Birthing Unicorns: A Practical Guide to Legal Aspects of Launching Digital Media Startups

Pillsbury Winthrop Shaw Pittman LLP
Birthing Unicorns:
A Practical Guide to Legal
Aspects of Launching
Digital Media Startups
Ron Fleming
Partner, Head of Emerging Companies
Pillsbury Winthrop Shaw Pittman LLP
December 8, 2015

Defining Success
 The “Shiny Red Apple” approach
 Implement legal and financial structures that do not impede your
ability to raise capital in a timely and expedient fashion, grow the
business or execute a sale or IPO process
 Optimize for attracting capital and talent and facilitating liquidity
 Key questions--What is company’s timeline? Capital needs? Plans to
issue equity to employees and other advisors?
 Allow potential investors/acquirers to focus on the merits of the
business and the quality of the team, and not be distracted by
background noise
1 | Birthing Unicorns: A Practical Guide to the Legal Aspects of Launching Digital Media Startups

Being Opportunistic
 Most M&A exits of digital media companies do not
result from an orchestrated, investment-banked
process, but instead opportunistically arise
 The bonanza deals are virtually always
companies that are “bought, not sold”
 Buyers approach, and transactions can happen
fast (sometimes as quickly as a few weeks)

Choose the Right Co-Founder
--Carefully select co-founder the way one picks any partner—be highly
discerning
--Enter into equity vesting arrangements to ensure that co-founder forfeits equity
if leaves prior to the fourth anniversary of joining team
--Only an “at will” employment offer letter
Carefully limit board rights, other governance provisions

Chose the Right Form of Entity
 As a general rule, digital media companies should be organized as a
Delaware “C” corporation if the plan is to raise institutional funding in
next 12 months
 LLCs are becoming more commonplace, particularly if no near-term
plans to raise capital. Note that many VCs can’t or won’t invest in
LLCs, and will condition investments on conversion to C-corp
 LLCs have complexities involving options, K-1 reporting, etc. that
generally make them less than ideal vehicles for media/tech high
growth company
 Ambiguous case law, poorly drafted statutes and the lack of IRS
guidance, practitioners are often on their own to determine the tax
consequences of compensatory partnership options

Trials and Travails of the Wrong Entity
Type
 Consider drawbacks to using S-corp structures including major diligence
process by acquirer/investors seeking to ensure compliance with numerous
technical requirements
 Catastrophic if S--corp characterization fails – end up with taxable income in
corporation. Note that 338(h)(10) election fails if you have a bad S, so
intense scrutiny
 Examples of technical requirements we see:
 Ineligible stockholders - LLC that is treated as partnership because more
than one holder, so not disregarded
 Non-proportional distributions to stockholders
 Loans to stockholders that aren’t documented as loans, shareholder using
the company as a checkbook

Set up In the Right Location
 Delaware, Delaware, Delaware…If in doubt, Delaware is the right locale for organization.
 It’s virtually malpractice to incorporate in New York-- NY and NY alone has a very
entrepreneur/investor unfriendly provision --Section 630(a) of the New York Business
Corporation Law (applicable only to privately held corporations, not to LLCs or investment
companies) renders the ten largest shareholders personally liable for employee
compensation
 It covers not just wages and salaries, but other types of monetary compensation as well,
including overtime, vacation, severance pay, contributions to insurance or welfare benefits,
pension or annuity funds.
 The stockholders are liable jointly and severally. This means that the employees can
choose to go after one stockholder for the whole amount instead of all ten. The law allows
that shareholder to seek pro rata contributions from the other largest stockholders.

