¨   Liability Risks and Protections in Business

¨   Choice of Entity – Tax /State law Structures

¨   Patents, Trademarks & Proprietary Rights

¨   Contracting for Employees, Subcontractors

¨   Product, Sales and Finance Arrangements

¨   Nonprofit Corps – Organization, Tax Status

By Robert A. Adelson, Esq.

 EXAMPLE (Hypothetical and Fictitious) 

FREEDOM TRAIL TECHNOLOGIES – ENTITY CHOICE /OTHER ISSUES 

                                            FREEDOM TRAIL TECHNOLOGIES

Waltham, MA

Founded 2008

Founders                                                                               Financials

Paid in

P. Revere, d, Pres 10,000                      P/L (FY 09 -Projected)*

J. Adams, d, VP/Sec 10,000                Revenue 500   Expenses 500

H. Knox, d,Treas  10,000                       Balance Sheet (12/31/09)*

J. Hancock, director  [10,000]            Assets                    Liabilities                 

P. Henry – employee                                 A/R, Equip,         A/P, Loans – 275

F. Marion – employee                               Cash, Other         Shareholders     

T. Paine – employee                                                                   Equity                40

Total – 8 – 6 employees                                         300           Accum Deficit (15)           

            2 contractors                                              (*,ooo omitted)            

           Freedom Trail Technologies was founded in 2008 by techies P. Revere, J. Adams, and H. Knox, three former employees of giant Bay Colony Scientific Inc. Each contributed cash, equipment and know-how, and Knox also advanced additional funds as needed to fund the company.  So far, most of revenues come from consulting often work bundled into big projects. The economy hasn’t helped.  Lots of work they thought they’d get didn’t come in.  They’ve retooled. They’ve lost assignments because they aren’t  incorporated and had some collection problems.  Most of the clients have been satisfied but there are two problem accounts which raise some concern with the founders.  Though no suit has been filed, Knox is concerned about protecting his new home “Ft. Knox” in Weston.  In any case, the group wants to spend more time developing e-Revolution™ a new product they feel can make an impact in B2B e-commerce.

          A colleague of Revere, J. Hancock who led Tea Party Inc. and other successful companies in the past, has likewise expressed desire to see the group spend more time in development and has said he’d like to invest $10,000 to match contributions by the founders.  Besides his own willingness to invest, Hancock introduced Revere to A. Hamilton the wealthy managing partner of Below-Zero Stage Investments, a Cambridge-based VC fund.  Hancock  also suggests meeting M. Gandhi, a US resident with key contacts in Banglapore India (Gandhi, Nehru & Mountbatten). Hancock says she may be helpful raising funds off-shore (and Revere thinks… in providing additional programmers if and as needed.)

          In the meantime, Adams has interested G. Washington, CEO of  First-In-War Co. a nationally known VAR out of Arlington, VA, in e-Revolution™, so much so that Washington asked for detailed product specifications, information on where it’s been marketed, revenues and prospects to this point.  Adams is gathering information to send Washington who just sent his 20-page standard Exclusive License.  Revere likes FIWC.  It’s marketed other e-products and is well known, so he’s tempted to sign.

          Both Adams and Knox have pushed Revere to form a corporation or LLC for financing reasons.  He just wants to get the work out.  Unfortunately, that’s gotten harder of late since B. Arnold, a valued employee since launch, quit FTT recently and joined the competition.  Arnold felt he wasn’t appreciated enough.  Meanwhile, other recruits, P. Henry, F. Marion & T. Paine have also asked for equity.  Revere particularly doesn’t want to lose Patti or Frances or even vociferous Tom.  Time has been short since the move to a bigger space in Waltham. However, the founders have decided it’s time to attend to paper work – to consider some form of business “entity”, whether to sign the VAR contract, whether to get a costly  patent of e-Revolution and other “legal stuff”.  Time and money are short. What will we recommend? 

IS IT REALLY NECESSARY

TO INCORPORATE? 

… and Other Questions to help you tell -

Is a Corporation the best choice for me?

¨     What are your motives? What are your goals and objectives in choosing an entity (new entity) under which to conduct business?

¨     Have you lost business because of concern over lack of incorporation, “continuity of existence” or lack of commitment to the enterprise?

¨     Are you selling products or services now? What potential liabilities do you face?  Were you sued?  What assets do you want to protect?

¨     Does your business have sufficient capital?  Have you borrowed? offered loan guarantees? collateral?  What are your expected capital needs in the near future?  expected capital sources?  Is any offshore?

