______________________________________

113

BUY-SELL AGREEMENT

A buy-sell agreement is an agreement between the

company and its shareholders that controls the

purchase and sale of a shareholder’s shares if that

shareholder (i) wishes to sell shares, (ii) leaves the

business, (iii) re�res, (iv) gets divorced, (v) becomes

disabled, or (vi) passes away. This agreement will

provide for an orderly transfer of that ownership in a

manner previously agreed by all par�es.

(Note that these concepts can also be used for an

LLC, but for simplicity, we will address this from a

corpora�on/shareholder perspec�ve in this chapter.)

By planning ahead, the

company can also provide

for how such obliga�ons

will be met. For example,

the company may not have

suﬃcient cash to

repurchase a shareholder’s

shares upon that

shareholder’s death, but the company can provide,

under the buy-sell agreement, that it will take out a

life insurance policy on the shareholder, and that

those funds will be used to saƟsfy all or part of the

purchase obligaƟon upon the shareholder’s death.

Buy-sell agreements

can be used to

address repurchases

of equity under

diﬃcult

circumstances.

114

One oŌen ignored circumstance is the divorce of one

of the shareholders. Especially in a small company,

the remaining shareholders are not interested in

having the hosƟle spouse of its current shareholder

own any porƟon of that owner’s shares. The buy-sell

agreement can provide that those shares will either

be allocated to the shareholder when the marital

property is divided, or if not, those shares would

then be subject to repurchase by the company or

other shareholders.

Because the terms of the buy-sell agreement will

apply to assets jointly held by the shareholder and

his or her spouse, it's important that each buy-sell

agreement includes spousal consents, so the spouse

will be obligated to those same terms.

The following are consideraƟons that a company and

its shareholders should explore as part of the process

of creaƟng a buy-sell agreement:

1. Events which could trigger a buy-out of a

shareholder’s shares

A. A proposed sale of the shares.

· This generally triggers a right of rst refusal

where the corporaƟon, and then the other

115

shareholders have the opƟon to purchase the

· Generally, transfers of shares to or from a

living trust are permiƩed, but the transferred

shares remain subject to the buy-sell agreement

B. Transfers among family members (this is

generally prohibited, except as part of a plan to

transfer ownership rights and/or management

responsibiliƟes to the next generaƟon)

C. TerminaƟon of an employee-shareholder's

employment by the corporaƟon

D. For licensed professionals, any acƟon that

terminates their license to pracƟce the profession

E. The death of a shareholder

F. An employee-shareholder's disability

G. Divorce

· Divorce generally triggers a buy-out if any

shares are awarded to the non-employee

spouse

· The employee-spouse generally has an

opƟon to purchase the shares of the other

spouse

· If the employee-spouse doesn't purchase

116

all the available shares, the corporaƟon and

then the other shareholders generally have

opƟons to purchase the shares which remain

available

H. Death of a spouse

· Generally, this triggers a buy-out if any

shares go to someone who does not already

own shares of the company

· The employee-spouse generally has an

opƟon to purchase the shares of the deceased

spouse

· If the employee-spouse doesn't purchase

all of the available shares, the corporaƟon and

then the other shareholders generally have the

opƟon to purchase the shares

2. Who will be enƟtled (or required) to buy the

shares?

A. The corporaƟon

B. The person who sold or transferred the shares to

the selling shareholder (for example, if the

shareholder giŌed shares to his children, but one

child wants out, that giŌing shareholder might have

a rst opƟon to buy the shares back)

117

C. The other shareholders

· OŌen a goal is to allow each shareholder an

opportunity to retain his or her ownership

posiƟon in relaƟon to the other remaining

shareholders

3. Will the purchase be opƟonal or mandatory?

(This can depend on the type of triggering event)

A. The corporaƟon can have an opƟon and, if it is

not exercised in full, the other shareholders can:

· Have an opƟon to purchase the balance of

the available shares or

· They can be required to purchase any

shares which the corporaƟon does not

purchase

· Note: The selling shareholder is always

required to sell his shares if the opƟon is

exercised

B. If neither the corporaƟon nor the other

shareholders are required to buy the shares, are

there circumstances in which a shareholder should

have a right to require them to buy his shares?

Examples:

 Death

118

 Complete disability

 ReƟrement aŌer a parƟcular age or period of

service

4. How will the value of the shares be determined?

The three principal methods of valuing the shares

are (i) an appraisal of the shares when a triggering

event occurs, (ii) a formula wriƩen into the buy-sell

agreement, or (iii) an agreed value that is reviewed

periodically by the shareholders

A. Appraisal Method

An appraisal of the business is performed by an

independent third party cerƟed to conduct business

appraisals.

· Advantages of the Appraisal method

- RelaƟvely objecƟve and can consider any

developments that were not anƟcipated

when the agreement was signed

- Leaves much less room for tacƟcal

maneuvers to reduce or increase the value of

the shares. A formula or agreed value price

invites such maneuvers, which can lead to

liƟgaƟon and bad feelings

· Disadvantages of the Appraisal method

- An appraisal can be expensive ($10,000 to

119

$15,000 per appraiser is not unusual).

- Appraisals take �me to prepare.

- The value might be a surprise to the

shareholders. This risk can be reduced by

appraising the business now.

B. Formula Method

 A formula price is

usually based on book

value, earnings, or a

combina�on of both.

Formulas can be simple or

quite complex. For

example, a mature

manufacturing business

with appreciated real

property might use book value (subs�tu�ng the

appraised value of the real estate) plus ve

�mes the most recent year's earnings. If

earnings are an important measure of value,

several years of earnings can be considered,

with the most recent years weighted more

heavily

 Formula Examples for Calcula�ng Per Share

Price:

· Book Value Formula: A corpora�on’s book

value is the diﬀerence between the total assets

and the total liabili�es, divided by the number

of shares outstanding as of the date the book

value is determined.

Many formulas

are available.

You need to

nd the best

one best for

your business.

120

· MulƟple of Book Value Formula: The sum of

the book value of the corporaƟon and an

amount equal to [number] Ɵmes the average

annual net earnings of the corporaƟon, divided

by the number of shares outstanding as of the

date the book value is determined.

· Average Annual Net Earnings MulƟple

Formula: Dividing by ve the aggregate net

earnings or losses of the corporaƟon, aŌer

federal and state income taxes, for the ve

scal years of the corporaƟon immediately

preceding the date of the event causing the

purchase and sale, then divided by the number

of shares outstanding as of the date the value is

determined.

· Prot MulƟple Formula: An amount equal

to [number] Ɵmes (i) the aggregate of the

corporaƟon’s losses and net prots aŌer taxes

for the ve complete scal years preceding the

date of the event causing purchase and sale

under this Agreement, (ii) divided by ve then

(iii) divided by the number of shares

outstanding as of the date the value is

determined.

· Weighted Average Prot MulƟple Formula:

The quoƟent determined by dividing, by 15, the

121

sum of the following products: ve Ɵmes the

net prot of the most recent scal year; four

Ɵmes the net prot of the second most recent

scal year; three Ɵmes the net prot of the

third most recent scal year; twice the net

prot of the fourth most recent scal year; and

the net prot of the Ōh most recent scal

year, divided by the number of shares

outstanding as of the last day of the ve-year

period.

· Book Value + Goodwill Formula: (i)

CalculaƟng goodwill by mulƟplying by [number]

the excess of (a) the average annual net

earnings for the ve complete scal years

immediately preceding the date of the event

over (b) [number] percent of the average book

value as of the end of each of the same ve

scal years, then (ii) adding book value, then

(iii) dividing by the number of shares

outstanding as of the date of the event.

· Advantages of the Formula method

- Less expensive and faster than an appraisal.

- No surprises, since the parƟes can

determine the formula value at any Ɵme.

122

· Disadvantages of the Formula method

- The formula looks backward at past

opera�ng results and does not consider future

events such as a recently obtained favorable

contract, a promising new customer or the

loss of an important account.

- Over �me, the variance between the

formula value and the perceived actual value

may increase.

C. Agreed Value Method

The par�es can agree to value the shares annually

or at some other interval.

· Advantages of the Agreed Value method

- Reects the par�es' subjec�ve

expecta�ons concerning the prospects of the

business.

- Can consider economic trends and the sale

price of comparable businesses.

- If you are using insurance to fund the

eventual purchase of shares, you probably

have a specic value of the shares in mind

when you purchase the insurance. That can

serve as the ini�al agreed value. If you intend

to review periodically whether the insurance

coverage is suﬃcient, you should plan to

update the agreed value at those intervals.

123

· Disadvantages of the Agreed Value method

- Requires unanimous consent to change. So,

if one party becomes seriously ill, the others

may be unwilling to update the value to

increase the purchase price.

- Shareholders oŌen are too busy to

consider valuaƟon, which may become

controversial and tangled with other sensiƟve

issues. An agreement that uses an agreed

value should always include a formula or

appraisal value as a backup. The backup

method would apply if no agreed value had

been determined for a period of Ɵme (oŌen 18

to 24 months).

5. How will the purchase price be funded and paid?

The principal ways to fund the purchase price are

advance funding in the form of insurance or corporate

reserves, future funding in the form of installment

payments of the purchase price, or some combinaƟon

of these. ParƟcularly with the death buy-out,

insurance is oŌen a preferred method as it will ensure

the funds are available when the buy-out is required.

Note: It is always possible that the business will be

sold or the corporaƟon liquidated before any

triggering event occurs. In that event, or if the stock

becomes publicly traded, no buy-out under the

agreement would ever occur.

124

A. Lump Sum Payment

This method is most oŌen used for shareholders with

a small percentage interest in the business.

If the value of the stock is low (as it might be for an S

CorporaƟon with few valuable assets or for a

shareholder with a small interest in the business) or

the corporaƟon has reserved substanƟal liquid assets

to fund the buy-out, it might be best to require

payment for the stock to be made all at once.

If the corporaƟon or the other shareholders needed

addiƟonal cash to fund the purchase, they would

borrow from a lending insƟtuƟon at that Ɵme.

However, the lender might be reluctant to make a

loan for this purpose.

· Advantages of Lump Sum Payment

- The selling shareholder (or the surviving

family) is not dependent on the future success

of the business (as they would be under an

installment payment arrangement)

- Avoids the necessity of ne-tuning a payment

plan in advance

· Disadvantages of Lump Sum Payment

- For many companies, this is not realisƟc for the

purchase of a large block of shares because the

purchase price will be too high in comparison to

both the corporaƟon's anƟcipated liquid assets

125

and the likely borrowing capacity of the

corporaƟon and its shareholders

B. Life Insurance

The corporaƟon could purchase life insurance on its

shareholders to fund the eventual purchase of their

shares.

· Advantages of Life Insurance

- Life insurance shiŌs the

risk of an early death and

buy-out obligaƟon to the

insurance company

- Assures that at a

shareholder's death the

funds to purchase that

owner’s shares will be

available and can be

distributed to the decedent

shareholder's family. The

payment to the decedent's

family does not depend on the future success of

the business

- The owners of a whole life policy can benet

from the tax-free "inside build-up" of the funds

invested in the policy

- If a shareholder-employee terminates

employment before death, a policy of permanent

insurance can serve as a down payment for the

shares. The terminaƟng shareholder-employee

then has several aƩracƟve alternaƟves: use the

policy for reƟrement or estate planning, borrow

Insurance can

be a great way

of guaranteeing

the funds will be

available to

repurchase

shares in the

event an owner

passes away.

126

against it, or surrender it to the insurance

company for its cash value

· Disadvantages of Life Insurance

- Uses current funds to purchase insurance to

pay for a future buy-out. If the business needs

capital, this use of funds might slow the growth of

the business, parƟcularly if the funds in the

business generate a higher aŌer-tax return than

funds in the insurance policy. If this is a concern,

consider a leveraged life insurance purchase to

leave the funds at work in the business but

achieve the risk-shiŌing benets of insurance

- If a shareholder terminates employment for a

reason other than death, the life insurance

provides funds only to the extent of its cash

surrender value, which may be low in the rst few

years aŌer the policy is acquired. (If this is a

concern, consider a no-load or low-load policy)

- Note: Separate policies are usually necessary to

cover terminaƟon of employment resulƟng from

disability.

C. Installment Payments

Generally, the corporaƟon should be required to

make as large a down payment as it anƟcipates will

be feasible, and the balance should be paid over a

number of years. (Life insurance can be used to fund

127

just the down payment, rather than the enƟre

purchase price.)

· Interest

- How oŌen should interest be paid?

- Generally, for the sake of simplicity, the

interest rate should at least equal the Applicable

Federal Rate (the minimum rate necessary to

avoid imputed interest for tax purposes). The rate

can be xed at the buy-out date based on the

prime rate or the corporaƟon's cost of borrowed

funds at that Ɵme, or it can oat with the prime

rate or another interest rate.

· Security and OperaƟng restricƟons

- The selling shareholder can have a security

interest in the shares sold or in other assets.

- The corporaƟon could be prevented from using

its cash for any unusual purpose unƟl all of the

installment payments are made, unless the note

holder consents to the extraordinary expenditure.

Financial raƟo requirements may be imposed,

requiring the company to maintain certain

nancial metrics.

 Note: If the restricƟ

ons constrain

management too much, they could harm the

business and increase the risk to the recipient

of the payments.

128

· AcceleraƟon events

- Generally, the enƟre unpaid purchase price for

the shares would be due if the corporaƟon

dissolved, merged into another corporaƟon, sold

its business or entered into bankruptcy.

 Promissory notes made by the remaining

shareholders could accelerate if they sold their

stock in the corporaƟon or became bankrupt.

· Advantages of Installment Payments

- Compared to insurance funding, an installment

payment arrangement frees current cash for

investment in the business.

- Matches future payments with funds earned in

the future

- Both insurance funding and installment

payments are complex. Installment payments

defer most of the complexity unƟl a buy-out

occurs

· Disadvantages of Installment Payments

- The payment to the selling shareholder (or the

family) depends on the success of the business. If

the business does poorly, they may never receive

full payment or payments may be delayed. This

risk is aggravated if the only security is the shares

of the other shareholders.

129

6. Will all community property interests in shares be

covered?

· If stock is held in the name of a husband and

wife, the agreement should specify which one of

them has the right to vote and to sell the shares

· The agreement should provide a way to recover

shares from a non-employee spouse at divorce or

at the spouse's death

· The spouse of each shareholder should sign the

agreement

· If an employee-shareholder marries, the law

might permit the new spouse to acquire a

community property interest in the shares – but

the new spouse might not be bound by the

agreement unless the new spouse signs it.

Accordingly, the new spouse should be required to

sign the agreement

7. Should the buy-out arrangement aﬀect related

businesses?

· If the same people own more than one acƟve

business together, should a triggering event in one

business also trigger a mandatory or opƟonal buy-

out in the other businesses?

· OŌen a corporaƟon rents real estate and

130

equipment from a partnership formed by the

shareholders. They do not usually require a buyout

of the partnership interest at the same �me that

the shares are repurchased. (The exis�ng

partnership agreement should exclude or create

an excep�on to the "business opportunity" rule so

that the remaining shareholders can form a new

partnership and acquire new property in the new

partnership, not the old one)

8. Should a depar�ng shareholder agree not to

compete with the corpora�on?

· If a shareholder with a substan�al interest in

the corpora�on agrees not to compete with the

corpora�on within a reasonable geographic area

and for a limited �me, California courts generally

will only enforce the agreement if it is ac�vated by

a sale of the shareholder's stock of the

corpora�on. The agreement generally would

remain in eﬀect for three to seven years.

9. Will the agreement aﬀect anyone else?

· Are the shares currently pledged?

· Is an exis�ng buy-sell agreement or

shareholders agreement in eﬀect? Do the

incorpora�on documents or the bylaws restrict the

transfer of shares?

131

10. Is the corporaƟon an S CorporaƟon for tax

purposes?

· Because certain issuances or transfers of shares

can terminate the S Corporaon status, a buy-sell

agreement can help to retain the valuable S status

by prohibing such transacons.

· Will the S Corporaon be required to make

distribuons in an amount sucient to enable the

shareholders to pay their taxes on their shares of

the corporaon's income?

Once the above issues are thoroughly considered,

the buy-sell agreement process should include a

corporate aorney as well as a CPA, so all legal and

tax issues can be thoroughly veed. These

agreements are typically complex, and because

certain events such as divorce, disability, and death

make modicaon dicult or impossible, it is crical

that the agreement be correct from the beginning.

132

NOTES

_______________________________________

133

SPOUSAL CONSENTS

For those living in “community property” states

(currently Arizona, California, Idaho, Louisiana,

Nevada, New Mexico, Texas, Washington, and

Wisconsin), the enƟty and the individual may want to

consider requiring a spousal consent when certain

documents are being executed. This stems from the

fact that the spouse may have certain rights that

might later be asserted in a manner contrary to their

spouse.

For example, when a person purchases equity in a

corporaƟon or LLC, that equity may be deemed a

community property asset. If one spouse agrees to

sell the ownership in conjuncƟon with a transacƟon

proposed by the company, what will be the result if

the other spouse refuses to consent to that

transacƟon? Under community property laws, each

spouse may have equal say on that asset, and even

more drasƟcally, nonconsenƟng spouses may have

the right to void certain transacƟons.

A spousal consent is a document signed by the

spouse of an equity investor, under which the

spouse consents to the terms of the agreement.

Assume a Restricted Stock Purchase Agreement is

entered into between the company and Mrs. Smith.

When Mr. Smith signs a spousal consent, Mr. Smith is

agreeing to all of the terms of the Restricted Stock

Purchase Agreement, even though he is not a direct

134

signer on the Restricted Stock Purchase Agreement.

The same concept extends to LLC operaƟng

agreements, shareholder agreements, voƟng

agreements, leases, real estate transacƟons,

beneciary designaƟons, guarantees, and any other

agreements for which the spousal consent applies.

By having a spousal consent in place, the company

and/or other equity owners can enforce, against the

equityholder's spouse, the transfer and voƟng

restricƟons and other obligaƟons contained in those

agreements.

In some cases, an individual is

reluctant to bring their spouse

into the discussion and secure

the spousal consent. This

should be a warning sign for

several reasons. One might

quesƟon the integrity of

someone who acƟvely keeps

informaƟon from their spouse;

however, the larger issue from

the company’s standpoint is that this refusal to

secure the spouse’s consent creates potenƟal risk to

the company. If the company agrees to proceed

without the spousal consent, it takes the risk that

those spouses will be at odds in the future, and the

company’s ability to move forward with shareholder

consent may be compromised.

Failure to secure

spousal

consents may

mean the

spouse is not

bound to the

terms of the

agreement.

135

In draŌing a spousal consent, it is important that the

spousal consent specically references the applicable

agreement(s). Failure to do so will likely result in a

spousal consent that is unenforceable.

A spousal consent must clearly specify the

agreement to which they are consenƟng.

136

NOTES

_______________________________________

137

STOCK OPTIONS

At the early stage of the company, shortly aŌer

formaƟon, it is typically preferable to issue founders

shares to all of the owners. However, as the value of

the company increases, granƟng shares can create

signicant tax consequences, as the receipt of shares

will be taxed at the fair market value of those shares.

As a result, employee stock opƟons are typically

used as a tool to incenƟvize employees by providing

them with the opportunity to parƟcipate in the

upside growth of the business without having to

make a cash investment (or incur tax) at the Ɵme of

grant.

A stock opƟon is an agreement that provides the

holder (the “opƟonee”) a right to purchase a specic

type of stock (usually common stock) at a

predetermined price (the “exercise price”). Stock

opƟons are non-transferable, and if the employee

fails to exercise the opƟon, the opƟon terminates.

Most companies will adopt a stock opƟon plan which

establishes the opƟon pool, i.e., the number of

shares reserved for distribuƟon as opƟons. The stock

opƟon plan should be approved by the shareholders,

aŌer which Ɵme the board of directors can grant

opƟons from the pool of shares.

The size of the stock opƟon pool varies, but generally

in start-ups it will range between 15% and 20% of the

company’s fully diluted shares. When calculaƟng the

138

fully diluted shares, the issued shares are added to

any converƟble securiƟes along with the number of

shares allocated to the stock opƟon plan itself.

The exercise price is calculated on a per share basis

and is typically set at 100% of the fair market value

of one share at the Ɵme of grant. While the exercise

price can be higher, pricing the opƟon at a per share

price below 100% of the fair market value can result

in tax consequences to the opƟonee, accounƟng

charges to the company, and potenƟal violaƟons of

securiƟes laws.

