• Vesting of Founder’s Stock. Founders may agree that their interest in the stock of the company will “vest” over time (typically 1-3 years), and grant to the company the right to acquire any unvested stock when the Founder’s service with the company ends.

• Termination. The agreement may define the circumstances in which a Founder’s service with the company can be terminated. If termination is for “cause” (i.e. bad acts by the Founder), the company and/or the other Founders may have a right to purchase some or all of the terminated Founder’s stock in the company (including vested stock).

• Restrictions on Transfer of Founder’s Stock. Founders typically agree not to transfer their shares in the company without the consent of the other Founders, except in limited circumstances such as transfers to specified persons (ex. children or spouse) or for estate planning purposes. Founders often grant to the company and/or the other Founders a right of first refusal to purchase any shares proposed to be transferred by a Founder, except as permitted by the agreement.

• Tag-along Rights. Founders may grant each other the right to participate in any sale of a Founder’s shares to a third party. Any potential purchaser of stock from a Founder would then be required to purchase shares held by all Founders, usually pro rata based on the Founders’ relative ownership interest.

• Voting of Founder’s Stock. Founders often agree to vote all of their shares to elect specified individuals (usually including each Founder) to the company’s Board of Directors.

• Non-competition. Founders sometimes agree not to compete with the business of the company or solicit employees or customers for a certain period of time following the end of their service with the company.

While these provisions are common, a Founders Agreements should be customized to fit the needs of the Founders. Your lawyer can help you create an agreement that’s right for you and your company.

The Charter is the document filed with the Secretary of State in the corporation’s state of organization to give life to the corporation. Charters are publicly available from the Secretary of State, and often available in PDF from the Secretary of State’s website. The Charter goes by different names in different states (Articles of Organization in Massachusetts, Certificate of Incorporation in Delaware, etc.) and the information required in the Charter varies somewhat from state to state, but typically a Charter must include, at a minimum, basic information about the corporation’s line of business, its place of business, its equity structure, its founders and its initial officers and directors. Often the Charter will also include optional provisions concerning matters, such as the extent of any indemnification of the corporation’s officers and directors, and some corporate actions or activities may only be permitted if explicitly authorized in the Charter. For example, shareholders of a Massachusetts corporation may take action by written consent, but all such consents must be unanimous unless the Charter permits action by less-than-unanimous consent (by contrast, Delaware permits shareholder action by less-than-unanimous consent unless prohibited by the Charter). Amendments to the Charter usually require approval of the corporation’s Board of Directors and its shareholders.

Bylaws are the operating manual of a corporation. Bylaws typically describe in detail how corporate decisions must be taken, including: how directors are elected and officers are appointed; how authority is divided among the corporation’s shareholders, directors and officers; and what procedures must be followed for actions requiring approval of the shareholders or Board of Director. Bylaws often also describe procedures for issuing stock, the form and content of required corporate recordkeeping, and procedures for any indemnification of officers and directors. Unlike the Charter, Bylaws of private companies are typically not publicly available (Bylaws of publicly traded companies must be filed with, and are available through, the Securities and Exchange Commission). Shareholders always have the authority to amend the Bylaws, but some states also permit the Board of Directors to amend the Bylaws without shareholder approval, provided that the shareholders are promptly notified of the amendment and do not vote to overturn it within a certain period of time.

The three exemptions from registration encompassed by Regulation D are found in Rules 504, 505 and 506, while the remainder of the rules in Regulation D set forth further limitations applicable to offers and sales of securities pursuant to each of the three exemptions (we plan to delve into some of these limitations at a later date). The most important aspects of each exemption are summarized below, but please note that the summaries do not purport to cover all aspects of Rules 504, 505 and 506, and should not be considered legal advice. Legal counsel should always be consulted in advance of an issuance of securities.

Rule 504: Rule 504 offers a broad exemption from federal registration for offerings of not more than $1 million over a 12-month period. Unlike Rules 505 and 506, Rule 504 does not impose any restrictions on the use of general advertising and solicitation to promote the offering, or the number or sophistication of investors, and the issuer is not required to provide any disclosure materials regarding the offering to potential investors (though it is often advisable to do so). Securities offerings made under Rule 504 remain subject to state securities laws (also referred to as “Blue Sky” laws), which may impose additional restrictions and requirements. Issuers relying on Rule 504 must either register or qualify for an exemption from registration in each state in which securities are offered.

Rule 505: Rule 505 permits an issuer to offer and sell up to $5 million of securities to an unlimited number of accredited investors and up to 35 non-accredited investors. The issuer must furnish detailed information about the company’s business and finances to non-accredited investors, as required by Rule 502(b)(2). Rule 505 also prohibits the use of general advertising or solicitation to promote the offering; either the issuer or an agent of the issuer (officer, director, employee or intermediary such as a placement agent) must have had a “substantive and pre-existing relationship” with any prospective investor. As with Rule 504, Rule 505 offerings are subject to state Blue Sky laws, which may impose additional restrictions and requirements and must be considered on a state-by-state basis.

Rule 506: Rule 506 permits an issuer to offer and sell an unlimited amount of securities to an unlimited number of accredited investors and up to 35 non-accredited investors, but unlike offerings under Rule 505, any non-accredited investor must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” As with offerings under Rule 505, in a Rule 506 offering the issuer must furnish non-accredited investors with detailed information about the company’s business and finances (required by Rule 502(b)(2)) and the Issuer is prohibited from using general advertising or solicitation to promote the offering. Unlike offerings under Rules 504 and 505, however, offerings that meet the requirements of Rule 506 are exempt from state Blue Sky laws pursuant to the National Securities Markets Improvements Act of 1996, though states may still require issuers to provide notice of the offering to state securities regulators.

To understand the importance of accredited investors, it is necessary to first understand that a primary goal of the U.S. securities laws is to reduce the possibility that ordinary people will lose their shirts by investing in dodgy companies. This is accomplished in part by requiring that companies provide to potential investors – even to friends and family of a company’s principals – detailed information about the company’s operations and finances, as well as the risks inherent in the company’s business. This information must be provided in a written document (called a private placement memorandum or “PPM”) that can take significant time to prepare and generally requires careful review by the company’s lawyers and accountants. Complying with the disclosure requirements would therefore be cost-prohibitive for companies seeking to raise small amounts from outside investors if not for the fact that the SEC relaxes the disclosure requirements in limited circumstances, including when companies sell only to accredited investors.

A person or entity is “accredited” if he/she/it falls within one of the categories of investors set forth in the definition of “accredited investor” found in Rule 501 of Regulation D, which was adopted pursuant to the Securities Act of 1933. These categories attempt to get at whether an investor has sufficient knowledge and skill to evaluate the risks of a potential investment. For a natural person to be accredited, he or she must be a director, officer or general partner of the issuer or must have, at the time of purchasing securities, either (a) individual net worth, or joint net worth with the person’s spouse, in excess of $1,000,000 or (b) individual income in excess of $200,000 in each of the two most recent years or joint income with the person’s spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.  [UPDATE: The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law July 21, 2010, provides that individuals may not include the value of their residence in determining  if their net worth exceeds the $1,000,000 threshold for being an accredited investor and requires that the SEC periodically review and update the net worth and income thresholds for accredited investors.]

Because accredited investors are considered better able to fend for themselves, Regulation D permits companies to sell to an unlimited number of accredited investors without requiring that they furnish the information that must be provided to non-accredited investors; provided that the company is available to answer questions from potential investors and provide to them, upon request, the same kind of information that would have to be provided to non-accredited investors, and that the offering also complies with the other applicable restrictions on the scope and manner of the offering. This can save a company thousands of dollars in legal and accounting fees, as well as the time necessary to prepare a PPM. We should point out that the rules of Regulation D allow companies to offer and sell securities to anyone, including friends and family, if applicable restrictions are met; however, if you want the cost savings afforded by streamlined disclosure requirements, then before offering securities to your Aunt Bertha, you’ll want to make sure she’s accredited.

One note of caution: in determining what information to provide to potential investors, it is important to remember that even when offering securities only to accredited investors pursuant to Rule 506, a company is still obligated to comply with the SEC’s anti-fraud rules (we’ll discuss these in a future post), which generally make it illegal to make a misstatement or omission of a material fact in connection with an offering of securities, as well as with any applicable state securities laws. Your legal adviser can help guide you through the intricacies federal and state securities laws.

Corporations and limited liability companies (generally referred to as “LLCs”) offer two major advantages relative to other forms of business entity. First, corporations and LLCs afford their owners maximum protection from the liabilities incurred by the business.  In most circumstances, the liability of the owners of a corporation or LLC (“shareholders” or “stockholders” for a corporation and “members” for an LLC) is capped at the value of their investment in the company, meaning that the personal wealth of the owners is not at risk, even if the business goes belly-up. Second, with a corporation or LLC it is possible, subject to satisfying certain conditions, to choose whether the income of the business will be attributed directly to the owners, and therefore taxed at each owner’s applicable individual tax rate, or taxable to the company. Before forming your company you should discuss with your tax adviser which tax treatment is most advantageous for you and your business.

While corporations and LLCs are similar in many respects, there are several reasons most technology businesses choose to organize as a corporation. One reason is that equity incentive grants (e.g. stock options) are simpler to make from a corporation than from an LLC, which is important because most start-up technology businesses rely on stock options as an important element of the compensation they pay to employees. A second reason is that venture capitalists generally prefer to invest in corporations rather than LLCs, and while it is possible to convert from one form of entity to another, this adds time, cost and complexity to a financing transaction.

No matter what type of business you are starting you need to consider your specific circumstances before choosing the best form of business entity for your business.

Remember that the discussion above may not cover all of the factors relevant to your decision, so you should consult a lawyer if you have any questions.

The first reason keeping your lawyer informed is cost-effective is that it is always cheaper to do things right the first time, rather than pay to fix mistakes later. Of course, no client deliberately puts off resolving a potentially costly legal problem, but often the magnitude of a problem, or even its existence, is not obvious even to an experienced business person. By keeping your lawyer apprised of what your business is planning, you give him a chance to spot potential legal issues before they become problems.

The second reason keeping your lawyer informed is cost-effective is that by doing so you can leverage the wealth of experience of the firm’s attorneys. By making your lawyer aware of a potential legal issue before it becomes a crisis, your lawyer has time to see whether someone else has previously faced and solved a problem similar to yours. This process can take time because busy colleagues may take a while to respond to a query, but this isn’t time that gets billed to the client so if the query turns up empty you haven’t spent a dime. If, on the other hand, someone has the answer to your problem, you get that answer for a fraction of what it would have cost for your lawyer to research the questions. By contrast, if you wait to raise an issue until the last minute, there may not be time to see if the answer to your question is available in the firm’s collective consciousness, so your lawyer may be forced to re-invent the wheel.

If you’re worried that the cost of spending just five minutes each week updating your lawyer will outweigh the potential savings, keep in mind that when a problem does arise you will need to bring your lawyer up-to-speed on precipitating events, but if your lawyer is already well informed about what has been happening with your business this will take less time. Second, if you call your lawyer once a week to give him a five minute update on what’s happening at your company and what might be on the horizon, there’s a decent chance you won’t get billed for some of those calls. If, however, you call your lawyer only when you have a problem and spend 20 minutes giving him the background he needs to get up to speed, you can bet you’ll be billed for every minute.