¨     Is your business capital intensive?  Does it involve substantial investment in real estate, oil, gas, cattle or other investment assets?

¨     Do you expect to encounter substantial losses?  Is immediate pass-through of losses or differential pass-thru to investors important?

¨     Is your business people intensive?  Is employee and executive recruitment important?  Do you want to offer equity incentives?

¨     Is your business family held?  Do you seek to keep in the family ownership? Management?  What other family goals are sought?

¨     Are you a life-style company?  If not, what is your exit or harvest strategy?  Is planning for that important to you now?

¨     Do you have important concerns over timing /fiscal year? Cash basis vs. Accrual accounting? Fringe benefits?  Deduction of expenses?

 STATE LAW CHOICES OF BUSINESS ENTITY

(MASS. STATE LAW)

ADVANTAGES of Incorporation over

Partnership or Sole Proprietorship 

1)      Limited Liability (without insurance)

• exceptions: professional malpractice
• limited partnership/LLC and LLP also provide limited liability
• Single member limited liability in corp.

2)      Ease of Transfer of Interests & Financing

• Sale Securities/IPOs
• Potential ease in liquidity to investors
• Debt Financing – lender confidence however, personal guarantees may still be required

3)      Continuity of Enterprise

• Sale confidence, credibility in business dealings
• Familiarity of corporations,
• Rules established by case precedent & Structure to dealings
• Security of structure and rights to employee recruits
• Security of structure to strategic allies 

DISADVANTAGES of Incorporation

1) Complexity and Paperwork  

• Organizational documents,
• Minutes, annual meetings, notices, upkeep . . .
• Tax returns, bank accounts, separate financial records
• Corporate form – operating in corporate form

2) Cost  

• Professional Fees, Accts. Lawyers
• State Taxes, Filing fees, Ann Reports
• Separate Capital maintained for corporation/ no shell

3) Taxes  

• Profits and Capital Apprec. potentially Taxed Twice

            -     exceptions: S Corps and many offsetting issues (see Taxation)

TAXATION OF BUSINESS ENTERPRISE

PATENTS, TRADEMARKS AND

PROPRIETARY PROTECTION

 Patent -     Strongest protection for proprietary technology but also hardest to attain

• Subjects: Process, Machine, Manufacture of Composition, but not naturally occurring. 
• Patentable Only if New, Useful, Unobvious
• Time Bars:     U.S.: 1-Year from invention;Foreign: 1-Year from US filing if not disclosed
• Prior Art@ search on novelty, publication
• Patent Application required with US PTO, Claims (coverage)Review, approval or appeal
• Inventorship, Documentation, Ownership

Advantages – Limited Monopoly, covers Ideas, upheld against innocent users, reengineering

Disadvantages – High Threshold to achieve, cost, time, claims may be limited/circumvented. Policing

Copyright -        protection for expression, against reproduction of proprietary matter, easier to attain

• Subjects: Original works of Authorship, Fixed and Tangible medium or expression
• Copyright Coverage? Only if Expression, Reproduction or Derivative of the same Does not cover Ideas or concepts
• Registration, deposit with Copyright Office, Notice (c Name Year) useful, not required

Advantages – Long Duration, low cost/threshold

Disadvantages – Not protect ideas, only copying, not against independent devlpt or innocent use

Trademark -         word or symbol describing product or service protection available with use in commerce

• Mark cannot be descriptive or generic Prior search advisable
• “Likelihood of Confusion” test for registration or infringement
• Common Law marks or Federal or State registration,
• Proof of use in commerce (state or interstate) normally required in one or more of 42 international classes of goods or services
• Federal filing allowed with Intent To Use in 6 months (extendable)
• U.S. Priority based on First Use (or ITU filing date), Federal filing establishes use in all 50 states
• Foreign priority generally based on 1^st to file; Paris convention Federal filing date gives 6 month window to foreign filing
• Use of Ô (state or common law) or Ò (federal), other protections Affidavit of Use required after 5 years

 Trade Secret –    Broadest subject matter.  Protection for business Competitive advantages, easy to gain, difficult to maintain

• Covers: Information used in trade or business Giving advantage over Competition, and not generally known  Can include customer lists, market info, sources of supply, as well as new inventions
• Applies based on nature of secret, action to preserve it, no formal filing
• Must show value or cost in development
• Must show reasonable efforts to preserve

