LEGAL CORNER

The Making of RockStar Incorporated
(Part II – The Creation Story)
By Daniel A. Shmalo, Esq.

To incorporate or not to incorporate? A silly question – it is almost always beneficial to operate a business as a chartered entity e.g. corporation or limited liability company. The creation of the business entity (let us call her RockStar Incorporated) is usually the first serious legal step in the life of a startup technology business. A well-organized corporation will memorialize the business relationship among the founders and other key players in mutually agreeable and legally sound contracts. These agreements set legally enforceable rules and expectations that will carry RockStar Incorporated forward on firm footing.

For tech-based startups, incorporation usually creates a significant change in the founders’ relationships. Before incorporation, they may be working as a team, but ownership of the technology they have created may not be shared among them. If some but not all founders have developed the technology, they own it, not the whole team. Investors almost always require that the founders transfer ownership of the technology (and all relevant intellectual property) to the company. Since the company is owned by all the founders (and, sooner or later, investors), those who contributed the technology now are sharing ownership with all of the others who own stock in the company. This is an irrevocable act; if the company doesn’t succeed, the founder who provided the technology can’t take it back and start again. Outside investors and creditors of the company may have first dibs on the technology and other business assets. There are alternatives to an outright transfer (license, sale-lease back, repurchase rights) that can have an effect on the allocation of ownership and on the contributing founder’s future rights but that is a subject for another time.

At the startup stage a corporation is typically embodied in three legal documents:

1. Charter. The corporate charter (called the “Articles of Incorporation” in most states) is typically filed in the office of the secretary of state. Many businesses chose to incorporate in Delaware over their “home” state (yup, yet another article). The charter sets the core legal framework of the company. It should include the capital structure, terms of the company’s classes of stock, relative rights of each group of stockholders, and – optionally - indemnification protection for directors and officers. As investors contribute money to RockStar Incorporated, they will typically receive preferred stock, giving them special rights. These rights are implemented either in provisions in the charter or in other contracts such as a shareholders agreement, a voting agreement or an investors rights agreement.

2. Bylaws. The bylaws establish more specific rules for governing RockStar Incorporated. They typically cover issues such as how stockholder and board of directors meetings are called, how directors and officers are appointed and removed, and the scope of their authority. The bylaws have a significant effect on who controls the management of the company and thus its operations. The bylaws must be drafted to be consistent with the laws of the state of incorporation.

3. Shareholder Agreement. The Shareholder (or stockholder) Agreement is a contract among some or all of the shareholders of the company. This agreement is private and not filed with a state or federal agency. It is highly flexible in terms of the subjects it can deal with and the ability of the parties to change it before or during its life.

Issues typically covered in a Shareholder Agreement include:

• Election of Directors and Officers
• Voting Agreements
• Buy-Sell
• Restricted Stock – Buybacks
• Transfer Restrictions / Right of First Refusal
• Drag-Along, Tag-Along

These terms and more will be discussed and expanded upon in The Making of RockStar Incorporated, Part II – The Shareholder Agreement.

Take Away: Good order is the foundation of all things - Edmund Burke. For a new company, a well thought out set of organizational documents will limit the surprises and uncertainty down the road.

For more complete information, serious analysis, and sold legal advice, contact:
Daniel A. Shmalo, Esq.
dshmalo@360vLaw.com
404.575.4360

or visit www.360vLaw.com