PenalƟes relaƟng to the issuance of opƟons below

fair market value can be avoided by securing a 409A

valuaƟon (discussed in more detail in a separate

chapter). ValuaƟons performed pursuant to SecƟon

409A of the Internal Revenue Code provide a “safe

harbor” so long as the valuaƟon has been conducted

in the last 12 months and there have not been

material changes in the business that would be

expected to signicantly change the value of the

shares.

There are two types of opƟons that can be granted:

IncenƟve stock opƟons (“ISOs”) and nonstatutory

stock opƟons (also referred to as “nonqualied

stock opƟons” or “NSOs”).

IncenƟve stock opƟons may be granted only to

employees, and cannot be granted to non-employee

directors, advisors, consultants, and other service

139

providers. The exercise price of an

ISO must be 100% of the fair

market value as of the date of

grant; if the ISO is granted to

someone who owns more than 10%

of the equity of the company, then

the exercise price of the ISO must

be 110% of the fair market value as of the date of

grant. ISOs have addi�onal requirements which

must be sa�sed for them to retain their preferen�al

tax treatment.

Any op�on that does not meet the requirements of

an ISO will be treated as an NSO. NSOs are used

typically to incenƟvize non-employees, including non-

employee directors, independent contractors,

advisors, consultants, vendors, and other service

providers.

ISOs and NSOs receive diﬀerent tax treatments.

When an ISO is exercised, no tax is due for regular

income tax purposes (although tax may be due for

AlternaƟve Minimum Tax purposes); tax on any gain

(i.e. the amount by which the sale price exceeds the

exercise price) will be assessed at the �me the shares

acquired via the op�on are sold. For example, if the

op�on is exercised at an exercise price of $1 and fair

market value on the date of sale is $10, tax will be

assessed on the $9 gain. Keep in mind that the rate

of tax an op�on holder pays on the sale of stock

received from an ISO exercise depends on how long

ISOs can

only be

given to

employees.

140

the stock has been held and whether it was sold as a

“qualifying” or “disqualifying” disposiƟon.

When a NSO is exercised, the oponee will be

required to pay tax at ordinary income rates on the

amount by which the fair market value of the stock

on the date of exercise exceeds the exercise price

paid; when the stock acquired through that exercise

is sold, addiƟonal capital gains tax will be due on the

amount that the sale price exceeds the fair market

value on the date of exercise. For example, if the

opon is exercised at an exercise price of $1, and the

fair market value at the date of exercise is $4, tax will

be assessed in that tax year on the $3 gain; if the fair

market value is $10 on the date of sale, addional

tax will be assessed on the $6 gain realized between

the date of exercise and the date of sale. While

these are general guidelines, anyone exercising

opons should conrm the tax consequences with

their CPA prior to any exercise of opons.

There are three scenarios where stock opƟons will

not be exercisable. The rst scenario is when the

opƟon is “under water,” meaning the current fair

market value is below the exercise price (this would

be equivalent of buying $1 for $1.10). If you wanted

to acquire shares, you would be beer o purchasing

shares directly from the company if the fair market

value is less than the opon price.

The second scenario is where the opƟon expires. An

ISO must not be granted with a term longer than 10

141

years, and if granted to someone owning 10% or

more of the company, the term must not be longer

than ve years. While there is no limit on the term

of an NSO, it is typical that the stock opƟon plan will

limit that term to 10 years as well.

The third scenario is where the opƟon terminates.

Most stock opƟon plans provide that when an

employee or service provider is no longer providing

services, that individual has a limited amount of Ɵme

to exercise the opƟon. This exercise is generally 30 to

90 days following the terminaƟon of services date.

The stock opƟon plan will typically permit this period

to be extended by 12 months for the opƟonee’s

disability, or 18 months in the event of death of the

opƟonee.

Stock opƟon grants are typically subject to vesƟng.

The most common vesƟng period is four years, with

25% of the shares vesƟng aŌer one year, and the

remaining shares vesƟng 1/36 per month over the

next three years. As discussed in the VesƟng

chapter, these opƟons may be subject to

acceleraƟon in certain circumstances.

Some stock opƟon plans will also provide for “early

exercise” of the opƟon, allowing the opƟonee to

exercise unvested shares. The benet of doing so is

that the opƟonee will begin their holding period on

those shares, which will allow them to receive a

preferred tax treatment; of course, by doing so, the

142

opƟonee has put their money at risk, as the stock

could decline in value, even below the exercise price.

Even in the case of an early exercise, the shares

remain subject to the vesƟng schedule and the

company will retain a right to repurchase (at the

exercise price) any shares that remain unvested.

Because the shares are sƟll subject to repurchase by

the company, the opƟonee is not permiƩed to

transfer any shares that are sƟll subject to the

vesƟng schedule. In the event an opƟonee chooses

to avail themselves of the early exercise opportunity,

the opƟonee must le an 83(b) elecƟon with the IRS

within 30 days of the early exercise.

143

VESTING

Ves�ng is a contractual concept that provides

someone with the opportunity to earn a payment,

asset or benet upon the sa�sfac�on of certain

condi�ons.

Vesng can take place within a number of dierent

agreements, such as stock purchase agreements,

shareholder agreements, and phantom stock

agreements; however, most oen, we see vesng

used in the employer-employee relaonship, such as

in the granng of stock opons. Stock op�ons,

when granted, are typically subject to a ves�ng

schedule, and upon the employee’s sasfacon of

that schedule (typically by remaining as an employee

for the required period of me) those opons are

vested and the employee can, if they choose to do

so, exercise those opons.

In the context of stock opons, those opons are

typically vested over a four-year period. Most

commonly, 25% of the shares vest aer one year of

employment, with the remaining 75% vesng equally

over the subsequent 36 months. If the employee’s

employment terminates, vesng immediately stops.

“Cliﬀ ves�ng” is when some or all of the vesng

occurs in one large chunk. In the example above, the

rst 25% would be considered cli vesng, because if

the employee le at 11 months, they would not vest

into any opons. However, if that same employee

144

le aer 13 months, the employee would have

vested into 13/48ths of the stock opon grant.

Vesng which occurs evenly over me, i.e. years 2-4

in the above example, is referred to as “graded

vesƟng.”

It is not unusual for companies

to use a combinaon of cli

vesng and graded vesng.

Cli vesng provides the

company with several benets:

it is simple to manage, it is cost

eecve, it delays certain

payments that otherwise might already vest, and it

creates an incenve for employees to remain for at

least that cli period since all benets will otherwise

be lost. On the other hand, if cli vesng is spread

over too long of a period, it fails to movate

employees, as they have not earned anything unl

they survive the cli period. As a result, companies

oen use a combinaon (such as that used in the

example above). By doing so, employees who last

less than a year do not receive a benet, but those

that have passed the one-year mark will start to see

their commitment reected on the vesng schedule

in the form of vested shares that they can choose to

exercise.

While vesƟng is oŌen based on a certain period of

Ɵme passing, vesƟng can also be aƩached to other

milestones (instead of, or in addion to, the me-

based milestones), such as funding milestones, R&D

Most stock

op�on grants

u�lize both cliﬀ

ves�ng and

graded ves�ng.

145

milestones, revenue milestones, or individual

milestones (such as a sales

representaƟve’s performance).

UlƟmately, vesƟng is intended to

delay the granƟng of that

payment, asset or benet unƟl

certain performance has been

received by the company.

VesƟng can be subject to acceleraƟon upon certain

events, but it is not always the case. For example, a

company might provide that all vesƟng on stock

opƟons accelerates if the company is sold or merged;

in other cases, those stock opƟons do not accelerate

so long as the acquiring company assumes the stock

opƟons. In other cases, they do not accelerate in any

event, and in the event of a sale or merger, any

unvested opƟons are simply lost.

As a recipient of a stock opƟon or other payment,

asset, or benet that is subject to vesƟng, it is

important that you understand the condiƟons on

which that benet is granted. Similarly, it is

important that the company be very clear as to the

vesƟng condiƟons -- failure to do so can result in an

employee suing for what they feel they earned. In

the event the company is poised for sale, it can cause

a potenƟal buyer to reconsider a purchase or

merger, or at the very least, demand addiƟonal

nancial assurances from the company and its

shareholders for any liability that might arise due to

the uncertainty of the vesƟng program.

Most stock

opƟon grants

vest over

four years.

146

NOTES

_______________________________________

147

409A VALUATIONS

A 409A valuaƟon is an independent appraisal of the

fair market value (“FMV”) of a private company’s

stock. The valuaƟon is made as of the date of

issuance and is used to set the exercise price for

stock opƟons and stock grants issued to employees.

SecƟon 409A of the Internal Revenue Code provides

a framework for valuing stock for compensaƟon

purposes. Performed by an independent, third-party

appraiser, a 409A valuaƟon is used to determine the

proper value of stock opƟons and stock grants. A

properly performed valuaƟon provides a “safe

harbor,” protecƟng the company and its employees

from IRS penalƟes that may arise if

the FMV has not been determined

appropriately. The safe harbor

concept assumes that because it

was performed by a qualied third

party, the calculated FMV is a

reasonable fair market value of the

company’s stock and can be relied

upon by the company.

There is no universal formula for determining the

FMV of a company. The determinaƟon of the

company’s FMV requires the judgment of the

appraiser, who may use a variety of methods in

determining FMV. The following three methods are

409As lower

your risk that

the stock

opƟon value

is later found

to be

incorrect.

148

most common, and may be combined in the

discre�on of the valua�on company:

 Income Approach - this approach focuses

on the income producing capabili�es of the

company by es�ma�ng future income and

cash ows.

 Market Approach -- this approach values

the assets, revenue and earnings of the

business compared to other companies. If

the company has had a recent nancing

event, and those investments have been

nego�ated on an arms length basis, those

investments will provide addi�onal

guidance as to the company’s FMV.

 Asset approach-- this approach is used in

early-stage companies that have not had a

funding event and do not yet produce

revenues, and focuses on the net asset

value of the company (based in part on the

cost to replace such assets).

Independent appraisers have an obliga�on to ensure

that the 409A and the FMV resul�ng from it are

“fair.”

A 409A valua�on is ideally conducted before any

op�ons or shares are granted to any employees or

advisors, and then refreshed every 12 months, or

upon a material event occurring. Material events are

any events that might signicantly aﬀect the

company’s stock price, but will certainly include

events such as:

149

 a successful funding round

 the comple�on of a major milestone of

the company

 the acquisi�on, or loss, of a major

contract that will signicantly aﬀect

revenue

 receipt of a term sheet from a poten�al

acquirer, or

 changes in market condi�ons that will

aﬀect the company’s prot margins

It is not unusual for early-stage companies to elect

not to hire a third-party appraiser to perform a 409A

analysis, as the cost for an ini�al 409A might be

$3000-5000. However, choosing not to have a

properly formed 409A can expose the company and

its employees to signicant risk in the event the value

the company chooses to use is later deemed

inappropriate.

If the 409A valua�on is not performed using one of

the IRS-approved methods, penal�es can be

signicant, including (i) all deferred compensa�on

becoming immediately taxable, (ii) interest being

charged on that taxable amount, and (iii) an

addi�onal 20% penalty.

150

NOTES

_______________________________________

151

TYPES OF INVESTORS

When a business starts seeking investment, there are

a number of types of investors that might be

approached.

Friends and Family are usually the rst stop. This

group is typically approached when very small

amounts of money are being requested. Their

investments are oŌen in the form of SAFEs (Simple

Agreement for Future Equity) or, alternaƟvely,

common stock. Unfortunately, if the business

opportunity does not work out, this is the most

uncomfortable money to lose, as you may be talking

about it next Thanksgiving. Friends and family oŌen

don't invest much, but they may also have a very low

tolerance for risk on the money they have invested.

They may not be sophisƟcated and may not fully

appreciate the fact they might lose their complete

investment (no maƩer how oŌen you tell them

otherwise). For that reason, it is very important to

make sure that even though they are friends and

family, the business has provided proper

documentaƟon relaƟng to the nancing, which

clearly spells out all the risk

factors.

Angel Investors, typically high

net worth individuals, will

generally make investments in

very early-stage companies.

The earlier the

investment, the

higher the

returns the

investor expects.

152

Angels will typically invest between $25,000 and

$500,000 in a “seed round” (commonly in either

converble notes or preferred stock) and their

investment usually also includes oering advice and

mentorship, as well as their connecons. They

typically will not require a board seat or other

approval rights, and they are generally not involved

in day-to-day acvies of the company. Angel

investors have a higher risk tolerance, choosing to

invest in high-risk ventures because they are looking

for high rewards.

Venture Capitalists, or VCs, typically manage funds

which in turn make investments in high growth

companies. Their investments are larger than angel

investors and usually come in aŌer the startup phase

when businesses need substanƟal capital in order to

grow. VCs will typically invest $2,000,000 or more, in

a Series A, Series B, or later rounds, and will typically

receive preferred stock. It is not unusual for the VC

to require a board seat as part of their investment.

Their investments are sƟll considered high risk, as

they expect many investments to fail with a few

yielding signicant returns. VC's will typically look for

a 10X return over ve to seven years.

Private Equity investors typically invest capital in

companies that have matured. They will oen

require signicant ownership stakes in exchange for

their investment -- in many cases, they will require a

controlling interest in the company. Investments can

be anywhere from $10 million to $100+ million.

153

Because of these late-stage investments, they have a

more moderate risk tolerance, and they are looking

for a steady return on investment over ve to seven

years, at which me they're looking for the company

to either sell or le for a public oering.

Corporate Investors and Strategic Investors are

larger companies that invest in smaller companies to

diversify their porolios or ll a niche need in their

business. Because these investments are typically

strategic, they are also seeking ways to collaborate.

For example, an investment might be placed in a

smaller company beer situated to research and

develop new products, with the strategic investor

providing access to cash and technology. While this

type of investor is aracve in the sense that they

typically have deep pockets, it is not uncommon to

nd that there are work-culture gaps between small,

nimble, early-stage companies and large, slow

moving, instuonal companies.

154

NOTES

_______________________________________

155

INVESTOR VALUATIONS

Before talking about diﬀerent methods to value your

business for purposes of investment, it is important

to understand the terminology investors use.

“Pre-money” and “post-money”

terms relate to value. Pre-money is

the term used to state the value of

the company before the

investment is made. Post- money

is the term used to state the value

of the company aŌer the

investment is made. For example,

if the company is worth $4 million

prior to the investment (i.e. the pre

-money value) and the investor is

inves�ng $2 million, then the company will have a

post-money value of $6 million. Assuming there is a

single class of stock, and the company has 8 million

shares outstanding prior to the investment, it will

need to issue another 4 million shares to the investor

for his $2 million investment.

The earlier stage the business is in, the harder it is to

answer the ques�on “What is the value of my

company?"

Value will vary based on a number of factors:

Learn the

terminology

and how to

calculate

company

value before

you start

asking for

money.

156

 Is the company protable? Companies can

have no prot but sƟll be valuable (but

protability doesn’t hurt!).

 What are its annual prots? Obviously, the

higher the prots, the higher the valuaƟon.

 Are prots dependent upon a small number

of customers rather a large number of

customers? A lack of client diversicaƟon

may result in a potenƟally lower value.

 Are prots trending up or down? Are prots

climbing up rapidly or slowly? Prots that

are trending up at a quick pace will jusƟfy a

higher valuaƟon than prots that are

climbing slowly.

 Are distribuƟon channels for its products

broad or narrow? The more distribuƟon

channels that are in place, the beƩer.

 Does the company own intellectual

property (“IP”)? Are patents registered?

Are trademarks registered? Have copyrights

been registered? Have all employees and

contractors signed condenƟality and

invenƟon assignment documents? It is

criƟcal to have all IP rights protected, and

registraƟon is a very important step in that

process. Patents and trademarks which

have not achieved registraƟon run a risk of

not ever being approved, which results in a

discounted IP value.

 Is it expected that employees will remain

with the company for the foreseeable

future?

157

 What are the most signicant risks of the

company moving forward?

UlƟmately, investors will be looking to receive a

substanƟal return in an early-stage company, but

smaller returns on more mature companies. For

example, an investor might be looking for the value

of their investment to mulƟply by 5X in three years

with an early-stage company, where they might be

seeking a substanƟally smaller return from a well-

established company.

UlƟmately, when seeking money from investors, it is

important not only to evaluate the price they are

willing to pay but also consider the value they can

bring in the form of non-cash contribuƟons. For

example, an investor with a lot of market experƟse

and connecƟons (oŌen referred to as “smart

money”) might be a beƩer partner than one willing

to pay more cash but who is not bringing any

strategic value (referred to as “dumb money”).

158

NOTES

_______________________________________

159

TERM SHEET, LETTER OF INTENT

A term sheet is a non-binding agreement that

idenes the basic terms and condions of a

transacon. A term sheet is also referred to as a

leƩer of intent or “LOI.” Term sheets are used in a

variety of transacons.

Companies raising money will

oen provide a term sheet to

potenal investors that states

all the material terms of the

investment. In those

circumstances, the term sheet

will outline rights, preferences,

and protecons aorded to the investor, as well as

provide informaon about the oering itself, such as

any minimum investment required. In the case of

small investors, the term sheet is generally not open

to much negoaon; however, it is very common for

the lead investor to negoate nancial terms,

including valuaon and an-diluon protecons, as

well as non-monetary terms such as their ability to

appoint a board member, informaon rights, vong

rights, the size of the stock opon pool, and other

rights and protecons that may or may not extend to

other holders of the same shares.

When companies seek to enter into a transacon to

acquire/sell a substanal amount of assets, or if two

companies are ancipang a merger, the transacon

Term sheets are

non-binding,

except for a few

terms, such as

condenƟality.

160

will typically be spelled out on a term sheet prior to

moving to nal documentaon. Likewise, if a

company intends to purchase the shares of another

company from that company’s shareholders, those

terms will generally be rst idened on a term

sheet.

While a term sheet is generally non-binding, it is also

possible to have certain binding provisions within the

term sheet. Most oen, those binding provisions

relate to condenality and “no-shop” clauses. The

condenƟality provision will state that while the

pares are not obligated to enter into a transacon,

they will keep the existence of the transacon

condenal as well as any informaon that they may

learn from the other party during the process. The

no-shop provision is oen a part of a term sheet

when the purchase of a business is being

contemplated. The no-shop provision states that, for

a period of me, the seller will not seek or entertain

any other oers; the purpose of this is to give the

buyer and seller me to complete the transacon,

and to prohibit the seller from using the buyer’s oer

as a “stalking horse” to negoate a beer deal with a

third party. The length of the no-shop period will

vary, but is typically a period of me long enough to

allow the pares to complete the ancipated

transacon.

The intent of a term sheet is to allow the pares to

negoate and nalize all material deal points before

they incur the me and expense of draing deal

161

documentaon. If the pares cannot reach an

agreement on the material terms within a term

sheet, there is no reason to proceed to document

draing.

In circumstances where documentaon is being

draed by legal counsel, using a term sheet is even

more important, as it will provide a clear road map as

to which terms need to be included in the nal deal

documentaon. This will make the draing faster,

and by extension, less expensive.

It is important to note that while a

term sheet is non-binding, making

changes aer it is agreed to will be

dicult. It is non-binding in the

sense that the pares are not

obligated to enter into the deal

that is laid out in the term sheet.

However, once the term sheet is agreed upon, it will

be very dicult for either party to go back to the

other party with any material changes; once the term

sheet is agreed upon, those terms are considered

“the deal” and “re-trading” is viewed negavely.

Based on that, negoang a very clear and

acceptable term sheet is crical; failing to do so can

potenally jeopardize the transacon if one party

proposes changes post-signing.

While term sheets are not required to be executed,

as they are non-binding, it is good pracce to have

them executed so that each party is clearly agreeing

The more

thorough the

term sheet,

the smoother

the deal.

162

to the terms contained within the term sheet. Of

course, if the term sheet includes any binding

provisions, such as a condenƟality provision or a no-

shop provision, then without quesƟon the term

sheet should be executed by all parƟes intended to

be bound by those provisions.

163

FINANCING YOUR BUSINESS

There are mulƟple ways to nance your business.

Equity - When you sell equity in a business, you are

selling ownership. Examples of equity include SAFEs

(Simple Agreement for Future Equity), common

stock, preferred stock, member interests and

partnership interests.

Debt – When you nance your business with debt,

you are issuing promissory notes in exchange for

loans. For early-stage companies, it is quite common

that these loans be secured with the assets of the

business and/or by a personal guarantee from the

founders. When loans are obtained through the

Small Business AdministraƟon program, a personal

guarantee will be required.

For a company to qualify for a tradiƟonal bank

business loan, the business will need to have stable

cash ow; without stable cash ow, the company

may need to resort to other non-bank debt nancing

strategies.