–Internal security – employee confidentiality

–External security – plant / computer security

–Document control, visitor non-disclosure agmts

• Not lost due to disclosure in violation of confidentiality agreement; however, gives no protection against independent discovery

CONTRACTS FOR EMPLOYEES AND SUBCONTRACTORS

Employment Agreements – Executives and key Employee contacts

 1.         Founder and Key Employees, both for loyalty and to secure key human assets

2.         Duties, Outside Affiliations, Board Control

3.         Salary Compensation, Benefits

4.         Confidentiality, New Inventions, Non-compete and restrictive covenants

Employee Manual       – Employment terms of other salaried employees

• Company policies including Confidentiality

Service Contacts – independent contractor

1.         Description of Services, milestones, reports

2.         Fees, flat, formula, segment; Expenses

3.         Warranties, indemnification, Confidentiality, non-disclosure

4.         Independent Contractor status

 Cash Compensation and Benefits

• Salary, Incentive Income (limited for start-up)
• Deferred Compensation
• Insurance/Benefits, Expense Reimbursement

 Equity Incentives / Participation

• Stock Purchase Plan
  • Income Tax on Value over Amount pai Tax paid when no substantial risk of forfeiture,
• Repurchase for Vesting / ’83(b) Election
• Attraction for 93 Tax law & 97 law rollover
• Stock Option – ISO, Incentive Stk. Option Plan
  • Strike price is original FMV, limits on amount, exercise  
  • Capital Gain on sale of stock, subject to AMT
• Stock Option – Non-Qualified
  • No IRC limits on strike price, terms or exercise 
  • Income Tax on Value over Amount paid
  • Tax paid when option is exercised – ordinary tax not CapGain
• Equity Based Compensation
• • Phantom Stock 
  • Stock appreciation Rights (SARs), Tax Gross-Ups

 Shareholder / Share Purchase Agreements

• Founders Buy-Sell Agreement
  • Goals: stabilize management, ownership provide liquidity, valuation of share
  • Means: restriction on share transfer
  • Involuntary transfer – death, disability, by legal process (divorce) – redemption/ cross sale
  • Funded Plans – via insurance – co-sale for step-up, avoid AMT 
  • Voluntary Transfers – right of 1st Refusal
• Employee Stock Restriction
  • Company Repurchase Rights 
  • IRC §83 election; standoff 
• Investor Stock Purchase
• • Warranties and Information covenants 
  • Registration Rights or exemption 
  • Tag Along and Cash-out rights 

CONTRACTS FOR PRODUCTS -MANUFACTURE  & MARKETING

Production Contracting Arrangements

 1.         Supply contracts and Purchase Orders – Battle of Forms

• Delivery, Risk of Loss
• Warranties: patent, copyright infringement, express of implied product warranties
• Remedies and Damages 

2.         Payment and Credit Terms

3.         Equipment Leasing

4.         Service Contracts

5.         Manufacturing Arrangements

• Delivery, Risk of Loss

Distribution of Products or Services

1.         Identification of Company=s market niche,

2.         Distributor and Dealer Agreements

a.         Territory, Exclusive or Non-Exclusive

b.         Sales levels, Pricing, Credit Terms

c.         Product, Parts, Supplies, Service

3.         Sales Agent / Representative

• Agreements – where customized services / products

4.         Sales Contract Terms

5.         Marketing and Promotional Arrangements

 Product Licensing

           1.         Types: Use, Manufacture, Distribution, Trademarks, Licenses, OEM, VAR, Agreements 

2.         License Terms

a.         Grant, Exclusivity Back Licenses

b.         Royalties and Audit Reports

c.         Intellectual Property Protection

d.         Warranties, Liabilities, Expert Controls

3.         Software Licensing Issues

a.         Source Code, Object Code, Escrows

b.         Shrinkwrap

c.         Boxtop licenses, Enhancements

Strategic Technology Alliances and Joint Venture Arrangements

1. Alliance of type listed above, contributions, mutual benefit
2. Can include formation of Joint Venture partnership or LLP

CONTRACTS  FOR MONEY:

Raising Capital and Securities Law Compliance

Venture Capital Finance

1.         Development of Financing Strategy

2.         Business Plan

a.         Product, Technology, Uniqueness, Edge

b.         Market, Competitive Strategy, Penetration

c.         Management Team, motivation, track record

d.         Financial Forecast, underlying assumptions

e.         Capital Sought, financing stage, funds use

3.         Valuation – from Company’s pre-money worth

4.         Presentation, negotiation, commitment, then Venture Capital Due Diligence

NONPROFIT CORPORATIONS:                           

