Business Law For The Netpreneur Seminar Covington & Burling May 18, 1998 COVINGTON & BURLING Covington & Burling 1998
CHOOSING THE FORM OF ENTITY Bruce Wilson Partner Covington & Burling COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity What Are the Seven Basic Choices? u When Is It Time To Decide? u What Matters in Deciding Which Form? u COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Are the Seven Basic Choices? – Sole Proprietorships -- A Fancy Name for You – Corporations -- “S” and “C” Types – Partnerships -- Limited and General – Limited Liability Companies (“LLCs”) – Limited Liability Partnerships (“LLPs”) COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u When Is It Time to Decide? – The "Follow the Money" Rule: • When There Are Multiple Owners/Investors • When The Business Generates Revenues Or Assets COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Matters in Deciding Which Form? – – – Who Owns (Or Will Own) the Business? What is the Nature of Each Owner's Interest? Who Manages (or Will Manage) the Business? How (and When) Will the Money Flow? "Personal Recourse" (Are You Putting Up The House)? – What Happens on April 15? COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Matters in Deciding Which Form? – Who Owns (Or Will Own) the Business? • • • One Individual A Few Individuals Lots of Owners Any Corporate Owners (Venture Funding)? The Same Group Over Time, Or Will Owners Vary (Transfers Among Owners)? COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Matters in Deciding Which Form? – What Is the Nature of Each Owner's Interests? • • “Common” Interests “Preferred” Interests “Carried” Interests “Convertible” Interests COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Matters in Deciding Which Form? – Who Manages (or Will Manage) the Business? • One Owner • A Few Owners • A Mix of Owners and Non-Owners COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Matters in Deciding Which Form? – How (and When) Will the Money Flow? • Investment: Self, Angel, Venture, Private, Public • Revenues: When in Your Business Plan? • Expenses: How Fast and How Deep? COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What Matters in Deciding Which Form? – "Personal Recourse” Are You Putting Up The House? • Limited Liability is Commonly a Misnomer COVINGTON & BURLING Covington & Burling 1998
Choosing The Form Of Entity u What happens on April 15? COVINGTON & BURLING Covington & Burling 1998
TAX TREATMENT OF ENTITIES Robert Shaw Of Counsel Covington & Burling COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Corporations – State-law Corporations (other than S Corporations) – Foreign entities on "Corporation List" – Entities that "elect" corporate tax status (including partnerships and LLC's) COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u S Corporations – Corporations That Are Eligible For, and Elect, "Subchapter S" Status – Eligibility requirements include: • 75 or fewer shareholders • Shareholders must be individuals (other than non-resident aliens), estates or certain trusts or tax exempt organizations • Only one class of stock COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Partnerships – Domestic partnerships and LLC’s (with at least 2 members) – Other non-corporate entities with at least 2 members that "elect" partnership tax status COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Layers Of Tax – Corporations: Double layer of Federal and State income tax • Net income generally taxed to corporation at corporates (currently up to 35% ) • Distributions generally taxable to shareholders COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Layers of Tax – S Corporations: Single layer of Federal and State income tax (except for "C" corporation gain and certain States, including DC) • S Corporation not subject to tax • Net income taxed pro rata to shareholders (whether or not distributed) • Stock basis increased by net income to allow taxfree distributions COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Layers of Tax – Partnerships: Single layer of Federal and State income tax • Partnership not subject to tax • Net income taxed to partners (whether or not distributed) • Partners can choose any sharing ratio that has “substantial economic effect” • Basis in partnership increased by net income to allow tax-free distributions COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Distributions of Cash – Corporations: Taxable as dividends (to extent of earnings and profits), then as nontaxable return of capital (to extent of basis in stock), and then as capital gain – S Corporations: Taxable only if exceeds basis in stock – Partnerships: Taxable only if exceeds basis in partnership interest COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Complexity – Corporations: Least complicated, easiest to take "public" – S Corporations: Ownership restrictions and only a single class of stock allowed – Partnerships: Most complex, substantial tax "boilerplate, ” difficult to take “public” COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Flexibility – Corporations: Flexible employee incentives. Flexibility on classes of shares, reorganization, etc. – S Corporations: All distributions and tax items must be shared pro-rata. Limited flexibility on employee incentives and reorganizations – Partnerships: Greatest flexibility making distributions and allocating tax items. Limited flexibility on employee incentives COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Summary of Corporations – Double layer of federal and state income tax – Cash distributions taxable as dividends to the extent of earnings and profits, then as nontaxable return of capital to the extent of basis in stock, and