The benet of issuing equity is that there is nothing

to repay. If the company fails, the investor loses their

investment. Their only hope to recoup any of their

investment is if there is residual value leŌ in the

company aŌer it is liquidated and all creditors have

been paid rst. Because of that risk, selling equity at

164

a very early stage is oen more dicult, and an

investor may prefer a converƟble note.

When an investment comes in on a converble note,

the investor holds the note and collects interest, but

also has the opon to convert that note to equity. In

that sense, the investor has the best of both worlds,

being secured while holding the note and having the

upside of equity once they convert. The converble

note will dictate when the note converts at the

investor’s discreon and when it converts

automacally.

Increasingly, SAFEs are being used instead of

converƟble notes. With a SAFE, the investor is

receiving an equity interest, but the value and nature

of that interest is determined in the future. For

example, a SAFE might provide that the SAFE will

convert into whatever equity is raised in the next

round, but at a discount. If the next round raised is

preferred stock at $1.00 per share, the SAFE holder

might receive their shares of preferred stock at a

20% discount (i.e. $0.80 per share). This discount

rewards the SAFE investor for placing their money

into the company at an earlier me when the risk

was higher.

Factoring of Receivables. If the company has an

acve ow of accounts receivables, it may be able to

nance its business by factoring those receivables.

In this approach, the company sells its unpaid

invoices, i.e. accounts receivable, to a third-party

165

company referred to as a "factor.” The factor

provides cash immediately on those receivables,

taking a percentage of the invoice values as their

transacƟon fee. While the company sacrices a

percentage of its receivables, it is able to access

funds quickly instead of waing for those receivables

to be paid over me. In “recourse factoring,” the

business is responsible in the event the customer

does not ulmately pay; in “non-recourse factoring,”

the business risk of non- payment is shied to the

factor. If non-recourse, the factor will require a

larger percentage of the receivables as their fee, to

oset some of their collecon risk.

See the chapter on “Types of Investors” to learn

more about the dierent proles of investors and

how they typically parcipate in funding businesses.

166

NOTES

_______________________________________

167

USING FINDERS

Raising funds to get your business o the ground (or

to the next level) is one of the most signicant

challenges an entrepreneur can encounter.

Entrepreneurs oen reach out to people they know

to try to tap into those networks and will oen agree

to pay those people (“nders”) a percentage of funds

raised, oen termed a “nders fee.” It's clear why

entrepreneurs would want to do this; however,

unless certain specic requirements are complied

with, these individuals may not be permied by law

to earn success fees when raising capital.

Unfortunately, many nders do not live up to

expectaons; they oen require a lot of informaon

from the company, then fail to deliver any

meaningful connecons.

Finders typically have not

registered as broker-dealers

with the Securies and

Exchange Commission (the

“SEC”), and generally are not in

compliance with state laws

applicable to broker-dealers

either. Finders have generally

been under the impression

(incorrectly) that they are exempt from those

requirements. While the SEC has proposed an

exempon that might provide nders some relief

Using a nder

may not be

legal in your

state…if it is,

there may be

compliance

requirements.

168

from the broker-dealer registraƟon requirement,

such exempƟve relief is not yet nalized and does

not appear to be on the SEC’s list of prioriƟes.

For now, if a nder acts in a manner that requires it

to be registered as a broker-dealer, and no

exempƟon applies, the nder must be registered

with the SEC and the Financial Industry Regulatory

Authority (“FINRA“). It is important to note that

state laws sƟll need to be complied with as well.

While some nders are familiar with the legal

requirements but ignore them, many others are

completely unaware that what they are doing is in

violaƟon of the law – but unfortunately, as the adage

goes, ignorance of the law is no excuse.

There is a signicant risk to the company when the

company engages a nder who is an unlicensed

broker-dealer. Agreements with new investors can

become void, and an investor potenƟally will be

granted rescission rights. These rescission rights will

essenƟally let the investor reverse their posiƟon and

receive a refund of their investment, which

essenƟally provides the investor a guarantee against

losing any money… if the investment works out, the

investor does not complain, but if the investment

does not succeed, the investor seeks rescission and a

refund of the failed investment.

Technically, the exempƟon which provides nders

relief from general broker-dealer licensing

requirements is not a statutory exempƟon, but

169

originates from a no-acƟon leƩer, where the SEC

stated it would not recommend enforcement acƟons

against nders where the nder was providing a

potenƟal list of investors in exchange for a

commission. However, the SEC claried that this was

based on the assumpƟon that (i) the nder had a

very limited role in negoƟaƟons, (ii) the business

introduced by the nder was a going concern (not a

shell company), (iii) the nder gave no opinion as to

the value of the securiƟes, or whether the company

should issue the securiƟes, (iv) the nder did not

assist anyone in obtaining any nancing, (v) the

nder did not prepare or

distribute materials about the

transacƟon, and (vi) the nder

was not engaged in due

diligence or any analysis

regarding the transacƟon. In

short, the nder is expected to

make the introducƟon and

then step out of the way. If

this is all the nder does, the

nder may be able to avoid registering as a broker-

dealer.

California has passed its own regulaƟons on this

topic. AŌer earlier legislaƟon had barred nders

completely, the state revised the law to permit

nders to operate in very limited circumstances.

A nder needs to

make the

introducƟon

then withdraw

from further

conversaƟon

with the

prospect.

170

In California, a nder must be a natural person and

must NOT take any of the following acƟons:

1. Provide services to an issuer for a

transacon or a series of related

transacons for the oer or sale of

securies of the issuer that exceeds a

securies purchase price of een million

dollars ($15,000,000) in the aggregate.

2. Parcipate in negoang any of the terms

of the oer or sale of the securies.

3. Advise any party to the transacon

regarding the value of the securies or the

advisability of invesng in, purchasing, or

selling the securies.

4. Conduct any due diligence on the part of

any party to the transacon.

5. Sell or oer for sale in connecon with the

issuer transacon any securies of the

issuer that are owned, directly or

indirectly, by the nder.

6. Receive, directly or indirectly, possession

or custody of any funds in connecon with

the issuer transacon.

7. Knowingly receive compensaon in

connecon with any oer or sale of

securies unless the sale is qualied under

California law or unless the security or the

transacon is exempt or not otherwise

subject to qualicaon.

8. Make any disclosure to a potenal

purchaser other than the following: (A) the

name, address, and contact informaon of

171

the issuer, (B) the name, type, price, and

aggregate amount of any securies being

oered in the issuer transacon, and (C)

the issuer’s industry, locaon, and years in

business.

In addion to complying with the above restricons

by California, the nder must also

1. At the same me as making the

introducon, provide each person the nder

introduces with a wrien agreement

disclosing (i) the nder’s compensaon, (ii)

the fact that the nder is not providing any

advice, (iii) disclosing whether the nder

owns any securies of the company, (iv)

disclosing any conicts of interest, and (v)

advising the party that they have the right

to pursue remedies at law for any breach of

the nder agreement.

2. Register with the State of California and pay

the ling fee (currently $300.00) to the

Department of Financial Protecon and

Innovaon, along with a statement of

informaon which includes the name and

address of the nder. Once registered, the

nder will be required to make annual

lings and pay annual renewal fees, at

which me the nder will need to disclose

any transacon-based compensaon

received in the prior 12 months.

172

The law regarding nders remains very unseƩled,

and companies choosing to use nders should

proceed very carefully. It is recommended that

companies using nders rst engage appropriate

legal counsel who can review the acƟviƟes of the

nder and provide guidance to help ensure that the

corporaƟon has not hired an individual who should

have registered with the SEC and FINRA as a broker-

dealer.

173

BASIC FORMATION DOCUMENTS

The core documentaƟon required to set up a

corporaƟon includes the following:

1. FormaƟon document – Depending on the

state of formaon, the document led with

the applicable Secretary of State for

purposes of forming a corporaon will be

Arcles of Incorporaon or a Cercate of

Incorporaon;

2. Bylaws – this document sets forth detailed

provisions governing the responsibilies of

the directors, shareholders and ocers of

the corporaon, the manner of calling and

holding meengs of the shareholders and

board of directors, and requirements for

reports to shareholders, maintenance of

corporate records, execuon of contracts,

and other miscellaneous maers pertaining

to the operang procedures and

governance of the corporaon. Essenally,

it serves as the “rules of the road” for how

the corporaon will operate. Each

corporaon is required by law to have

Bylaws adopted;

3. WriƩen Consents and/or OrganizaƟonal

Minutes – this group of documents will

cover the appointment/elecon of the

Board of Directors, appointment of ocers,

issuance of shares, and other inial and

ongoing operang maers;

174

4. Ownership Transfer Ledger (also called a

Stock Ledger)– this document sets forth the

shareholders, their addresses, number and

type of shares held, the purchase date of

the shares, the cercate numbers, and

price paid to the company for such shares;

5. Statement of InformaƟon (if California) or

other informaonal lings – in California,

this ling is due within 90 days aer

formaon, and states the company’s

principal place of business, its ocers and

directors, its agent of service, and type of

business (other states require similar lings,

e.g. annual reports);

6. SecuriƟes ling -due based on the sale(s) of

shares by the corporaon. In California, for

example, this is known as a 25102(f) ling;

7. Employer IdenƟcaƟon Number (“EIN”) of

the corporaon (this can be obtained online

at www.irs.gov);

8. If applicable, the corporaon’s Subchapter S

ElecƟon (Form 2553); and

9. Stock CerƟcates.

175

The core documentaƟon required to set up a limited

liability company includes the following:

1. FormaƟon document – Depending on the

state of formaƟon, the document led with

the applicable Secretary of State for

purposes of forming a corporaƟon will be

ArƟcles of OrganizaƟon or a CerƟcate of

OrganizaƟon;

2. OperaƟng Agreement – Every member of a

limited liability company must be a party to

the operaƟng agreement. It is the primary

document that denes the characterisƟcs of

the LLC, the relaƟonship of its members and

the duƟes of its members and managers (if

manager-managed). An operaƟng

agreement is required by law. While

statutes of states will vary, those rules and

procedures will apply to the LLC unless the

operaƟng agreement indicates otherwise;

3. WriƩen Consents and/or OrganizaƟonal

Minutes – this group of documents will

cover the appointment of the Manager (if

the LLC is manager-managed), issuance of

member interests, and other iniƟal

operaƟng and ongoing maƩers;

4. Ownership Transfer Ledger (also called a

Member Interest Ledger)– this document

ets forth the members, their addresses,

number and type of units held, date of

purchase, and price paid to the company for

such shares;

176

5. Statement of InformaƟon (if California) or

other informaƟonal lings – in California,

this ling is due within 90 days aŌer

formaƟon, and states the company’s

principal place of business, its members or

managers, its agent of service, and type of

business (other states require similar lings,

e.g. annual reports);

6. SecuriƟes ling - due based on the sale(s) of

units by the LLC. In California, for example,

this is known as a 25102(f) ling;

7. EIN (this can be obtained online at

www.irs.gov);

8. If applicable, the LLC’s Subchapter S ElecƟon

(Form 2553); and

9. Member Interest CerƟcates.

177

OBTAINING AN EIN

An employer idenƟcaƟon number, or “EIN" is a

unique nine-digit number that idenƟes your

business for tax purposes. You will need an EIN in

order to open your business bank account, apply for

business licenses, and le tax returns. An EIN is

required when a business has employees. However,

even a business without employees is required to

have an EIN if it operates as a corporaƟon or a

partnership; if they have no employees, a sole

proprietor or single-member LLC can use his or her

Social Security number or apply for an EIN. Many

sole proprietors and single-member LLCs choose to

secure an EIN for privacy reasons; with an EIN, they

do not have to provide their Social Security number

to other parƟes (such as when they need to

complete a W-9 for a client).

An EIN can be obtained online,

through a simple applicaƟon on the

IRS website (www.irs.gov).

Typically, you will be provided with

the EIN immediately at the end of

the EIN applicaƟon process. The applicaƟon process

takes about 10 minutes to complete, but make sure

that the applicaƟon is led out correctly before

submiƫng it electronically.

You can only apply for an EIN aŌer the corporaƟon,

LLC, or partnership is in existence. If formed as a

corporaƟon, prior to compleƟng the applicaƟon, you

Geƫng an

EIN is quick

and easy.

178

should seek advice from your CPA as to whether the

corpora�on will elect to be taxed as an “S

Corpora�on.” If formed as an LLC, then prior to

comple�ng the applica�on, you should seek advice

from your CPA as to whether the LLC will elect to be

taxed as a C Corpora�on, S Corpora�on, or

partnership (or a disregarded en�ty if the LLC has

only a single member).

On your applica�on, you will need to iden�fy a

“responsible party” and you will need to list the

responsible party’s Taxpayer Iden�ca�on Number

(i.e. social security number). A responsible party is

the person who ul�mately owns or controls the

en�ty or who exercises ul�mate eﬀec�ve control

over the en�ty. The responsible party must be an

individual (i.e. a natural person), not a legal en�ty

such as a corpora�on or LLC.

179

SHARE OFFERINGS AND SECURITIES

REGULATIONS

When you sell (“issue”) securi�es, a series of state

and federal regula�ons kick in. “SecuriƟes” are

nancial instruments which typically fall under the

broad categories of equity (such as stock and

member interests), debt (such as promissory notes),

derivaƟves (such as op�ons and warrants) and

hybrids (having equity-like and debt-like features,

such as conver�ble notes).

In addi�on to the federal

Securi�es Act of 1933 (the “1933

Act”), most states have enacted

their own securi�es laws as well,

referred to as “blue sky laws.” Any

issuance of securi�es must sa�sfy

both federal and state requirements, including the

registra�on of oﬀered securi�es, unless the security

is exempt from registra�on. Unless the security is

registered or qualies under an exemp�on, no

security may be transferred to another party.

In the event you fail to comply with federal and state

regula�ons, any purchaser who purchases a non-

exempt, non-registered security is en�tled to rescind

(void) the purchase and collect back any funds that

were paid for the security (and possibly, addi�onal

damages).

“Blue sky

laws” are the

securiƟes

laws of each

state.

180

Even if the security qualies as exempt from

registra�on, the company s�ll has “an�-fraud”

obliga�ons regarding the securi�es, such as the

obliga�on not to make untrue statements of material

fact or, conversely, omit material facts…what you

say in the course of oﬀering the securi�es must be

true, and you can’t leave out any informa�on that

would be material to an investor evalua�ng the

investment.

For purposes of this chapter, the focus will be on

private oﬀerings, where the securi�es are oﬀered by

the company to a small number of qualied investors

who understand and accept the risks of the

investment. Oﬀerings of securi�es by early-stage

companies are most commonly made under

Regula�on D which contains exemp�ons under Rule

504, Rule 506(b) and Rule 506(c).

Before discussing the exemp�ons, it is important to

understand the concept of an “accredited investor.”

An accredited investor is an investor who, because of

their wealth or experience, is deemed by the

government to be sophis�cated enough to fend for

themselves in investment opportuni�es. For those

who do not meet those qualica�ons, i.e. the non-

accredited investors, the securi�es laws impose

certain requirements if a company wishes to sell

securi�es to them, in order to provide some

addi�onal protec�ons for those non-accredited

investors.

181

How can individuals qualify as an accredited

investor?

Most oen, individuals qualify as an accredited

investor by having

 Net worth over $1 million, excluding their

primary residence (individually or with spouse

or partner), OR

 Income over $200,000 (individually) or

$300,000 (with spouse or partner) in each of

the prior two years, and they reasonably expect

the same for the current year

While it happens less frequently, individuals can also

qualify as accredited if they are

 Investment professionals in good standing

holding the general securies representave

license (Series 7), the investment adviser

representave license (Series 65), or the

private securies oerings representave

license (Series 82)

 Directors, execuve ocers, or general

partners (GP) of the company selling the

securies (or of a GP of that company)

 A “family client” of a “family oce” that

qualies as an accredited investor

 For investments in a private fund,

“knowledgeable employees” of the fund

182

How can enƟƟes qualify as an accredited investor?

En��es can qualify as an accredited investor by

 Owning investments in excess of $5 million

 Being a corpora�on, partnership, LLC, trust, 501

(c)(3) organiza�on, employee benet plan,

“family oﬃce” or any “family client” of that

oﬃce, any of the forgoing having assets in

excess of $5 million

 Being an en�ty in which all equity owners

individually meet the accredited investor test

 Being an investment adviser (SEC- or state-

registered or exempt repor�ng advisers) or a

SEC-registered broker-dealer

 Being a bank, savings and loan associa�on,

insurance company, registered investment

company, business development company,

small business investment company or rural

business investment company

With the knowledge of what

cons�tutes an accredited investor,

the next step is evaluaƟng which

exempƟon would be most

appropriate for your oﬀering. For

this analysis, we will focus on exemp�ons under Rule

504, 506(b) and 506(c).

How much can be raised from the sale of securiƟes?

Under Rule 504: Up to $10 million within a 12-month

period

Knowing

whether an

investor is

“accredited”

is criƟcal.

183

Under Rule 506(b) and 506(c): There is no limit

Who can invest in the securiƟes?

Under Rule 504: Anyone

Under Rule 506(b): An unlimited

number of accredited investors,

and up to 35 non-accredited

investors

Under Rule 506(c): An unlimited

number of accredited investors, but NO non-

accredited investors

What informaƟon needs to be provided to

investors ?

Under Rule 504: No specic informa�on is required,

but best pracƟce is to provide informaƟon about the

investment, the risk factors, and that the investment

is a high-risk investment that may result in complete

loss of capital. InformaƟon provided must be free of

any material misstatements, and there must be no

omissions of material fact.

Under Rule 506(b): No specic informa�on is

required to be provided to accredited investors, but

best pracƟce is to provide informaƟon about the

investment, the risk factors, and that the investment

is a high-risk investment that may result in complete

loss of capital. Non-accredited investors must

receive extensive disclosure, similar to registering an

oﬀering with the SEC. All informaƟon provided must

Only

accredited

investors are

allowed under

Rule 506(c).

184

be free of any material misstatements, and there

must be no omissions of material fact.

Under Rule 506(c): No specic informaƟon is

required, but best pracƟce is to provide informaƟon

about the investment, the risk factors, and that the

investment is a high-risk investment that may result

in complete loss of capital. InformaƟon provided

must be free of any material misstatements, and

there must be no omissions of material fact.

How do you demonstrate the investor is accredited?

Under Rule 504: It's not required

Under Rule 506(b): The investor

provides a statement with

informaƟon supporƟng their

accredited status, and the

company can reasonably rely on

that statement

Under Rule 506(c): The company

must ac�vely verify the investor

is accredited, by using third party

resources or by reviewing

investor nancial informaƟon

Can you adver�se the oﬀering?

Under Rule 504: No general solicitaƟon or general

adverƟsing is allowed

Under Rule

506(b), you

can rely on

the

statements as

to accredited

status….under

Rule 506(c),

you need to

verify that

informaƟon.

185

Under Rule 506(b): No general solicitaƟon or general

adverƟsing is allowed; sales are

permiƩed only to investors with

whom there is a pre-exisƟng

relaƟonship

Under Rule 506(c): The are no

limitaƟons on adverƟsing

Does the oering also need to comply with state

blue sky laws?

Under Rule 504: Yes. Depending on the jurisdicƟon,

compliance with Rule 504 alone may not saƟsfy state

law requirements.

Under Rule 506(b): No. Compliance with Rule 506(b)

saƟses state law requirements, although a noƟce

that securiƟes have been sold may be required by

the state.

Under Rule 506(c): No. Compliance with Rule 506(c)

saƟses state law requirements, although a noƟce

that securiƟes have been sold may be required by

the state.

As a praccal maer, any securies oered under

Rule 506 should be oered only to accredited

investors. While Rule 506(b) does allow sales to non-

accredited investors, the burden of the informaƟon

disclosure requirements outweighs the benets of

selling to non-accredited investors. Another factor

to consider is that non-accredited investors will

Only Rule 506(c)

allows for

general

adverƟsing.

186

typically invest less, will be less able to aﬀord the

loss of their investment, and will most typically be

the par�es who sue if the investment does not work

out as hoped. Non-accredited investors should only

be accepted under a Rule 504 oﬀering, and even in

that case, it is generally not advisable.

Rule 504 Rule 506(b) Rule 506(c)

Limit of

oﬀering

size?

$10MM in a

12 month

period

No limit No limit

Who can

invest?

Anyone 35 or less non-

accredited,

unlimited ac-

credited

Only accredit-

Info to

provide to

investors?

No require-

ment

No requirement

for accredited,

extensive for

non-accredited

No require-

ment

Conrm

investor is

accredited?

No require-

ment

Can rely on

investor state-

ments

Need to ac-

�vely verify

General

Adver�s-

ing?

No No Yes

S�ll need

to comply

with blue

sky laws?

Yes No, but no�ce

may be required

No, but no�ce

may be re-

quired

187

CORPORATE TRANSPARENCY ACT

The Corporate Transparency Act (“CTA”), eecve

January 1, 2024, is recent federal legislaon enacted

to combat money laundering and terrorism nancing

through United States enes. The CTA requires

certain business enes to le Benecial Ownership

Informaon (“BOI”) and Reporng Company

Informaon with the U.S. Department of the

Treasury’s Financial Crimes Enforcement Network

(“FinCEN”). Benecial ownership informaon refers

to idenfying informaon about the individuals who

directly or indirectly own or control a company.

Reports must be submied electronically. FinCEN has

developed an online system to submit the

informaon, named the “Benecial Ownership

Secure System (BOSS).” Only “Reporng Companies”

are required to report

A BOI ling integrates three classes of parcipants:

Repor�ng Companies, Benecial Owners, and

Applicants.

Only companies falling under the denion of

Reporng Companies are required to report BOI and

enty informaon to FinCEN. A “Repor�ng

Company” is a domes�c or foreign en�ty that is (i) a

corpora�on, (ii) a limited liability company, or (iii)

any en�ty created (or a foreign en�ty registered in

the U.S.) by the ling of a document with a

secretary of state, or any similar oﬃce under the

188

law of a state or Indian tribe. It does not maer

how long ago the enty was formed.

Generally, trusts are exempted from reporng, as are

23 categories of exempt enes. The 23 exempted

enƟƟes include (i) securies reporng issuers, (ii)

governmental authories, (iii) banks, (iv) credit

unions, (v) depository instuon holding companies,

(vi) money services businesses, (vii) brokers or

dealers in securies, (viii) securies exchanges or

clearing agencies, (ix) other Exchange Act registered

enes, (x) investment companies or investment

advisers, (xi) venture capital fund advisers, (xii)

insurance companies, (xiii) state-licensed insurance

producers, (xiv) Commodity Exchange Act registered

enes, (xv) accounng rms, (xvi) public ulies,

(xvii) nancial market ulies, (xviii) pooled

investment vehicles, (xix) tax-exempt enes (e.g.

organizaons formed under 501(c), 527(e)(1) or 4947

(a)), (xx) enes assisng tax-exempt enes, (xxi)

large operang companies, (xxii) subsidiaries of

certain exempt enes, and (xxiii) inacve enes.

For a company to qualify for the “large operaƟng

company” exempƟon, the company must have (i)

more than 20 full-me employees in the U.S., (ii)

more than $5 million in gross receipts or sales from

U.S. sources, as evidenced from the federal income

tax return led in the previous year, AND (iii)

operaons in a physical oce located in the U.S. All

of these condiƟons must be met to qualify for this

exempƟon. The large operang company exempon

189

requires that the enƟty itself employ more than 20

full-Ɵme employees in the United States;

consolidaƟon of this employee count across mulƟple

enƟƟes is not permiƩed.

To qualify for the “inacƟve enƟty” exempƟon, the

enƟty must (i) have been formed prior to January 1,

2020, (ii) not have engaged in any business acƟvity,

(iii) not be owned by a foreign person and not have

had a change of control in the prior 12 months; (iv)

not have paid or received funds in an amount greater

than $1,000 in the prior 12 months; and (v) hold no

assets or interests in any other enƟty (i.e. not a shell

company). Again, all of these condiƟons must be met

to qualify for this exempƟon.

To qualify for the “tax-exempt enƟty” exempƟon,

any of the following four criteria must apply: (a) the

enƟty is an organizaƟon that is described in secƟon

501(c) of the Internal Revenue Code (“Code”) and

exempt from tax under 501(a) of the Internal

Revenue Code, (b) the enƟty is an organizaƟon that

is described in secƟon 501(c) of the Internal Revenue

Code, but lost its tax-exempt status less than 180

days ago, (c) the enƟty is a poliƟcal organizaƟon, as

dened in 527(e)(1) of the Code or (4) the enƟty is a

trust described in paragraph (1) or (2) of secƟon

4947(a) of the Code.

190

Who are Benecial Owners?

A “Benecial Owner” is any individual who owns or

controls 25% or more of the ownership interest in

the ReporƟng Company and/or any individual who

exercises “substanƟal control” over the ReporƟng

Company.

It is important to note that all

Bene

cial Owners are

individuals. In the event an

owner is an enƟty (such as a

corporaƟon or LLC), the

reporƟng Company must look

through the enƟty to its

individual owners.

For example, assume the

ReporƟng Company has three

owners: Individual A at 50% ownership, Individual B

at 40% ownership, and Individual C at 10%

ownership, as well as a President who owns no

equity. In such a case, BOI lings must include

Individual A and Individual B (based on ownership of

25% or more) and the President (based on

substanƟal control).

If we assume the same scenario, but assume the

owners are Individual A at 50% ownership, EnƟty B at

40% ownership (EnƟty B being held 50% each by

Individual X and Individual Y), and Individual C at 10%

ownership, then the ling obligaƟons will change.

Benecial

owners are

people…if a

company is the

owner, you need

to drill down to

the individual

owner level.

191

Individual X and Individual Y, by virtue of each owing

50% of EnƟty B, are each deemed to own 20% of the

ReporƟng Company (i.e. EnƟty B’s 40% of ReporƟng

Company mulƟplied by their 50% interest in EnƟty B

= 20%). Thus, under this revised set of facts, only

Individual A will be deemed to exceed the 25%

ownership threshold.

For purposes of LLCs and other enƟƟes issuing capital

or prot interests (including enƟƟes treated as

partnerships for federal income tax purposes),

ownership interests are based on the individual's

capital and prot interests in the enƟty…a right to

receive 25% or more of distribuƟons will trigger a BOI

ling requirement, even if ownership is less.

For example, if ve members of an LLC each hold a

20% ownership interest in the LLC, but the prots are

split 30%, 30%, 30%, 5%, 5%, then the company will

need to make BOI lings on the three members

receiving 30% prot distribuƟons. If either of the 5%

owners is in a substanƟal control posiƟon, such as a

manager, a BOI ling will need to be led for that

individual as well.

The deniƟon of “ownership interest” is very broad,

including any ownership of (i) stock, (ii) capital or

prots interest (“units”) in an LLC or partnership, (iii)

any converƟble instrument (e.g., converƟble debt,

SAFEs), (iv) any puts, calls, opƟons, and warrants,

and (v) anything else used to establish ownership.

192

There are no excep�ons for future/con�ngent

conversion rights.

Individuals having “substanƟal control” include (i)

senior oﬃcers, (ii) those with authority to appoint or

remove certain oﬃcers or a majority of directors,

and (iii) other important decision-makers, including

any individuals with any other form of signicant

inuence over the Repor�ng Company. In short, the

deni�on requires a BOI ling for anyone who is able

to make important decisions on behalf of the

Repor�ng Company.

Examples of direct ways to exercise substanƟal

control over a repor�ng company include: being

represented on the board, ownership or control of a

majority of the vo�ng power, or rights that are

associated with nancing or interest. Examples of

indirect ways to exercise substanƟal control over a

repor�ng company include: controlling one or more

intermediary en��es that separately or collec�vely

exercise substan�al control over a Repor�ng

Company, or exer�ng control through arrangements

or nancial or business rela�onships with other

individuals ac�ng as agents.

Benecial owners can own or control a Repor�ng

Company through trusts. They can do so by either

exercising substan�al control over a Repor�ng

Company through a trust arrangement or by owning

or controlling the ownership interests of a Repor�ng

Company that are held in a trust. If the trust is a

193

benecial owner, the trustees are to be reported.

The registraon of a trust with a court of law merely

to establish the court’s jurisdicon over any disputes

involving the trust does not make the trust a

reporng company.

Filing ExempƟons

Individuals who are exempted from the reporng

requirements are (1) minor children (2) nominees,

intermediaries, custodians or agents (3) employees,

(4) inheritors, and (5) creditors.

An individual qualies for a minor child excepon if

they are a minor child residing in the state in which

the Reporng Company was rst created, and where

a parent or legal guardian’s informaon is being

reported in lieu of the minor child’s informaon.

An individual qualies for the nominees,

intermediaries, custodians or agents excepon if

they are performing ordinary advisory or other

contractual services (such as tax professionals or

aorneys) to the Reporng Company.

Employees are exempt from ling if (i) any

substanal control is derived solely from their

employment status and (2) that employee is not a

senior ocer of the reporng company.

If an individual’s only interest in the reporng

company is a future interest through a right of

194

inheritance, they qualify for the inheritor’s

excep�on.

An individual qualies for the creditor excep�on if

the individual is en�tled to payment from the

Repor�ng Company to sa�sfy a loan or a debt, so

long as this en�tlement is the only ownership

interest that the individual has in the Repor�ng

Company.

Homeowners’ associa�ons (HOAs) may be required

to report if they are not recognized by the IRS as a

sec�on(c)(4) organiza�on and are incorporated by

ling documents with a secretary of state or a similar

oﬃce.

Who are Company Applicants?

An “Applicant” is the individual (i) who directly les

the document that rst forms or registers the

enƟty, or (ii) who is primarily responsible for

direcƟng or controlling the ling of the relevant

document by another. A Repor�ng Company may

not have more than two (2) Applicants.

Applicants of preexis�ng en��es that were formed

prior to January 1, 2024, are exempt from any ling

requirement.

What are the ReporƟng requirements?

As to the company itself, the Repor�ng Company

must report the following informa�on:

195

Full legal name & any trade name;

Principal place of business address;

JurisdicƟon of formaƟon / registraƟon; and

Tax IdenƟcaƟon Number or EIN.

As to the Benecial Owners and Applicants, the

ReporƟng Company must report the following

informaƟon:

Required Applicant/Benecial Owners

InformaƟon:

Full Legal Name;

Date of Birth;

Current ResidenƟal Address; and

Non-Expired U.S. IdenƟcaƟon Document,

or a Foreign Passport (including an image of

the idenƟcaƟon document).

When is the ReporƟng due?

For those ReporƟng Companies that were formed or

registered before January 1,2024, the CTA iniƟally

required they report BOI for their Benecial Owners

(but not any Applicants) no later than January 1,

2025.

Generally, ReporƟng Companies must report BOI for

both their Benecial Owners and Company

196

Applicants within 30 days aer formaon or

registraon.

If there are any changes in the idenes of Benecial

Owners or to any BOI informaon (including change

of address, passport numbers, etc.), a Reporng

Company will be required to le an updated report

with FinCEN within 30 days of the change, regardless

of when the Reporng Company learns of it.

FinCEN IdenƟers

Reporng Companies, Benecial Owners and

Applicants can each obtain a numerical “FinCEN

Idener” which may be supplied to the ler instead

of the detailed informaon. For example, an

aorney ling the enty (and who, by doing so,

becomes an Applicant), may choose (for privacy or

security reasons) to provide the Reporng Company

with his or her FinCEN Idener, instead of providing

the Reporng Company with his or her date of birth,

passport, and residence.

In the event someone is a

Benecial Owner of mulple

Reporng Companies, a FinCEN

Idener will be a more

ecient way of providing

informaon. Further, if any

changes need to be made, the

change can be made to the FinCEN Idener, instead

of having to update each Reporng Company ling.

If you will be

part of mulƟple

lings, consider

geƫng a FinCEN

IdenƟer.

197

Foreign EnƟƟes

In addiƟon to companies that are in the 50 states

and the District of Columbia, a company that is

created or registered to do business in a U.S.

territory will be required under the CTA to report

benecial ownership informaƟon to FinCEN. U.S.

territories include the Commonwealth of Puerto

Rico, the Commonwealth of the Northern Mariana

Islands, American Samoa, Guam, and the U.S. Virgin

Islands.

A foreign enƟty needs to report benecial ownership

informaƟon to FinCEN if they have registered to do

business in the United States by ling a document

with a government agency to obtain (1) an IRS

employer idenƟcaƟon number (2) a cƟƟous

business name, or (3) a professional or occupaƟonal

license that does not create a new enƟty.

Who can use BOI informaƟon?

The informaƟon collected pursuant to CTA lings is

collected on a secure, non-public database. While

the informaƟon will not be made public, it would be

available to federal, state, local, and trusted foreign

agencies for law enforcement purposes. The

informaƟon is not subject to requests under the

Freedom of InformaƟon Act.

198

Those who could access the CTA informa�on include:

Federal agencies, if engaged in na�onal

security, intelligence, and civil and criminal

law enforcement

State, local, and tribal law enforcement

agencies, if “a court of competent

jurisdic�on” rules that those agencies

should be allowed access to that

informa�on

“Trusted” foreign law enforcement, if

obtained via an intermediary U.S. federal

agency

The Department of the Treasury, if in

connec�on with its oﬃcial du�es, including

tax administra�on

Financial insƟtuƟons, in order to meet

customer due diligence requirements

under applicable law, but only if the

Repor�ng Company consents to the search

Benecial ownership informa�on reported to FinCEN

will be stored using rigorous informa�on security

methods and controls typically used in the federal

government to protect non-classied yet sensi�ve

informa�on systems at the highest security level.

FinCEN will work closely with those authorized to

access benecial ownership informa�on to ensure

199

that they understand their roles and responsibiliƟes

in using the reported informaƟon only for authorized

purposes and handling in a way that protects its

security and condenƟality.

What if a ReporƟng Company fails to report?

PenalƟes may be assessed when there is a failure to

report, or a failure to report accurately. It is unlawful

for any person to willfully provide false or fraudulent

BOI, or to willfully fail to report a complete BOI and

update that BOI when informaƟon changes.

However, no penalƟes will trigger in the event an

individual who provides inaccurate informaƟon (i)

did not know about the inaccuracy, (ii) was not

aƩempƟng to evade reporƟng requirements; and (iii)

corrects inaccurate informaƟon “voluntarily and

promptly,” but no more than 90 days aŌer

submission of the inaccurate ling.

FinCEN will consider all facts relevant to a

determinaƟon of willfulness when deciding whether

to pursue enforcement acƟons. Civil reporƟng

penalƟes are currently $500 per day for each day of

an outstanding violaƟon, up to $10,000. Criminal

penalƟes are currently up to a maximum of 2 years

imprisonment.

If an individual misuses the CTA ling informaƟon, it

can result in criminal nes up to $250,000 and 5

years imprisonment.

200

What if previously reported informaƟon changes?

If there are any changes to the required informaon

about the Reporng Company or its benecial

owners, your company will be required to le an

updated BOI report no later than 30 days aer the

date on which the change occurred. The same 30-day

meline applies to changes in informaon submied

by an individual in order to obtain a FinCEN

idener.

The following are examples of changes that would

require an updated BOI report: (i) any change to the

informaon reported for a reporng company, such

as registering a new DBA, (ii) a change in benecial

owners, such as a new Chief Execuve Ocer (or

another person now having substanal control) or

upon a sale that changes the ownership interest

threshold of 25% ownership (iii) or any change to a

benecial owner’s name, address, or unique

idenfying number provided in a BOI report.

Further, when a benecial owner that was a minor

child reaches the age of majority (18 to 21 years old,

depending on the state), you must le an updated

BOI report, idenfying the individual as a benecial

owner.

Updated BOI reports should be led electronically

though the secure ling system. There is no

requirement to report a company’s terminaon or

dissoluon.

201

Senior Oﬃcer Liability

Importantly, senior oﬃcers of a

Repor�ng Company that fail to

le a required BOI report may

be held personally accountable

for that failure. For example,

should the Repor�ng Company

fail to le, and then a $10,000

ne be assessed, the senior oﬃcers may be

responsible for paying the ne in the event the

Repor�ng Company lacks the means to do so.

Failing to le a

BOI report can

create liability

for the oﬃcers

of the company.

202

NOTES

_______________________________________

203

AN INTELLECTUAL PROPERTY

OVERVIEW

The Four Pillars of Intellectual Property

Intellectual property refers to those intangible

crea�ons of the human mind…those ideas, designs,

methods, sayings, and so forth that have value…but

unlike tangible property, intellectual property can’t

be protected by locking it in a safe.

Intellectual property falls into one of four categories:

1. Copyrights

2. Trademarks

3. Patents

4. Trade Secrets

Each of these will be discussed in detail, but in

general:

Copyrights are used to protect original works of

authorship xed in any tangible medium of

expression, including wri�

ngs, artwork,

choreography, songs, movies, etc. Copyrights are

exclusively governed by federal law (specically, the

U.S. Copyright Oﬃce).

Trademarks are words, phrases, logos and symbols

used in conjuncƟon with certain goods or services.

Shapes, sounds, fragrances and colors may also be

You may have

mulƟple ways to

protect your IP…

consider all of

them!

204

registered as trademarks. Trademarks are issued and

monitored by the federal government (the Patent

and Trademark Oﬃce), but they may also be

regulated by state law.

Patents grant a patent holder

the exclusive right to make,

use, import and sell the

patented innova�

on, in

exchange for disclosing all

details about the inven�on.

Patents are exclusively

governed by federal law (the Patent and Trademark

Oﬃce).

Trade secrets can be viewed as the opposite of a

patent. With a patent, a patent holder is granted

exclusive use for a period of �me in exchange for full

disclosure about the inven�on. Trade secret law

allows a party to keep the idea a secret, and prevent

others from using it, so long as the secrecy is

maintained (note that in some limited scenarios,

such as where there is addi�onal informa�on related

to your patent which is not required to be disclosed,

your patented inven�on might also have aspects that

qualify as a trade secret). The Uniform Trade Secrets

Act, adopted by most states, provides protec�ons in

regard to trade secrets. However, unlike patents, if

someone obtains the same trade secret by lawful

means (such as independently discovering the same

idea later), the second party cannot be prevented

With a patent,

you reveal all…

with a trade

secret, you

reveal nothing.

205

from using the trade secret or from revealing it to

others.

Which method of intellectual property protecon is

best will depend on the facts and circumstances. For

example, suppose a sculptor has discovered a

process in which she treats the molds in a certain

manner, allowing her to accelerate producon of

sculptures. Even though that process might qualify as

a patentable process, she may decide, based on the

cost of securing a patent and the cost and diculty

of enforcing the patent, that it might be best to keep

that process as a trade secret, rather than revealing

it to the world.

Creators, whether an arst, designer, or a

mechanical engineer, may oen nd that they can

employ mulple forms of intellectual property

protecon:

 the work itself may be copyrighted

(painngs, soware code, non-funconal

design elements, etc.);

 the product’s brand, or the creator’s brand

(e.g. Ralph Lauren®) may be trademarked;

 a customer list may be protected by trade

secret; and

 the product itself and/or the processes to

create it may be the subject of a trade

secret or patent.

206

Knowing your opƟons will help you decide the best

way to protect the creaƟons of you and your

company…every creator, and every company, has

intellectual property to protect, so read on, and

let’s learn how to protect it!

207

COPYRIGHTS

What can be protected by copyright?

such as literary works, musical works, dramaƟc

works, pictorial and sculptural works, moƟon

pictures, audiovisual works and architectural works.

The type of arƟsƟc expression protected by copyright

law is broad, ranging from the familiar to the less

expected, including artwork,

soŌware code, cartoons,

posters, fabric designs, games,

puzzles, collages, toys, bumper

sƟckers, jewelry designs,

sculpture, stained glass designs,

technical drawings, architectural

drawings, weaving designs,

plays, movies, choreography,

and even pantomime.

What is not protected?

Ideas cannot be protected

under copyright law. Neither can

discoveries, principles, formulas,

procedures, processes, systems,

methods of operaƟon, and

concepts. Also, words, symbols,

Ɵtles, slogans and short phrases

Authorship vs.

idea:

J.K. Rowling

can copyright a

Harry PoƩer

book (a work),

but she can’t

keep someone

else from

wriƟng a book

about a young

boy who goes

to a school to

learn magic (a

concept or

idea).

208

cannot be copyrighted (but as discussed later, can

potenƟally be protected under trademark law).

Under copyright law, the copyright owner has the

exclusive right to make copies, prepare derivaƟve

works, sell or distribute copies, and display the work

in public. Anyone else doing so, without permission,

will infringe upon those intellectual property rights.

How is a copyright created? Do I need to le

something?

Prior to March 1, 1989, it was required that the

works that were published. Omiƫng the noƟce on a

work published before that date would mean the

work lost copyright protecƟon (unless the omission

was cured within ve years following publicaƟon).

 The date of publicaƟon; and

 The copyright owner’s name.

2013 John Smith.”

For works created on or aŌer March 1, 1989, use of

the copyright noƟce is opƟonal. So, are you required

to put the copyright noƟce on your works? No. Is it a

good idea to do it anyway? Yes.

209

At the very least, placing the copyright line may

prevent your copyrighted material from being used

by someone else who does not understand you hold

a copyright to that work. For maximum protecon

and ability to collect damages, you should also le

the created work with the Copyright Oce.

PublicaƟon is achieved when there is distribuon of

copies of the work, by sale, rental, lease or lending.

Even the oering of copies for distribuon or display

constutes publicaon; however, when only a single

work exists, such as an original painng or a unique

sculpture, public display does not constute

publicaon. Publicaon is an important concept, as it

will impact the type and number of copies that will

need to be submied when copyright registraon is

applied for.

How long does a copyright last? What happens aŌer

that?

The simple answer is that, for any qualifying work

created on or aŌer January 1, 1978, copyright

protecon for individuals lasts for the life of the

author (i.e. the creator) plus an addiƟonal 70 years;

if created by an enty (such as by Disney arsts), it

will last for 120 years aŌer creaƟon or 95 years aŌer

publicaƟon, whichever is less.

If you are looking to use someone else’s creave

work in any way, determining when a copyright

expires can be important; once a copyright expires,

210

the work is in the public domain and anyone can

freely use it. However, depending on when a work

was created, calcula�ng the dura�on of the copyright

is not as easy as it might seem. To answer it, you may

need to explore mul�ple versions of the U.S.

Act, looking at when each copyright period started

and when it expired.

For works created before January 1, 1978, each work

was protected by a common law copyright when it

was created, which ran un�l the work was published.

Upon publica�on, the owner had to comply with the

1909 Act requirements (including aﬃxing a copyright

no�ce to the work); if not, the work entered the

public domain. If federal copyright protec�on was

secured, the copyright ran for 28 years, with a

poten�al renewal of another 28 years (with another

possible extension under a later Act).

The Copyright Act of 1976, which is now the basis for

U.S. copyright law, changed the star�ng point of

date of creaƟon. Under the 1976 Act, copyright

protec�on generally lasted for the life of the author

plus an addi�onal 50 years, or 75 years from crea�on

for corporate authorship (such as Disney).

As if that wasn’t complex enough, the 1998

extending protec�on of the author to life plus 70

211

years, and for works of corporate authorship to 120

years aŌer creaƟon or 95 years aŌer publicaƟon,

whichever is earlier.

At some point, however, copyrights expire…and

when they do, they cannot be renewed. At that

point, the work enters the public domain and is

available for use by anyone, anyƟme, anywhere,

without restricƟon.

So, what is the boƩom line when calculaƟng the life

of a copyright? Generally speaking,

 For works created on or aŌer January 1,

1978, copyright protecƟon lasts for the life

of the author plus an addiƟonal 70 years (or

for corporate authorship, 120 years aŌer

creaƟon or 95 years aŌer publicaƟon).

 As of 2024, any work published before

January 1, 1929 would have now entered

the public domain.

 Works which fall in between these dates

need to be reviewed on a case-by-case

basis, as numerous factors will inuence

whether the work has entered the public

domain, including whether it was published,

and if so, when it was published.

 How do you nd the relevant dates? In a

book, the publicaƟon date should be right

inside the cover. For other works, searching

212

the Library of Congress website

(www.loc.gov) and the Copyright Oﬃce

website (www.copyright.gov) can help you

determine the publica�on dates of many

crea�ons.

One nal point to keep in mind regarding public

domain works…although certain works may now be

in the public domain, new works incorpora�ng the

public domain work into new treatments may s�ll be

protectable under copyright law, such as Andy

Warhol’s contemporary images of the Mona Lisa.

Before you use a work you think is now in the public

domain, it is important to conrm whether it is (or is

not). Otherwise, your ac�ons may cons�tute

What is registraƟon? How expensive is it? Do I need

a lawyer to do it?

when you 

le your

receive a registra�on

number, and that ling will

serve as evidence of the fact

that you created the work

on or before your ling

date. The process is fairly

simple, does not require a

lawyer, and is denitely something you can learn to

A basic registraƟon

can be done online

for as low as $45!

At that price,

it’s easy to register

the creaƟve works

you think most

important to

protect.

213

do on your own; if you don’t feel comfortable with it

(or if you have a more complicated ling), it might be

worth hiring a lawyer to help on the rst ling or

two, and then maybe you’ll be able to y solo from

there.

What is infringement?

As a copyright holder, those who violate your

Infringement ul�mately rests on a nding of

substanƟal similarity from an ordinary observer’s

point of view. This “audience test” is a subjec�ve test

and has been used by many courts and modied

many ways, but it essen�ally asks whether someone

who was not trying to determine the ways in which

two works diﬀered would generally overlook those

diﬀerences and regard the two works as the same.

Put another way, it asks whether the defendant

wrongfully copied so much of the plain�ﬀ’s work to

cause the average person to immediately see the

two works as similar, without anyone sugges�ng to

that person how the works are similar.

Hopefully, before your work is infringed upon, you

have already completed two things:

1. Your work already has a copyright noƟce

required for copyright protec�on, it is the

214

rst step in proving the infringement was

intenonal; and

2. You have already led your copyright with

the U.S. Copyright Oﬃce. If you have not,

you should do so immediately upon learning

of the infringement; however, you won’t be

entled to certain benets if this is done

aer the infringement occurs. For example,

if you register your copyright prior to the

infringement, even if you can’t prove actual

damages, you can obtain statutory damages

that range between $750 and $150,000 per

act of infringement.

The next step is to serve the party with a cease-and-

desist le�er. This warning leer idenes your work,

states that you own the copyright to the work,

idenes the infringing acts they have taken, and

orders that all infringement cease immediately or

else you will le legal acon against them. If you

have led your copyright already and have the

cercate back from the U.S. Copyright Oce, you

should aach that to your leer as well. If the

infringing product is being sold online, you should

also send a takedown noce to the Internet host

service, which informs them of your rights to the

copyrights and noes them of the links which have

infringing products.

The next step will be to le a lawsuit in Federal

Court, where you’ll have several remedies:

215

 requesng restraining orders and

injuncƟons

, to prevent further

infringement;

 requesng monetary damages; and

 in some cases, being awarded aƩorney’s

fees.

Damages against innocent infringers (i.e. those who

honestly believed their use was “fair use”) are

typically less steep than willful infringers. While

innocent infringers have to stop infringing and may

have to pay a reasonable royalty rate for their use of

the image, that may be the extent of their liability.

Intenonal infringement carries much steeper

penales. As menoned, statutory damages can

range between $750 and $150,000 per act of

infringement.

Addionally, if you believe the infringement rises to

the level of a criminal oense, you may be able to le

a criminal complaint with the FBI’s Intellectual

Property Fraud Unit. Criminal prosecuon typically

requires that the wrongdoer connued infringement

aer your warning leer and commied those

infringements for nancial gain. Penales can range

from ve years in prison to a $500,000 ne.

The Fair Use Doctrine

Fair use is a concept under copyright law that allows

someone who is not the copyright owner to sll use

216

the copyrighted materials for certain limited

purposes. This includes using copyrighted works for

purposes such as cri�cism, comment, news

repor�ng, teaching, scholarship and research.

Sec�on 107 of the U.S. Copyright Act addresses four

factors for evalua�ng whether a use falls under the

fair use excep�on:

1. The purpose and character of the use, including

whether the use is of a commercial nature or is for

nonprot educaƟonal purposes

Is the purpose of the use to make money?

Courts are more likely to nd non-commercial uses

to be fair use, such as nonprot educa�onal use.

However, in some cases, non-commercial use can be

found to not be fair use, where certain commercial

use is found to be fair use.

Is the use transforma�ve?

If the use creates something new or has a much

diﬀerent purpose or character, the use is more likely

to be considered fair.

While this commercial nature component is an

important factor, the balancing test looks at the

purpose and character of use along with the other

factors below.

217

2. The nature of the copyrighted work

How creaƟve is the work?

The more creaƟve, the less likely that fair use claims

will prevail. Use of creaƟve works, such as songs,

books and poems are less likely to be considered fair

use, as opposed to works that are more factual in

nature (such as news reports and technical manuals).

Has the work been published? If not, it is less likely

that a fair use excepƟon will apply.

3. The amount and substanƟality

of the porƟon used in relaƟon to

the copyrighted work as a whole

How much of the work was

used?

The greater the amount of the

work that is used, the less likely fair use will be

found. Contrary to a common belief that you can use

a certain percentage without violaƟng a copyrighted

work, there is no percentage of use that creates a

safe harbor.

If a small part of the work was used, how “core” to

the work is that part?

Using a very small part of the work can be found to

not be fair use if it is the “heart” of the work, such as

a summary of a biography which excerpts the most

unique and interesƟng stories.

What is used,

not how much

is used, is more

of the focus in

fair use review.

218

Since it is only one factor in the four-part test, it is

possible that using the en�re work can s�ll be found

to be fair use under some scenarios.

4. The eﬀect of the use upon the poten�al market

for or value of the copyrighted work

Does the use impact the value of the underlying

When the current or future market value of the

copyrighted work is negaƟvely impacted, fair use is

less likely to be found. For example, if the use of a

video by a news outlet impacts the ability of the

videographer to sell the video to other news outlets,

fair use is less likely to be found.

Because fair use is determined by weighing the

above four factors, and potenƟally other factors, it is

always a case-by-case analysis. There are no bright-

line rules; but the rst and fourth factors (purpose

and character of the use, and the eﬀect on the

poten�al market) are usually the most inuenƟal.

Keep in mind that images posted on social media,

whether on TwiƩer, Facebook or other social

networking plaƞorms, are protected by copyright

just as much as those printed in a book. While social

media plaƞorms are built for “sharing” and are less

formal, use of images from such sites must sƟll meet

the same fair use excepƟons. Similarly, just because

you nd an image on a website, that does not mean

it is available to grab and use…even the use of

219

somewhat innocuous items like photos of furniture

or signs can later be found to be an infringing use.

Finally, remember that just because use is related to

one of the general excepƟons, such as criƟcism or

news reporƟng, nding fair use is not automaƟc. For

example, use of someone else’s photograph in your

news story may not be permiƩed under the news

reporƟng excepƟon unless the photograph itself is

the news story. Use of an image on a t-shirt

distributed to students at a school may not fall under

the “teaching” excepƟon.

The fair use excepƟon essenƟally grants the right to

use someone else’s copyrighted, creaƟve expression

without their permission, but the excepƟon is

narrow. If you intend to be an unlicensed user of

someone else’s copyright, your use should be

evaluated very carefully before you move ahead with

it.

Use of Someone Else’s Copyrights in Your Work

Let’s assume you have found a photograph taken by

someone else that you wish to use as a “source

work” in your work. Assuming there’s no quesƟon

that the photograph is sƟll protected by copyright,

are you allowed to use it? UlƟmately, the answer to

this quesƟon revolves around fair use, discussed

earlier in detail.

You are permiƩed to use other copyrighted works

within your own work provided your own work is

220

suciently transformaƟve. For example, creang a

sculpture from a photograph where every eort is

made to make the sculpture a three-dimensional

representaon of that photograph will not be

suciently transformave. However, the use of a

poron of the copyrighted work in a collage may

avoid a copyright infringement claim.

People are oen inspired by the work of others, and

it is not unusual to then rely on someone else’s work

as “source materials” when creang their own

works. The key when using these copyrighted

materials is to avoid over-reliance; the less reliance

on the source materials, the more likely your work

will be transformave. When creang certain wrien

and musical materials, reuse of copyright protected

materials belonging to someone else can somemes

be unconscious, so if something “sounds too

familiar,” you may want to check your research. It’s

important to note that copyright protecon aaches

to a number of materials you might rely on as source

materials for your own creaons. A cast iron car you

use as a model for the car in your painng may

already be copyrighted. Photographs, parcularly

those within books and websites, are somemes

overlooked as copyrighted properes. For example, if

you paint a photograph from a book, it’s highly likely

that work will be infringing, unless the arsc

imagery you add suciently transforms that

underlying work.

221

FIVE COPYRIGHT MYTHS

There are a number of myths that exist about

outdated law, or maybe they were just made up by

conduct—either way, these myths are widely held

and are wrong. So, let’s clear up a few of them:

Myth #1: If I don’t make any money from it, it’s not

While not making any money may decrease the

amount of monetary damages awarded to the

righul copyright owner, it won’t eliminate them.

Damage has sll been done by your infringement.

Imagine that you copied your favorite Bruce

Springsteen album for all your friends. While you

might have meant well (and made your friends

happy), the result is that none of your friends need

to buy the album any more…so Bruce and his E-

Street Band just lost out on all of those sales. Bruce is

unhappy, and you have a problem.

Truth #1: Infringement is the act of copying it, not

only the selling of it.

222

Myth #2: If I copy 20% or less, it’s not copyright

infringement.

This is the “it’s not stealing if I only steal a lile bit”

defense. Unfortunately, there’s no clear-cut rule

about exactly how much of the prior work you can

use before it becomes infringement.

Whether it’s 5%, 10%, 5 notes, 1 sentence, or making

it in a diﬀerent size, the real test is if a “reasonable

person” would nd your work to be “substan�ally

similar” to the original. Since “reasonable person”

and “substan�ally similar” tests are decided based

on the unique facts of the case, relying on the “I only

used a lile bit” defense requires some real

unbiased evalua�on rst.

Truth #2: There’s no standard measurement for how

much is “safe” to use vs. how much equals

infringement—it all depends on the facts.

Myth #3: If there’s no copyright noƟce, there’s no

If the work was created in the last 35 years or so,

s�ll has a copyright on her original content from the

�me of crea�on…automa�cally.

Truth #3: No copyright noce may be required.

Never assume the work is public domain…do your

research!

223

Myth #4: If I give credit to the copyright owner, it’s

not copyright infringement.

Sorry — just iden�fying who you stole it from doesn’t

make it right. Controlling the use of the original work

is exactly what the owner has a right to do. What

kind of law would it be if you could get around it

simply by referencing the original creator? If you

need to use part of someone else’s work, get

permission.

Truth #4: Giving credit is nice, but it’s not enough.

Myth #5: If I hire someone to create an original

work, I own the copyright.

Maybe. In the case of your employee…yes. But it’s

not necessarily true if you hired an independent

contractor for the same exact project. This ques�on

is a very tricky one, and we have covered it in more

detail in another chapter.

Let’s assume you hired an ar�st to paint a portrait of

your cat. Who owns it? Without a contract

otherwise, you may own the actual pain�ng, but the

painter owns the copyright. Can the painter do

anything with the image he wants (such as making

and selling posters)? Most likely.

224

The same may apply if you hire someone to design a

logo or a website…the designer may have the right to

repurpose that logo or website for other clients,

unless your contract provides otherwise.

One more note for those of you familiar with the

independent contractor “work made for hire”

concept…it is only opera�ve in certain circumstances,

so without other language clearly assigning

ownership of all copyrights to you, it s�ll may not be

enough, even if you specify that the work is “work

made for hire.”

Instead, every contract with an independent

contractor should be in wri�ng and explicitly provide

that (a) the company owns all works created under

the agreement, (b) the independent contractor

assigns to the company any and all copyright rights

(in the event that any residual rights may remain

with the independent contractor), and (c) the

independent contractor will execute all

documenta�on required to make such assignments

eﬀec�ve.

Truth #5: He who pays for the creaƟon and he who

owns the copyright are not necessarily the same

person.

225

TRADEMARKS

Trademarks are authorized under federal law (the

Lanham Act) and are also governed by laws of each

State. Registra�on of trademarks can also be

accomplished interna�onally under diﬀerent

interna�onal trea�es.

Trademarks can be obtained by use (which provides

the user with common law rights) or by federal

registra�on with the U.S. Patent and Trademark

Oﬃce or with individual states.

In order to apply for a

federal registra�on, the

applicant must establish

either actual use of, or an

intenƟon to use, the Mark in

interstate commerce. To

receive registra�on, you

must ul�mately show use in

interstate commerce.

Interstate commerce

requires that goods or

services be oﬀered across

state lines. For example, a restaurant located in

California which does not adver�se, or render

services to anyone, in any other state would likely

not qualify for a federal trademark (although it could

poten�ally qualify for a state trademark).

While you can le

for a trademark

with only an

intenƟon to use it,

the mark will not

provide evidence

of actual use in

interstate

commerce.

226

What is the benet of a federal registraƟon?

 NaƟonwide protecƟon of the mark

 The right to sue in Federal Court

 Use of the symbol

 Incontestability aŌer ve years of proven

conƟnuous use

 Priority of use is established from the date

of the applicaƟon



Greater recovery of damages for

infringement, including aƩorney fees and

statutory damages

 The right to claim priority for registering

internaƟonally

The right to stop the imporƟng of goods

which infringe upon the mark

In the United States, the rst party to use the

trademark, not the rst to le an applicaƟon, has

superior rights to that trademark. For example, if I

open “Dandy Jay’s Dry Cleaners” in San Jose,

California, and never le for a trademark, I sƟll have

common law rights relaƟng to that trademark. If,

several years later, someone applies for a federal

registraƟon of “Dandy Jay’s Dry Cleaners,” they will

not be able to prevent my use of that trademark in

San Jose, even if they are granted a federal

227

registraƟon. However, the federal registrant will be

able to prevent me from using it elsewhere.

“Marks” can take several forms:

1. Trade name: idenƟes a company or

business (Verizon®)

2. Trademark: idenƟes certain goods of a

copany (Life Savers®)

3. Service Mark: idenƟes the services of a

company (Roto-RooterSM)

Marks that idenƟfy and

disƟnguish a specic product

from others in the market

can take many forms, such as

a word (Adidas), name

(Smith’s Food and Drug

Stores), logo/symbol (Nike

swoosh), slogan (Melts in

your mouth, Not in your

hands), domain name (www.google.com), design

(Pepsi logo), device (Coca-Cola contour boƩle),

sound (NBC’s chimes), or color (pink Owens Corning

berglass).

The primary purpose of a trademark is to indicate the

source of origin of the goods or services. In other

words, it is to ensure that when you buy a product

such as a pair of shoes with the Nike swoosh, you can

Trademarks can

be words, names,

logos, symbols,

slogans, domain

names, designs,

devices, sounds,

and even colors.

228

be condent that those shoes were manufactured by

Nike and not from some other source.

Trademarks help guarantee the quality of goods

carrying the mark, and as the trademark develops

more recognion, it can carry a high monetary value

to a company. Products carrying the mark eventually

create a demand for those products, such as with

Gucci sunglasses or a Louis Vuion bag.

When a trademark is applied for, the mark must

idenfy a parcular class of goods or services to

which it belongs. There are currently 45 internaonal

classes of goods and services, and your mark must

fall within one of these classes. For example, you

might think “art products” is one class; however,

paint is in one class, chalk is in a dierent class,

coloring books are in a third class, etc. Depending on

your products or services, applying for trademarks in

several classes may be necessary if you wish to fully

protect your mark.

Before a trademark can be registered with the

United States Patent and Trademark oce, the

trademark must be reviewed by a

trademark examiner for

disncveness. Marks cannot be

generic, and the more “fanciful”

the mark is, the more likely

registraon will be granted.

The more

unique the

word, the

stronger the

trademark.

229

The disƟncƟveness of a trademark follows the

following spectrum:

 Fanciful, meaning the word has essenƟally

been created by the applicant (such as

Kodak, Exxon, or Zappos)

 Arbitrary, meaning the word exists in our

vocabulary but is not typically associated

with those types of goods (such as Apple

computers, Tide detergent or Camel

cigareƩes)

 SuggesƟve, where the word suggests

properƟes of the product (such as Caress

soap, Coppertone sunscreen, or Sweet’N

Low sweetener)

 DescripƟve, where the word describes the

product aƩributes (such as Spray ‘n Wash or

Hamburger Helper)

 Generic, where the product is named for

exactly what it is (such as bleach or gas)

Certain words, such as aspirin, became generic based

on their use. As a result, companies try to take

acƟons limiƟng the use of their trademarks in a

generic form. Xerox would like you to say you are

making photocopies, not xeroxes, and Kleenex would

prefer you call it a facial Ɵssue instead of a kleenex.

230

Trademarks should be used as adjecƟves, not nouns.

For example, it would be proper to adver�se that

consumers should “Use Kleenex facial �ssues when

you have a stuﬀy nose” but it would be incorrect to

adver�se “Use a Kleenex when you have a stuﬀy

nose.”

Trademark conicts generally revolve around

“likelihood of confusion.” When a trademark is

applied for, it will be compared to other exis�ng

registered marks, and if a similar mark is used in

conjunc�on with a similar type of goods or services,

the registra�on will be denied.

