Legal "Tech Specs" for Start-ups

by Vault Law Editors | February 03, 2011

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-- By: Eli R. Shahmoon and Hays Ellisen 

“Goldman Sachs Values Facebook at $50 Billion in Private Offering.” “Groupon Rejects $6 Billion Offer and Readies IPO.” Headlines like these reflect the explosively-growing market in high-tech companies, especially social-networking websites. Although very few entrepreneurs will be lucky enough to experience the amazing success of a Facebook, Groupon or LinkedIn, hundreds of tech wizards are launching new ventures every day. To help these cash-strapped startups avoid common legal pitfalls, our law firm, Shahmoon & Ellisen, recently launched the Tech Law Project.

The Tech Law Project offers qualifying high-tech startups free legal services, including the drafting of corporate organizational documents and the preparation of website terms-of-use-and-privacy policies. We begin by helping a new client choose an appropriate form of legal entity. This is key, since it protects the individual from liability for any corporate debts or legal obligations. But many tech entrepreneurs are unsure of exactly what type of entity to form.

High-tech companies have three basic options: a C corporation, an S corporation and a limited liability company (“LLC”). Both S corporations and LLCs offer significant tax benefits since, unlike C corporations, they are treated as “pass-through” entities for tax purposes. Normally, any income for these entities will only be taxed once, at the individual level.

S corporations, however, have three important restrictions. First, no corporate investors are allowed—generally, only “natural persons” (i.e. humans) and certain estates may invest. Second, the maximum number of investors is limited to 100. Third, and most importantly for tech companies, S corporations may only issue one class of stock. Many tech startups want the flexibility to issue preferred or non-voting shares to investors, developers and outside contractors, and that is virtually impossible without having at least two classes of stock.

In contrast, an LLC offers a tech startup the ability to structure the management and ownership of the enterprise in just about any way it pleases. In the LLC’s operating agreement (the analogue to a corporation’s by-laws), a tech founder may create various classes of membership interests, customize management structure and create rules governing transfers and voting however he or she chooses. For these reasons, most Tech Law Project clients who are in very early stages of development opt to form an LLC.

The main exception is a client who is lucky enough to be expecting imminent financing from a Venture Capital (“VC”) firm. VC firms strongly prefer investing in Delaware “C” corporations (and some will not even consider an investment in any other). Although LLCs can be converted into C corporations without too much trouble, for clients on the verge of a VC investment, it may be more efficient to form a C corporation immediately. But for most early-stage high-tech companies whose prospects are uncertain, locally-formed LLCs are likely the best option due to their tax benefits, flexible rules, and low set-up costs.

The Tech Law Project
Shahmoon & Ellisen site

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Eli R. Shahmoon and Hays Ellisen are the co-founders of Shahmoon & Ellisen LLP, a boutique New York City law practice focusing on corporate, real estate and technology clients. Eli has a BA in Computer Science from Columbia and a JD from NYU School of Law. Eli has practiced corporate law at Cravath, Swaine & Moore LLP and Sidley Austin LLP in New York and was also general counsel to the Limewire peer-to-peer music-sharing service and a London-based hedge fund. Hays has a BA in Philosophy and Norwegian from the University of Minnesota and a JD from Michigan Law School. Hays has practiced corporate securities law in New York at Brown & Wood LLP, Sidley Austin LLP, McKee Nelson LLP and Katten Muchin Rosenman LLP.

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