PLANNING

 Different Purpose of Nonprofit from Business Corporation

• Civic, charitable or other public purposes
• Not formed for personal, pecuniary gain
• Can engage in limited commercial activity but profits used for organizational purpose and not distributed for private benefit
• Funding largely from contributors, grants, dues, merchandise sales, admissions

Planning for Nonprofit entity

• Goals and mission statement
• Nature and number of participants
• Operational weeds – employees, financing
• Regulating requirements
• Exposure to liability
• Tax considerations

NONPROFIT CORPORATIONS:                   

ORGANIZATION

 Articles of Organization (M.G.L. Ch: 180)

• Filed with Secretary of State
• Nonprofit purposes: civic, educational, charitable, religious,                               social clubs, chambers of commerce, business league
• Limiting assets to qualify purpose and other terms for                                            tax exempt status

 By-Laws

• Regulation and management of corporation
• Management by Board of Directors or Board of Trustees
• Meetings, treasurer, elections, committees
• Include or not include members

Registration with Division of Public Charities

• Office of Attorney General
• Before engaging in charitable work or raising funds

Annual State Filings

• Filed with Secretary of State

NONPROFIT CORPORATIONS:   

TAX EXEMPT STATUS

 Application for Federal Tax Exemption

• IRS Form 1023
• Enables tax deductible contributions to corporation
• If filed within 27 months of incorporation (15 months plus 12 month extension) tax exempt shares retroactive to filing date of incorporation

Annual Tax Reports

• IRS Form 990

Application to Mass. Department of Revenue (DOR)

• Application for Original Registration as Exempt Purchaser
• Exempt for State Sales taxes

ABOUT THE SPEAKER AND PRESENTATION . . .

           These materials were prepared by Robert A. Adelson, Esq., Partner at Engel & Schultz, LLP, 265 Franklin Street, Suite 1801, Boston, Massachusetts 02110, (617) 951-9980, fax: (617) 951-0048.  His e-mail addresses radelson@engelschultz.com. Mr. Adelson is a graduate of Boston University, Phi Beta Kappa and Northwestern University Law School in Chicago where he was a member of  Law Review.  He also has an LL.M. degree in Taxation from New York University and is a member of the Massachusetts, New York and US Tax Court Bars.

          Robert Adelson began his legal career in 1977 as an associate at major New York City law firms, first Dewey Ballantine and later Weil Gotshal & Manges, before returning home to Massachusetts in 1985, where he has been a partner at several Boston firms before joining his present firm as senior business law partner in 2000.  Mr. Adelson is specialized in corporate, taxation, finance, commercial and technology contracting law.  In those areas, he frequently represents startup and smaller companies in software, and other technology-based fields.  He also represents executives or consultants in executive compensation and stockholder arrangements, incorporation and liability protection, intellectual property protection, and in vendor, client and subcontractor contracting arrangements.

          Mr. Adelson’s  law firm, Engel & Schultz, LLP, is a small but broad service law firm of 6 attorneys in Boston.  The firm complements Mr. Adelson’s work in business and tax law with seasoned attorneys in family, probate, real estate and litigation matters. 

          Mr. Adelson is a frequent speaker at business forums. Additional information on the subjects on which he speaks is shown at www.engelschultz.com/index.php/category/publications/  Further information on Mr. Adelson’s background and his past published articles is available at his law firm website www.engelschultz.com/index.php/attorneys/partners/robert-adelson/

           The speaker thanks Artem Efremkin, for the invitation to speak to Young Entrepreneurs of Tufts (YET) on the topic of “Business Formation and Early Stage Tax and Legal Issues” at the YET meeting in Medford, Massachusetts, on March 3, 2010.

          The examples on page 1 of these Materials are hypothetical and fictitious in their entirety (although the questions on page 2 are drawn from actual client questions).  The purpose of the examples and materials, as developed by Robert Adelson, is solely to illustrate planning concepts and stimulate meeting discussion.  The purpose of the remainder of these materials is to illustrate and offer rough outlines of broad areas of corporate, tax, contracts and business law which affect choice of business entity and issues in the structure of start-up and early stage businesses including issues of finance, executive and employee recruitment, stock and compensation in high technology and more traditional fields.  Thus, it is hoped these materials will be informative to those in attendance.  These materials are not legal advice and not intended as any substitute for professional advice or counsel in a particular case.

By Robert A. Adelson, Esq. ©2010.  All Rights Reserved.