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    Top 3 Business Formation Options

    Giving Your Start-Up a Head Start

    It’s time to commit to that great business idea you’ve been fantasizing about. This is a brave and bold move. Although you will face many challenges, watching your company grow and succeed will be extremely rewarding.

    By now, you’ve Googled how to start a business, done your research, hopefully started a business plan and financial plan. Now you’ll need to determine your business structure. This is a very important step in the process and can be a bit confusing. It is always wise to reach out to a knowledgeable business attorney who can help you select the business structure that best meets your unique needs.

    There are several business structure options to choose from. This decision will significantly impact your business profit, liability and taxes. You can always reevaluate and change your business structure as your business grows and needs change. Getting the assistance of an attorney, capable of navigating the nuances of business formation will ensure that your amazing business idea is set-up for success from day one.

    To get started deciding which business structure best fits your needs and goals, here are the 3 Top Business Formation Options.

    1. Limited Liability Company (LLC):
      • Owners of an LLC are called members rather than partners or shareholders. You can form an LLC with only one member, like a sole proprietor (without the personal Liability), or with multiple members.
      • This type of business formation carries with it similar benefits of both a Corporation and a Limited Liability Partnership (LLP), without some of the burdens those business structures may involve.
      • Similar to a corporation, an LLC is a separate entity from the owner, providing legal and financial protection. This protection allows an owner to avoid taking on the personal responsibilities for any debt or liabilities of their business.
      • Most small business start-ups will open as an LLC rather than a corporation. Forming an LLC is generally less expensive to start, has less formalities and you don’t have to pay corporate taxes on top of individual taxes. Limited Liability Companies share the same tax benefits as an LLP, where each member is taxed based on the owner’s individual income.
    2. Corporation
      • A Corporation is a company or group of people that are authorized to act as a single entity. This option is preferred by companies who are looking for outside investors or who want to take their company public.
      • Forming a corporation is essentially creating a person (legally a person). It is not a human being of course, but it is a single entity, that has a lot of the same rights and obligations of a person. This ‘person’ has a name, must pay taxes, debts and is liable for any wrongdoings.
      • Some believe that a corporation is the most advantageous business structure. A corporation is made up of individual directors (board of directors), officers and its members, called shareholders, which own a percentage of the business or stocks. This single entity is separate from the owners, providing legal and financial protection to its members, similar to an LLC.
    3. Limited Liability Partnership (LLP)
      • The main advantage of an LLP is that all partners are protected by some form of liability protection. An LLP is basically a general partnership, but it gives the partners some limited personal liability. In this jointly-owned business, two or more people agree to share in all assets, profits and financial and legal liabilities.
      • It is similar to an LLC in many aspects, including how individual owners are taxed. The structure does differ in that an LLP must have a managing partner that is liable for the actions of the partnership.
      • It is important to be aware that some states recognize LLPs formed in other states (called foreign LLPs), and some states do not. This could affect the limitation of liability in the other states, possibly treating your business as a General Partnership. With a General Partnership, owners are left unprotected. They are personally responsible for business liabilities and debts. This means that their personal assets can be seized and partners may be sued for business debts.
      • The degree of liability limitation for an LLP varies from state to state. It is crucial to do your research and/or reach out to a qualified attorney.

    Yes, these options can be confusing and there is so much more to consider when starting a business. Will you have members, partners or shareholders?  How will you divide the company? Should you have a Start-up Equity Agreement and Co-founder Equity Agreements? Fortunately there is help.

    Attorney, Matthew Rossetti, specializes in start-up businesses and the formation of companies. He is the premier “Slicing Pie” expert in the midwest. Rossetti uses a custom dynamic business formation model to create a perfectly fair equity split, in the early stages of a company. Set up a 30 minute consultation for guidance.

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    Non-Competes: Useful Or Futile?

    By Matt Rossetti

    Originally Published on Forbes.com here.

    Bound by a Non-Compete?

    At least half of the founders who contact me are contractually bound by some sort of covenant not to compete with a current or former employer. A covenant not to compete is a contract between an employer and employee or contractor in which the employee or contractor agrees not to work for competitors of the employer for a specific amount of time after the employee or contractor completes their service to the employer. Whether you are an employee, contractor or employer, there are three basic issues to think about when analyzing your non-compete: purpose, restrictions and enforceability.

    Purpose

    Non-compete agreements protect proprietary information and restrict where an employee or contractor may work during the contract — and sometimes after they complete their service to an employer.

    The first purpose of a non-compete is tantamount to a non-disclosure agreement, as its goal is to keep a current or former employee or contractor from disclosing proprietary information to a third party. Proprietary information includes more than just intellectual property and can be anything from financial plans to marketing strategies and data.

    The second purpose is a work restriction on the current or former employee or contractor. Work restrictions contractually limit a current or former employee or contractor from working for a competitor in the same market or geographical area for a set amount of time.

    Restrictions

    Non-competes are a severe restriction on commerce and an individual’s ability to make a living. Because of this, the prevailing trend is to limit or bar the enforceability of non-competes. This enforceability, however, varies greatly by state.

    In states like California, non-competes are unenforceable as a matter of law if they restrict an employee or contractor’s activities after the term of the contract. There is a common misconception that non-compete clauses are still enforceable against California contractors (they are not). The relevant provision of CA’s Business and Professions Code Section 16600 states: “16600. Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”

    Other states like Georgia provide employers specific guidelines for the enforceability of restrictive covenants Ga. Code Ann. § 13-8-53 (May 11, 2011).

    When reviewing your non-compete, you should have an attorney check the laws of the state where both the employer and the employee/contractor are located for restrictions.

    Enforceability

    For a covenant not to compete to be enforceable, there must be some form of consideration. Consideration may come in the form of payment with something of value or money. If an agreement containing a non-compete is signed at the outset of an employee or contractor’s employment, most courts will find that continuing employment is adequate consideration for the non-compete. However, if an employer tenders a non-compete to a current or former employee or contractor without consideration, then most courts will find that non-compete invalid for want of consideration.

    Because a non-compete may severely restrict an individual’s ability to make a living, the restrictions must be reasonable in scope. I recently had a software engineer present me with an independent contractor agreement that would have restricted him from performing any services as an engineer, whether indirectly or directly competitive with his employer, for five calendar years post-employment and without a geographic limitation. If enforceable, this agreement would have prevented the contractor from working as a software engineer in any capacity for five years.

    While proprietary information protected by a non-compete may be broadly interpreted and include more than just intellectual property, work restrictions must be reasonable in duration and geographic location. Generally speaking, a covenant not to compete should only last for one to two years maximum. The geographic limitation should also be reasonable in light of the circumstances. While a software engineer might be restricted from working in a certain market, it is probably not fair to ask a fast food worker not to work for a competitor globally.

    In many states, the employer bears the burden of showing that restrictions are both reasonable and necessary to protect against unfair competition. While some states might enforce this agreement, a state’s courts often are allowed to “blue pencil” non-compete provisions to those aspects that are absolutely necessary to prevent a competitor from gaining an unfair advantage.

    Restrictive covenants like non-competes can be unenforceable as a matter of law or cause all involved significant hardship in the future. I highly encourage employers, contractors and employees to avoid using form or stock agreements that contain non-competes without a licensed attorney’s review. An ounce of prevention is worth a pound of cure.

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    After the Equity Split: Compete or Non-Compete

    By Matt Rossetti

    Original article written for SlicingPie.com

    One of the often-overlooked features of the Slicing Pie model is the logical outcomes regarding a person’s ability to compete with the startup after a separation. Getting a fair deal for everyone is more than just splitting equity correctly.

    In any company, there are four basic conditions under which a person can be separated from the firm:

    1. He or she can be fired for good reason
    2. He or she can be fired for no good reason
    3. He or she can resign for good reason
    4. He or she can resign for no good reason

    These are universal conditions, although they have different names in different places. In the UK and Europe, I often hear the terms “Good Leaver” for conditions B and C, and “Bad Leaver” for conditions A and D. I also hear fired or terminated for cause or no cause. Use whatever language works, the important thing is that different separation conditions have different logical outcomes when it comes to fairness. The outcomes should always do two things:

    1. Reflect the fair market value of each person’s contribution. This is their “bet.” Bets are always worth what they’re worth, they don’t have special powers.
    2. Align everyone’s interests so that each participant has incentives to act in the best interests of the business. No person should ever be given an incentive to act selfishly or greedy.

    You can read what happens to a participant’s slices here, but when it comes to whether a person should be free to engage in direct competition with a former employer, it breaks down like this:

    If a person is fired for good reason or resigns for no good reason, he or she should not compete with the company or solicit employees. This removes the incentive to deliberately undermine the company’s activities. For example, it wouldn’t be fair for someone to work for a startup during the proof-of-concept stage only to quit and start his or her own company once the business model is figured out.

    Conversely, if a person is fired for no good reason or resigns for good reason, the company should not take any action that would hinder the person’s right to engage in competitive activity. The company can, of course, enforce patents, trademarks, copyrights and trade secrets including in-process innovations, customer lists, and other confidential information. For example, it wouldn’t be fair for someone to work for a startup during the proof-of-concept stage only to get fired once the business model is figured out and then preventing him or her from applying his or her skills and knowledge to a new company.

    Enforceability

    Of course, companies ask employees to sign non-compete agreements all the time and enforceability varies in different states and countries. According to Slicing Pie lawyer, Matt Rossetti: “Non-competes are a severe restriction on commerce and an individual’s ability to make a living. Because of this, the prevailing trend is to limit or bar the enforceability of non-competes.”

    But legal isn’t the same thing as fair. It’s important to adhere to what is fair, even if local laws provide opportunities to act unfairly. Just because you live in a place where a non-compete isn’t enforceable doesn’t mean it’s fair to do so.

    (I should note, however, that breaking the law should always be avoided.)

    The Fair Logic in Action

    Merrily and Anson start a lemonade stand and developed a special secret formula for making lemonade.

    Scenario One: Anson slacks off on the job and, after two clear warnings, he is fired for good reason. It would not be fair for him to open a competing lemonade stand. If he wanted to be in the lemonade business, he should have corrected his behavior.

    Scenario Two: Merrily decides she no longer needs Anson, so she fires him for no good reason. It would be fair for Anson to start a competing stand. If Merrily did not want this, she should have thought twice before firing him for no reason. Anson may not steal the secret formula or any other intellectual property, but he is free to come up with a new formula and go into business.

    Scenario Three: Merrily decides they are going to sell kittens instead of lemonade. This is a different business, so Anson would be able to resign for good reason and, as in Scenario Two, would be free to start a lemonade stand. This probably won’t bother Merrily because she abandoned the lemonade concept, but Anson still can’t steal the secret formula. In this case, it would probably be more practical for Merrily to quit the lemonade stand, but she may want to return to selling lemonade, so she wants to retain the trade secret.

    Dealing with Ideas

    The next two scenarios are common sources of founder disputes because they deal with the idea upon which the company was founded.

    Scenario Four (it starts getting more interesting): Let’s pretend that during the planning stage for the business Anson invented the secret formula. Merrily decides she no longer needs Anson, so she fires him for no good reason. It would be fair for Anson to start a competing stand. Anson may not use the secret formula even though it was his idea. The company owns the intellectual property (IP) he developed on the job. Anson will have to come up with a new formula to go into business.

    The key legal concept here is called an assignment of rights or work made for hire. Slicing Pie logic assumes an assignment of rights. But all startups should have an assignment of rights contract or at least a clear policy in place.

    Scenario Five: Let’s pretend that Anson invented the secret formula prior to starting the business with Merrily who agrees to treat the formula as a trade secret. Merrily decides she no longer needs Anson, so she fires him for no good reason. It would be fair for Anson to start a competing stand. But this does not necessarily mean Anson can extract his IP. In this case, Anson’s rights would be defined by the license agreement he has with the company. If the license agreement was exclusive, he could not use it for his new company, but he would continue to receive the fair market royalties as allocations of slices or cash. If the agreement was non-exclusive, Anson could license the IP to his new company.

    Sadly, many founders with pre-existing IP don’t put an agreement in place with the new company. If you feel that you substantially own documented IP upon which a company was founded, it would behoove you to engage an attorney and do a licensing deal with the newly-formed company. This applies to trade secrets, patents, trademarks, and copyrights.

    If the fair market value of time and materials were included in the Pie, it should be treated as a work made for hire and the IP would assume to be owned by the company. The owner of the IP should decide, in advance, whether developing the IP was an independent act or simply part of his or her role in the business. In most cases, a person should be able to get slices for time and materials and a royalty.

    Startup companies are always changing, but Slicing Pie always delivers an objectively fair deal to participants.

    Aligned Incentives

    Adhering to the competition logic in Slicing Pie employees think twice before slacking off or quitting and startup managers think twice before firing someone or breaking commitments (which provides good reason to resign). People are free to make their own decisions with full knowledge of the logical consequences that will result. Any agreement that goes against this logic will provide opportunity for one party to benefit at the expense of the other—that’s not fair!

  • dynamic equity misconceptions
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    The Truth about Slicing Pie

    Originally Published on Forbes.com here.

    Overcoming The Misconceptions Of Dynamic Equity

    By Matt Rossetti

    These days, most startup attorneys I meet have at least heard of the slicing pie model for equity distribution, but many have yet to use it. There are a few common misconceptions that cause them to steer clients away from slicing pie toward more conventional equity split models. In this article, I will address a few of the common concerns and hopefully dispel them as myths.

    Dynamic equity is not Impossible

    When I first learned about slicing pie I was, like many of my peers, skeptical of its promise to not only deliver a fair equity split but to also provide a framework for avoiding common equity disputes. I was fortunate to meet the model’s inventor, Mike Moyer, who referred a few clients and encouraged me to develop a legal solution. Since then I’ve done over 1,000 consultations on the model and it has become my default recommendation for equity distribution in bootstrapped startups.

    Before trying the model, I found that no matter how carefully founders planned, at least 50% of them had a dispute over their equity split that required legal intervention within the first year or so of formation. Many of my colleagues who serve early-stage companies are all too familiar with this exceedingly common problem. In my experience, the slicing pie model has virtually eliminated equity disputes among founders and problems that do arise can usually be addressed within the framework.

    There are three basic areas of concern that prevent attorneys and founders from applying the model: concerns about future issues, concerns about implementation and concerns about non-compliance with the model.

    1. Concerns About Future Issues

    Teams often express concerns about future issues that may arise, especially when it comes to how the model is perceived by third parties such as investors and taxing authorities. The fear is that future investors will view the model as too ambiguous or complex and that it might trigger undesirable tax events.

    Having seen companies using the model grow and move through multiple funding rounds, I have yet to encounter an investor who takes issue with the model or cites it as a reason to pass on an opportunity. On the contrary, the idea that each founder is entitled to equity in proportion to their contribution is usually viewed in a positive light by investors, especially when they explore the underlying logic and cut through the perceived complexity.

    A key point to consider is that not all resource consumption garners a higher valuation. For example, a company that hires a janitor to take out the trash for $20 an hour and 10 hours per week did not just become $4,400 more valuable. Similarly, since the model terminates before any major financial transactions that require a valuation, tax consequences are about the same as any other model.

    2. Concerns About Implementation

    The slicing pie model requires a tabulation of the fair market value of the contributions from each participant. The prospect of tracking these inputs is often distasteful for founders who relish freedom from the structure of corporate life. In practice, the model simply accounts for transactions that most companies track as a matter of course. For instance, most successful companies track payroll, expenses, sales, investments and other financial activities. A key difference, however, is that most monitoring systems are based on financial transactions and most founders do not feel the need to track non-financial events such as not getting paid or not getting reimbursed for expenses. Unfortunately, the absence of this discipline can skew the teams understanding of their own business model. Once teams understand how important this activity is, this concern is no longer a hurdle to implementation, especially given the availability of tools to manage slicing pie record keeping.

    Other implementation concerns focus on the conversion of the slicing pie hypothetical split into actual ownership of shares or membership interests in the company. This process, from a legal standpoint, is quite simple and often occurs in the context of a structural change in the organization as it matures or takes on professional VC funding. Once the shares or membership interests are formally issued, they are subject to more conventional terms set by management or the angel or Series-A investor.

    3. Concerns About Non-Compliance

    The last major area of concern deals with a series of what-if scenarios. For example, what if a participant reports more time than they actually spend. Or what if someone demands a set percentage of shares. Most of these fall into the category of management issues, rather than an issue with slicing pie. For instance, a person who is unproductive or dishonest will eventually be terminated for good reason and the model will impose logical consequences. The slicing pie model allows managers to make rational business decisions and provides protection for all participants.

