©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Legal Issues for Start-Ups Merrill M. Mason December 2, 2010

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Steve Jobs, founder of Apple and Pixar: “The thing that drives me and my colleagues both at Apple and Pixar is that you see something very compelling to you and you don’t quite know how to get it, but you know, sometimes intuitively, it’s within your grasp. And it’s worth years of your life to make it come into existence.”

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. “Starting companies are like having babies – fun to conceive but hell to deliver.” -- Anonymous …and Then On the Other Hand…

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Role of the Corporate Lawyer Legal Advisor Business Advisor Value Adder Voice of Reason Introducer Sounding Board Confidant

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Issues During Start-Up Formation Making Initial Decisions Forming Legal Entity Planning for the Future Choice of Entity Incorporation jurisdiction Founder’s Equity Allocation Incorporation Bylaws Board IP Assets Tax Issues

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Choice of Entity Continuity of existence Ease of transfer of ownership Easier to raise capital Separate entity from owners C Corporation Considerations Regular corporation meeting IRS test Difficult choice for startups S Corporation “Incorporated Partnership” Tax issues in liquidity events Flexibility in operating agreements LLC Limited liability for stockholders

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. State of Domicile Developed case law Business-like attitude Willingness of counsel to provide opinions Ease of governance DelawareOther jurisdictionsv. Differences on specific points of law Local allegiances Administration issues

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Process of Incorporation Corporate Name – Need for Distinction Par Value of Stock – Significance Initial Officers and Directors Adopt Bylaws Payment for Stock File Charter Follow up on organizational matters Appoint Board Issue stock Foreign qualifications Tax ID number Charter is a public document

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Forming Legal Entity: The Bylaws Rules of governance “pulled” from state statutes What are bylaws? What do bylaws address? Officers, Directors – election, meetings, authority Organization of Board – special committees Stockholder meetings What may be included? (contract v. charter v. bylaws) Share transfer restrictions to control shareholder pool Indemnification to protect Board members

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. A Critical Asset: The Board of Directors Number Outside Directors Role/Level of Involvement Compensation

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Going Forward Issues Identification & Perfection of IP Rights Assembling management team – identify needs – cash and equity compensation IP Assets Allocation and vesting of Founders’ equity Dilution v. protection of Founder Interests Founders’ Equity I.R.S. Section 83(b) Elections Importance of Timing and Consistency in Valuation of Stock Avoiding Taxable Income Taxes

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Start-up Legal Mistakes - People Improper or non-existent non-compete and invention assignment agreements. Employment agreements with out-of-market terms for severance or other items. Inappropriate use of titles (too many VP’s who aren’t really VP’s). Outrageous nepotism.

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Start-up Legal Mistakes - Capitalization Issuance of stock (as opposed to options) to non-founders. Establishing unreasonable valuations by selling small amounts of equity at high prices. Having dozens of small investors. Selling preferred stock in small amounts resulting in rights and preferences that need to be revoked when a venture round comes together (and the preferred is converted to common). Not establishing an option pool. Running afoul of securities laws in issuing stock.

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Start-up Legal Mistakes – Corporate Governance Not establishing a board of directors. Not having bylaws. Not taking minutes and recording them.

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Start-up Legal Mistakes - Customers License agreements with toxic terms (e.g. rights to source code). Agreements to provide maintenance or other services without getting paid.

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Start-up Legal Mistakes – Technology and Intellectual Property Using open source code in a proprietary product requiring it to also become open source. Poor or non-existent patent writing (and strategy). Failure to maintain patents. Failure to file international patents and maintain them. Poor license agreements for in-licensed technology. Out licenses with partners which give rights away without compensation. (Selling the company w/out selling it.)

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Start-Up Legal Mistakes - Other Privately held company bad habits on the balance sheet (e.g. cars, planes, rental property). Related party transactions for real estate or any service.

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P. Buzz Words S corp C corp Option pool Founders Vesting Restricted Stock Incorporation Executive Summary Business Plan Intellectual Property Common Stock Preferred Stock 83(b) Election Dilution In/Out License Spin-Out

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.... and Then What... “Only one thing is certain about a new venture: It’s going to turn out very different from its business plan.” -- William Congolton, Venture Capitalist

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.

©2010 SMITH, ANDERSON, BLOUNT, DORSETT, MITCHELL & JERNIGAN, L.L.P.