Counseling the Startup - Sp06 _Shellzo_ - COUNSELING THE START-UP

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Counseling the Startup - Sp06 _Shellzo_ - COUNSELING THE START-UP Powered By Docstoc
					                          I.     INTRO TO COUNSELING THE START-UP

   a) What kind of a company? (Toys vs. Software)
      i) Need to know type of company they are to figure out what their legal issues will be
           (1) They‟re selling the software to make the toys, then outsourcing the actual making of the
               toys to other companies
      ii) Product
           (1) Designatoy
      iii) Cost & Sales of Product
           (1) Cost will be $10-$12 per item, sold wholesale for $20, and sold in stores for $38
           (2) Alpha Toys (Makes Software)  Ships to Retailer  Sells to Consumer (orders product
               via email)  Alpha Toys Outsources the Order to Manufacturer of Toys (ships end
               product)  to consumer
   b) How will the company make money?
           (1) Alpha Toys gets paid when they sell the software to the retailers
           (2) Alpha Toys pays the manufacturer after they ship the toy (think about all the time that
               elapses b/w when Alpha Toys gets paid by the retailer and has to pay $ to the
               manufacturer) =
      ii) FLOAT – difference in time b/w when you get $ and when you have to pay out $
           (1) What do you do w/ the $ in the meantime? INVEST
           (1) Take the information from the consumer when they submit their emails to Alpha Toys then
               sell this information to other companies
   c) LEGAL ISSUES that need to be dealt with if you are the company‟s lawyer:
      i) Intellectual Property
           (1) Copyright of software
      ii) Privacy Laws
           (1) Sale of personal information of customers
      iii) Formation/Organization of Company
           (1) What Kind of Company?
               (a) LLC?
                   (i) No – want to go public
                   (ii) Looking for financing (more traditional form for investors)
               (b) C Corporation - Yes
                   (i) Want to go public
                   (ii) Want different classes of stock
           (2) Dynamics b/w 3 main people involved w/ the company
      iv) Products Liability
           (1) Safety requirements of end products
           (2) Regulations relating to children‟s products
      v) Employment Issues
           (1) Compensation
      vi) Tax Issues
           (1) Float
      vii) Financing
           (1) Investors
               (a) Securities Regulations
      viii) Contracts
           (1) w/ Retailers/Manufacturers
      ix) Real Estate
           (1) Office space
      x) Insurance
      xi) Licenses and Permits
      xii) Manufacturing Issues
      xiii) Strategic Alliances (or Licenses)
           (1) Software – how and who else can use the software
      xiv) IPOs
      xv) Merger
      xvi) Bankruptcy
           (1) If business fails – what‟s protected?
2) CONFIDENTIAL DISCLOSURE AGREEMENT (aka NDA – non-disclosure agreement)
   a) Protection of Business Idea
      i) Good thing to have, especially for an idea that anyone can do like this company (no special
           talent needed to run this business)
           (1) Allows people to talk about the idea w/o having it stolen away
      ii) Protection is not actually that great but they are enforceable
      iii) Some people won‟t sign (especially venture capitalists)
           (1) All they do it hear ideas and don‟t want to be bound or have the issue come up – if they
               reject an idea b/c of the founder of the company and not the idea for instance.
      iv) If talking to a retailer or manufacturer it‟s a good thing to have
   b) Art to Writing NDAs
      i) Not too short and not too long (1.5 pages max)
   c) Structure of NDA
      i) Intro – discusses the business
      ii) Definition becomes important
      iii) Related directly or indirectly to the business
   d) Individual Portions
      i) Precautions To Protect Confidentiality - Para 2
           (1) Recipient agrees to take such precautions as may be necessary to maintain such
               Information confidential and secret, and not to disclose, or republish any such Information
               to any third person . . .
               (a) Note – some agreements say reasonable and customary instead of may be necessary
               (b) Note – some agreements may also say the same precautions as recipient uses to protect
                   its own most highly valued secrets
                   (i) This is open to various interpretations so it‟s difficult to decide which language you
                        should choose, since most people won‟t give you option # 1 (if you choose this you
                        should be sure the recipient is someone who is very careful w/ their own secrets
               (c) Note – could also say recipient uses to protect its own most highly valued secrets
                   provided that such standards meet the norms of the industry -
           (2) Language you choose depends on your position
               (a) Recipient of the confidential information you probably want reasonable and customary
                   (i) “Reasonable” protections are weaker than necessary protections
               (b) Discloser of the confidential information you want may be necessary
                   (i) Negotiating the various types of language is what transactional lawyers do.
      ii) Escape Clause for Confidentiality – Para 3
           (1) These restrictions do not apply to information that becomes generally obtainable to the
               public unless it happened by an act or omission by the recipient
      iii) Use of Information - Para 4
           (1) You won’t USE the information provided to you.
               (a) If technology is involved, it‟s possible to use it in a product w/o disclosing the
           (2) This Agreement intends that the prohibition against “USE” by recipient be construed as
               broadly as possible
               (a) This clause is NOT usually seen in NDAs but it is important
   a) This is an internal business plan, (Para 2) it‟s not an offer to sell or a solicitation of offers to
      purchase any of the Company’s securities . . .
      i) This is to ensure that it‟s not construed as an offer to sell securities b/c there are limitations on
           the # of offers that can be made for private companies and other securities regulations that
           must be complied with.

                                          I.      BUSINESS PLANS

      i) Importance of business plan
          (1) Indicative of how serious someone is about starting a business
          (2) Even those not looking to raise $ should write a business plan
               (a) Points out potential flaws in your thinking
               (b) How to market product (know your audience)
                   (i) Knowledge of market is key – you must know who will buy your product
               (c) How to price product (take into account cost, office space, employee costs etc.)
               (d) How to quantify how big a product you are talking about
      ii) Note – Most of your clients don‟t really want to hear your suggestions about their business
      i) Don‟t want people to say you‟re selling securities
      ii) Will be different from an internal business plan
2) Content of Business Plan (What should it contain?)
      i) Frequently it‟s the only part of the business plan that gets read – if interest isn‟t piqued w/ this
          all is lost
      ii) Few pages (5 pages is too long) that describes the business and states why it will be successful
      i) You have to know who‟s going to buy your product; you can‟t just say there‟s a really big
          market out there and if I can get a piece of it it‟ll be great – Chasalow would reject business
          plans of those who said if I can just get 1% of the market things will be great
          (1) Ostrich example – if I can get 1% of US beef market we‟ll all be rich – but not even 1% of
               US beef market wanted to eat ostrich. Also, too many people became involved w/ market
               so price of ostrich went way down – not factored into most people‟s calculations.
      i) Hockey-Stick Growth – Most people want to see this
          (1) Not a ton of growth in the beginning (kind of level) but after a few years the business takes
               off and the graph curves upward
          (2) Not just immediate growth but they want to know that there‟s the potential for the business
               to take off
   d) RAISING $
      i) Want to know you‟re raising the right amount of $ (art of balancing how much $ you need to
           (1) Based in part on what your projections are
               (a) How much $ you need to get to the point where you don‟t need to raise any more
      ii) Why is raising the right amount of $ at the right time important?
           (1) When you first start raising $, you have to give away a much bigger chunk of the company
               – as you start doing more things that proves your company can do well, the company starts
               to get more valuable and you need to give up less of your company than you would at the
           (2) If you raise too much $ upfront, you can wind up selling your company at the
               beginning for too little.
      iii) Venture Capitalists
           (1) Sometimes venture capitalists will encourage people to borrow too much at the beginning -
               $ is more expensive at the beginning of the process than when the business is up and
               running so you don‟t want to borrow too much but you also don‟t want to have to go back
               and ask for more $ so you need to make sure you‟re asking for the right amount
      iv) People will often want to meet w/ the CEO before they invest
      i) Real potential problems w/ the business
           (1) Not just std statements like the market has the potential to change
      ii) Discuss tough areas and explain how they will be overcome
           (1) Ex – Barriers to Entry - Distribution that is traditionally controlled by major players in the
               industry – here‟s how we plan to combat that
      iii) Someone who doesn‟t think they have any challenges does not feel like a sophisticated
   f) Terms to Know
      i) CASH FLOW – how much $ comes in and how much $ goes out
           (1) NOT equivalent to profits
               (a) Profits usually limited to certain period of time
               (b) Profits can include money that you are owed but have not yet been paid
      ii) BURN RATE - how quickly you‟re going through cash
           (1) Usually given as a monthly figure
           (2) Start-ups are always on the verge of running out of cash
      iii) BREAK-EVEN POINT – where you have enough $ coming in to cover the $ going out
           (1) When you hit a certain place in your business that you‟re profitable
               (a) Note – difference b/w being profitable going forward (point at which you start taking
                   in a profit) - and making enough $ to cover all your costs that led up to this point (what
                   you put into the business initially) – when you reach this point, this is when you reach
                   break-even (when you can cover all your costs that led up to reaching profitability)
      i) While all other toys are technically competition, there is no direct competition for the
           Designatoy product. Nothing provides the interactive hands on ability to design a custom
           product and then delivers that same physical product to the child as he designed it. Alpha
           Toys believes that it will capture sales from portions of each of the software market, the action
           figure toys, dolls and stuffed toys market
           (1) “No direct competition”
               (a) Slightly too bold of a phrase – not a thoughtful statement and does not inspire the
                   confidence that it‟s meant to inspire – probably makes them sound inexperienced &
           (2) “Nothing provides the interactive . . .”
               (a) Might be too misleading and it sounds like you have a better reading of the business if
                    you‟re more realistic about it.
               (b) What about Build-A-Bear?
                    (i) You have to tell them that they should change this for legal reasons
      i) Based upon our conservative projections, Alpha Toys will make $7,546,514 million of net
           profit by year 3. Even using the most pessimistic projection model, the Company still shows a
           smaller profit of $2,652,236 million by year 5.
           (1) Just to be clear, the most pessimistic projection is that the company will go out of business
               and lose everyone‟s $ - but no one would write that.
   c) FOUNDERS - type of management team you would look for
      i) Managers matter more than products to investors (experience and drive are the most important
           factors in management)
      ii) Connections and luck are most important to the success of a business
      iii) You want a team w/ good, varied experience (different types of management experience that
           will fit different needs w/in the company – want to know where people have worked and what
           they‟ve done)
           (1) Bill Harris – yrs of experience in the toy industry- has worked in senior management for
               both Mattel and Hasbro. Will serve as president and CEO of the company.
           (2) Carol Jones – yrs of experience in marketing and research w/ special focus on children.
               Also has an MBA and an advanced degree in child psychology. Will serve as Executive
               Senior VP of Marketing
           (3) Diane Indigo – yrs of experience in toy design and strong software engineering
               background. Will serve as Executive Senior VP of Design and Engineering.
      iv) This is a good team
   d) Law & Accounting Firms
      i) If a start up is trying to show it‟s legitimate you want big names for your accounting and law
           firms – if a big firm takes you on, it‟s a vote in your favor w/ investors, especially ones that
           specialize in start-up companies.
      i) Sometimes people may not want to be on a Board of Directors b/c of liability issues – in that
           case you can create a Board of Advisors
      i) Not directors of the company but smart knowledgeable people who have been around and will
           agree to occasionally get together and meet w/ the company to give advice
      ii) Given stock options in exchange
      iii) NO fiduciary duties – more of an executive consultant position
      iv) Lawyers – can serve as an advisor BUT if you take stock in a company, it‟s a conflict of
           interest – but it‟s a waivable conflict
           (1) If I have stock in a company, I get emotionally involved w/ the choices the company
               makes and that‟s a COI.
           (2) Usually when lawyers get stock, you should have an outside lawyer review your deal w/
               the company giving you stock – can also state that the lawyer advises the company to get
               outside counsel but this is still not the best idea
           (3) Fees – lawyers would bill at regular rates and get paid out of first round of financing –
               would also state that they had the right to buy X % of stock at the founders‟ rates –
               occasionally they would say that they had the right to invest in some future rounds.
   a) Proprietary information
   b) Internal Strife
   a) Research toy industry – find out more about the business of the client
   b) Read over business plan – tell them where they‟re overreaching
   c) Know that management matters more than products to investors
   a) First Year Projections
      i) Total Revenue
           (1) Total Wholesale Revenue
           (2) Gross Licensing Profit
           (3) Total “Float” Revenue
      ii) Cost of Goods Sold (COGS)
      iii) Expenses
           (1) Cost of employees
               (a) Salaries
               (b) Benefits and SS taxes
           (2) Equipment
           (3) General and administration
           (4) Legal/accounting
           (5) Research and development
           (6) Total real estate costs
           (7) Software package and shipping costs
           (8) Sales and marketing
           (9) Miscellaneous and contingency costs
      iv) Cash Flow – cumulative (not just for 1 period)
   b) DON’T just look at the #s on the spreadsheet
      i) MUST look at assumptions page next to the #s
           (1) Assume # of customers will grow each year
           (2) Assume they will have less than ½ of 1% of the total toy market
           (3) COGS assumes that for every product you sell, you make 40 cents on the dollar – over
               time is it assumed that the costs of goods goes down b/c you are producing more
      ii) Know whether these assumptions are based on research or mere approximations
      iii) With every spreadsheet there is 1 box that drives the total amount of expected profitability
           (1) In this case it‟s the # of customers – this will drastically affect the expected profitability
           (2) MUST scrutinize projections to see if they are realistic

                            II.     FINANCING (2 Categories – equity and debt)

1) FINANCING (2 Categories – Equity & Debt)
   a) DEBT – a loan
      i) When you borrow money you don‟t give up any part of your company
   b) EQUITY – traditionally stock in a company
      i) You are giving up a % of ownership in the company
      i) How you pay operating expenses of the company
2) EQUITY – stock in a company
   a) STOCK – sold when a company is started (common vs. preferred)
      i) Base level of ownership in a company
         (1) Residual stake in profits and losses of company
         (2) Last in line to get paid
        (3) Only good to have stock if the company is doing well
        (1) Usually given to founders of company - residual interest in the profits and losses of the
            company but also last in line to be paid
        (1) Given to investors
            (a) Preferred stock has rights, preferences, and privileges that are superior to common
            (b) Usually have liquidation preference, voting rights, and can approve/disapprove certain
   i) Most companies have at least 3 rounds of financing and each round generates a new class of
        preferred stock (dilutes ownership interests of original investors)
        (1) Most companies underestimate their monetary needs – not being deceitful, they just fail to
            understand how long it can actually take to get a deal done – people will be encouraged to
            raise a little more than they need.
   ii) Venture capitalists sometimes urge people to raise more than they need b/c they get a bigger
        piece of the company.
        (1) Must remember to leave something on the table – if you buy 97% of someone‟s company,
            their incentive to make it work goes down b/c they can take the $ and run. As a venture
            capitalist you want management to get really rich if the company succeeds.
        (2) Venture capitalists – if they invest in 10 companies, only three of them need to succeed for
            them to have a phenomenal year, 2 successes is still pretty good.
            (a) It‟s really hard to be successful and it‟s really hard to know who will be successful –
                too many factors involved to predict success
            (b) Part of the reason venture capitalists extract such onerous terms from the companies.
   i) You can‟t start a company w/o raising money, but raising $ makes my % of the company less -
        The more shares you sell the more your percentage ownership is diluted (raising $ dilutes
        your % ownership)
        (1) Note – the earlier you raise money, the more you are diluted b/c the stock you sell in the
            beginning is not worth much – only after the company is proven to have staying power is
            the stock worth any real money
   ii) Pros to Dilution?
        (1) Others share the risk – can benefit the company & you sometimes want to be diluted if it
            benefits the company
            (a) 50% of 1 million is better than 100% of $10
            (b) 50% of 1 million is not as good as 100% of $800k.
   iii) Why does dilution matter?
        (1) Voting – if diluted below 50% you may lose control of the company
        (2) Payout – the greater the % ownership you have, the more you get paid
   i) Right to purchase stock at a certain price
        (1) Often, when someone invests in a company or does business in a company instead of being
            given stock they‟ll be given warrants
        (2) Better than stock b/c you don‟t have to pay for them upfront – you only pay when the
            company is doing well
        (3) Sometimes have a timeframe to them but you get extra time to figure out where the
            company is going and how well they‟re doing so there is less risk
   ii) Why would a company prefer to give warrants to some people other than stock?
          (1) Giving warrants doesn‟t affect their right to control the company – shareholders have
      i) What the company is worth before I (as the investor) put money in. The investor wants this
          value to be lower and the company wants this value to be higher.
          (1) As you go further along, w/o raising $, the pre-money valuation goes up and the less of
              your company you have to give up to the investors, but the longer you wait, the less $ you
              have to drive the business and actually make it work.
          (2) Also, you can‟t spend all your time raising $, so you can‟t say that you‟ll raise the $ as you
              need it. You have to compromise b/w wanting to wait a long time to raise your $ and
              raising enough so you have time to run the business w/o having to stop to raise more
      i) What the company is worth after the investor puts money into the company.
      i) Need to meet tests when raising $
          (1) limits on how many people you can talk to and
          (2) how much $ you can raise
      ii) Long period of due diligence
          (1) Business scale – as a lawyer you read documents,
              (a) You call suppliers and talk to customers
              (b) Call others in the field to look at what company is proposing, see if technology is
              (c) Often done in conjuction w/ confidentiality agreements
          (2) Legal Scale
              (a) Depending on how long the company has been in business there‟s usually not that
                  much to do – if the company has been in existence for a long time you‟ll want to check
                  out litigation issues and contracts
              (b) Comes up all the time when IP is involved – make sure company has all the right
                  patents etc. make sure the technology actually belongs to the company
   a) Pros to Borrowing
      i) No Dilution - When you borrow $ you don‟t have to give up any part of your company
   b) Problems w/ Borrowing
      i) Bank doesn’t give a lot of $ to start-ups
          (1) Not in the business of gambling so you usually need collateral which is unusual for a start-
              up to have
          (2) Banks don‟t like to loan $ to start-ups b/c they often don‟t succeed – if their best case
              scenario is that they will get a 10% return on their $, their potential reward does not
              correspond to their risk – investors want a huge return on their investment b/c start-ups are
              SO risky.
              (a) In the 90s, accountants, bankers and lawyers wanted to participate in the success of the
                  company. They used a model where they lent $ w/ lower interest rates in return for
                  options to buy stock in the companies – if companies failed, bank just made a bad loan
              (b) These types of agreements blur the lines b/w equity and debt
      ii) Bank charges interest
          (1) Huge impact on cash flow – most companies don‟t have payment of interest built into their
              cash flow plans
          (2) Investors don‟t get paid – only participate in the appreciation of the company
   c) Promissory Notes – given when you lend – (2 Types)
        i) Bond – usually secured
        ii) Debentures – usually unsecured
             (1) Convertible debenture – can be converted into stock
             (2) Convertible Subordinated Debenture – Sometimes the convertible debenture will
                 subordinated behind a loan that is already there
     d) Stock as a Form of Debt
        i) You can modify the terms of an investment so that it looks like a loan – preferred stock that
             gets 7.5% return every year – it‟s classified as stock but it certainly looks like a loan
     e) Debt that goes along w/ warrant
        i) Debt that is convertible into stock (debt that looks like a warrant)
        ii) You make a loan into the company and the holder of loan has option of saying the money
             owed is converted into stock
             (1) Biggest questions:
                 (a) At what price?
                 (b) Who gets to decide?
                 (c) Are interest payments included?
     a) Hierarchy of Payments
        i) Creditors get before equity holders
        ii) Preferred shareholders get before common shareholders
        iii) Convertible Subordinated Debenture - sometimes convertible debentures will go behind other
             loans that are already there.
     a) Maxing out your credit card
     b) Raising $ from friends
6)   ANGELS (term that came about in the 90s)
     a) Venture capitalists – seen as evil and greedy – BUT Angels tended to be rich people who had
        made a lot of $ and wanted to invest $ in a company – usually came in early on before the venture
        capitalists came in
     b) Tended to give $ in the $100K range – not millions of dollars
     c) Angels – sometimes involved in helping/advising the company
        i) Google Story – when Google first started, the guys who started it were looking for $ - angel
             gave them $100K - made it out to Google Inc so they had to incorporate to cash the check
     d) Read “In Search of an Angel” – Wall Street Journal
     a) Gets you past the point of being a start-up to your first major round of financing
     b) Sometimes done in b/w rounds of financing
     c) Usually made up of investors of the company
        i) Features
             (1) Set up like a loan
             (2) Stated interest rate
             (3) Fixed date for repayment
                 (a) More like an investment b/c everyone knows that if the company fails, the money is
                     gone and they won‟t be able to pay it back
                 (b) But, if the first round of financing is something that the bridge lender doesn‟t like, they
                     can get paid back from the first round of financing
        i) Usually terms of conversion are NOT stated – usually state loan will be converted to stock on
             same terms and conditions as the first major round of financing (piggyback on terms set up by
             venture capitalists)
      ii) Usually provided by Angels
          (1) Good for Angels b/c it gives them the opportunity to get involved in a company that they
              would not usually be able to participate in
              (a) Can participate on protected terms negotiated by venture capitalists
          (2) Good for company
              (a) Puts them on better footing w/ the venture capitalists
      i) Big Issues
          (1) Automatic Conversion of Bridge Loan (§2) on subsequent transaction
              (a) NOTE - Investor always wants the option to be repaid or converted into stock.
              (b) Section 2.2 – subsequent transaction defined as $7.5 million b/w certain period
                  (i) Minimum standard set for conversion
              (c) Section 2.3 – Warrants – sweetens the deal for the lender
                  (i) Often part of bridge loan – usually get a few warrants automatically and as time
                       passes, the number of warrants you get increases.
                  (ii) For every $100 you invest, you get 2.5 warrants or 2.5% warrant coverage
                  (iii)Price of warrants is set at 95% of the subsequent transaction
              (d) Section 2.4 – company at its option may pay the interest accrued on the loan or convert
                  it into additional securities
                  (i) Good for company; investor should want the choice of whether the interest
                       converts or doesn‟t convert
          (2) Repayment §4
              (a) If a deal does not close by August 31, 2006, the lender shall be paid back along w/
                  interest – it would be better for the lender if it is at his option.
                  (i) If a transaction occurs in September or for $7.3 M and the lender wants to
                       participate, he is out of luck b/c he must be paid back – should negotiate for the
                       option to participate in a subsequent transaction
          (3) Additional Provisions §6 (miscellaneous)
              (a) Company and investor shall not assign their rights and obligations
              (b) Entire understanding of parties is contained in this agreement and supersedes all
                  existing agreements – if the agreement says it, it‟s not part of the deal.
              (c) Choice of Law
              (d) Attorney‟s Fees Provision
      ii) SAMPLE WARRANT (Review Handout on Bridge-Loan Warrant)
          (1) Adjustment provisions
              (a) For stock splits etc – put in place to protect warrant holder
8) CORPORATE PARTNERS (doesn‟t happen as often now)
   a) Upside
      i) Know-how and connections or investors that a small company may not have
          (1) If you‟re a struggling software company and Intel wants to invest this could be great b/c of
              their know-how and connections
   b) Downside
      i) Could be prevented from doing business w/ Intel‟s competitors
      ii) What they want might be the rights to your technology and all you‟re doing is selling it more
          cheaply to them.
          (1) Ex – Dole and Naked Juice
              (a) Dole wanted to make an investment in Naked. As part of the investment, they made
                  performance requirements where if they didn‟t meet them, Dole got more ownership.
              (b) In the end the Naked people ended up selling their entire company to Dole for ½ the
                  price and got barely anything
           (2) Apple computers
               (a) Microsoft invests money in Apple b/c they wanted to avoid monopoly status.
               (b) MS made a lot of money off the deal as a side benefit.
   a) A good VC will bring more to the table than just money.
      i) They have connections w/ other companies they invest in that they can bring you together with
           to help them both succeed.
   b) How VCs work and think
      i) If they invest in 10 companies, only 3 have to succeed to have a great year.
           (1) 2 is a good year
           (2) 5 is unheard of
      ii) They are not dumb nor are they inexperienced.
           (1) They reject and scrutinize every company.
           (2) It is hard to recognize who will be successful. There are too many factors involved.
      iii) They get onerous terms from the companies b/c of the low success rate.
      iv) They only invest in companies w/ potential for huge returns.

                       III.    VENTURE CAPITAL FINANCING (central to class)

   a) Reservation of Shares for Employees (pre-set allocation of shares that will be used for stock
      option plans or stock incentive plans – found in most deals )
      i) Purpose – everyone in the company should be incentivized, not just the people at the top
      ii) Usually 10% of equity will be allocated to employees
      iii) Investors – want to pre-agree to the amount that will be set aside for the employees (don‟t
           want their interest diluted by giving later shares to employees)
      iv) Companies – want to ensure that they have something set aside for their employees
   b) Preferred Stock
      i) Given to investors (may give them different rights than founders)
           (1) Note – the structure of PS and CS may influence the owners/founders not to sell the
               company – if all the money will go to the PS, the owners of the CS will not have the
               incentive to sell the company
      ii) Rights of preferred stock
           (1) Dividend Payouts
               (a) Mandatory OR Optional
                   (i) If optional,
                        1. Only given if declared by the Board of Directors
                        2. Usually optional in start-up companies (want $ to be reinvested into the
               (b) Cumulative or Non-Cumulative
                   (i) If cumulative, dividends add up each year
                        1. Might be paid directly to me
                        2. Might go to increase my equity
                        3. Might go to bulk up my shares of stock
                   (ii) If non-cumulative
                        1. dividends go away if they‟re not paid out
               (c) Provision is included so that if there is a dividend payout, the preferred shareholders
                   get to stand in front of the common shareholders
           (2) Liquidation Preferences
    (a) Used more and more as a tool to leverage a payback over just protecting your initial
        (i) Ex – you invest $5M and liquidation preference is $5M, this means before the
             common stock gets paid, you get your $5M – but it doesn‟t have to be $5M, it
             could be 3xs your investment for instance (you would get $15M before the
             common stock gets anything)
    (b) 3 Kinds of Liquidation Preferences (liquidation = any sale of the company)
        (i) Non participating preferred
             1. Normal kind – you get your investment back then the common stock gets
                 whatever is left over
                 a. Note – even if you have a non-participating preferred, their initial
                     liquidation preference may still be 3xs their initial investment, so they
                     would still get 3xs what their investment is before the common stock gets
        (ii) Participating preferred
             1. We get our initial share and after we get our initial investment, we still get to
                 share in 1/3 of whatever is left over (if 1/3 was the amount you initially
        (iii)Participating preferred w/ limit on participation
             1. You get your liquidation preference, then you get to share in what‟s leftover up
                 to a certain limit (limit can be a percentage of your investment)
    (c) Dividends
        (i) You can have your liquidated preference, plus accrued but unpaid dividends
             1. Adding the dividends will increase the amount that you walk away from the
                 deal with.
        (ii) Dividends may also get added to the dollars that you can convert into common
             1. Which option you choose depends on whether it‟s more profitable to have the
                 common stock or just walk away with the dividends
(3) Right to Convert - preferred stock is convertible into common stock
    (a) If it looks like there‟s a lot of $ for common stockholders, the preferred stock will
        convert to common stock (based on what you think you‟ll get as a common stockholder
        and what you‟ll get as a preferred stockholder – based on liquidation preference)
    (b) Note – a liquidation refers to any sale of the company – even a sale at a high value
        (i) Ex - Suppose you have a sale of the company – if you have a 1/3 of the company, if
             you convert, you will get 1/3 of the profit (so you have to figure out whether it‟s
             better for you to convert to common stock and share in proceeds of sale, or keep
             your liquidation preference and take what you get under that)
        (ii) Only time you don‟t have to make that decision is if you have a participating
             preferred w/ no cap & participating SH is participating at a rate = to the
             participation of common stock
(4) Anti-Dilution Protections
    (a) Intended to protect the preferred SHs so their percentage ownership is not diluted as
        more and more stock is issued
        (i) Ex. I have 5M shares and there are 10M shares of common stock and company
             decides to issue another 15M shares, my investment is cut in half (protection says if
             you‟re going to issue more stock then I want more stock) – not always (if I bought
             stock for $1 a share and you‟re selling for $2 a share, this is ok b/c my stock is
             more valuable – but if you pay .50 a share, it means I paid too much for my shares
             and I‟m being diluted)
        (ii) When common stock is issued, the conversion ratio is changed, so the effective
             price is decreased to the lower price that the stock has just been sold for.
    (b) Full Ratchet Anti-Dilution Provision - Conversion ratio shifts so your effective price is
        decreased to the low price that the stock was just sold for)
        (i) Provision – would automatically change my convertible provision (if you sold for
             .50 a share, instead of having 5M shares that were convertible into 5M shares of
             common stock, my 5M shares would be convertible into 10M shares
        (ii) Best protection you can hope for
    (c) Partial Ratchet Anti-Dilution Provision
        (i) I won‟t cover all of it – so instead of being able to convert into 10M in the above
             example, you can convert into 7.5M
    (d) Another Form of Protection
        (i) Instead of adjusting your conversion ratio, I‟ll just give you more shares – doesn‟t
             really happen except for most powerful investors
    (e) Pro Rata Rights – Protection (Pay to Play)
        (i) If company wants to sell more stock, you have the right to participate in that round,
             up to your percentage – you are basically guarding your % to maintain your
             original %.
    (f) Note – anti-dilution protection is not automatic – this gives the investor the ability to
        take an affirmative step to protect his percentage, perhaps if he doesn‟t have anti-
        dilution protection.
        (i) If you ever choose not to exercise those rights, they will go away
(5) Redemption Rights
    (a) Right of an investor to sell their stock back to the company OR
    (b) Right of the company to repurchase the stock of an investor
        (i) May be used on founders deals – don‟t want their family to have to be involved if
             they die.
(6) Voting Rights
    (a) Usually vote on an as-converted basis. PSH gets voting rights based on the conversion
    (b) PSH gets rights on which he alone has a say (reserved to preferred stock - can almost
        be a veto right)
        (i) Conversion
        (ii) Merger
        (iii)Refinancing (no new raising/borrowing of $ unless it is approved by the preferred
        (iv) Information rights – right to look over books and records
             1. Sarbanes Oaxley – applies to public companies – but as an investor w/ a start-
                 up, you may require compliance w/ these requirements so there isn‟t a
                 stumbling block before the company can go public
(7) Registration Rights
    (a) Background - When a company goes public and sells their stock (this means that they
        issue new stock to the public to bring new $ into the company & investors will NOT
        sell their stock) – when stock is sold on a public forum it needs to be registered
        (i) This means that holding stock in a company does not mean you are entitled to sell
             the stock just b/c company is publicly traded
    (b) Registration rights requirement – requires company to register shares of investor so
        the shares can be sold
        (i) Demand registration – makes company go through process and do it if they
             weren‟t going to do it initially
                  (ii) Piggy-back registration – if company was going to do it anyway, then I want you
                       to register me as well
              (c) Rule 144 (means registration rights are almost never used)
                  (i) If you have held stock in a company for more than one year, and the company is
                       publicly traded, then you can submit your stock and have it publicly traded
                  (ii) Limits on Rule 144
                       1. You can‟t do it w/ more than 5% of the stock of a company – you can use Rule
                           144 multiple times if you hold more than 5% of the company
              (d) Lock-Up Agreement
                  (i) I promise not to sell my stock for a certain period of time (usually 6 months) –
                       usually when the company goes public – Why have these?
                       1. Hard to get a company off the ground if the people most intimately involved are
                           cashing out
                       2. Depresses the value of the stock (when there is an IPO) if all the investors are
                           trying to cash out
                  (ii) Provision – usually says, if we ever go public, then you investor agree in the future
                       to sign a lock-up agreement
          (8) Right of First Refusal
              (a) If an investor is going to sell their stock, the company (or other investors) gets the right
                  to buy it first – before you sell to an outside, you offer it to the insiders
                  (i) Way of giving people a first shot at buying stock in the company
                  (ii) Strict Version – you go out and find a buyer and then tell me the terms and give
                       me the right to buy it
                  (iii)Looser Version – you offer it to me at a certain price, and if I turn it down, you‟re
                       not allowed to sell it to someone else at a lower price w/o offering me that lower
                       price first.
          (9) Co-Sale Right (aka Tag a Long Rights)
                  (i) If someone is selling their stock, they can‟t do that w/o giving me the right to
                       participate – I want the right to participate in your exit
          (10)         Board Representation
              (a) Most venture capitalist firms want someone on the board BUT don‟t want control of
                  the board
                  (i) Don‟t want burden of fiduciary duties
              (b) Works in conjunction w/ veto rights of preferred stock – veto rights are the preferred
                  method of controlling the Board
   c) Note – one thing you have to think about when including all of these provisions is what type of
      incentives you‟re creating for the company and the people who manage it
      i) Suppose you as the investor get 3xs your investment when cashing out – this creates an
          incentive for the company not to sell, until they‟re sure that the common stock will get
          something back as well.
      ii) Drives company towards a bigger exit strategy than might be appropriate – only way for the
          company to generate profit for the founders – might lead them to take bigger risks than they
          otherwise might
   d) Common Stock
      i) Given to founders
2) ***Note – Read over and insert into outline chart that summarizes the interests of the investor
   versus the interests of the company*** (pg 199)
                               IV.     ARTICLES OF INCORPORATION

Example Given: Company X

                   Shares                                Type of        Investment
Investors ( +      2,000,000          41.8%              Preferred      $7 M @ price of
Bridge Lenders)    200,000            4.18%                             $2.50 per share
Founders           2,257,143          54.64% (before     Common
                                      use of reserves)
                                      – 46.47% after
                                      use of reserves
Reserved For       400,000            8.24%

   a) Describes the rights and privileges of owning stock w/ respect to the company
   b) Describes the rights of owners vis a vis the company
      i) Example Given Above
          (1) Investors invest $7 M at $3.50/share = 2 M shares = 41.8% of the company
          (2) Bridge lenders get 200,000 shares = 4.18% of the company
          (3) Founders get 2,257,143 shares = 54.64% founders have majority control over company
          (4) Reserved for e/ees = 400,000 shares = 8.24%
              (a) After e/ees, founders have 46.47%
          (5) Pre-money valuation of the company is $10M
   a) When investors negotiate to buy into a company all their rights and privileges w/ respect to their
      stock and the company must be described in the amended articles of incorporation
3) Various Provisions of Articles of Incorporation
   a) Issuance of Classes of Stock §5.37– First Round of Financing
      i) Investors want to issue 2.2 M preferred series A but the founders want to issue 3M.
          (1) Founders
              (a) Don‟t want to set a limit on the amount of preferred stock that the corporation can issue
                  (want to have a cushion so they can issue more stock in the future if they need it). We
                  are only talking about adding additional investors to this round of financing not about
                  future rounds
              (b) Additional stock – gives flexibility; ability to attract new investors and move quickly –
                  it can only help the company to have more people that can help it do well
          (2) Investors
              (a) Want to set a limit on the amount of preferred stock that is issued
                  (i) Restrict funds coming in to what the company actually needs
              (b) Want to make sure their control is not diluted - don‟t want voting rights diluted by the
                  issuance of new stock
              (c) Don‟t want to give that much flexibility to the company
                  (i) I‟m taking on the risk now and I want more control – maybe you can issue more
                       stock 8 months down the road when I feel this is a safer investment
      ii) Resolving Conflict b/w Founders & Investors
        (1) If investor is concerned about risk of new investors, then founder can give the investor the
            right to approve of the transaction (who invests, how much they invest etc) – investor will
            allow it if it will help the company and he has some protection
   iii) One Point
        (1) Arguments that you make about what you want to include in the documents are legal
            arguments and life arguments (not really about the law – really about what‟s good for the
b) Dividends §5.38
   i) Founders
        (1) Want to be able to issue dividends at the discretion of the Board
            (a) (“when, as and if declared by the Board of Directors; non-cumulative, and no right
                 shall accrue to holders of Preferred stock if dividends are not paid or declared”)
        (2) Want dividends to be non-cumulative and non-mandatory
            (a) Want to limit payments to ensure that $ is returned to the company
            (b) Can say that the investor will get a bigger return on the investment if the money stays
                 in the company (especially w/ start up companies) – it will hurt the company to pay the
                 investors dividends
        (3) Issuing dividends will mean having to change the business plan
            (a) Business plan is based on a $7 million investment and company will not be able to
                 perform as projected if it needs to pay dividends to the investors
   ii) Investors
        (1) Want dividends to ensure that they have some return on their investment
        (2) If the founders don‟t want to pay dividends the investor can ask for some other concession
            from the founders
            (a) Maybe the dividends can kick in after a while – investor can say the numbers allow for
                 some payment of dividends after 5 years for instance
            (b) Maybe the dividends can be cumulative if cash flow is a concern - can accumulate and
                 be added to the investment in the company
        (3) Want to ensure that dividends are NOT paid on the common stock until the investor
            receives some dividends
            (a) “payable in preference and priority to any payment of any dividend on Common
c) Liquidation Preference §5.39
   i) What the preferred stock is going to get paid ahead of the common stock
   ii) What should the liquidation preference be?
        (1) Founders
            (a) Want to give them exactly what they invested in the company and nothing more
            (b) It will lower our [employees and founders] incentives to succeed if you (the investor)
                 have a huge liquidation preference
                 (i) If the company had a $10M valuation and I invested $7M then the investor gets
                      $14M before anyone in the company sees anything (assuming the investor wants to
                      double their return in the case of liquidation)
        (2) Investors
            (a) Want at least their investment back plus perhaps interest on the money they put in
            (b) Options for Investors
                 (i) Convert to Common Stock
                      1. Goal is not to get your liquidation preference – goal is to convert to common
                          stock – you want the company to succeed greatly
                 (ii) Participating Preferred w/ Limit
                     1. After the investor gets their liquidation preference, there is an additional
                         category where $ is split up w/ common stockholders up to a certain amount
                         (after that point the $ is allocated only to the common stock)
                         a. Take you initial return $3.50 as your liquidation preference then get
                             additional $ through this participating preferred w/ limit provision
             (c) The investor has to figure out what type of mathematical equation will allow him to get
                 the best deal (his initial investment plus something else)
d)   Right to Convert
e)   Automatic Conversion
     i) Not strongly negotiated – most times preferred stock will convert automatically at an IPO –
         negotiated terms are at what level of an IPO will the automatic conversion occur
         (1) What type of exchange
         (2) How much will the IPO price be etc?
f)   Adjustments to Conversion Price for Diluting Assets §5.44
     i) Anti-Dilution Provision
         (1) When the company issues more stock the conversion price for preferred stock will be
     ii) Exceptions to Adjustment of Conversion Price (para. 3 §5.44(3)(A))
         (1) No adjustment is granted when more stock is issued b/c some of preferred stock converts
         (2) No adjustment to stock issued to officers, directors, employees or consultants pursuant to
             stock incentive plans up to a maximum of ____ (assume # has been pre-negotiated)
             (a) Investor wants to exclude consultants b/c of concern that they will give stock to family
                 and call them consultants
             (b) Founders may claim that consultants can be more helpful than other employees – can
                 be instrumental to the success of the company & this would allow the company to
                 maintain some cash reserved by granting stock instead of cash for services performed
                 (i) Note – we are only talking about how we allocate the 400,000 shares reserved for
                     employees, not increasing it to add more shares for consultants
             (c) Compromise
                 (i) Investors can request a provision where they get to approve when consultants can
                     get stock
         (3) To financial institutions or lessors (banks) . . . subject to unanimous approval by the Board
             of Directors [b/c start-ups may want to use stock as currency]
             (a) Ok w/ investor b/c they will have a representative on the Board
             (b) Investors probably don‟t want to give stock to banks to make sure their value is
                 preserved and their shares aren‟t diluted
             (c) Don‟t want the company to give away all available stock then come back and ask for
         (4) Strategic Partnerships
             (a) Board must unanimously approve
g)   Notice Provisions
     i) Can be important as there are a lot of rights coming up
         (1) When is notice effective? When mailed or when received?
             (a) Mailbox rule
         (2) You can draft the notice provision that works for you
             (a) Email notice, mail, fax etc.
             (b) Email provisions are not sufficient – hard copies are good according to Chasalow
         (3) Boilerplate language but can become important if you don‟t get notice of something
h)   # of Directors and # of PSHs the Company Will Have
i)   Veto Rights (Protective Provision)
      i) How long will they persist?
          (1) Sometimes will go away when enough of the preferred shareholders have converted to
              common stock and there are still some PSHs left
          (2) Desire might be different depending on whether you represent the investors or the bridge
      ii) What do they consist of & deal with?
          (1) Dividends
          (2) Adding to Board of Directors
          (3) Sell Company
   j) Redemption Provision
      i) Company can be forced to buy back stock of investors

                       V.     PREFERRED STOCK PURCHASE AGREEMENT

   a) Purchase agreement is the central document, but document w/ least substance
      i) Framework for a lot of what the other documents will become
      ii) Will refer to amended and restated articles, will refer to buy/sell agreement, will refer to
           agreements b/w the founders – does not contain a lot of meat
      iii) More of a generic document
      iv) Bulk of this agreement lies in reps and warranties
   c) Use of Proceeds from Sale of Stock §1.3
      i) Net proceeds from the sale of the Shares issued by the Company shall be used for general
           corporate purposes, including working capital
           (1) This clause only really comes up when the investor and the company disagree over what
               funds should be used for – if they‟re both in agreement then it won‟t be an issue –
               (a) Company usually has control over this aspect of the business b/c they are the experts
                   and the investors already have some protections in place re certain business decisions
                   (veto power etc)
           (2) Investor
               (a) Wants to restrict the use of the funds to some extent – want some limits on what
                   general corporate purposes might be (not used for salary increases):
               (b) Approval over what funds are used for w/ respect to:
                   (i) Budget (if already in place) – 10% deviation is ok
               (c) “I have expertise in certain areas of financing so that I should have a say in what‟s
                   done w/ my money”
           (3) Company
               (a) Don‟t want limitations on their business decisions (don‟t want investors controlling
                   business decisions) – want flexibility & fluidity to run the company
               (b) Founder is the expert in this area – you‟re investing in my company b/c you think I can
                   do this – if you don‟t think I can do it, then you shouldn‟t invest in the company
   d) Subsequent Closings of Series A Preferred Stock §2.2
      i) How long will we keep the window open on this round of financing?
           (1) Company can sell the balance to 1 or more additional purchasers, at a price not less than
               the price per share of shares on closing date w/in X number of days
   e) Representations and Warranties (bulk of agreement)
      i) Section where the purchaser is saying here‟s what you‟re buying and I will represent and
           warrant that what you‟re buying is in a certain state or condition – promises made that thigns
           you are buying are in a certain condition
           (1) “As Is” is the opposite of reps and warranties
ii)    Buyer is relying on the company conforming to the reps and warranties
iii)   If you lie, it is potentially fraud
iv)    Bring out information that might not have been covered in negotiations
v)     Exhibit E can alter reps & warranties
       (1) Except as set forth in Exhibit E, the company represents and warrants:
           (a) Organization and Standing: Restate Articles of Incorporation
           (b) Corporate Power
               (i) We have the power to act in this way
           (c) Subsidiaries
               (i) We don‟t have any
           (d) Capitalization
               (i) How many shares have been issued
           (e) Litigation
               (i) There is no action (no investigation or suit) . . . to the best of the Company‟s
                    knowledge (Company must exercise due diligence and thorough investigation),
                    currently threatened against the Company that threatens the validity of the
                    Investment Agreements . . ., or that might result, either individually or in the
                    aggregate, in ant material adverse changes in the assets, conditions, or affairs of the
                    Company, financially or otherwise, when taken as a whole, or any change in the
                    current equity ownership of the Company. The foregoing includes . . . suits . . .
                    pending or threatened involving the prior employment of any of the Company‟s
                    employees . . .
               (ii) This is only a problem if litigation comes up
               (iii)Investor usually wins this
                    1. This is not my problem, if there‟s something out there that the company doesn‟t
                         know about they should be responsible – I‟m trusting your company w/ my
                         money and if there‟s something out there it‟s your problem
                    2. If you‟re worried that anything might be out there you should write it on
                         Schedule E so I don‟t have to worry about it
                    3. Company is in a better position to know if there‟s anything out there
                         a. Maybe there‟s a private suit against the Company by a former employee
                             hasn‟t been filed
                    4. Note – Company is expected exercise due diligence and conduct a thorough
                         investigation to determine if there is currently threatened litigation
           (f) Any threat that will affect the agreement or the company
               (i) Any suit against the company or any other entity that will affect the company
                    1. If you were an internet gambling company and the government has a suit
                         against a similar company, it must be disclosed
           (g) Change in equity ownership of the company
           (h) No Material Agreements
               (i) Except as set forth in Schedule of Exceptions
                    1. There are not agreements . . . to which the Company is a party . . . other
                         than (1) Ks for the purchase of supplies and services entered into in ordinary
                         courts of business that do not involve payment of $50K . . . and (2) Ks that are
                         terminable at will by the company on no more than 30 days notice w/o cost or
                         liability to the Company and that are not material to the conduct of the
                         Company‟s business.
                    2. Company – wants “to the best of company‟s knowledge”
                         a. Concerned about possible oral agreements that have been made
                    3. Investor – wants full disclosure of all Ks
             a. Might be concerned about a ton of Ks that are under $50K (could insert
                 language saying individually or in the aggregate the Ks are not to exceed
    (ii) NOTE
         1. Negotiations here will center around “to the best of our knowledge,” “material,”
             and “reasonably”
         2. May also center around “individually or in the aggregate”
(i) Company is not in material default under any of the Material Contracts
    (i) Company - wants to insert “to the best of the Company‟s knowledge they‟re not in
         1. They may not know if they‟re in default.
    (ii) Investor – wants as much disclosure/information as possible
         1. Wants to know as much as possible about the company
(j) Other than the material Ks, there are no agreements . . . to which the Company is a
    party . . . that may involve the license of the any patent, copyright . . . or
    proprietary right to or from the Company . . . or provisions restricting or affecting the
    development, manufacture, or distribution of the Company‟s products or services.
    (i) Company – soften w/ “to your knowledge”
    (ii) Investor – do your homework w/ respect to intellectual property
(k) Company has not (1) paid any dividends . . . (2) incurred any indebtedness for
    money borrowed or any other liabilities individually in excess of $25K, in excess
    of $100K in the aggregate . . . (3) made any loans or
    (i) Company - $100K is too low, especially for a $10M company
    (ii) Investor – $100K is reasonable b/c if you know about your debt you should put it in
         Schedule E.
(l) Title to Properties and Assets: Liens
    (i) Properties and assets of Company are not subject to any mortgage, pledge, lien,
         encumbrance . . . other than (1) lien of current taxes not yet due and payable and (2)
         possible minor liens and encumbrances which, when considered individually or
         together, do not detract from the value of the property . . .
(m) Employees
    (i) Company is not aware that any officer or key employee intends to terminate his
         employment w/ Company nor does Company have intention of terminating any of
         the prior employees
    (ii) Investor wants to know if there are problems w/ management or if employees want
         to leave
(n) Employment of each officer and employee is terminable at will of the Company
    (i) Investor wants at will Ks – don‟t want problem employees sticking around
(o) Governmental Consent
    (i) Necessary permits have been obtained
    (ii) Company wants to insert language saying that the permits have been obtained or
         will be obtained
(p) Offering Requirements
    (i) Exempt from requirement of registration under Section 5 of Securities Act
(q) Brokers or Finders
    (i) Investor wants to know if there are any finders fees to be paid; don‟t want to invest
         in companies that have to pay huge fees ($1M of the $7M just invested for
(r) Permits
                    (i) To the company‟s knowledge they have all franchises, licenses that it needs to
                         conduct its business and the company believes it can obtain all the necessary
                         permits that will be required to run its business
                (s) Changes
                    (i) No event that can negatively impact the business
                (t) Financial Statements
                    (i) Fairly represent the company
                    (ii) W/ Sarbanes Oaxley they may require the CEO & CFO to personally sign off on
                         the financial statements
                (u) Full Disclosure
                    (i) Company has provided each purchase w/ all the information that such Purchaser
                         has requested for deciding whether to purchase the shares. Neither this Agreement .
                         . . contains any untrue statement of a material fact or omits to state a material fact
                         necessary to make the statements herein or therein, when taken as a whole, not
       vi) Purpose of Reps and Warranties
            (1) Not to get your money back from the company; but to uncover potentially damaging
                information w/ the threat of personal responsibility to the officers of the company if
                something happens – can be sued personally for fraud if there are lies in the reps and
10) Reps and Warranties of Purchaser
    a) Sole purpose – qualify the stock deal for exemption under the securities law
       i) We’re sophisticated; I have a certain new worth; I understand this is a risky investment; there
            will be restrictions on transfer;
       ii) Purchaser has had an opportunity to discuss the Company‟s business, management, and
            financial affairs w/ the Company‟s management . . .
            (1) Usually is you‟re the lead investor you have read everything and looked at all the books;
                this is not usually the case w/ small investors or bridge investors and it‟s not something
                you can do anything about (people just usually sign this)
11) Conditions to Closing of the Purchasers
    a) Usually signed ahead of time
       i) Reps and warranties are still true and correct
       ii) Covenants have been performed
       iii) Blue Sky laws have been complied with
       iv) Compliance Certificate – delivered by President and certifies that everything has been done
    b) Company – wants to make sure there isn‟t an easy out for the purchaser – should be things the
       company has control of
       i) Purchase still believes in viability
       ii) Include things that are verifiable by the company not by the purchaser
12) Covenants of the Company
    a) Things the company promises to do
       i) Vesting of employee stock options – must put certain limits etc on stock options
       ii) Prompt payment of taxes – Company will promptly pay all lawful taxes, however, such tax
            need not be paid if the validity thereof shall currently be contested in good faith by appropriate
            proceedings and if the Company shall have set aside on its books adequate reserves w/ respect
            (1) Company – doesn‟t want to set aside anything b/c they want the cash to be free for use;
                may be too cash strapped to pay the taxes; don‟t want to have a new round of financing
                which could dilute the interest of the investors.
            (2) Investor – don‟t want to jeopardize the company by having property foreclosed etc.
               (a) Becomes a problem if Company can‟t pay their taxes or there is some unfair tax being
           (3) Solution – board approval of whether or not you try to contest a tax – unanimous approval
               since investor will usually have one representative on the Board.
13) Miscellaneous Important Provisions
    a) §8.2 Entire Agreement
    b) 50 % Required to Amend the Agreement
       i) Provision should be in all agreements – if you need a super-majority to amend the other
           agreements but you can amend the investor agreement w/ a majority, you need to watch out for
           this b/c you can go around the super-majority you may need to amend the other agreements.