When reviewing whether a likelihood of confusion

exists, the trademark examiner will look at several

factors, including:

 whether the goods/services compete with

each other

 how similar the marks are, in spelling,

sound, appearance, and meaning (including

transla�ons)

 how strong each mark is (on the fanciful to

generic scale)

 whether the two marks share the same

customers

The same mark can exist with diﬀerent trademark

holders where no likelihood of confusion exists. For

231

example, Delta Faucets is allowed for plumbing

xtures at the same me as Delta Air Lines is allowed

for air transportaon—since there is no likelihood

of a consumer thinking an airline is also making

faucets, or that a faucet maker is also ying

passengers around, both marks can coexist.

Before using a mark or ling an applicaon for

registraon, at the very minimum, be sure to take

some me to surf the Internet to see if anyone is

using a similar mark in similar goods or services—it

will save you money and heartache when you avoid

using a mark that someone else has already invested

me and treasure to develop.

Prior to trademark registraon, you are permied to

use the symbol. Once a trademark registraon is

granted, you are permied to use the symbol. In

both cases, the purpose is to put others on noce

that you are claiming trademark rights for that mark.

Trademarks achieving registraon are registered for

10 years (although there is a “Secon 8” ling

required between years 5 & 6, declaring the mark is

sll in use or there is

excusable non-use). Aer the

mark is registered for 5 years,

and the mark is sll in use in

commerce, you can also le a

“Secon 15” declaraon of

incontestability, which will

protect you from challenges

A trademark can

be renewed every

10 years for as

long as you wish,

as long as you

keep using it!

232

that your mark is not disncve and lacks secondary

meaning, is confusingly similar to a mark that

predates your registraon, or that it is a “funconal”

mark which simply describes a product feature. A

trademark can be renewed every 10 years,

indenitely, so long as there is connuous use of the

mark (unless the mark becomes generic).

Once your trademark is granted, you must:

 Use the trademark exactly as it is registered

 Use the trademark as an adjecƟve and not

as a noun

 Use the symbol (if using it in text, such as

markeng literature, use of the symbol in

the rst instance where the trademark is

used is typically sucient)

Where possible you should also highlight the

trademarked word, either by using bold, italics, all

capital leers, underlining, or using a combinaon of

these.

Enforcing Trademark Infringement

If you have a trademark worth protecng from

infringement, hopefully you have taken steps to le

your federal registraon on that trademark already.

Depending on the trademark, your lawsuit will need

to be led either in a state court or a federal court;

usually, it will be the laer.

233

To prevail in a trademark acƟon, you will need to

show there was unauthorized use of a trademark or

service mark on or in connecƟon with goods or

services, in a manner that is likely to cause

confusion, decepƟon, or mistake about the source of

the goods or services.

Likelihood of confusion is found when the origin of

the goods is uncertain, meaning a buyer believes he

is buying it from the company that holds the

trademark, but in fact, the buyer is buying it from

someone else.

In response, the sued party will raise defenses, such

as the fact there is no likelihood of confusion. When

considering likelihood of confusion, criteria include

looking at the strength of the mark, the similarity of

the marks, similarity of markeƟng channels,

evidence of confusion in the marketplace, and the

defendant’s intent. To support your case for

confusion in the marketplace, surveys can be

performed, but they can be expensive and need to

meet the court’s standards.

Other defenses include challenging the claimed

trademark, denying infringement occurred, or

asserƟng a defense against the allegaƟons, such as a

statute of limitaƟons defense.

234

If you prove trademark infringement, you have

several remedies available to you:

 restraining orders and injuncƟons, to

prevent further use of the mark

 an order requiring destrucƟon of goods

containing the infringing mark

 monetary damages

 in some cases, you can be awarded

aƩorney’s fees

If you are awarded statutory damages (which are

calculated by law and used when actual damages are

dicult to calculate), the court will determine your

judgment and order the defendant to pay it. Before

actual damages (damages based on your actual

harm) are awarded, the court may rst require that

you present evidence from a forensic accountant

explaining to the court the extent to which you have

suered nancial damage.

Whether you are the party whose trademark has

been infringed upon, or the party being sued for

infringement, it’s important to seriously consider the

costs of ligaon. When balancing the costs of taking

the maer to court, negoang a selement of the

lawsuit may leave more money in the pockets of all

pares (except the lawyers).

235

However, someƟmes liƟgaƟon cannot be avoided; in

that case, seek legal counsel early in the process so

you can be informed about your opƟons and the

strength of your case. If you sue for infringement,

can you win? If you win, what is the likelihood the

defendant will have the money to pay the judgment?

Keep in mind that suing for trademark infringement

is very expensive, oŌen running well over $100,000.

It is unlikely a law rm will take an infringement case

on a conƟngency basis, so you will have to pay your

aƩorney’s fees while your case is going on.

236

NOTES

_______________________________________

237

PATENTS

Patents grant you, as the patent holder, the exclusive

right to make, use, import and sell the patented

innovaƟon in exchange for disclosing all the details of

the invenƟon. It’s essenƟally a trade: you have an

idea, and in return for sharing it with the world, you

get an exclusive period to exploit the invenƟon –

typically 20 years from the earliest ling date of your

applicaƟon.

First, be sure your idea qualies for a patent. For

patentability, it will need to meet ve requirements:

1. It must be a patentable subject maƩer,

which falls within four general categories:

 a process or method (way of doing

something)

 a machine (a “thing” that has xed or

moving parts, or a combinaƟon of devices)

 a manufacture (a “thing” that is

manufactured from a variety of materials

which take on a new form, made by a

human or by a machine, as opposed to

something found in nature)

 a compound (something that is composed

of two or more substances that are

combined, such as mulƟple gases, powders,

uids, or solids)

238

2. It must have uƟlity (meaning it must have

usefulness)

3. The idea must be novel (i.e. a new idea, not

something that has been thought of

previously)

4. The idea must be nonobvious (not

something that would be easy for anyone to

come up with), and

5. The applicaƟon must provide the

enablement (a clear descripƟon of how to

make and use the invenƟon).

Types of patents include:

1. UƟlity patents are by far the

most typical, covering any new

and useful process, machine,

arƟcle of manufacture, or

composiƟons of maƩers, or any

new useful improvements to

those categories

2. Design patents cover new, original, and

ornamental design for an arƟcle of

manufacture

3. Plant patents are granted to those who

invent or discover and asexually reproduce

any disƟnct and new variety of plant

UƟlity patents

are the most

common form

of patent.

239

So, let’s assume you have a patentable idea. Beware!

There have been some criƟcal changes to U.S.

patent law since 2013—these changes, which went

into eect as of March 2013, are very signicant.

Following previous strategies as to when to le a

patent can result in you losing the opportunity to

ever patent your invenon (so be careful about

relying on what your friends think they know about

patents).

Old laws don’t count…

Previously, U.S. patent law operated on a “rst-to-

invent” basis, meaning that even if you led your

patent applicaon aŌer someone else led on the

same invenon, your applicaon could sll prevail

provided you could prove that you invented the

claimed invenon rst. This concept is now

inapplicable.

On March 16, 2013, the “rst-inventor-to-le”

provisions went into eect. Under 35 U.S.C. § 102(a)

(2), an applicant is not entled to

a patent if the claimed invenon

was described in a U.S. patent or

in a published U.S. patent

applicaon which names another

inventor and has an eecve

ling date preceding the eecve

ling date of the claimed invenon. In simple terms,

this means that the inventor who les rst wins. In

contrast to the prior law, it no longer maers if you

In the land of

patents, the

rst to le

beats the rst

to invent.

240

invented the claimed invenon rst. This rst-to-le

policy places the U.S. patent law in line with that of

many other countries in the world, which generally

reward the rst person who les a patent

applicaon.

Some inventors want to be able

to test market demand for the

invenon before spending

money to le their patent. If the

claimed invenon is described

in a printed publicaon, or put

in public use, on sale, oered

for sale, or otherwise made

available to the public before

the eecve ling date of the

claimed invenon, the inventor has twelve months

from that disclosure date to le the patent

applicaon; however, disclosing prior to ling the

patent applicaon may put your internaonal patent

rights at risk. Note that if the disclosure is made

under a wrien nondisclosure agreement, it will not

be considered a disclosure that starts the twelve-

month clock and is also not considered a disclosure

with regards to foreign rights.

What does all this mean? Inventors need to move

more quickly than ever to establish some level of

patent protecon over their invenons. This means

geng a patent applicaon on le as soon as

possible.

AŌer ling a

provisional

applicaƟon,

you have 12

months to le

your full

patent

applicaƟon.

241

Patents are exclusively governed by federal law (the

Patent and Trademark Oce), so your applicaon for

a patent will be led with the Patent Oce and

assigned to a patent examiner. This examiner will

work with you during the applicaon process and

nofy you of any deciencies in your applicaon.

If you are sll rening your idea, or you need to get

the money together for ling your patent, you might

consider ling a provisional applicaƟon. A

provisional applicaon is sll a patent applicaon but

has less burdensome requirements than a non-

provisional applicaon. Cheaper and faster to dra

than a full-edged patent applicaon, this step can

buy you some me to test the market and cra

language for your non-provisional applicaon.

A provisional applicaon sll establishes an ocial

United States patent applicaon ling date for the

invenon and permits you to use the term “Patent

Pending” in connecon with the invenon. However,

aer ling a provisional applicaon, you must le the

non-provisional applicaƟon within the following 12

months. While the language in provisional patents

can be very general or very specic, you should sll

try to describe the invenon in as much detail as

possible, to prevent a dispute later as to the scope of

your invenon.

Be aware that while you can le patent applicaons

on your own, this is an area where a do-it-yourself

approach can lead to disastrous results if you have

242

no experience doing so. Failing to properly state your

claims within the patent may result in a patent that

does not cover important aspects of your idea…

meaning those novel ideas will not be protected.

243

TRADE SECRETS

Virtually every company has intellectual property

assets, including trade secrets. Is there something

that you think gives your company an advantage

because other companies do not have that

informaƟon? If so, you may have a trade secret.

Trade secrets can take a variety of forms, but

generally involve informaƟon that is not publicly

available. Examples can include customer lists,

manufacturing methodologies and other business

“know how” that are valuable

because the informaƟon is

closely held by the company.

Unlike patents, trade secrets do

not have a specic term. They

are a trade secret so long as

they are properly maintained as

a secret.

Trade secrets are governed by both state and federal

law, depending on the violaƟon. The Uniform Trade

Secrets Act (“UTSA”) has been adopted by at least 40

states.

The UTSA denes a “trade secret” as:

 informaƟon, including a formula, paƩern,

compilaƟon, program, device, method,

technique, or process

Don’t overlook

trade secrets

—chances are

you have

some!

244

 that derives independent economic value,

actual or poten�al, from not being generally

known (or readily ascertainable through

appropriate means) by others who might

obtain economic value from its disclosure or

use, and

 there are eﬀorts taken that are reasonable

under the circumstances to maintain the

secrecy of that informa�on

Obviously, a trade secret must be a “secret” to begin

with. But how is that decided? Several factors help

determine whether certain informa�on rises to the

level of a trade secret:

 the extent to which the informa�on is

known outside of that par�cular business

 the extent to which it is known by

employees and others involved in that

par�cular business

 the extent of the measures taken by the

business to guard the secrecy of the

informa�on

 the value of the informa�on to that

par�cular business and to its compe�tors

 the amount of eﬀort or money expended by

the business in developing the informa�on

245

 the ease or diﬃculty with which the

informa�on could be properly acquired or

duplicated by others

Require that your employees

sign condenƟality agreements,

and remind them regularly

about the assets that the

company considers to be trade

secrets. This goes a long way in

protec�ng valuable trade secret

informa�on.

If a trade secret exists, someone

who discloses or uses it without

a right to do so may be liable, if:

 they discovered the

secret by improper means,

 their disclosure or use cons�tutes a breach

of condence placed in them by the other in

disclosing the secret to them,

 they learned the secret from a third person

with no�ce of the facts that it was a secret

and that the third person discovered it by

improper means or that the third person’s

disclosure of it was otherwise a breach of

his duty to the other, or

Every

employee

should sign a

condenƟality

agreement;

aŌer that,

frequent

training of

employees will

help keep your

secrets safe.

246

 they learned the secret with noƟce of the

facts that it was a secret and that its

disclosure was made by mistake

In the event there is a misappropriaƟon of your

trade secrets, you may be enƟtled to injuncƟve relief

(where the court orders the other party to stop using

the trade secrets), damages (where the court orders

the other party to pay you money) and possibly even

repayment of your aƩorney’s fees (when the court

nds that the misappropriaƟon was willful or

malicious).

However, not all uses of your trade secrets by

someone else are illegal. Trade secrets can be

obtained by lawful means, such as independent

discovery, reverse engineering, or disclosure that

results from the trade secret holder’s failure to

properly protect the trade secret.

Assuming that ling a patent is an opƟon, is there

ever a scenario when you would not le for

one? Compared to patents, maintaining informaƟon

as a trade secret can be less expensive (no

registraƟon costs) and provides an unlimited term of

use. However, unlike patents, if someone legally

discovers (or reverse engineers) the same process

later, you will not be able to prevent them from

using that process (while you would have the right to

do so if it was patented). Also, as the holder of a

patent, you can license that know-how to another

247

party; doing so with a trade secret is much more

diﬃcult.

Don’t underes�mate the value of your trade secret

assets. You would most likely never turn over your

customer list to a compe�tor, so don’t overlook

protec�ng the trade secrets of your business.

248

NOTES

_______________________________________

249

EMPLOYEES vs. INDEPENDENT

CONTRACTORS

In our modern-day workforce, many businesses use a

combinaƟon of employees and independent

contractors in their operaƟons. While both are

important contributors to the workforce, there are

legal and nancial implicaƟons if those workers are

misclassied. Classifying workers incorrectly can

impact employers and workers alike and correct

classicaƟon is necessary to make sure that the

business can properly comply with tax laws and labor

regulaƟons.

While standards used to classify

employees and independent

contractors may vary between

federal and various states laws,

there are some factors that

apply universally. Those factors

include the level of control of

the worker, the nature of the

work being performed, and the relaƟonship

between the business and the worker.

UlƟmately, the disƟncƟon lies in the working

relaƟonship that the business has with the individual.

1. Does the worker have control over how,

when, and where the work is performed?

Does the worker work independently

without supervision?

Classifying

workers as

employees vs.

contractors is

a fact-based

decision.

250

2. Does worker provide their own tools and

materials, such as their own computer and

telephone? Is the worker responsible for

their own business expenses?

3. Is the worker performing a “high skills” form

of services?

4. Is the worker performing services that

would not be considered a regular or

integral part of the business?

5. Is the worker’s work arrangement

temporary rather than permanent? Is the

work project based? Does the assignment

have an end date aŌer which the worker

will no longer be employed?

6. Is the worker paid by the job or upon

achieving certain milestones, as opposed to

payment based on hours worked?

7. Can the worker hire their own employees,

and assign them part of the work

responsibility?

8. Has the worker secured their own liability

insurance? Is the worker responsible for his

or her own health insurance and other

benets? Has the company disclaimed any

obligaƟon to pay vacaƟon, sick leave and

PTO to the worker?

9. If the worker is terminated, does it give rise

to an acƟon for breach of contract (i.e.

cannot be terminated at will)?

The more condently the above quesƟons can be

answered “yes,” the more likely the worker may

qualify as an independent contractor.

251

To further enable this analysis, California has put in

place the “ABC test.” In the event the ABC test does

not apply for some reason, the courts would then

apply a test based on the totality of the factors, such

as those menƟoned above.

If the ABC test does apply, a worker is deemed to be

an employee rather than an independent contractor

unless all three of the following condiƟons are met.

Those three condiƟons are:

A. The worker is free from the control and

direcƟon of the hiring enƟty in connecƟon

with the performance of the work, both

under the contract for the performance of

the work and in fact

B. The worker performs work that is outside

the usual course of the hiring enƟty’s

business (by way of example, if a retail

clothing store hires an outside plumber to

x a leak, those plumbing services are not

part of the company's usual business;

however, if a bakery hires cake decorators

to work on a regular basis on its custom-

designed cakes, that would be considered in

the usual course of business), and

C. The worker is customarily engaged in an

independently esta

blished trade,

occupaƟon, or business of the same nature

as that involved in the work performed.

252

Note that the third prong of this test not only

requires that the worker be able to perform these

services elsewhere, but also that they are acƟvely

engaged in doing so. Another indicaƟon of an

independent contractor relaƟonship is that the

worker has formed an independent business, has

other clients, is adverƟsing that business, and holds

appropriate licenses to run that business.

If the company determines someone does qualify as

an independent contractor, the engagement of that

independent contractor should be set out in a wriƩen

independent contractor agreement which clearly

states the scope of work and the compensaƟon.

As an independent contractor, those workers are

responsible for their own tax obligaƟons, including

paying income tax, Social Security, Medicare and self

-employment tax. Independent contractors should

le quarterly taxes to avoid any penalƟes.

In the event your business misclassies an employee

as an independent contractor, the IRS may impose

signicant penalƟes based on your failure to properly

withhold the correct taxes. Even worse, if the

employee who was wrongly classied as an

independent contractor fails to pay their taxes, and

now has no money to do so, the taxing authoriƟes

will hold your business responsible for those taxes

on the basis that those taxes would have been paid if

you had properly classied the worker.

253

By misclassifying an employee

as an independent contractor,

that worker has also lost certain

employee-related benets such

as sick me, workers

compensaon, unemployment

benets and the right to

unionize. The denial of these

benets can potenally lead to

an acon by the employee

against the company.

Oen, a worker desires to be an

independent contractor so that they can take

advantage of certain write-os and potenally

reduce the amount of taxes that they pay. Unless

they truly qualify as an independent contractor, the

company cannot allow this, even if the worker prefers

it. Just because the worker agrees with the

classicaon, that does not shelter the company

from liability.

Proper classicaon of employees is crical. Failing

to do so opens the business up to a number of

liabilies, from employment lawsuits and other legal

acons to tax penales. If in doubt, the best pracce

is to classify the worker as an employee.

If a worker

needs to be

classied as an

employee,

don’t classify

them as a

contractor,

even if they

are agreeable

to it!

254

Ownership of Intellectual Property Created by a

Worker

ClassicaƟon of employees and

independent contractors is also

criƟcal in the area of ownership of

intellectual property. All creaƟve

works which an employee creates

for the company, and all copyrights

associated with those works, will

be owned by the company.

However, absent a wriƩen

agreement to the contrary, an

independent contractor may very likely be the

on the company’s behalf. Many companies are

surprised to hear that even though they paid the

independent contract for the work, the company may

not own the rights to it; although the company may

have the right to a royalty free license, it may not be

able to prevent the independent contractor from

using that work product elsewhere.

The company’s typical expectaƟon is that it has the

exclusive right to exploit those copyrights, create

derivaƟve works, and license works to others. No

company wants to nd out later that the

independent contractor actually has those rights

instead.

One example of where this issue arises is with

website development. A company hires someone to

Make sure

your

agreement is

clear that

you own the

IP your

contractor

develops!

255

develop a unique look and feel for their website, and

pays signicant sums to do so, only to later see the

same template used on another site. Without the

proper agreements, the independent contractor has

the right to use that design with others, and the

hiring party has no right to stop it. This same

example could apply to a myriad of other scenarios,

such as to soware the independent contractor

develops, a logo they developed, or a song they

wrote for your commercial.

When using an independent contractor, the

company should not rely solely on the employee

versus independent contractor test or on the “works

made for hire” doctrine (which is limited to nine

categories of works and requires a wrien

agreement between the pares specifying that the

work is a work made for hire).

Instead, every contract with an

independent contractor should

be in wriƟng and explicitly

provide that the company owns

all works created under the

agreement, the independent

contractor assigns any and all

that any residual rights may remain with the

independent contractor), and that the independent

contractor will execute all documentaon required

to make such assignments eecve.

All independent

contractor

agreements

should be in

wriƟng.

256

NOTES

_______________________________________

257

OFFER LETTERS AND EMPLOYMENT

AGREEMENTS

It is crical to document every employee’s hiring

condions in wring. This typically takes the form of

either an oer leer or an employment agreement.

An oer leer typically states the

job descripon, compensaon

and benets the employee will

receive and (importantly) claries

that the engagement of the

employee is on an “at-will” basis.

When employed on an at-will

basis, both the employee and the employer have the

right to terminate the working relaonship at any

me, with or without noce. Of course, even at-will

employees cannot be terminated for reasons that

violate law or public policy. For example, an

employer cannot terminate an employee based upon

their race and then claim the terminaon was

allowed under the at-will provision.

