LAW 531 Week 6 Business Forms and Governance Example

From LLC to Venture-Backed Corporation: Choosing a Business Form and Governance for an E-Bike Maker

[Student Name]

University of Phoenix

LAW/531: Business Law

Week 6 Assignment

[Instructor Name]

[Date]

Willamette Cycle Works, its owners, investors and figures are composites written for a model paper; this is not legal advice.

Willamette Cycle Works was formed eight years ago as an Oregon limited liability company. Its two founders own 85 percent; eight early employees and an angel investor own the rest. The company now plans to raise $30 million from venture capital investors to expand production and enter Europe. Two term sheets have arrived, and both require the company to become a Delaware corporation before closing. The founders want to understand why, what they would give up and how the company would be governed. This paper answers those questions, from the choice of form to the design of the board and the duties of directors, and closes the course's analysis of Willamette's legal environment by linking governance to the risks examined in earlier weeks.

Comparing Business Forms

Bagley (2019) compares business forms on liability, taxation, management, transferability of interests and ability to raise capital.

Sole proprietorships and general partnerships offer simplicity but expose owners to unlimited personal liability, which no growing manufacturer of batteries should accept.

Limited liability companies protect owners from personal liability and offer pass-through taxation, so profits are taxed once on owners' returns. Management is flexible, set by an operating agreement. These features suited Willamette's early years.

C corporations also shield owners from personal liability. In return for paying tax twice, once on company earnings and again on shareholder dividends, corporations offer standardized governance, freely transferable shares, multiple classes of stock and a familiar structure for stock options.

Why Investors Insist on a Corporation

Venture funds often have tax-exempt and foreign limited partners who prefer not to receive pass-through business income, which an LLC would generate. Venture deals rely on convertible preferred stock with liquidation preferences, anti-dilution protection and protective provisions, which fit corporate law easily. Stock option plans, central to hiring engineers, work most simply in a corporation. And Delaware's corporate law, specialized courts and large body of case law make outcomes more predictable for investors who hold stakes in many companies. Pass-through taxation, the LLC's main advantage, matters little to a company that expects to reinvest profits for years.

The Conversion

Oregon and Delaware both permit conversion of an LLC into a corporation. The steps include approval by members under the operating agreement, filing a certificate of conversion and a certificate of incorporation in Delaware, adopting bylaws, issuing common stock to existing members in proportion to their interests and adopting a stock option plan. Tax advisers should confirm that the conversion can be structured to avoid immediate tax for members. Contracts and permits held by the LLC generally continue, though some agreements, such as the retail agreement, may require notice or consent.

Governance After the Round

The term sheets propose a five-person board: the two founders, two directors appointed by the lead investors and one independent director with manufacturing experience agreed by both sides. Investors would also receive protective provisions, requiring their approval for major actions such as selling the company, issuing senior stock or taking on large debt.

Directors owe the corporation fiduciary duties. The duty of care requires them to act on an informed basis and in good faith; the business judgment rule protects informed, good-faith decisions from second-guessing. The duty of loyalty requires them to put the corporation's interests ahead of their own and to handle conflicts of interest through disclosure and approval by disinterested directors. Investor directors face a particular tension: they owe duties to the corporation and all its shareholders while also representing their funds.

Once the founders sit on a board with investors, their company becomes a corporation with duties to all its shareholders, not only to them.

What Research Says About Venture Governance

Hellmann and Puri (2002) studied Silicon Valley start-ups and found that venture-backed companies were faster to professionalize, adopting human resource policies, hiring marketing leaders and adopting stock option plans sooner, and were more likely to replace founders as chief executive with outsiders. Daily et al. (2003) reviewed corporate governance research and argued that boards serve monitoring and resource provision roles and that governance should be understood as balancing these, rather than only as control of managers. For Willamette, investor directors bring capital, networks and expertise but also oversight, and the founders should expect pressure to add professional managers.

Governance and the Course's Legal Risks

The board's oversight should cover the risks analyzed in this course. A product safety committee of the board, chaired by the independent director, would review recalls, incidents and regulatory reporting, addressing Week 2's liability issues. The audit committee would oversee contract risk and compliance, including Week 3's contract playbook and Week 5's customs and European requirements. The board would review the intellectual property strategy from Week 4 annually. And the legal risk map from Week 1 would become a standing board agenda item.

What the Founders Give Up and Keep

The founders' main concern is control. After the round, they will own about 60 percent of the shares, but investors' protective provisions mean that major decisions, selling the company, raising more money on senior terms or borrowing heavily, will need investor approval. The board, not the founders alone, will hire and fire the chief executive. In exchange, the company gains capital to grow and directors with experience scaling manufacturing companies. Founders keep day-to-day management as long as the company performs, and their stock options and common shares give them a large stake in the outcome. Understanding this trade before signing helps avoid conflict later. Many founder disputes with investors begin not with bad faith but with founders who did not realize how much the term sheet changed their authority over hiring, spending and strategy.

Preparing for Due Diligence

Investors will review the company's legal position before closing. The issues raised in this course will surface: the battery recall and its contract terms, the retailer dispute, the pending patent and unassigned contractor inventions, and compliance gaps. Addressing these before due diligence, by settling the retailer dispute, obtaining patent assignments and adopting the contract playbook, would strengthen the founders' negotiating position and reduce the chance that investors demand special indemnities or lower the valuation.

Recommendations

Convert to a Delaware C corporation as a condition of the investment, with tax advice to structure the conversion.

Negotiate for an independent director chosen jointly and for protective provisions limited to major decisions.

Adopt bylaws, committee charters and a conflict-of-interest policy.

Purchase directors and officers insurance.

Establish board committees for audit and product safety.

Conclusion

Willamette outgrew the LLC form when it chose to raise venture capital. A Delaware corporation offers the stock structures, option plans and legal predictability investors require, at the cost of double taxation and shared control. Good governance, a balanced board, clear fiduciary duties and committees focused on the company's real legal risks, would turn the change of form into a stronger system for managing the legal environment this course has examined.

References

Bagley, C. E. (2019). Managers and the legal environment: Strategies for business (9th ed.). Cengage Learning.

Daily, C. M., Dalton, D. R., & Cannella, A. A., Jr. (2003). Corporate governance: Decades of dialogue and data. Academy of Management Review, 28(3), 371-382. https://doi.org/10.5465/amr.2003.10196703

Hellmann, T., & Puri, M. (2002). Venture capital and the professionalization of start-up firms: Empirical evidence. Journal of Finance, 57(1), 169-197. https://doi.org/10.1111/1540-6261.00419