Question: What is the correct legal entity for a startup currently based in Israel but building a SaaS product serving the US market? Should they incorporate in the US first, or in their locally?

Answer: There is no “correct” legal entity choice here really. The particular tax circumstances of the Founders of the entity, and the nature of the business operations of the entity—in terms of the ebbs and flows of cash and expenses, will dictate the identity of the best type of legal entity through which to conduct the business. Add to that the advice of US and Israeli tax consultants, and you can then begin to make an intelligent decision.

Where the business operations that result in the creation of the product, and where the administrative offices and executive function for the company are located, more than where the product is used, should dictate the jurisdiction in which the business entity is formed. The fact that the product is a SaaS product being sold into the US market, if that is the only contact that the business operations have with the US, does not mean that the company should be incorporated in the US.

Peter Rothberg

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: Can you deduct business expenses before your company has revenue? If so, what business expenses are deductible?

Answer: Apart from organizational expenses of the business which will be capitalized (e.g., which constitute part of the “tax” investment in the company and are recoverable through depreciation, amortization and/or sale of the business) you most certainly can deduct business expenses before your company has revenue. Such deductions will result in your company generating net operating losses, which can be “banked” and carried forward generally for several years into the future to offset future tax bills on revenue that is generated later. Generally, the following business expenses are tax deductible: employee compensation, professional advisor fees, rent, utilities, income taxes, property taxes and travel and entertainment expenses (subject to specific limitations).

Peter Rothberg

Question provided by Andrea Zapatka

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: Is there a “tax attractiveness” difference with respect to an acquisition if the company being sold is a corporation or an LLC?

Answer: From an acquisition tax attractiveness perspective, while sale of a regular C corporation (as compared to an LLC that elects treatment as a partnership for tax purposes) would generally be considered to be tax detrimental as compared to sale of an LLC, an S corporation may be able to provide certain LLC-type tax benefits.  For example, an acquirer of at least 80% of the S corporation’s stock (with an accompanying Internal Revenue Code (IRC) Section 338(h)(10) election, which election is required to be made jointly by buyer and seller in order to be effective) or an acquirer of the S corporation’s assets, can obtain a “purchase price”  tax basis in the S corporation assets similar to acquisition of assets or membership interests from an LLC.  This enables the acquirer to claim additional depreciation/amortization deductions, as well to use any additional non-depreciated/amortized tax basis, to reduce/offset future taxable income or gain as would occur with an LLC.  With the sale of an S corporation or an LLC the selling shareholders/members recognize only a single level of tax in such acquisition, and they may be eligible to pay tax at the preferential long-term capital gains tax rate.  The foregoing would not be available for an acquirer of less than 80% of the S corporation’s stock (e.g., the selling shareholders retain more than 20% of the S corporation’s stock).  In addition, even when the acquirer acquires at least 80%, but less than all, of the selling shareholders S corporation stock (with the selling shareholders retaining the un-acquired stock), the “tax basis step-up” in the acquired S corporation’s assets that would result from the making of a Section 338(h)(10) election would come at a tax cost to the selling shareholders (e.g., there would be a deemed taxable sale of 100% of the S corporation’s assets even though the selling shareholders sell less than all of their S corporation stock).  Finally, in all likelihood, the selling shareholders’ retained shares will lose the benefit of S corporation status, with the result that the investment in the retained S corporation shares will “convert” for tax purposes into an investment in a regular C corporation.

By comparison, the acquirer of a C corporation could only obtain a “purchase price”/“stepped up” tax basis in the C corporation’s assets at a tax cost to the selling shareholders of two levels of income tax – a corporate-level income tax and a shareholder-level income tax (which would be recognized at such time that the C corporation distributes, or is deemed to distribute, its after-corporate income tax sale proceeds to the shareholders).  This tax cost could be significantly reduced if the C corporation (and its stock) qualifies for the benefits of IRC Section 1202 (partial exclusion for gain from certain small business stock, with the amount of such reduction further depending on when the qualified small business stock is acquired—with the exclusion being 100% if the qualified stock is acquired before the end of 2010).

Finally, if a C corporation (but not an LLC that is treated as a partnership for tax purposes) were to incur debt any portion of which is written off as part of the sale transaction, any resulting “cancellation of indebtedness” income would not flow-through and be taxed to the shareholders.  However, in the case of an S corporation or an LLC that is treated as a partnership for tax purposes, the members of the LLC or the S corporation shareholders would be required to report, and pay tax on, such income (in the absence of an otherwise applicable exemption or exception).

Peter Rothberg

Question provided by Caroline Byrne, founder of Know It All Neighbor.

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: At what stage should startups incorporate?

Answer: The short answer to this question is that a startup should incorporate (or work through a limited liability entity) as soon as it commences commercial operations.  Commercial operations begin with the first activities that are undertaken by the business, even if they are not revenue generating in themselves. For example, the hiring of employees or independent contractors, or the purchase of supplies for the business, both of which may precede the performance of activities directly related to the generation of revenue, constitute activities which are part of commercial operations.  Even at the early stage, you will want to protect your personal assets from the claims of creditors by using the shield of operating in corporate form.

Peter Rothberg

Question provided by Simran Anand and Andrea Zapatka

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: I’m an independent consultant focused on working with early stage startups in exchange for equity.  What’s the best way to structure equity-based compensation with nascent/small companies?

Answer: I believe the best way to structure this type of compensation is to receive an option to acquire shares of the startup at an exercise price that is equal to the “fair market value” of the securities underlying the option on the date that the option is granted. Of course, this begs the question: “What’s the fair market value of those securities?”

Well, that’s a question that you can’t get around, no matter how you slice it. The IRS is going to tax you on the compensation that you received from the startup, so you need to determine the amount of compensation received—the value of the securities– at some point. The startup can get a valuation for its securities these days from an independent consultant for approximately $5,000 if it has to go outside the company because it doesn’t have anyone sufficiently skilled to do it internally. If they hunt around, they might even find someone hungry enough to do it cheaper (although as in all things, you get what you pay for).

Back to you—the recipient of the compensation. The reason why an option works is that if the “non-qualified” option (the only type that you, as a consultant, can receive) is granted to you at an exercise price equal to fair market value on the date of grant, the IRS does not regard you as having received compensation at the time of option receipt. Hence no tax THEN. When you exercise the option, and acquire the underlying securities of the startup, you will be taxed THEN on the difference between the exercise price and the fair market value of the underlying securities on the date of exercise. But that’s not a bad problem to have—at least you’re being taxed on real value received, and you get to choose when you get taxed: at the time of option exercise. Ostensibly, you wouldn’t have gone out of pocket to pay the exercise price if the securities didn’t have value at the time of exercise. Under other scenarios, you might have been taxed on the value of what you received at a time NOT of your choosing.

Answer provided by Peter Rothberg – (website, LinkedIn @FatherR), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: Are there any benefits to registering as an INC vs. LLC in terms of attractiveness to future investors/acquirers?

Answer: Although there are a number of reasons for entrepreneurs to organize their companies as LLCs (e.g., tax planning; avoidance of double taxation on profits—at the entity and the personal level), there’s one very important reason to incorporate your startup. Venture Funds, and many institutional Angel Groups, don’t like to invest in LLCs.  There are many reasons for that, and we have begun to see some institutional venture deals done with LLCs. But the reasons why don’t matter.

If you are planning to raise money from Venture  Funds at a time that is early enough in your startup’s development that you won’t have sufficient time to reap the tax benefits accorded to LLC membership, then just bite the bullet and go directly to incorporation. It’s cheaper and easier to go that route in the first place. Plus, you will save the cost, time and headache of conversion to a corporation later when your institutional investors tell you that they’ll only invest if you do so.

Answer provided by Peter Rothberg – (website, LinkedIn @FatherR), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What are the most tax effective ways for founders to “Pay themselves” for efforts in a startup after the initial startup share allocation round. Is there a more effective method apart from options?

Answer: Well, option grants are a tried and true method of post-funding Founder compensation, but not all options are created equal. Option grants to Founder employees working for a funded corporation should be made under the terms of a stockholder- approved employee incentive plan (“Plan”) that permits the issuance of incentive stock options (“ISOs”). With ISOs, the tax on any increased value of the underlying shares between the dates of option grant and option exercise is deferred until the underlying shares are sold—not on option exercise. In addition, with ISOs, the tax on such increased value can be paid at the preferential long-term capital gains rates, rather than the higher ordinary income rates, depending upon how long the underlying shares are held after ISO exercise (although the paying corporation would not be entitled to any compensation deduction for the value of the gained realized on sale of the shares underlying such ISOs). This is quite a difference from non–ISO options, or non-qualified options (“NQOs”), where the holder of the NQO is required to recognize ordinary compensation income on option exercise equal to the difference between the option exercise price and the fair market value of the underlying shares on the date of option exercise itself. Any tax payable on that gain is not deferred until the underlying shares are sold—resulting in the potential for a tax payment when there are no proceeds from the sale of the underlying shares to defray the tax. Finally, with NQOs, if the NQO holder is an employee – rather than an independent contractor –the gain recognized on option exercise constitutes “wages” with respect to which the company would be subject to withholding/payroll taxes.