    The other form of non-compliance, which is more difficult to manage, occurs when a participant attempts to renegotiate the terms of the deal in their favor, usually by holding the company hostage. A recent example from my own practice was a CTO who shut down the company’s software product and email system unless he was granted a fixed equity stake in the business. Sadly, this scenario is not completely uncommon under any framework and usually represents a situation in which one person overvalues their own contribution while undervaluing the contributions of others. Slicing pie’s alignment with fair market values most certainly mitigates this risk, yet some egos don’t respond well to logic. In my experience, a frank, lawyer-to-lawyer discussion can disarm what could otherwise be an explosive situation.

    In spite of what you may or may not have heard about the slicing pie model, the most common misconceptions can be easily addressed with a concerned client. The benefits of implementing the model far outweigh any perceived problems and going with conventional methods carries far too much risk. I highly encourage anyone who counsels early-stage companies to familiarize themselves with the benefits and help clients to implement so that they can avoid the common pitfalls of unfair equity splits and the infamous founder’s dilemma.

    If you are interested in using a dynamic equity framework to fairly distribute equity to your startup team, please contact us today via email to [email protected] or by phone at (312) 650-9087.

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    Matt Rossetti – Five Reasons an Attorney Should be Reviewing Your Business Documents

    Don’t just do it yourself! Here are 5 reasons to hire an attorney including commentary by the founder of Sentient Law and Forbes Legal Council Member, Matt Rossetti.

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    Illinois Supreme Court Commission on Professionalism Lawyer Spotlight: Matthew Rossetti

    The Illinois Supreme Court Commission on Professionalism’s Lawyer Spotlight recognizes attorneys throughout the state who are admired for their professionalism and civility in the legal field. The founder of Sentient Law, Ltd., attorney Matthew Rossetti, was featured in the Lawyer Spotlight today. Read more here.

    Matthew Rossetti

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    Matthew Rossetti: When should your startup consider consulting an attorney?

    When You’re in a Heavily Regulated Industry

    If your startup is doing business in a heavily regulated industry, then find an attorney with the proper experience. It is also prudent to make certain that any attorney who claims to be a “specialist” is actually certified as such if a certification program is available to them in their jurisdiction. –Matthew RossettiSentient Law, Ltd.

    Matthew Rossetti

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    2015 University of Chicago New Venture and Small Enterprise Lab Class

    The University of Chicago New Venture and Small Enterprise Lab at the Booth School of Business

    Client applications are now being accepted for the 2015 New Venture and Small Enterprise Lab at the University of Chicago Booth School of Business.

    The New Venture and Small Enterprise Lab at the University of Chicago Booth School of Business places teams of four to six MBA students with Chicago-area startups and small businesses to work on a special project over a 10-week quarter. The class gives students exposure to the working environment and culture of smaller companies and the opportunity to work with owners and managers while earning academic credit towards their MBA.

    Client companies get to tap the talent and expertise of Booth students through a structured, 10-week class after which they will receive a delivered project addressing their specific business challenge. Past projects have included marketing strategies, sales programs, client assessment tools, investor packages, pricing strategies, developing new markets and even customer-service dashboards.

    This course offers a blend of theoretical constructs and practical experience as they relate to emerging businesses through classroom lectures and on-site client experiences. It is taught twice during the 2015-2016 academic year. Once in the Fall quarter starting in late September and once in the Winter quarter starting in January.

    If you are interested in learning more about becoming a client company for the University of Chicago New Venture and Small Enterprise Lab please visit www.34701.org and complete a client application.

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    UpCounsel to connect entrepreneurs to lawyers in Illinois

    upcounselCheck out an article featuring quotes from the founder of Sentient Law, Ltd. about the launch of UpCounsel in Illinois. We’re proud to be a part of this. “UpCounsel, an online marketplace connecting attorneys and small business owners, announced Tuesday it had expanded services to Illinois, the company’s fifth market. The San Francisco-based company, launched in 2012 by Matt Faustman and Mason Blake, uses algorithmic matching to connect entrepreneurs with transparently priced legal help. UpCounsel’s service is also available in California, New York, Texas and Massachusetts, with plans to add a state at least every other month, Faustman said.” Continue Reading here.