then as capital gain – Least complicated, easiest to take "public" – Flexible employee incentives – Flexibility on classes of shares, reorganization, etc. COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Summary of Corporations – Other Issues • Pre-contribution gain subject to two levels of tax • Distribution of appreciated property triggers two levels of tax • Losses can only be used at the corporate level COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Summary of S Corporations – Single level of federal income tax (except for "C" corporation gain) – States differ on whether subject to single (VA, MD) or double (DC) layer of tax – Cash distributions taxable only if exceed basis in stock – Eligibility rules include ownership restrictions and only a single class of stock allowed COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Summary of S Corporations – All distributions and tax items must be shared pro-rata – Limited flexibility on employee incentives and reorganizations – Other Issues: • Pre-contribution gain on appreciated property allocated pro-rata (shifts possible) • Distribution of appreciated property triggers single level of tax • Losses limited to tax basis in stock plus amounts loaned to the S Corporation COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Summary of Partnerships – Single layer of federal and state income tax – Cash distributions taxable only if exceed basis in partnership interest – Most complex -- substantial tax "boilerplate" – Greatest flexibility making distributions and allocating tax items – Limited flexibility on employee incentives (profits interest) COVINGTON & BURLING Covington & Burling 1998
Tax Treatment of Entities u Summary of Partnerships – Other Issues: • Pre-contribution gain on appreciated property taxed back to contributing partner • Generally, appreciated property can be distributed without triggering gain • Losses limited to tax basis in partnership interest plus partner's share of all of the partnership's liabilities (generally: recourse liabilities shared by economic risk of loss; nonrecourse liabilities shared by profits interest and partner loans only to loaning partners) COVINGTON & BURLING Covington & Burling 1998
CORPORATE GOVERNANCE Techniques for Predictable Sharing of Control W. Andrew Jack Of Counsel Covington & Burling COVINGTON & BURLING Covington & Burling 1998
Corporate Governance --Techniques for Predictable Sharing of Control u Situations that raise control issues – Start-up (“prenup” for the co-founders) – Entrepreneur with employee shareholders (avoiding mutiny) – Outside financing (giving the venture capitalists a voice) – Estate planning (shifting equity, but not control, to the next generation) COVINGTON & BURLING Covington & Burling 1998
Corporate Governance -- Techniques for Predictable Sharing of Control u Mechanisms to Address Control Issues – Shareholder Agreements – Voting Trusts – "Irrevocable" Proxies – Articles of Incorporation provisions – Bylaws provisions COVINGTON & BURLING Covington & Burling 1998
Corporate Governance --Techniques for Predictable Sharing of Control u Control Issues for Decision – Election of Directors • Board size • Board composition – Ground Rules for Major Company Decisions • Sale of substantially all assets or merger • Amendment of Articles or Bylaws – Issuance of Additional Shares • Preemptive rights/antidilution protection COVINGTON & BURLING Covington & Burling 1998
Corporate Governance --Techniques for Predictable Sharing of Control u Control Issues for Decision – Share Transfer Restrictions • • Company call rights Company rights of first refusal Shareholder rights of first refusal Sale participation rights (i. e. "tag along" and "drag along" rights) – Resolution of Deadlocks COVINGTON & BURLING Covington & Burling 1998
STOCK COMPENSATION FOR THE NETPRENEUR Amy N. Moore Partner Covington & Burling COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u Why Use Stock Compensation? – Stock is plentiful; cash is scarce – Gives employees a stake in the success of the business – Favorable accounting treatment – Favorable tax treatment • Flexible timing • Lower tax rates COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u What's On The Menu? – Nonqualified Stock Options – Incentive Stock Options – Discounted Stock Options – Stock Appreciation Rights – Restricted Stock – Phantom Stock – Stock Purchase Plans – ESOPs COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u How Do You Get The Best Tax Results? – Incentive stock options (ISOs) • No tax at grant • No tax at exercise • Capital gain tax at sale of stock – 28% if you hold stock 12 months – 20% if you hold stock 18 months – 18% (after 2000) if you hold stock 5 years COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u What Are The Drawbacks Of ISOs? – – – – Vesting limited to $100, 000 per year 10% shareholders must pay 110% of market value Must hold stock two years from grant, one year from exercise Shareholders must approve plan Employer gets no deduction Employee might owe alternative minimum tax (AMT) Available only to employees COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u What Are The Drawbacks Of ISOs? – – – – Vesting limited to $100, 000 per year 10% shareholders must pay 110% of market value Must hold stock two years from grant, one year from exercise Shareholders must approve plan Employer gets no deduction Employee might owe alternative minimum tax (AMT) Available only to employees COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u Is There A Less Restrictive Alternative? – Nonqualified stock options • No grant limits or holding periods • No tax at grant; no AMT • Ordinary income tax and FICA tax at exercise – Maximum income tax rate is 39. 