1 3. Business Legal Structure 3.1 Why Be Concerned About Legal Structure? 3.2 Forms of Legal Organization 3.3 VC Investor and Entrepreneur Information and Incentive Conflicts 3.4 Google Case History on Incorporating and Raising Angel Investment

2 3.1 Why Be Concerned About Legal Structure? The main focus of the entrepreneur should be marketing / sales, not legal and organization structures, but these need attention We discuss both and the link to information, incentives, financial contracting Cost and formality of organization Transferability of ownership interests –Limitations on transfers of ownership Continuity of existence Management and control Ease in raising capital –Easier for entities that exist independent of owners; will find investors more amenable to invest equity Tax implications –Corporate earnings taxed or pass through; flexible allocation of gains and losses Personal liability implications –Liability limited to business assets or include personal assets

3 3.2 Forms of Legal Structure Sole proprietorship: –one owner –earnings pass through / entity not taxed –owner is personal unlimited liability –only transfer ownership through sale of business –Pros: inexpensively formed, low cost, no double taxation –Cons: raising money difficult, unlimited personal liability not separate from business, life of business determined by life or desire of owner –Generally small business (e.g. local construction cos., non-chain retail stores) –Usually incorporate as grow larger Limited / general partnership –two or more owners –earnings pass through / entity not taxed –each owner have personal unlimited and full liability –partner interests transferable with approval of other partners –E.g. real estate investors informally partner on investing in a building; more formal partnerships include law or accounting firms –Pros: inexpensively formed, low cost, no double taxation –Cons: unlimited personal liability, difficult to sell, difficult to raise capital $ beyond partners, life of business limited to owners, one partner can be responsible for actions of others

4 3.2 Forms of Legal Structure S Corporation: –can have up to 75 shareholders; all must be US citizens –earnings pass through / entity not taxed –owners have limited liability to extent of investment –transfer ownership without approval of other owners –Pros: limited liability, no double taxation, entity existence independent of owners, ease of transferability –Cons: only US citizens can be shareholders Limited Liability Corporation: –unlimited number of owners –earnings pass through / entity not taxed –each owner has limited liability –owner interests transferable without approval of other partners –many states restrict professional services businesses from forming as LLC’s –Pros: no double taxation, any number of owners, limited liability, ease of transferability –Cons: not available to professional firms in some states

5 3.2 Forms of Legal Structure C Corporation –legal structure of most large, publicly-traded corporations –unlimited number of shareholders and classes of stock –earnings taxed at both corporate and personal level when returns realized (dividends historically taxed at higher income rate and capital gains at lower rate) –limited liability to investments –shares transferable without approval of other owners –Pros: limited liability of shareholders, ease of transfer, easy to raise capital by floating stock –Cons: double taxation at corporate and personal level, corporations in general are costlier in administration

6 3.2 Forms of Legal Structure Corporations are the best form of legal organization to obtain VC equity investments –May be a condition of investing Delaware is generally the preferred jurisdiction for incorporation of venture-backed companies for many reasons, including: –Delaware General Corporation Law (the “DGCL”) is a modern, current and internationally recognized and copied corporation statute which is updated annually to take into account new business and court developments; –Delaware offers a well-developed body of case law interpreting the DGCL, which facilitates certainty in business planning; –the Delaware Court of Chancery is considered by many to be the nation's leading business court, where judges expert in business law matters deal with business issues in an impartial setting; –Delaware offers an efficient and user-friendly Secretary of State's office permitting, among other things, prompt certification of filings of corporate documents.

7 3.2 Forms of Legal Structure Review the National Venture Capital Association Certificate of Incorporation and Right of First Refusal Stock Sale template agreements

8 3.2 Forms of Legal Organization Corporation form of legal organization limits the liability of the entrepreneur, it does not protect the entrepreneur from director’s and officer’s liability –Securing D&O insurance should be a condition of accepting VC funds

9 3.3 VC Investor and Entrepreneur Information and Incentive Conflicts Asymmetric information leads to incentive conflicts –E.g. Presenting your BP to raise capital while VC’s interest may be competitive information rather than investment Incentives to not reveal information and information is costly to gain (e.g., valuation) Pre-Agreement problem –Information is the issue; both investor and entrepreneur concerned about exploitation by other party

Information and Incentive Conflicts Post-Agreement problem –Incentives (and information ) are the issue: Investment already sunk creates moral hazard problem for entrepreneur Entrepreneur decisions may no longer be in the best interests of the investor –E.g., The CEO may make a questionable acquisition to secure the position of the CEO as it is difficult to terminate a CEO that structured the business (“they can’t fire me now”) –This may occur if: »the VC had asymmetric (inferior) knowledge of the acquisition value » the present value of the CEO’s compensation is greater than the PV of her harvest value as the entrepreneur

Information and Incentive Conflicts Adverse selection: when poor companies continue to exist due to distortions in projections and good businesses are crowded out VC’s apply high costs of capital for valuation due to this possibility Entrepreneurs with good business cases and realistic projections may not be funded due to undervaluation Good businesses are foregone and poor business cases are funded and continue to exist Solution to asymmetric information and adverse selection: –earn-out sale of the business to avoid the adverse selection problem: –final price depends on the future performance of the business

Information and Incentive Conflicts Review Google’s history as a start-up: