Both drag along rights and tag along rights can be very beneficial in an LLC Operating Agreement or a corporation’s Shareholder Agreement. They both relate generally to when an owner (or a group of owners) holding a certain percentage of the equity of a company (usually a majority) wish to sell their interests in the company to a third party. Tag along rights are beneficial to minority owners, while drag along rights are beneficial to majority owners.
Power Purchase Agreements a/k/a “PPAs”
A power purchase agreement is an arrangment between usually two parties – the host and a services provider – whereby the host allows the provider to install a renewable energy system on its property and agrees to purchase the power generated by the system for a specific time frame, usually around 20 years. The host does not own the system. PPAs are used for solar and wind installations, with solar being the most prevalant by far. I have heard that geothermal transaction of this type was is in the works, if not done already. The power created by the system is used by the host, who has the right to sell any excess power created above and beyond the host’s needs to the local utility.
Granting LLC Profits Interests
In a startup company, its common for certain employees to be compensated with some form of equity. When you incorporate, you would adopt a stock option plan and then issue options to the corporation’s employees to compensate them for their past services and to incentivize them to stay and keep up the hard work – make sure you vest!
With LLCs becoming ever more common, the owners of a startup organized as an LLC want to be able to compensate and motivate their employees and contractors in the same manner. They can do so by granting employees LLC profits interests.
New Craze: Hack-a-thons
A client of mine just got a great write up in entrepreneur.com (read it here). MyMusic has a great product and have a huge promotional caimpaign about to begin – see their website here. What they needed was a software upgrade for their product, digital music stands. They came up with the brilliant idea that they could host a hack-a-thon, get the best programmers around to pull a weekend long hack-fest to upgrade their software, and give any donations received to charity. This particular one gave the proceeds to the local symphony, hence its title Hacking for Music.
As discussed in the Entreprenuer article, this particular type of program is an off-shoot of crowdfunding, but instead of funding, people give their programming talent. MSNBC did a similar write up.
To hit on the legal aspects of this, and one I stressed prior to the event, was that each hacker should sign off on an Participation Agreement which transfers all of that programmers efforts to the entity hosting the hack-a-thon.
Also look for an article in the NY Times regarding Hack-a-thon’s soon.
Installing a Solar PV System – Credits/Incentives
Obviously using renewable energy sources, such as solar, is a worthy sustainable practice. Although, installing solar panels may be worth it from a financial standpoint now. Really. If you have the up front money to cover the installation for your industrial, commercial, non-profit or residential use, you look to save a good deal of money over the next couple of years – generally an installation will “pay” for itself over a seven year timespan.
Vesting the Founder’s Stock
This is a very important topic to ensure that your startup continues to be controlled by founders dedicated to its cause. What you want to avoid is a situation where a group of founders form a startup and each hold a similar percentage of the issued shares – without any restrictions on such shares. If only one or two of the original founders continue working for the corporation, and the rest stop, and either get other full-time jobs, move away, leave the country, etc., then the founders that are still around can be stuck and essentially handcuffed from making certain corporate decisions. If the corporation, as most due, requires the majority of the issued shares to take certain actions, and the corporation brings in other people from the outside as shareholders and/or directors (usually investors), then the founders who have stuck around will have essentially less of a say in major corporate actions. And if there is a liquidation event, then the founders who have left will get paid without having to put in the hard work.
Choice of Business Entity – LLC v. Corporation
This is one of the earliest questions that comes up when an entreprenuer or group of founders want to formalize their company or business relationship. The usual advice is that if you have current income and are not looking for investors and will not have to bring on other owners in the near future, an LLC is usually a good choice. They are flexible, light on required paperwork and are similar to doing business as a sole proprietor, assuming you continue to have the LLC disregarded for tax purposes. Sole member LLC’s are inherently flexible. Multi-member LLC’s are also flexible, but will require a carefully crafted Operating Agreement to cover certain actions each member can take, breakdown of membership interests, profits, and exit options. LLC’s are great vehicles to hold real estate.
Now if your company is seeking investors, especially institutional investors of either angel or VC level, it goes without saying that you will need to be set up as a corporation. Usually the investors will want a Delaware corporation. This will allow the corporation to issue preferred shares with various beneficial provisions in favor of the investors; right to convert to common, liquidation rights, registration rights, anti-dilution provisions, etc. While all of these are technically possible to do in an LLC format, they are not as commonly used. Investors feel more comfortable with the corporation form, notably c-corps, and they are the ones putting up the money so they usually get their way. Also, and more importantly, most investment funds have prohibitions in their organizational documents prohibiting investments in LLC’s to ensure that the fund does not receive any unrelated business income tax (UBIT). While you will hear some buzz around the internet, and maybe directly from some startups that institutional investors invested in their LLC, this is most likely through a “blocker” corporation, which is essentially a sole purpose corporation owned by the fund which holds the interest in the LLC. Most investors do not like this structure as it has its drawbacks, but it is done. Honestly, if you are running a startup, you would rather be negotiating investment terms and trying to get the best deal that you can, so you don’t want to already have one foot in a hole with respect to your entity situation.
Of course, no matter which entity you choose, you can always later either convert (depending on what state your company was formed in) or merge the existing LLC or corporation into another that you have formed. This will of course, require legal assistance, and is not always an easy process, especially if your company has signed certain non-assignable contracts or has other liabilities. But, as with most things, there is a way that it can be done.
Lock Down all the IP
One of the most important things founders of a startup have to do is make sure that everyone, and I repeat everyone, that has performed services, or provided goods, ideas, etc. to and for the company signs an assignment form transferring any and all such interests to the company. This can be done in connection with a subscription agreement or stock purchase agreement where the founders are receiving shares, or in connection with an employment/contractor agreement for previous and/or current employees or contractors.
The nightmare situation, and one that does still occur, is that a few years after a company begins to make substantial revenue, a person will claim that they are entitled to a portion of the ownership of the company based on what they performed prior to the company being formed (whether it be a design, software programming, idea, etc.). The company is in the position of either having to give up some ownership of the company, thereby diluting the current owners interests, or the company has to take a stand, hire a litigator and defend any action in court. This issue has been on the front of people’s minds due to the recent Zuckerberg portrayal.
It’s easy to prevent this. Get those assignments signed and lock down all of the intellectual property as soon as you form your business entity.
Issuing Stock Options: Basics
There are qualified (a.k.a. “incentive”) stock options plans as well as non-qualified stock option plans. The basic difference is that incentive stock options receive special tax treatment, which is better from an employee’s perspective, but not necessarily from the company’s.
Incentive stock options are available for issuance only to employees. No income is reported when the employee exercises the option (with some AMT considerations), and the entire gain when the stock is sold can be taxed as long term capital gains (instead of regular income). Also, incentive stock options must be nontransferable, and exercisable no more than 10 years from grant, with an exercise price at least equal to the FMV at time of grant.
Non-qualified stock options result in taxable income to the recipient at the time they are exercised in the amount of the difference from the exercise price and the market value when exercised. Employers prefer non-qualified stock options because the company receives a tax deduction equal to the amount the stock receipient is required to include as income – the company is not allowed this deduction when using incentive stock options. Nonqualified stock options are issuable to anyone, may or may not have an exercise price and are transferable. We’ll explore the details in later posts.