A Founder of a corporation can also be compensated post-funding with “restricted stock”. Restricted stock awards are made without associated payment by the Founder recipient and can be made under the same Plan as ISOs. In general, a recipient of restricted stock must recognize ordinary compensation income when such stock vests, or immediately upon grant for the portion of such stock subject to an 83(b) election. The value of the award subject to tax equals the vesting date fair market value of the portion of the restricted stock that vests (or, in the case of an 83(b) election, the grant date fair market value of the entire grant). Such fair market value could be determined by reference to a recent arms-length equity or debt funding event for the company. If the restricted stock award vests over time – and no 83(b) election is filed– then the Founder would recognize ordinary compensation income on the vesting date (and the company would have a corresponding withholding and employment tax obligation in respect of such income) equal to the fair market value of the restricted stock that vests on that vesting date. Accordingly, this can create the “perverse” situation in which the Founder’s successful efforts to increase the company’s enterprise value could have an adverse “economic” impact by causing a corresponding increase in restricted stock valuation (and, thus, a corresponding increase in taxable income liability for the Founder and an increase in withholding and employment tax liability for the company) over the vesting period. The Founder and the company could find themselves in the unenviable position of being unable to sell (or otherwise monetize) a sufficient amount of the vested shares, or otherwise be unable to raise a sufficient amount of cash from other sources, to pay the resulting income tax liability or, in the case of the company, the resulting withholding and employment tax liability.

One means of addressing this increasing enterprise valuation “problem” is for the Founder to consider making an “83(b) election” to pay immediate tax on the value of the entire restricted stock award at the time it is granted, even though the entire award may never vest. By making this election the Founder would have only a single compensation tax event in respect of the restricted stock award, with the Founder immediately recognizing ordinary compensation income equal to the fair market value of all the restricted stock subject to the award determined without regard to the vesting to which the stock is subject. The Founder and the company would have an immediate compensatory tax event as a result of the election, and would need to have sufficient cash to pay the resulting income and withholding and employment tax liabilities, as applicable, at a time when cash may be in short supply for both the Founder and the employer-company. The subsequent vesting of the restricted stock in accordance with the original terms of the award would not be a tax event and the Founder would only recognize additional income in respect of such stock upon the actual sale of the stock (to the extent of any gain above the fair market value of the shares on the date of the original award). Any resulting taxable gain from such sale would constitute preferential long-term capital gain (rather than ordinary income) if the shares are held for more than one year from the date of the award. However, the downside of making the 83(b) election for a restricted stock award includes: (a) the Founder would not be entitled to claim any loss deduction (or otherwise have any refund claim) on any of the previously-paid income tax if the shares do not vest; and (ii) the Founder may only recover any decline in value of any non-forfeited restricted stock as a capital loss (even though the Founder would have paid tax at ordinary income tax levels by making the 83(b) election).

Finally, if the Founder’s business is being conducted as a “limited liability company” (rather than as a corporation), a Founder can be compensated by being issued a “profits interest” in the limited liability company— a specially designed economic interest in a company’s profitability. Under current IRS guidance, such a “profits interest” could be issued free of income tax and withholding/employment taxes. In addition, since such a “profits interest” would constitute an interest in the limited liability company, the Founder would be taxed on, or receive a deduction equal to, his/her allocable share of the limited liability company’s income and gain or loss, as applicable. Also, except for the Founder’s share of certain assets of the limited liability company, the Founder would recognize preferential long-term capital gain if the “profits interest” was held for more than one year prior to its sale. That said, however, it should be noted that Congress is currently considering legislation that could subject certain types of “profits interests” to ordinary income treatment (e.g., carried interests in private equity funds).

Answer provided by Peter Rothberg – (website, LinkedIn @FatherR), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question:

1. Is it legal and acceptable for a start up to receive donations from fans or well wishers through its website to fund business operations? For example, having a donation section which enables fans to send donations via checks or accepts credit card payment from the website or paypal account.
2. Are there tax implications?
3. Does this impede or cause complications if the firm expects to be funded by an angel or VC in the ensuing months.
4. Is there any other question i should have asked but did not mention?

Classic Scenario: The business focuses on a particular team or sport; publishes fan content and creates a professional social media website that aggregates fans of that particular sport and it facilitates their viral communication on its platform. Examples include Lakers-Fan, Yankeestown and The Red Sox Fan Site

Donation is used fund commuting, interviews, video processing, website maintenance, hosting cost, consultants and much more.