6% – FICA tax rate is 7. 65% (1. 45% above wage base) • Capital gain tax at sale of stock COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u How Do You Exercise An Option Without Cash? – Stock appreciation rights – Pyramiding – Stock-for-stock exercise – Reload options – Cashless exercise – Discounted options COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u How Do You Exercise An Option Without Cash? – Stock appreciation rights – Pyramiding – Stock-for-stock exercise – Reload options – Cashless exercise – Discounted options COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u How Do You Retain and Motivate Key Employees? – Options that expire at termination of employment – Options that vest • After a given number of years, or • When performance targets are reached – Restricted stock COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u What If You Expect A Sharp Rise In Stock Price? – Vested options • Exercise immediately – Restricted stock • Make § 83(b) election COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u What If Stock Is Closely Held? – Phantom stock or performance units • S Corporation (shareholder limit) • Single-member LLC • Non-stock entities • Valuation issues COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u Are There Broad-based Stock Compensation Plans? – Employee Stock Purchase Plans • Tax treatment similar to ISOs • Must cover all employees – Employee Stock Ownership Plans (ESOPs) • Tax-qualified retirement plans • Permit tax-advantaged borrowing • Provide tax benefits for large shareholders – Tax-deferred rollover – Estate planning opportunities COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u Are There Broad-based Stock Compensation Plans? – Employee Stock Purchase Plans • Tax treatment similar to ISOs • Must cover all employees – Employee Stock Ownership Plans (ESOPs) • Tax-qualified retirement plans • Permit tax-advantaged borrowing • Provide tax benefits for large shareholders – Tax-deferred rollover – Estate planning opportunities COVINGTON & BURLING Covington & Burling 1998
Stock Compensation u What Other Pitfalls Should You Know About? – Corporate governance issues – Securities law issues – Going-public issues – Accounting issues COVINGTON & BURLING Covington & Burling 1998
TRADEMARK AND COPYRIGHT ISSUES FOR NEW COMPANIES Kathleen Gallagher-Duff Associate Covington & Burling COVINGTON & BURLING Covington & Burling 1998
Trademark Law u What Is A Trademark? – Basic Purpose Is To Prevent Confusion – Selection of a Trademark or Company Name • Protection depends on distinctiveness • Generic, descriptive, suggestive, arbitrary, fanciful COVINGTON & BURLING Covington & Burling 1998
Trademark Law u Trademark Law Clearance – Why? • Protect against use of marks that violate other users' trademark rights • Avoid litigation – Clearance Steps • Preliminary Screening Search • Full Trademark Search • Discussion of Other Marks in Industry COVINGTON & BURLING Covington & Burling 1998
Trademark Law u Steps to Protect Your Marks – Federal Registration – Use of Trademark Symbols • TM and SM – ® (Federal Registration Symbol) – Monitoring Others' Use of Similar Marks – Domain Names COVINGTON & BURLING Covington & Burling 1998
Copyright Law u Copyright – Protects original expression – Rights held by copyright owners • • Right to make copies Right to distribute Right to display publicly Others COVINGTON & BURLING Covington & Burling 1998
Copyright Law u Copyright Issues Involving Web Sites – Determine ownership of web page design (designed by employee or by outside contractor with express "work for hire" provisions? ) – Before posting any written, graphic, audio or visual material on your web site, determine whether you are the author, for copyright purposes, of the material. – Is the material in the "public domain"? COVINGTON & BURLING Covington & Burling 1998
Copyright Law u Copyright Issues Involving Web Sites – Secure a transfer from copyright holder transferring right publicly to display, reproduce, distribute and transmit the work electronically on the Internet. – Secure right to create an adaptation or "derivative" work. – Obtain warranties and other protections for protection against possible infringement. – Copyright notice. COVINGTON & BURLING Covington & Burling 1998
EMPLOYMENT AGREEMENTS Jeffrey Huvelle Partner Covington & Burling COVINGTON & BURLING Covington & Burling 1998
Employment u Overview – Your employment objectives • What you need to accomplish • What you need to avoid – The basic principle • Fairness • Demonstrating fairness COVINGTON & BURLING Covington & Burling 1998
Employment u Written Agreements – The at-will rule • No fixed term • At any time for any reason or no reason – Written employment agreements • Term (length) of employment • Grounds for separation • Severance COVINGTON & BURLING Covington & Burling 1998
Employment u Confidential Information – Confidentiality obligations • Trade secrets, customer lists, confidential business strategy – But not general skill, knowledge and experience • Common law fiduciary duty • Written agreements • Practical realities of enforcement COVINGTON & BURLING Covington & Burling 1998
Employment u Restrictions on Employee Mobility – Non-compete agreements • A restraint on trade – Common law vs. statutory requirements – Consideration – Reasonableness • No greater than necessary for employer • Not unduly harsh to employee • Not contrary to public interest COVINGTON & BURLING Covington & Burling 1998
Employment u Restrictions on Employee Mobility – Restrictions • Scope Of Activity • Time • Geography – Enforcement • Injunction • Damages COVINGTON & BURLING Covington & Burling 1998
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