April 7, 2014

Whether you’re contemplating founding a startup or you’ve already taken the plunge, legal issues probably make you wish you had a lawyer on speed dial. If only you weren’t bootstrapping.

Ben Nowacky, the founder of North County Tech Startups feels your pain. He has arranged for the Meetup group to host two separate events during which local lawyers shared some of the common legal mistakes made by startups and provided clarification on common issues, such as company structure and distribution of equity. Brian R. Dirkmaat, an attorney with Coast Law Group in Encinitas, works almost exclusively with entrepreneurs. He advises clients what basic legal services they need and at what time, and his firm offers flat-priced packages for some common legal tasks, to help startups with limited funds build a strong foundation.

Below are abbreviated responses to some of the questions posed to Dirkmaat during a recent North County Tech Startup meeting.

Q: Where should I incorporate: California, Delaware, Nevada? I’ve heard different things about other states being a more favorable place to incorporate?

Brian Dirkmaat: If a company is incorporated outside of California but plans to do business here, it must qualify to do business in California. File a qualification form for a foreign entity with the state, such as an “Application to Register” for an LLC. You’ll pay a one-time filing fee, but be prepared to also pay a minimum of $800 franchise tax annually to California.

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Delaware has long established itself as a business-friendly place to incorporate, particularly by making its laws more favorable to management and large investors. It’s also friendly to small companies. A small company with 5,000 shares or less would pay a $75 flat tax. However, if you’re also doing business in California, you’ll have to pay at least $800 annually to its State Franchise Tax Board.

Incorporating in Nevada, another favorable tax state, when you live and do business in California will raise a red flag with regulatory agencies, including the IRS and California Franchise Tax Board.

Q: How do you determine the format of a company’s structure: sole proprietor, partnership, LLC, S corp or L corp?

Dirkmaat: Creating a corporation is creating another legal body: in many ways it’s like a person that has rights and pays taxes but cannot vote. It makes a company separate from the people who formed it, giving them protection from liability.

A sole proprietor is the most simple company structure. The sole proprietor is taxed on the company’s revenue and liable for all commitments and services made by the company.

A partnership is two or more people deciding to do business together to make a profit. The courts have found partnerships to exist when there has been no formal partnership agreement or document. It’s a very amorphous business arrangement. Partners can distribute responsibilities and equity. Tax considerations are similar to a sole proprietorship, but assets are owned by the partnership, not the individuals.

A limited liability company, or LLC, is a business structure that was not available in California until 1994. Its participants can determine the distribution of labor, investment and equity. Coast Law Group has standard LLC agreements to help founders do this properly, simply and on a tight budget. This company structure allows founders to be very creative, but the more unique the agreement the more you should anticipate in legal costs.

S corps and C corps are the more rigid business structures. While they have many similarities, an S corp elects a certain tax status defined by subchapter S under the Internal Revenue Code. Corporations are required to be treated as a separate entity with its own bank account and credit card, which cannot then be used for personal purchases. Corporation guidelines also clearly dictate certain procedures, such as the election of officers.

All corporations are C corps by default. A C corp pays income tax on its revenue. This could result in that money being taxed twice: once as revenue and again as distribution given to shareholders in dividends.

For an S corp, the shareholders must elect for the C corp to be taxed as an S corp. The tax responsibility flows through the corporation to the individual, like in a partnership or LLC. But there are limits on the number of shareholders and no entity can be a shareholder, as well as no non-resident alien. It also cannot issue preferred stock.

What starts out as an S corp can easily roll into a C corp.

Q. When should one apply for a copyright vs. a trademark?

Dirkmaat: It’s easy to go to www.copyright.gov and pay a $35 fee to apply for a copyright. However, you will need to submit a copy of what it is you’re seeking to copyright. For a tech company, that would include disclosing source code. You could seek the help of an attorney so that you would only have to submit a portion of the code. On a related note, you need to watch what open source code you are using and the applicable licensing restrictions, and make sure you’re not in violation.

A basic trademark costs about $325 per “class” at filing, along with legal fees. It’s worth it to protect your brand.

Q. Can you provide some advice on issuing equity?

Dirkmaat: When it comes to issuing equity, I would advise you to be really stingy! A lot of companies are cash-strapped so they decide to issue equity for services. It’s just reckless. It not only dilutes the company, it can be like herding cats when you have to find all these shareholders when you need an approval. The fewer shareholders the better.

Bootstrap as much as possible. Find creative ways to cut costs.

“Slicing Pie: Funding Your Company Without Funds,” a book by Mike Moyer, is all about creative ways to cut cost and goes into depth explaining a formula for what the author calls “a dynamic equity split,” which allows founders to acquire a percentage of equity based on work performed.

About North County Tech Startups:

Nowacky, a startup founder, was surprised at the lack of resources for startups in North County. He created the group to help entrepreneurs access resources and opportunities outside downtown San Diego, to provide a networking environment through which they could make connections to fuel their success. The group meets in space provided by SoCal Entrepreneurial Ecosystems Development (socaleed.org), which operates a coworking hub on Mission Ave, in San Marcos and has launched a wireless health incubator (meetup.com/wireless health hub).

Terri Somers, principal in Somers Media, a start-up PR company, was a beat and business reporter for 25 years. Send suggestions or ideas to [email protected]

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