                                    CO-SALE AGREEMENT

1) Investors’ Rights Agreement; Right of First Refusal; Co-Sale Agreement
   a) All do roughly the same thing (name is not that important – content is)
   a) Initiating Holder – any investor or investors, who in the aggregate, hold not less than ___ % of
      the Preferred Stock
      i) How big a percentage is necessary in order to enforce certain rights?
      ii) Relevant on 2 fronts:
          (1) What percentage does your client have?
          (2) What if your client wants to dispose of a certain percentage of their holdings? What your
              client may have down the road.
   b) Restrictions on Transferability (shows up in 2 sections)
      i) The preferred stock shall not be sold, assigned, transferred or pledged except according
          to provisions of §4 below.
          (1) §4 - Before you can transfer any stock you have to receive a written opinion from legal
              counsel satisfactory to the company [if reasonably requested by the company], or a no
              action letter from the SEC – additionally, company will not request a no action letter w/
              respect to transfers not involving a change in the beneficial ownership of the stock or . . . .
              (a) If an LLC invests in a company for instance, the company may purchase the stock as
                   one entity then pass out stock to the partners – in this instance the company will not
                   require an opinion of counsel or a no action letter from the SEC.
          (2) Notes
              (a) The opinion from the attorney is relatively easy to come by – exception for
                   sophisticated investors which most investors in this scenario would probably fall under.
                   (i) This is not really a problematic section for either the investor or the company (it‟s
                       relatively easy to come by for high stakes investors (sophisticated) and the
                       company just wants to make that the investors are complying w/ the SEC rules)
              (b) SEC is trying to protect inexperienced investors
      ii) Company’s Potential Problems w/ Transferring the Stock
          (1) If the stock is constantly being transferred the company will have to spend a lot of time
              dealing w/ the investors and not dealing w/ the business of the company
          (2) The more SHs you have the more difficult it is to get approval to make certain decisions
              and you have more personalities that may come into conflict – potential prob of a holdout
          (3) Company wants to maintain control of their business operations
          (4) Original investors were probably chosen in part b/c of their capital, commitment; contracts;
              experience; and past successes – don‟t want a new person coming in w/o the same contacts
              – venture capitalist companies can facilitate really difficult steps in the process
            (a) Distributors and suppliers for instance – there‟s a lot in the selling process that the
                venture capitalist (VC) can bring to the table – if they request the right to transfer at
                any time, it seems to undercut their commitment to the company
            (b) Unlikely that people will sell – VCs tend to sink or swim w/ the company but this is
                still a discussion that people tend to have
   iii) Other Plausible Restrictions on Transferability (Middle Steps)
        (1) Right of first refusal
        (2) Right of co-sale (tag-along)
        (3) Allowance of transfers subject to approval of board of directors
        (4) Transfers can be limited by percentages (e.g., 20%)
        (5) Exceptions for investors and family members or to a trust for the benefit of a family
        (6) Give preferred SHs no rights if they drop below a certain %
c) Registration Rights
   i) In case the company shall receive a request from initiating holders (note you have to have a
        certain percentage of stock to be an initiating holder), they will proceed to register . . .
   ii) Company can still get out of registration temporarily . . . “Notwithstanding the foregoing,
        the Company will not be obligated to take any action to effect or complete any such
        registration pursuant to section 5.1 . . .
        (1) Prior to the earlier of 6 months after the effective date of the Company‟s first registered
            public offering of the Common Stock or 3 years subsequent to the date hereof
        (2) If such registration is not proposed to be part of a firm commitment underwritten public
            offering w/ nationally recognized underwriters reasonably acceptable to the Company
        (3) If market conditions are unfavorable company can terminate or withdraw the offering –
            can‟t have deferral more than once a year
            (a) If the Company shall furnish to the Initiating Shareholders a certificate signed by the
                President stating that in the good faith judgment of the Board of Directors it would be
                seriously detrimental to the Company for a registration statement to be filed in the near
   iii) Investors Must Sign Underwriting Agreement
   iv) Going Public
        (1) When a company goes public, they sell new stock to the public
            (a) Under this agreement, investors may have the right to sell stock but it is generally
                frowned upon
            (b) The investors may be allowed to cash out
                (i) Underwriters may prohibit cashing out - even on a demand registration, the
                     underwriters (investment bank handling the IPO) can say that too many shares are
                     being offered and they can take some of the shares off the table – they can cut back
                     on the number of company and investors shares being offered as part of the IPO
                (ii) Lock-Up Agreements – usually state that once the company has gone public the
                     investors can‟t sell their stock for the first 6 months (which is why some investors
                     try to sell their shares in the IPO)
                     1. Hope is that when the company goes public it will continue to grow so you
                          don‟t want to sell (Best Case – IPO provide additional needed capital so the
                          company can really take off)
                     2. Some investors want to get out in case stock nosedives
   v) Non-Transferability of Registration Rights
        (1) Company does not want a ton of people holding registration rights and asking for things
   vi) Expiration – after 5 years
d) Indemnification Section
      i) When the company goes public the company will say certain things in the registration
           statement and the investor will provide certain information re things stated in the registration
           (1) Most companies finds themselves in lawsuits relating to the registration statement in an
               IPO b/c of broad scope of securities law and 10b5
      ii) What happens if the company is sued and there was some untrue information provided?
           Parallel provisions for the company and for the investors.
           (1) Company will cover
               (a) Litigation and fees for any untrue statement (or alleged untrue statement) of a material
                    fact contained in any registration statement . . .
           (2) Holder will cover
               (a) Litigation and fees for any untrue statement (or alleged untrue statement) of a material
                    fact contained in any registration statement that was provided by the investor
      iii) Any concern over these provisions?
           (1) Investor – will be liable for any alleged untrue statement – does not want to have to pay the
               costs of defending a frivolous claim. Company should pay defense fees is allegations
               against investor are proven false
               (a) Should claim – it‟s part of the cost of doing business – you‟re the company and you
                    should have to cover the cost of litigation – the investor should not have to cover that
                    cost if they did nothing wrong – this is no different than the company being sued for
                    some other misrepresentation that isn‟t true.
               (b) If the investor actually does something wrong then they should have to pay