Get Your House in Order
Anticipate the diligence process for various
capital raising, strategic or liquidity
transactions by keeping an updated virtual
dataroom – you need it for venture
financings, exits, your audit and your IPO

Get Your House in Order (cont’d)
Be prepared:
 Audited Financials
 Capitalization – make sure cap table is clean and correct
 Clean corporate governance (board minutes/stockholder actions)
 409A – make sure equity grants been done properly and well
 IP - does your company own it? Make sure all employees signed up
proprietary info agreements
 Salaries to employees - withheld/liability to directors

Aggressively deal with potential litigation
Deal with nasty grams from competitors
related to IP
Address allegations that you poached
confidential info/solicited employees etc.
Obtain releases from terminated employees

Corporate Controls
 Implement a system of good/clean controls and
systems
 Hire known national or regional auditors
 Experienced finance staff including a CFO with
transactional background
 Having financial statements prepared in
accordance with GAAP

Clean Capitalization
 Control your equity issuances
 Get equity issued “early” when fmv is low
 Ensure compliance with IRC Section 409A
 Get independent 409A valuations on a periodic basis once
you are an established company, and tie granting thereto
 Have one person in charge of capitalization table even if its
outside accountants or lawyers
 Do not issue warrants or other documents promising equity
as an evergreen percentage, but rather a fixed number of
shares
 Ensure warrants terminate on an exit?

Protect your IP
 Patents and trademarks – make sure filings are in order
 Assignment of inventions – all employees, consultants,
contractors, make sure company owns what he it believes
it owns
 Confidentiality agreements
 Trade secrets
 Domain names

Sales Tax
 There is no greater hot button issue than
compliance with the ever changing quagmire of
state sales tax rules
 Trying to assert nexis over internet sales and SAAS,
very aggressive re: taxing a provider based on the
presence of a user and saying that provider is present
in state or locality because user in state has
downloaded software or used SAAS
 If you offer service on the net, have to make sure
managed sales and use tax exposure properly

Employment Law Compliance
 Properly classify exempt vs. non-exempt,
employee vs. contractor
 Evaluate compliance with the overtime rules
under federal and state law
 What does your offer letter say?
 Confirm severance/release agreement up to date

Prudent Contracting
 Do your key customer/supplier (e.g., licenses) contracts have
change of control/anti-assignment provisions that will be triggered
by a sale?
 Are there any funky provisions that will slow you down, e.g., many
strategics ask for rights of first or last refusal/rights of first
negotiation, etc., are you burdened by any of those?
 Are you party to long term agreements that have unusual risk?
 Any odd non-compete provisions?
 Any long-term contracts that will burden the business, e.g., long
term lease that will prevent integration?
 Does your investment banking letter have a tail or entitle bank to
special rights?

Securities Law Compliance
 Make sure you have valid securities law
exemptions for all equity issuances
 Were Reg D and Blue Sky filings completed?
 Are your investors accredited?
 Have you gotten a primer on the new 506 Rules?

Related Party Transactions
 Make sure you’ve used good corporate
governance when dealing with related party
transactions
 KISS principle applies—avoid complex
structures, e.g,. the founding team retaining
IP and licensing to company

Regulatory Issues
 Proactively attack regulatory issues (e.g.,
escheat laws, gift cards)
 Deal with privacy landscapes here and
internationally—think Global

Keeping the Band Together
 Most investment or M&A transactions are
conditioned on keeping team in place
 Consider impact of single/double trigger
change of control provisions, including
severance/acceleration
 Design equity incentive plans to promote
retention post-closing

JOBS Act Impact
 Two key features of the Jumpstart Our Business Startups Act:
 General solicitation in Rule 506 offerings—
 Increased thresholds at which an issuer will be required to register
a class of securities under the Securities Exchange Act of 1934
(the “1934 Act”)
 When combined with certain advantages already enjoyed by
issuers in Rule 506 offerings, opens up an entirely new category
of "publicly offered private offerings" that are largely exempt from
substantive regulation at either the federal or state level, by
issuers that will be able to avoid becoming public companies, for
practical purposes, as long as they wish.

THE END GAME
 Be prepared to facilitate being opportunistic
 Keep your corporate and contractual records
clean and ready for prime time
 Avoid burdensome contractual terms that affect
the biz or the process
 Design equity plans and comp structures to keep
team incented to remain

Birthing Unicorns: A Practical Guide to Legal Aspects of Launching Digital Media Startups

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