Employment agreements are oen used when hiring

execuves, to provide that execuve with some

certainty around their employment (oen because

they may have le a good paying job in order to

come to the company, and don’t want to be red a

few months later for no reason). In addion to

detailing the job descripon, compensaon, and

benets that would be included, employment

Your oer

leer should

always state

the employee

is “at-will.”

258

agreements oen have a requirement that the

employer will only terminate the employee upon

“good cause” during the term of the agreement.

Denions of good cause may vary slightly, but

generally speaking, good cause can be found where

an employee engages in serious

misconduct, performs poorly, fails

to show up to work on a repeated

basis, violates company policies,

violates laws, harasses or

threatens employees or customers,

uses alcohol or drugs at work, or

generally fails to perform duƟes

that someone in their posiƟon

would perform, aŌer being given

noƟce of non-performance.

In the event an employment agreement is

terminated without good cause, the company may

sll be permied to do so under the terms of the

agreement so long as they pay a predetermined

severance payment.

Employment agreements can be for an indenite

term, but the best pracce is to have a start and end

date with the possibility to renew if appropriate.

That way, if the event the employer believes their

basis for terminang for good cause may be later

deemed insucient, the employer can instead wait

unl the stated end date and then choose not to

renew. In the event the company has terminated the

employee and the employee objects, believing the

“Good cause”

deniƟons

can vary…

clearly state

in all

employment

contracts

what your

deniƟon is.

259

employer failed to meet the good cause standard,

having an end date will also allow the company to

minimize damages, as lost wages should not extend

past the end date of the contract.

Employment agreements may also include provisions

(i) protecng the company’s condenal

informaon, (ii) prohibing the employee from

performing services for any other company during

the course of their employment, (iii) prohibing the

employee from bringing third party informaon into

the company, and (iv) prohibing the employee from

solicing customers and employees for a limited

period of me aer leaving the business (if allowed

under state law).

In the event an employee is creang intellectual

property as part of their employment, the oer leer

or employment agreement should specify that all

work created during such employment belongs to

the company.

260

NOTES

_______________________________________

261

PROPRIETARY INFORMATION

AGREEMENTS AND NON-COMPETE

AGREEMENTS

Given the substanƟal amount of Ɵme and treasure

businesses devote to developing their proprietary

informaƟon, it's important that companies do their

best to ensure that employees and contractors do

not use that informaƟon once they leave the

company.

Two common legal tools for protecƟng that valuable

informaƟon are Proprietary InformaƟon and

InvenƟons Agreements (“PIIAs”) and Non-Compete

Agreements (“NCAs”).

Proprietary InformaƟon and InvenƟons

Agreements.

When a business uses a PIIA, the

agreement serves mulƟple

purposes. The rst purpose is to

protect condenƟal and sensiƟve

business informaƟon, making it

clear to the employee that they

are legally bound to protect the

company’s proprietary informaƟon during their

employment and even aŌer their employment

terminates. “Proprietary informaƟon” is generally

all informaƟon that (a) is not known by actual or

potenƟal compeƟtors of the company or is generally

Every

employee

should sign a

PIIA!

262

unavailable to the public, (b) has been created,

discovered, developed, or otherwise become known

to the company or in which property rights have

been assigned or otherwise conveyed to the

company, and (c) has material economic value or

potenƟal material economic value to the company's

present or future business. This will include trade

secrets, but also all other discoveries, developments,

designs, invenƟons, formulas, soŌware programs,

processes, techniques, know-how, negaƟve know-

how, data research, techniques, technical data,

purchasing informaƟon, customer and supplier lists,

business plans and other informaƟon valuable to the

company.

It will also include an obligaƟon that the employee

keep any third party proprietary informaƟon

condenƟal as well, as it is common for businesses to

acquire condenƟal informaƟon of other parƟes as

they work together.

The second purpose is to make clear that any

invenƟons developed by the employee during the

course of their employment are the sole property of

the company, and that the employee has no rights to

those invenƟons while they are at the company and

aŌer they leave the company. The PIIA will also

contain provisions requiring the employee to assign

those rights to the company.

While it is clear that invenƟons conceived of, or

developed, during working hours using company

263

equipment, supplies, faciliƟes and other company

informaƟon are owned by the company, many states

will carve an excepƟon out for invenƟons the

employee creates outside of work hours using their

own resources. An example of such an exclusion is

California's Labor Code sec�on 2870, which allows

employees to own any invenƟons they create on

their own Ɵme; this is discussed in more detail in the

next chapter.

The best pracƟce is to have every

employee sign a PIIA, even those

that might not be thought of as

likely to invent anything. Any

employee may see a need of the

company and come up with an

invenƟve soluƟon for solving that problem, including

your minimum wage workers. Don't underesƟmate

the ability of your employees to nd soluƟons! Have

everyone sign a PIIA.

Non-Compete Agreements.

NCAs agreements prevent employees, contractors,

and owners from engaging in acƟviƟes that would be

compeƟƟve with the business of the company.

NCAs are diﬃcult to enforce and should not be used

unless they are clearly allowed in your jurisdicƟon.

In California, for example, it is unlawful for employers

to use non-compeƟƟon agreements with employees

(unless they meet a statutory excepƟon) and

PIIAs need to

comply with

state law.

264

employees are now able to seek damages, injuncve

relief and reasonable aorney fees when employers

try to enforce unlawful non-compete agreements.

California’s law (California Business and Professions

Code secons 16600.1 and 16600.5) extends its

protecon to workers even in circumstances where

the contract was signed, or the employment was

maintained, outside of California.

In fact, in California, if an employer uses a non-

compete agreement illegally, the employee can

report you to the California Aorney General’s oce,

which may result in nes and penalƟes. The

company will also be subject to civil liability,

including employee lawsuits for damages, injuncƟve

relief, and aƩorneys’ fees. Further, under California

law, if an employer entered into non-compete

agreement with a California employee aer January

1, 2022, the company is required to take further

acon and nofy those employees that those

agreements are void under California law, or face

nes for the failure to do so.

Despite California’s restricons, in

other jurisdic

ons, such

agreements are more enforceable.

The rst rule for using NCAs is to

proceed with care and conrm

your jurisdicon permits NCAs.

In the event your jurisdicon allows NCAs, then the

second rule for using NCAs is that they should be

Use NCAs

carefully and

strategically.

265

reasonable in scope, meaning of a reasonably short

duraƟon, a reasonably limited geographic scope, and

a dened business interest that is reasonably narrow

in scope. If the restricƟons are found to be overly

broad or overly burdensome, the agreement may be

unenforceable.

The third rule for using NCAs is that they should be

used strategically. While a court might nd it is

reasonable to have an NCA for a soŌware engineer

who has access to proprietary informaƟon, they are

less likely to enforce the same agreement against an

administraƟve assistant or someone working in the

warehouse.

266

NOTES

_______________________________________

267

LABOR CODE 2870 (CALIFORNIA)

Intellectual property assets are the lifeblood of many

businesses today. If you are star�ng a business, you

would not want to see a former employee walk out

the door with your intellectual property. As

discussed in the previous chapter, the Proprietary

InformaƟon and InvenƟons Agreement (“PIIA”) is

one crucial tool for protec�ng intellectual property.

However, at least nine states have enacted statutes

governing employee inven�

on assignment

agreements, so any PIIA will need to comply with

those applicable state laws. For example, in

California, the statute is codied under California

Labor Code sec�on 2870. The California statute and

others like it require the employer to no�fy the

employee that the PIIA does not apply to an

inven�on that does not qualify as the employer’s

inven�on under the state’s statute.

Employers want to make sure that the results of their

employees’ eﬀorts made on company �me belong to

the company. California Labor Code Sec�on 2870

qualies that right of the company, and states that

inven�ons of an employee are not assigned to the

employer if they are wholly developed on the

employee’s own Ɵme and if they are developed

without the uses of employer’s equipment,

supplies, faciliƟes, or trade secret informaƟon.

268

Labor Code 2870 does not, however, apply to

invenƟons that relate (at the Ɵme of concepƟon or

reducƟon to pracƟce of the invenƟon) to the

employers’ business or anƟcipated research or the

employer, or invenƟons that result from work done

by the employee in his or her capacity as an

employee of the company. If a California employee is

required, under their PIIA, to assign an invenƟon,

then the employer must provide a wriƩen noƟce to

the employee staƟng that this agreement does not

include invenƟons that qualify under SecƟon 2870.

That noƟce is usually provided as a secƟon within the

PIIA itself.

As an employee, if you develop a variaƟon of a

product or concept of your employer, you must

assume that the employer will aƩempt to claim

ownership rights unless the idea is in an unrelated

eld and is not part of a larger project to which you

are (or were) assigned. Working from home and

using your own equipment is not enough; if the

concept is derived from trade secrets or is a variaƟon

of an exisƟng project assigned by the employer, then

the employer can claim ownership of the invenƟon.

California’s SecƟon 2870 reads as follows:

(a) Any provision in an employment agreement

which provides that an employee shall assign, or oﬀer

to assign, any of his or her rights in an inven�on to

his or her employer shall not apply to an inven�on

that the employee developed en�rely on his or her

269

own �me without using the employer's equipment,

supplies, facili�es, or trade secret informa�on except

for those inven�ons that either:

(1) Relate at the �me of concep�on or reduc�on to

prac�ce of the inven�on to the employer's business,

or actual or demonstrably an�cipated research or

development of the employer; or

(2) Result from any work performed by the

employee for the employer.

(b) To the extent a provision in an employment

agreement purports to require an employee to assign

an inven�on otherwise excluded from being required

to be assigned under subdivision (a), the provision is

against the public policy of this state and is

unenforceable.

As menƟoned, while this chapter focuses primarily

on the California limitaƟons impacƟng a company’s

ownership of employee invenƟons, it is important to

understand if your jurisdicƟon has a similar

provision, as you will need to comply with that

state’s requirements.

270

NOTES

_______________________________________

271

CONTRACTS AND ARTICLE 2 OF THE

UNIFORM COMMERCIAL CODE

Hold on to your hats, because it’s Ɵme to cover some

somewhat boring (but important) contract terms!

Sales, no maƩer how informal or miniscule, are all

governed by contract law. Generally, common law is

the law that applies, but special rules have been

developed for the sale of goods.

These special contract rules are contained in ArƟcle 2

of the Uniform Commercial Code, typically referred

to as the “UCC.” The UCC has been adopted by most

states to some degree.

ArƟcle 2 of the UCC applies to the sale of any

“goods,” which includes all things that are movable,

so the rules will generally apply to all tangible,

personal property.

ApplicaƟon of the UCC is an all or nothing deal, so

when a contract includes both goods and services,

you need to decide whether the goods or the

services are the most important aspect of the

contract. To make that determinaƟon, use the

primary purpose test and look to see whether the

goods or services are the primary purpose for the

contract. For example, if you are commissioned to

create a sculpture, the UCC would apply to the

contract because, while you will perform the service

of sculpƟng, ulƟmately the sculpture itself is the

272

main reason for the contract. Therefore, in the

context of all types of sales, you will need to keep

the UCC in mind.

Transac�ons between two private, non-merchant

par�es will not be subject to UCC requirements, such

as when two private par�es engage in the sale of an

automobile. However, if one of those par�es is in the

business of selling automobiles, the UCC will need to

be addressed.

Now, before determining whether the UCC applies,

you rst need to conrm there is a contract for the

sale of goods, which starts at forma�on — was there

a contract to begin with? A contract, plain and

simple, is a legally enforceable agreement. A legally

enforceable contract requires an oﬀer, acceptance

and considera�on.

An oﬀer is a proposal by a party to another party,

indica�ng a willingness to enter into an agreement

based on certain terms.

When determining if there was an oﬀer, the UCC

does not require that an exact price was discussed; a

court can assume a reasonable price, e.g. the fair

market value. However, if there were vague or

ambiguous material terms, there was no oﬀer. For

example, in the context of the goods, if it is unclear

what is being purchased, the terms are too

ambiguous.

273

Acceptance is an unequivocal agreement to the

terms of the oﬀer (without any modica�on). It can

be verbal, in wri�ng, or implied though conduct. Any

change to the oﬀer creates a counteroﬀer, which

would then be available for either acceptance or the

crea�on of another counteroﬀer.

ConsideraƟon is something of value that is

exchanged by the par�es pursuant to the contract.

Considera�on can be money, a promise to do (or not

do) something, the performance of an act, or a

promise to perform an exchange (if you x my sink, I

will give you my NFL �ckets).

The ideal way to form a contract is for one party to

clearly oﬀer the item and the other to accept that

oﬀer by performing some act. For example, you oﬀer

to sell a product for a price and the buyer accepts the

oﬀer by making the required payment.

There may be instances in which

the contract exists but is not

enforceable. One important rule to

consider is the Statute of Frauds.

The Statute of Frauds requires

par�es to memorialize and sign

their agreements to prevent

conicts and reduce fraud (by

requiring evidence beyond just someone’s word).

Under the UCC, sales of goods over $500 must

comply with the Statute of Frauds.

The Statute

of Frauds

applies to

sales of

goods over

$500.

274

The easiest way to saƟsfy the Statute of Frauds is

with a wriƩen document. The UCC requires two

things in this document—(i) it must specify the

quanty you are agreeing to sell, and (ii) it must be

signed by the buyer. A standard sales receipt that

lists the quanty of the item and is signed by the

buyer suces for Statute of Fraud purposes. Having

a buyer sign a sales receipt should always be part of

your sales process, but when the sale is over $500,

it’s required!

There are a few excepons to the requirement that

there be a wrien document. For instance, when an

order is for customized goods that have already been

produced, or where goods have already been

accepted by the buyer, or where there is clearly a

contract that has already been completed in whole

or in part (such as where paral payment has been

made).

If the UCC requirements are not followed, one party

may be able to avoid his or her contract obligaons,

meaning the sale you thought you had made is

cancelled, and you now have no recourse. Be mindful

of the requirements, so you can keep the deal you

made.

275

DIGITAL SIGNATURES

In our increasingly electronic age, digital signatures

are frequently replacing tradional paper-based

methods of signing documents. These electronic

signatures bring transacon benets, including

increasing the speed and eciency of transacons,

as well as increased security, reduced paperwork,

and lower costs. However, as with most things,

digital signatures must meet certain requirements

to be enforceable.

A digital signature uses a

cryptographic method to verify the

authencity and integrity of a

digital message or document.

Unlike a simple electronic

signature, such as a scanned image

of a handwrien signature, a

digital signature uses public key

infrastructure (“PKI”) to create a

secure, unique idener for the

signer. This PKI is important, as it

serves as the cryptographic keys that are part of the

encrypon process needed to authencate dierent

people and devices.

A digital signature has three basic steps: creaƟon,

vericaƟon, and security. First, sender's computer

generates a unique hash value for the document's

contents. Next, the sender applies a private key

Digital

signatures are

as legally

binding as

hand

signatures…so

long as they

meet the

requirements.

276

(known only to the sender) to that hash. AŌer the

document and digital signature are sent, the

recipient can verify the signature by using the

sender’s public key to decrypt the signature. AŌer

generaƟng its own hash of the document, the

recipient compares it to the hash of the sender’s

document. If they match, that conrms that the

document hasn’t been altered since it was signed.

EncrypƟon and cryptography techniques create an

extremely secure process that resists forgery and

tampering.

In 1999, the United States passed the Uniform

Electronic TransacƟons Act (“UETA”), with a goal of

regulaƟng the use of electronic signatures and

records in commerce across state borders. Since

then, UETA has been adopted by most states. Under

UETA, electronic signatures are valid if there is an

intent to sign, there is consent to conduct business

electronically, there is an associaƟon of the

signature with the record, and there is proper

record retenƟon.

In 2000, the United States passed the Electronic

Signatures in Global and NaƟonal Commerce Act

(“ESIGN Act”). The ESIGN Act states that digital

signatures carry the same legal weight as

handwriƩen signatures, so long as those digital

signatures meet certain requirements (similar criteria

to UETA), i.e. an intent to sign, consent to conduct

business electronically, an associaƟon of the

277

signature with the record, and proper record

retenƟon.

To saƟsfy those criteria:

Intent to sign. Both parƟes intend to sign the

document.

Consent to do business electronically. Both parƟes

must agree to do business electronically, whether

they do so explicitly or implicitly.

Associa�on of signature with the record. There must

be some form of a mark (either graphical or textual)

on the document that can be associated with the

record.

Record reten�on. Each party must be able to access

and print and save the signed document.

How are UETA and the ESIGN Act diﬀerent?

EssenƟally, it is a maƩer of scope. While each state

in the United States may accept or reject guidelines

in the UETA, each state must have laws that validate

electronic signatures, i.e. because of the ESIGN Act,

no state has the power to deny the authenƟcity of e-

signatures.

Not all documents can be signed electronically,

which may vary by jurisdicƟon. Digital signatures

cannot be used for documents such as

 Wills, codicils, and testamentary trusts

278

 No�ces of default, foreclosure, evic�on, or

the cancella�on or termina�on of u�li�es

 Health proxies and “do not resuscitate”

orders

In the European Union, digital signatures are

governed by the Electronic IdenƟcaƟon and Trust

Services (“eIDAS”) Regula�on, which came into

eﬀect in 2016, with a goal to create a consistent

digital signing procedure across countries. Digital

signatures are also governed by interna�onal

standards, including ISO/IEC 27001 (informa�on

security management) and ISO/IEC 14888 (digital

signatures).

These standards provide guidance for the crea�on,

use, and valida�on of digital signatures across

diﬀerent jurisdic�ons, ensuring interoperability and

legal recogni�on globally.

The enforceability of digital signatures can also be

aﬀected by the laws and regula�ons in diﬀerent

jurisdic�ons. The ESIGN Act, UETA and eIDAS provide

broad recogni�on of digital signatures in the U.S. and

E.U., but varia�ons in na�onal laws can create a

scenario where a digital signature that is legally

binding in one country may not be enforceable in

another country; if you are using digital signatures

interna�onally, it’s crucial to stay informed about

evolving laws to ensure enforceability in those

jurisdic�ons.

279

DATA PRIVACY

In today’s digital world, businesses collect, process,

and store vast amounts of data, ranging from

customer informa�on to nancial records and

employee details. Doing so creates privacy concerns,

as we all become increasingly concerned with what

businesses can do with the data they collect.

Data privacy laws in the United

States are passed by the states,

such as the California Privacy Rights

Act (“CPRA”), which is generally

seen as the most comprehensive

(and restricƟve) of state privacy

laws.

In the European Union, they have adopted the

General Data ProtecƟon RegulaƟon (“GDPR”), which

denes strict guidelines about how data can be

collected, stored, used and processed. Fines for

viola�ng the GDPR can be severe.

Other countries have adopted their own data privacy

laws, so it is important to understand the

jurisdic�ons of the laws related to your business.

Otherwise, you may end up with signicant nes.

While nes are certainly something every business

wants to avoid, an equally important consequence is

a loss of customer trust. Data breaches and data

abuse are diﬃcult events from which to recover. As

Data

privacy is

based on

state law.

280

the frequency of cyberaƩacks increases and phishing

scams and ransomware climb, failing to protect

against data breaches can result in wrongdoers

gaining access to sensiƟve informaƟon of your

customers and employees, such as their names,

contact informaƟon, credit card numbers, or

employment records. The loss of trust and the

reputaƟonal damage related to a breach may

ulƟmately be a greater nancial consequence than

the direct nancial losses (ransom costs and nes).

To avoid the costs of data breach,

businesses should adopt a policy

that stresses data minimizaƟon. In

other words, a business should

collect and store no more data

than absolutely necessary for its

business purposes.

Do your customers pay by credit card? If so, is it

necessary to store that credit card informaƟon in

your system? If not, do not do it. Whenever it is no

longer necessary to retain any data, that is the Ɵme

to remove it from your system.

Consider uƟlizing well-established third-party

payment processors and cloud-based storage

vendors. This will alleviate some of the burden on

your business to be a data privacy expert; you will

sƟll need to ensure that those vendors adhere to the

same data protecƟon standards, but so long as they

Don’t keep

any personal

informaƟon

unless you

must!

281

are a respected provider, they are probably doing so

already.

If you decide to hold the customer data yourself

because it is important for business objecƟves,

consider anonymizaƟon and pseudonymizaƟon of

that data, so the privacy of your customers is

improved by reducing the risk that the accessed data

can be used to idenƟfy them.

Inside your business, employees are your rst line of

defense against data privacy threats. Human error,

such as clicking on phishing emails or mishandling

data, is a leading cause of data breaches. Train your

employees regularly on best pracƟces in data

privacy, such as requiring a phone call to conrm any

changes to any exisƟng payment instrucƟons.

As privacy laws conƟnue to develop, consumers are

receiving increased protecƟon, including

 The right to access their data

 The right to correct inaccuracies

 The right to delete data (i.e. the "right to be

forgoƩen")

 The right to transfer data to another service

 The right to object to processing their data

Having procedures in place to deal with the

consumers’ demands regarding their data is crucial

for any business that collects and retains that data.

282

ProtecƟng collected data is not an opƟon, but a

necessity. Businesses must take proacƟve steps to

protect sensiƟve data, as your business may survive

or fail based on the nancial and reputaƟonal costs

of any data privacy failures.

283

TYPES OF LIABILITY

In today’s liƟgious society, entrepreneurs and

business owners need to be aware of all forms of

liabiliƟes the business may encounter. Below are

some common types of liabiliƟes, but it is certainly

not a compete list.

Contract Liability. Contract liability arises when a

business fails to fulll the terms and condiƟons of a

contract. This might include contract breaches such

as a failure to deliver products or services, a failure

to make payments due, breaches of condenƟality,

and failure to honor warranƟes or guarantees.

Tort Liability. Tort liability arises when a business is

negligent, or its acƟons (or omissions) cause damage

to another party. Negligence is dened as a failure

to use reasonable care, which leads to injuries. Tort

liability, in the form of product liability, can also

arise when the products that are manufactured or

sold by the business end up harming the consumers

of those products. Tort liability can also extend to

defamaƟon (which includes libel and slander) if the

business spreads false informaƟon that harms

another party. Invasion of privacy is also an

intenƟonal tort, giving individuals a cause of acƟon

when the company publicly discloses private

informaƟon of an individual.

Employment Liability. When employees of the

company take certain acƟons, the company can be

284

responsible for those acƟons under a legal principle

known as vicarious liability. For example, if one of

your drivers causes an accident while driving on the

job, the company may be held liable for damages,

because that employee was acƟng within the scope

of their employment at the Ɵme the injury was

caused. AddiƟonally, your business will be liable

when employees sustain injuries while on the job.

It seems obvious that if your business is found to be

knowingly permiƫng systemaƟc discriminaƟon or

harassment of employees based on race, gender,

age, disability, etc., your business will be responsible.

If an employee is wrongfully terminated in violaƟon

of law or in violaƟon of their employment

agreement, the business will have liability related to

those claims as well. However, companies are

someƟmes surprised to hear that even if only one

manager is found to have discriminated against or

harassed an employee, your business may also be

responsible for that manager's acƟons, parƟcularly if

the company failed to take immediate acƟon once

learning of that conduct.

Intellectual Property Liability. Claims of patent

infringement arise when the business uses someone

else's patents without a license or other form of

permission. Similarly, copyright infringement can

arise when copyrighted content (or new content

substanƟally similar to copyrighted content) is used

without permission. This frequently occurs when the

company incorporates images found on the internet

285

into the company website (since those images

contain metadata that can make them traceable by

the copyright owner). Trademark infringement

arises when the company uses a name or logo that is

confusingly similar to another company’s trademark.

Companies must train employees on how to avoid

intellectual property infringement. For example, an

employee or contractor could potenally incorporate

proprietary code of another product into your

company’s soware, and no one may become aware

of that infringement unl it is too late. The company

should stress the importance of original content and

make it clear that no other content is permied

unless it is clearly in the public domain or properly

licensed.

Product Liability. Product liability claims can be

made against a company based on defecƟve design,

defecƟve manufacturing, or failure to warn

consumers by including sucient instrucons and

warnings that could have prevented injury.

Professional Liability. Professional liability, or errors

and omissions liability, can be incurred when the

professional services that were provided are either

incorrect or misleading in nature, or otherwise fail to

meet industry standards, and that failure caused a

nancial loss or other injury. For example, aorney

and doctor malpracce claims fall under this

category.

286

While it is not pracƟcal to list every form of liability a

company may encounter, it is imperaƟve that every

business take stock of where its most signicant risks

are and then put in place appropriate training and

insurance to miƟgate those risks.

287

INSURANCE

When operaƟng a business, it is important to limit

risks and personal liability as much as possible.

Forming your business as a limited liability enƟty,

such as a corporaƟon or LLC, is the rst step in doing

so.

The next step is securing insurance for your

operaƟon. Business insurance comes in a variety of

avors, and it’s important to pick those forms of

insurance appropriate to your business.

General Liability Insurance. General Liability

Insurance (or “GLI”) protects your business from

liabiliƟes related to accidents, injuries, or negligence

that occur on your premises or as a result of your

business operaƟons. This is a fundamental

requirement for businesses, especially if the

company has a physical locaƟon or has direct

interacƟon with clients. GLI can cover the following

types of injuries:

 Bodily injury claims, such as if a customer

slips and falls on your property

 Property damage claims

 Personal injury (e.g., slander or libel)

 AdverƟsing injury (e.g., allegaƟons of

intellectual property infringement)

288

Property Insurance. Property insurance will protect

your business’s physical assets (such as your building,

equipment, inventory, and furniture) against damage

or loss due to re, theŌ, vandalism, and certain

natural disasters. With the proceeds from this

insurance, the company can repair or replace those

assets, minimizing business disrupƟon. Having

property insurance is criƟcal if your business has a

signicant investment in physical inventory or real

estate.

Workers’ CompensaƟon Insurance. Workers'

CompensaƟon insurance provides benets to

employees who are injured or become ill while on the

job. It helps cover medical expenses, lost wages, and

other costs associated with work-related injuries or

illnesses. This insurance is mandatory in most

jurisdicƟons and having it will help the company

avoid costly lawsuits and nes.

Commercial Auto Insurance. If your business uses

vehicles as part of your operaƟons (whether a eet

of delivery trucks or a single vehicle used by

employees for business purposes), commercial auto

insurance will be necessary to cover vehicle damage

(collision and non-collision related) and auto accident

-related injuries to employees and third parƟes, as

well as losses resulƟng from vandalism and theŌ.

Professional Liability Insurance (Errors and

Omissions Insurance).

Professional Liability

Insurance, oŌen called Errors and Omissions (or

289

“E&O”) insurance, is important for businesses that

provide services or advice. It protects against claims

of negligence, errors, or omissions made by

professionals while providing their services. In the

event you are sued by a client who claims you

provided substandard services or advice, E&O

insurance will help cover any claims against you

related to professional mistakes or negligence,

including any defense costs (even if you are not

ulmately liable for the underlying claim).

Directors and Oﬃcers (“D&O”) Insurance. D&O

Insurance is oponal, but it is oen required once

investors or non-founders join the Board of

Directors. Also, if your company makes a strategic

hire as an ocer of the organizaon, that individual

may require D&O coverage to be in place before they

join. D&O insurance will protect the personal assets

of corporate directors and ocers in the event they

are sued for acons they have taken within the scope

of their ocial dues. The company is also covered

by D&O insurance in the event the board members

are sued. Coverage maers may include claims

related to mismanagement, breach of duciary duty,

or failure to comply with regulaons. D&O insurance

will cover the legal defense costs, as well as any

resulng selement or judgment.

Business Interrup�on Insurance. If your business is

forced to temporarily close or reduce operaons due

to a re, natural disaster, or equipment failure,

business interrupon insurance will compensate your

290

business for any lost income related to those events.

It will also pay for any operaƟonal expenses (such as

rent, uƟliƟes, and payroll) during any pause of your

business operaƟons. Business interrupƟon insurance

will allow the company to conƟnue paying bills and

employees, even though operaƟons have halted.

Cyber Liability Insurance. Cyber Liability insurance

protects against risks such as cyberaƩacks, data

breaches, and other technology-related threats. As

businesses become more dependent on digital

plaƞorms, more businesses are insuring for those

related risks. Cyber Liability insurance will cover data

breaches (and the costs of noƟfying clients about

those breaches), costs of data recovery, legal fees,

and any ransomware or other cyber extorƟon.

Product Liability Insurance. If your business

manufactures, distributes, or sells products, you may

want to consider product liability insurance. This

kind of insurance specically covers injuries or

damages (whether personal or property related)

caused by defects in your products, which may not

only include those stemming from operaƟng defects,

but also those related to design aws, manufacturing

defects, and improper labeling. Product liability

insurance will cover any damages assessed against

the company as well as the legal fees to defend the

claims.

291

Umbrella Insurance. Umbrella Insurance serves as

an extra layer of liability coverage, in case there are

claims that exceed the limits of other liability policies

like GLI or commercial auto insurance. Because it is

second in line, umbrella insurance is typically a cost-

eﬀec�ve approach to cover catastrophic claims.

Businesses are all diﬀerent, so while insurance is an

essen�al tool for managing risk, the right type and

amount of coverage will depend on your business’s

specic needs, size, and industry, as well as other risk

management considera�ons. In any event, the right

insurance package should enable you to grow your

company without undue worry about how it may be

impacted by unforeseen events.

292

NOTES

_______________________________________

293

RESOLVING DISPUTES:

MEDIATION AND ARBITRATION

Because running a business means working with

other people, disputes are inevitable. Of course, the

rst step is to try to resolve maers amicably

without lawyers, but somemes that is just not

possible.

Once ligaon is led, both sides of the dispute will

incur signicant costs as the maer moves through

the court system and the pares engage in discovery,

moons and other pretrial maneuvers.

MediaƟon and arbitraƟon are two methods of

alternave dispute resoluon, and they may allow

the pares to reach a conclusion faster and more

cost eecvely than taking the maer to trial in a

courtroom. In fact, prior to the maer going to trial,

the court will compel the pares to engage in either

mediaon or arbitraon, in hopes that one of those

processes will bring the pares to a resoluon.

In some cases, mediaƟon and arbitraƟon are

voluntary dispute resoluon opons available to the

pares. In other cases, mediaƟon and/or

arbitraƟon are required pursuant to the terms of the

contract between the pares (or because it is

ordered by the court).

MediaƟon is a nonbinding, collaboraƟve process

where both sides of the dispute mutually agree on a

294

neutral party, who will serve as

the mediator. This neutral party

will typically be a rered judge or

a very experienced aorney.

Prior to the day of mediaon,

each side will submit a mediaon

brief to the mediator, outlining its posions and any

selement eorts made to date. On the day of

mediaon, the pares may sit together briey at the

beginning, but in many cases, the pares never see

each other during the enre session. At some point,

the pares will be in separate rooms, and the

mediator will move back and forth between the

rooms, talking to each side about the strengths and

weaknesses of their posions. Mediaon is a less

formal proceeding than arbitraon.

All discussions that take place in the mediaon are

condenal and cannot be used as evidence in

subsequent legal proceedings. This includes any

selement oers made during mediaon.

Along the way, the mediator will try to get the

pares to reach a selement. Mediaon is

somemes very valuable (and eye opening) to the

clients as it provides a third party opinion as to the

strength of their case (as they may not always be

geng the full picture from their legal counsel,

either because counsel does not want to deliver bad

news or because counsel is too enamored with their

own arguments). With a good mediator, a selement

can be reached even if neither party expected to

MediaƟon is

collaboraƟve…

arbitraƟon is

adversarial.

295

seƩle when they arrived that day. If a seƩlement is

reached, a seƩlement agreement is draŌed that day

and signed by the parƟes. As menƟoned above,

mediaƟon is a non-binding process; the mediator

does not make a decision as to a winner and loser,

and either party can walk away from the mediaƟon

at any Ɵme. The mediator is simply there to

facilitate discussions and hopefully help the parƟes

reach a compromise they can all live with. As the

saying goes, the most successful mediaƟon is one

where everyone leaves unhappy – this means that

each side gave more than they wanted so they could

reach a compromise.

ArbitraƟon. ArbitraƟon is a

binding, adversarial process,

and is much more formal and

structured than mediaƟon, but

less rigid than the court process.

First, the parƟes will agree on a

neutral third party, called an

arbitrator. In the event the

parƟes are unable to agree on an

arbitrator, the court may choose

to appoint one. OŌen, the

arbitrator is either a reƟred judge or an aƩorney that

has experience with the subject maƩer at issue.

Once engaged, the arbitrator will set a preliminary

hearing where the parƟes can discuss procedural

maƩers, a schedule for discovery and any other early

-stage issues. The arbitrator may also begin ruling on

Mediators

facilitate

discussion and

negoƟaƟon;

arbitrators

make awards,

picking

winners and

losers.

296

any moons of the pares, such as discovery

challenges.

Prior to the day of arbitraon, each side will submit

an arbitraon brief. At the arbitraon, the arbitrator

will review presented evidence, listen to witness

tesmony, and make rulings as to the admissibility of

evidence.

Unlike mediaƟon, aŌer the arbitraƟon is completed,

the arbitrator will make a decision, known as an

“award,” and that decision will be legally binding on

the pares and enforceable in a court of law. In that

respect, it is very similar to a judge issuing a ruling.

Unlike a ruling from a court proceeding, awards are

generally not subject to appeal. The only excepons

are when there is misconduct by the arbitrator or

other procedural irregularies that jusfy review by a

court. However, pares cannot appeal simply

because they did not think the arbitrator reached the

right conclusion.

Mediaon is oen a quick and inexpensive way to try

to resolve a dispute. It is parcularly useful when the

pares wish to preserve their relaonship on a going

forward basis, as the process is more cooperave

than arbitraon or a court trial. Arbitraon and

court trials can create a “scorched earth” mentality

and can oen put the pares in an “all or nothing”

frame of mind, which does not encourage selement

eorts.

297

ArbitraƟon is beƩer suited to situaƟons where the

parƟes need a nal, binding decision, and where they

would like that faster than they might be able to

achieve with a full court trial. While arbitraƟon is

generally faster than a court trial, it is much more

expensive than mediaƟon. In fact, depending on the

case, the cost savings from arbitraƟon compared to a

court trial may be negligible (parƟcularly if a high-

prole arbitrator is used… unlike a court trial, the

parƟes will be paying the arbitrator an hourly rate for

his or her Ɵme).

298

NOTES

_______________________________________

299

EXIT STRATEGIES

Many entrepreneurs, when starng a business, are

already thinking about how they will be able to exit

that business and rere. Whether that is your

mindset now, or won’t be for some me to come,

business owners have a variety of ways to exit from a

successful company.

Ini�al Public Oﬀering. An inial public oering

(“IPO”) is an event where a private company oers

its shares to the public for the rst me, i.e. it

becomes a publicly traded company on a stock

exchange. It involves ling an S-1 registraon ling,

which is just part of a complicated, lengthy and

expensive registraon process (count on $1.0-$1.5

million dollars in legal and accounng fees). An IPO

has many benets, including

 Valuaon mulple -- public companies can

oen enjoy a higher price to earnings

mulple than a private company can

 Access to capital -- Raising substanal

capital is easier in a public company

 Liquidity -- because of public trading,

owners, investors, and other shareholders

have an available market in which they can

sell shares

 Awareness-- public companies get a boost in

credibility, allowing them to aract top

talent and market the company more

successfully

300

Many entrepreneurs see an IPO as being the

“ulƟmate success,” but IPOs are not right for every

company. Ongoing legal and accounƟng fees can be

quite signicant (from several hundred thousand

dollars to millions of dollars annually), and

inconsistent revenue streams can severely impact

value. Also, there will need to be a strong market for

the shares; otherwise, the share volaƟlity may be so

great that very few shares can be sold before the

share price goes into a tailspin, severely impacƟng

shareholder value and liquidity. For that reason,

companies typically need to achieve a certain level of

success before they go public; otherwise, they may

be siƫng with a public company (along with all the

costs of being public) without signicant market

interest to create a stock that has liquidity.

While an IPO is an event many business owners

dream of, it is a relaƟvely uncommon way to exit

your business. It is more common for a company to

merge or sell.

Mergers. A merger occurs when

two companies combine, with

one company surviving and the

other company disappearing. In

a direct or forward merger, the

company geƫng acquired (the

“target”) merges into the

acquirer, with the acquirer surviving and the target

disappearing. In the case of a forward triangular

merger, the target merges into a subsidiary of the

In a merger,

one enƟty

survives, the

other

disappears.

301

acquirer, with the subsidiary surviving and the target

disappearing. In the case of a reverse triangular

merger, the target merges with a subsidiary of the

acquirer, the subsidiary disappears, and the target

survives as a wholly owned subsidiary of the

acquirer.

Unlike an IPO, which can take a year or more to

complete, mergers can occur in the span of a few

months, providing owners with a faster path to

liquidity. Also, where the buyer is a compeƟtor or in

a complementary channel, synergies between the

two companies can make both enƟƟes more

successful going forward. In a merger, it is quite

common for employees to conƟnue with the new

enterprise, oŌen with retenƟon bonuses or stock

opƟons in the surviving enƟty.

One signicant advantage of a merger over a stock

purchase (which will be discussed below) is that a

merger typically does not require unanimous

approval by the company's shareholders. While it will

require a majority (or someƟmes, super-majority)

vote, uncooperaƟve minority shareholders have less

opportunity to obstruct the transacƟon. Note that if

there are mulƟple classes of stock, each class may be

required to vote separately, which means each class

must then vote a majority of votes in favor of the

merger before the transacƟon can be completed.

One factor to consider in a merger is what happens

to the target company’s exisƟng contracts with other

302

parƟes. In a merger where the target does not

survive, all assets and liabiliƟes will be assumed by

the acquirer or the subsidiary of the acquirer, and

third-party contracts will be deemed to have been

assigned or transferred to the acquirer. As a result,

third party consents are typically required. However,

in a reverse triangular merger, where the target

ulƟmately survives as a wholly owned subsidiary,

third party consents are not typically required, unless

there is a “change of control” provision in that

contract. A change of control provision states that in

the event of (i) a merger, (ii) a change in ownership

of more than 50%, or (iii) a sale of all or substanƟally

all of its assets, the other party must consent to the

transacƟon or otherwise have the right to terminate

the contract.

Stock Sales. Another method of

selling a business is the sale of

stock held by the shareholders.

This sale of stock might be to a

compeƟtor, a private equity

fund, a private investor, or even

through an employee stock

ownership plan.

From the seller's perspecƟve,

one benet of a stock sale is that all liabiliƟes (unless

specically excluded) are transferred to the acquiring

party. Of course, this is less favorable from a buyer’s

standpoint.

A stock sale

transfers all

assets and

liabiliƟes,

except

specically

excluded

liabiliƟes.

303

Another benet is that not all shareholders

technically need to parƟcipate. In a stock sale, the

parƟes to the transacƟon include the individual

shareholders. Assuming the buyer accepts something

less than full parƟcipaƟon, any shareholders who

choose not to sell can conƟnue as shareholders, post

-transacƟon.

Finally, in a stock sale, there can be tax benets to

both the buyer and the seller, depending on the

circumstances. The buyer may be able to take

advantage of seller’s net operaƟng loss carry

forward, and selling shareholders may enjoy certain

tax benets as well, as the stock purchase

transacƟon results in a single layer of tax at the

shareholder level; under an asset purchase from a C

CorporaƟon, tax would trigger at both the company

level (on sale) and shareholder level (upon

distribuƟon of proceeds).

However, if the buyer does not accept anything less

than full parƟcipaƟon, unanimous consent of the

shareholders will be required, since all shareholders

each need to agree to sell their shares. As a result, in

companies with many shareholders, the buyer will

typically use a merger approach; in companies with a

small number of cooperaƟve shareholders, a stock

sale is preferable as it is a liƩle less complicated.

304

Asset Sales. An asset sale, in the

context of an exit, is the sale by

the company of all or

substanƟ

ally all of the

company’s assets related to the

business operaƟon (except those

assets specically excluded).

However, no liabiliƟes are

transferred to the buyer unless

the buyer specically assumes

those liabiliƟes. As a result, the seller must then use

the sales proceeds to pay all liabiliƟes prior to

making any distribuƟon of sale proceeds to

shareholders.

Shareholder consent (typically, by majority vote) will

be required in order to complete the sale of all or

substanƟally all of the assets of the company.

In general, a stock sale is typically preferable to a

seller (because liabiliƟes transfer), while an asset

sale is typically preferable to a buyer (because

liabiliƟes do not transfer).

Generally, in the case of a distressed business being

put up for sale, the buyer will require an asset sale so

it can be condent that no liabiliƟes will be deemed

transferred to the buyer.

UlƟmately, all business owners want a successful

nancial exit. However, the best exit strategy will

depend on the business, its structure, and its goals

An asset sale

transfers

assets but no

liabiliƟes,

except

specically

included

liabiliƟes.

305

for the future. It will also obviously depend on deal

pricing and the tax impact of the deal structure, as

well as the willingness of shareholders to approve or

parƟcipate in the proposed transacƟon. Having

experienced legal and accounƟng advice will be

criƟcal as you make decisions on deal structure.

306

NOTES:

_______________________________________

307

NOTES

_______________________________________

308

NOTES

_______________________________________

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