The attorneys at Aegis regularly organize new entities for our clients in the commercial space industry. Below is some helpful information about organizing business entities that applies regardless of industry, with a few issues that pertain more particularly to the U.S. commercial space industry.
The choice of entity for a U.S.-based space company often comes down to whether the U.S. entity will solicit equity investments. If yes, a Delaware C-Corp is usually the best option, because this is the type of entity that investors will prefer. Other entities are problematic. For example, a corporation taxed as an S-Corp cannot have multiple classes of stock (and therefore no preferred stock), it can only have a limited number of shareholders, and it can’t have stockholders that are entities or foreign persons. LLCs also present a problem because, by default, they aren’t taxed; instead, the owners of an LLC must pay taxes on the LLC’s profits, regardless of whether profits were distributed. If the LLC reinvests all of its profits back into the company (which investors usually prefer, so that they company grows rapidly), the investors would have to shoulder substantial tax burdens, which they don’t want to do.
Similarly, the C-Corp is the preferred entity choice if the U.S. space company intends to offer equity incentives to its employees, advisors, and board members. Like investors, these persons would also like to receive equity without worrying about tax consequences every time the company turns a profit.
If the founders of a U.S.-based space company aren’t seeking equity investments and don’t intend to offer equity incentives, then the LLC is usually the simpler option.
Many (if not most) of our clients in the commercial space industry wish to participate in Small Business Innovation and Research (“SBIR”) and Small Business Technology Transfer (“STTR”) programs, particularly those offered by the U.S. Department of Defense and NASA.
SBIR programs have certain requirements, including:
SBIR programs have the same requirements as the SBIR programs, with a few additional requirements:
There are a few issues that arise when a U.S. business in the commercial space industry has foreign founders, investors, employees, or contractors.
First, the company will likely have significant export control obligations under the International Traffic in Arms Regulations (“ITAR”) and/or the Export Administration Regulations (“EAR”). This means that the company might have to obtain licenses from the U.S. government before sharing controlled information with these foreign persons.
Second, the Committee on Foreign Investments in the U.S. (“CFIUS”) might have jurisdiction to review any investments by foreign persons into the U.S. company, because U.S. companies in the space industry are often considered “TID U.S. Businesses” because they produce, design, test, manufacture, fabricate, or develop one or more “Critical Technologies.” If the investment results in “control” over the U.S. business by the foreign person (“control,” in this context, is defined incredibly broadly), then CFIUS might require that a National Security Agreement be put in place, with expensive oversight mechanisms, to prevent such control.
Third, before the FAA will grant a launch license to a launch provider, it must first conduct a national security review of both the rocket and all of its payloads. The FAA conducts this review in concert with the Department of Defense, Department of State, Department of Commerce, NASA, and other interested agencies. In recent history, the FAA has twice refused to grant a license (once to a launch provider and once to a payload owner) following the national security review, because the Department of Defense had an issue with the foreign ownership of the companies involved.
The attorneys at Aegis are experienced at reviewing these issues relating to foreign persons for our clients and creating strategies to avoid the resulting problems.
When a corporation is first incorporated, the charter document (we call this the Certificate of Incorporation in Delaware) will authorize a certain number of shares of common stock that the corporation may issue to its owners. Typically, a corporation will authorize 10 million shares of common stock with a par value of $0.0001 per share, which would allow the founders to purchase all of the stock for $1,000.00.
Typically, the founders of the corporation will purchase 80%-90% of the authorized common stock and reserve 10%-20% for a stock inventive plan, which they can use to compensate employees, advisors, and board members.
Common stock is typically purchased subject to a vesting schedule. the vesting schedule ensures that if a person separates from the company’s employment during the vesting period, they will not be able to walk away with all of the stock that they would otherwise receive if they stayed on for the full duration. A common vesting schedule is 48 months. Occasionally, vesting schedules will also contain a one-year “cliff.” This means that the first tranche of stock vests at the end of twelve months, and then the rest vests monthly after that.
The following graphic depicts a stock vesting according to a 48-month vesting schedule with a one-year cliff:
While founders, employees, advisors, and board members receive common stock, it is rare for investors to receive common stock. Instead, they either invest using a convertible instrument (e.g., a convertible note or a SAFE) in an unpriced round, or they invest in preferred stock in a priced round. These investment vehicles are discussed below.
A convertible note is a special type of promissory note. A promissory note is a document that a company gives to an investor in exchange for a loan of cash. The promissory note indicates that the borrower must pay the money back by a certain date (the “maturity date”) and with a certain amount of interest.
A convertible note is special because it indicates that upon the occurrence of a certain triggering event, instead of paying the debt back to the lender, the company will use the amount of the debt to purchase company stock on behalf of the lender and deliver the stock to the lender. Typically, the triggering event will be the sale of preferred stock during a priced round.
Lenders can also negotiate for two special features: a discount rate, and/or a valuation cap, both of which can decrease the price at which the lender purchases the preferred shares so that the lender gets a better deal than the other priced round investors. These features are intended to reward the lenders for lending at an early stage, when the investment was risker.
A SAFE (or, Simple Agreement for Future Equity) is a document invented by the famous Y-Combinator startup accelerator. The SAFE functions much like a convertible note, except that there is no maturity date, and there is no interest rate.
The chart below describes the features of convertible notes and SAFEs:
Preferred stock is authorized and issued during a priced round.
The chart below describes the features of common stock and preferred stock:
When selling a security, it’s illegal to make an untrue statement of material fact or omit a material fact. Such misstatements or omissions can be prosecuted as securities fraud. So, this begs the question: what is a security?
Broadly speaking, a security is any investment in a common enterprise with an expectation of profits from the efforts of others. This includes stock, convertible instruments, SAFEs, and many other investment vehicles.
Companies that are seeking investments must therefore be careful not to make material misstatements or omissions when speaking to investors (or to the press, when investors are likely to read the resulting material) and to hedge factual statements about future events with disclaimers.
Though it’s surprising to a great number of small businesses, the default rule in the U.S. is that all securities offered for sale must be registered with the SEC, which is a tremendously cumbersome and expensive process. Small businesses avoid this default rule by relying on certain listed exceptions.
You didn’t build your business to read regulations. You should be focusing your efforts on what you do best. But if you don’t follow the rules to the letter, you can lose big.
We know the regulations that affect businesses in the space industry. We work closely with our clients to explain the rules, put systems in place, and ensure compliance.
Contact us today for a free consult:
