3. Business Legal Structure

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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

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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

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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

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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 LLCs
• Pros no double taxation, any number of owners,
  limited liability, ease of transferability
• Cons not available to professional firms in
  some states

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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

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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.

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3.2 Forms of Legal Structure

• Review the National Venture Capital Association
  Certificate of Incorporation and Right of First
  Refusal Stock Sale template agreements

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3.2 Forms of Legal Organization

• Corporation form of legal organization limits the
  liability of the entrepreneur, it does not
  protect the entrepreneur from directors and
  officers liability
• Securing DO insurance should be a condition of
  accepting VC funds

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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
  VCs 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

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3.3 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 cant fire me now)
• This may occur if
• the VC had asymmetric (inferior) knowledge of the
  acquisition value
• the present value of the CEOs compensation is
  greater than the PV of her harvest value as the
  entrepreneur

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3.3 Information and Incentive Conflicts

• Adverse selection when poor companies continue
  to exist due to distortions in projections and
  good businesses are crowded out
• VCs 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

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3.3 Information and Incentive Conflicts

• Review Googles history as a start-up
• http//www.google.com/corporate/history.html