Answer:

Although in the context of for profit businesses the concept of “donation” or “gift” –a nontaxable contribution–doesn’t usually fit, “fan” donations to your startup business  might not be taxable income to the Company. The fan donations  should be for the purpose of adding to the capital of the Company, cannot be contributed in payment for specific goods sold or services provided by the Company  and  must be employed to generate additional Company income—in other words, the donations must benefit the Company itself and not constitute some form of a quid pro quo payment.

Where you could run into trouble is if the IRS considers the donations to be “solicited “ by the Company. If they are, the dollar amount of the fan donations could be viewed as additional taxable Company income. Just having a place on your web site where fans can make a donation to the Company “in gratitude” for the Company’s pursuit of its mission, without a public campaign for such donations or your web site turning into a ”beg-a-thon” for them, may not qualify as solicitation. But a detailed legal analysis, based upon the specific facts surrounding the donations, is very important here.

If you intend these donations to constitute a significant portion of the Company’s operating funds during its startup phase, and you plan to seek venture capital or other institutional financing for the Company, I’d seek a formal memorandum from your counsel or accountants on the issue. The folks that finance your Company will want comfort that you’ve paid all applicable taxes along the way. If you don’t pay taxes on these contributions when you should have, not only will it blow your credibility with those folks, but it will leave you with an expensive bill due to the IRS and state taxing authorities—not only will you owe the back taxes that were unpaid but you’ll owe interest and penalties on top of it.

So, be careful!

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What are the advantages and disadvantages of convertible debt vs. equity?

Answer: As we’ve discussed in previous postings, I am very much in favor of the convertible note scenario for non-institutional rounds of financing. To recap, the convertible note structure replaces the sale by early stage companies of equity securities, at a set valuation per share, with the sale of promissory notes that are convertible into Company equity in connection with the next round of equity financing by the Company (usually defined as the “first round of institutional equity financing”).

The upside to the convertible note structure is that you can get to a deal faster—without the haggling over valuation at an early stage of a company’s development when there usually isn’t a whole lot upon which to base that discussion. As a result of the transaction being a debt deal, the covenants and protective provisions with respect to Company operations are more abbreviated than those found in equity deal documentation. It is also unnecessary to spell out the detailed management and interest transfer provisions that are always found in institutional-level equity purchase documents. This translates into a transaction that allows the Company to obtain equity-like cash funding much faster and less expensively.

The downside to the convertible note structure results from the convertible note holders demanding a conversion rate for their debt that reflects too high a discount to the purchase price paid by the institutional players in the equity round. The institutional equity players are familiar with the convertible note structure and in almost all cases accept a discount of up to 15%–an acceptable cost for the “early funding” risk taken by the note holders. But when the convertible note holders demand a discount in excess of that level (and they frequently do—especially if the distance between note funding and equity round exceeds 12 months), you can run into resistance from the institutional round players. This can hold up—or kill– your equity round while the note holders and the institutional equity players have fun playing “chicken” –at your expense– over the acceptable level of discount to the purchase price.

So, be careful sports fans. It’s dangerous out there.

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What legal language does a typical disclaimer on a website have to have? (For review websites, product or business reviews.)

Answer: The type of disclaimer to be used on a web site is a very fact sensitive issue. You must first establish the nature of the transactions taking place on the website, and then select the disclaimer that best fits that situation. Not a one size fits all.

In the case presented here, we have a web site that will publish endorsements of products and other services. There is recent guidance from the Federal Trade Commission (FTC) on the subject of endorsements and testimonials. The context of the discussion is that the FTC considers endorsements and testimonials to be a form of advertising for the product or service being discussed, and applies “Truth in Advertising” concepts to those pronouncements and discussions. As a result, when there exists a connection between the endorser and the seller of the advertised product that might materially affect the weight or credibility of the endorsement (i.e., the connection is not reasonably expected by the audience of the endorsement), such connection must be fully disclosed.

So, in the event that a particular “endorsement” appears on a website that a reasonable consumer might not expect to be publishing  reviews of products or services that are sponsored by providers of the subject products and services, the fact of that sponsorship  must be disclosed. That disclosure can take the form of a Disclaimer on the website that is so placed that the reasonable site visitor can find it and be able to relate it to the subject  endorsements. If all the reviews on a website are “sponsored”, then a more general Disclaimer should appear quite prominently on the website, and perhaps also in the website’s Terms of Service.  A typical Disclaimer might take the following form: “THE VIEWS EXPRESSED ABOVE BY [IDENTIFY THE ENDORSER] ARE SPONSORED BY [IDENTIFY THE SPONSOR] AND MAY NOT REFLECT EITHER THE INDEPENDENT VIEWS OF [IDENTIFY THE ENDORSER] OR AN OBJECTIVE REVIEW OF THE PRODUCTS AND SERVICES DISCUSSED.”

Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.