George Grellas Startups May Benefit From Incorporating Earlier Than Small Businesses

February 16th, 2010 skmurphy

George Grellas has been practicing business law in Cupertino since 1984. He had some brief remarks relating to formation issues at today’s breakfast and then he opened it up for questions. What follows is an edited transcript of his opening remarks.

Startups are interesting. It’s a rather grim time in a macro-economic sense but for early stage startups it’s a pretty amazing time because the infrastructure has been built out. There is a lot of opportunity to launch companies creatively without the capital intensive needs that were there a decade or two ago.

Of course there are many situations where you have capital intensive needs and that occupies the traditional VC realm. But there is a huge and expanding area in the last decade, and the last few years in particular, where with creativity and innovative focus on areas like enterprise people can leverage very interesting business models in ways that used to be unthinkable without a lot of money.

So today is a time of expanded opportunities and many many people are venturing into startup mode. When they do there is always a desire to keep costs low on the legal side–which is a legitimate desire obviously–but I think that sometimes leads teams to ignore some strategic issues that they should focus on.

There are some distinctive elements of startups that set them apart from standard small businesses. Most of them have to do with the fact that most of the value is largely associated with intangibles like intellectual property. So when you form a startup you can have tax issues that arise from intellectual property that standard small businesses won’t see.

You have capital combined with entrepreneurial innovation. If they match at the same time you can have service income attributable to the entrepreneur unless it’s planned right. These are reasons to incorporate earlier rather than later.

Just to illustrate: if you have a new venture that you are launching as an entrepreneur and someone is going to put in 100K for 10% of the company, if you do that at the same time for the same class of stock you can have potential service income attributable to the entrepreneur or founding team, as much as 900K in that hypothetical situation.

The other major attribute of a startup is that you want some “strings” on the stock for the same reason: the value being contributed by each founder is often tied to the services they are providing going forward. So usually instead of outright stock grants you have restricted grants.  Meaning that the founders stock is subject to repurchase at the original price if the relationship with the company should terminate.

So, when people do these “insta corps” on-line they will often have a founding team and not factor these issues in as they are trying to save money. They will get the kit and issue stock and then you have a situation where founders can walk away and keep their stock instead of having to earn it.

The other thing that people tend to forget about is capturing intellectual property (IP) properly. They are working together as a founding team, they haven’t formed the company yet, and they are not focused on the fact that everyone working on the venture, in so far as they are doing things that may be generating IP, that IP does not belong to the venture it belongs to the individuals. They don’t factor in the need for an IP assignment agreement in exchange for stock in a corporation.

Related Links:

• “What is the difference between a startup and a small business?“
• Startup Law 101 Series – “Distinctive legal aspects of forming a startup business with a founding team.“
• “Silicon Valley Circa 1956, A Valley That is No More.“
• “George Grellas on Insightful vs. ‘Window Dressing’ Advisory Boards.“

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