           (2) Company – does not have to have to cover something that they should not be held
               responsible for
               (a) Company should purchase insurance that will pay for the defense of the company and
                    the investors in these suits
   a) Investor gets to buy up to their % of shares when there are new shares issued
      i) “Company hereby grants to each investor holding at least __ number of shares of Preferred
           Stock or Common Stock a right of first offer to purchaser such Investor‟s Pro Rata Share of
           any New Securities, which Company may, from time to time, propose to issue and sell”
   b) Investor – likes this type of provision
      i) Means that company can‟t dilute their % ownership in the company
   c) Company – this is a mandatory provision for the company
           (1) If they want new investors for the Company they have to go to the old investors first – the
               Company probably wants the option of going to other investors w/o having to go through
               the old investors.
           (2) May want new investors to have more connections; more pockets to reach into;
           (3) May want to dilute the shares of the old investors
   d) Provision mainly relates to control
      i) Who gets to decide what should happen if the company wants to go to new investors
           bypassing the old investors?
           (1) If something is good for both the company and the investors they will both agree to do it
               and waive any provisions that get in the way – it‟s only when there‟s conflict as to what‟s
               good for the company that the provisions become important
   e) Investor usually wins
      i) Usually gets pro rata rights
      ii) Pay to Play – if you don‟t use them in one round you may not be able to use them in a
           subsequent round
   a) Applies ONLY to Founder Shares
      i) Founder Shares – any securities of company issuable to or held by founder having voting
           rights in election of board or any securities evidencing an ownership interest in the company,
           or any securities convertible into or exercisable for any of the foregoing
      ii) “In the event either Found proposes to sell, transfer . . . any of the Founder Shares to any
           proposed purchaser , each purchaser shall have, (i) subject to the prior right of the company, a
           right of first refusal on the terms described below to purchase such Purchaser‟s Pro Rata Share
           of the Founder shares”
   b) Company gets the first opportunity to buy any Founder shares then the investors get a
      chance to buy the Founder’s shares if the company refuses.
   c) 2 ways it can be set up
      i) Ask me first
           (1) ABCD are founders – if C wants to sell, C can come to the other founders and say she
               wants to sell for X and the other founders can buy her shares for that price (better for C)
      ii) Ask me second
           (1) C goes to 3rd part and strikes a deal w/ that party. Once the deal is set, C can go to the other
               founders and allow them to match that offer
               (a) Usually the Founder will go out and strike a deal w/ a third party and come back to the
                   Company who will want to be able to buy any or all of the stock
               (b) If the Company does not buy any or all of the stock then the remaining investors have
                   the right to buy any or all of the stock at the price that was offered to the third party.
   d) Note - the any or all language is very important to the company and will be negotiated for - has
      the potential to mess up a deal w/ a third party who wants to purchase a certain amount of stock
   e) Time Limitations
      i) On how long the company or original investors get to decide
5) CO-SALE AGREEMENT (Tag Along Right)
   a) Right of first refusal and co-sale agreement may work independently or in conjunction w/ each
      other – in this particular agreement they work in conjunction w/ each other
      i) Even after the Founder has offered the stock to the Company and the investors and they have
           refused, they still have the tag-along right – that is, if the Founder gets to sell, the others get to
           tag along w/ the sale if they wish – the agreement b/w the shareholders can‟t bind a third party
           – so the Founder must purchaser the appropriate number of shares from the other investors in
           order to maintain that balance
           (1) Ex – suppose Founder C wanted to sell all of their shares (which represents 10% of the
               company – C would sell all of her shares to the 3rd party and simultaneously buy back 90%
               of her shares from the other investors
      ii) Purpose of Provision
           (1) This is supposed to avoid the situation where one Founder cashes out and leaves everyone
               else w/o a means of exiting
      iii) Founders generally agree to this provision even though they may not like it
   b) Exemptions
      i) Frequently you can sell up to a certain percentage of your holdings w/o being subject to the
           right of co-sale
      ii) Transfers to spouses, ancestors, descendants, etc.
   c) Note – these rights go away when an IPO happens

                                          VII.    LOAN FINANCING

   a) Most Common – borrowing $ from a bank
   i) You pay them interest and principal over time
b) Loan Characteristics
   i) No dilution of ownership
   ii) May still have to give up some control of company to lender
   iii) Lender only cares about balance sheet
   iv) Lender only cares that you do well enough to pay back the loan
        (1) May not allow company to take risks necessary for huge growth
   v) Bank has recourse if business can‟t pay back the loan (whereas, the investor can‟t ask for their
        $ back)
   vi) If banks don‟t get repaid on a loan it‟s a disaster
        (1) Not like investors where a 30% rate of success is a good thing – this is b/c the return on
            successful loans for banks is much less than the return on a single investment for a VC
c) Role of Counsel
   i) Protect the company
        (1) Assess risk and assess options
   ii) Sometimes the lawyer may be involved in financing, but the type of financing is a business
d) The Decision to Borrow
   i) Advantages to Borrowing
        (1) Lack of dilution to existing ownership structure
            (a) Not giving lender a piece of the company
        (2) Lack of Restrictions/Control
            (a) BUT sometimes lenders may put rigorous controls on your company – as much as an
                investor could, but a lender cares more about your balance sheet (may restrict risk
                needed to grow the company b/c it‟s not in lender‟s interest for company to take risks –
                in their interests for the company to stick around and pay them back.
        (3) Fixed cost – for use of funds w/ not dilution of ownership
        (4) Flexibility – most short-term loans offer the borrower advantage of using only as much of
            the loan as may be needed
   ii) Disadvantages to Borrowing
        (1) Repayment Timing
            (a) Debt service on loan – can be significant and hamper the growth of the company - If
                the company hits a rough patch the bank can demand that the company repay the
                money and destroy the company (investor can‟t do that)
        (2) Leveraging
            (a) Excessive borrowing w/o sufficient additional equity capital may cause the business to
                become too highly leveraged and will restrict further borrowing
        (3) Need for personal shareholder guaranties
        (4) Need for adequate collateral
            (a) You must have hard assets or you probably won‟t get a loan
        (5) Foreclosure
            (a) Loan default could result in foreclosure by lender and loss by the business of its assets
        (6) Guaranty Liability – lender will require investors to guarantee the loan personally and
            occasionally require that personal guaranties be secured by a deed of trust on residence of
            guarantor or a lien on personal property of guarantor
   iii) Today
        (1) Most start ups are technology companies w/o tangible assets that the bank can foreclose
            on.- banks won‟t give start-up loans
        (2) Also when a startup does well, everyone (investors included) get rich, but when a loan
            does well it doesn‟t have much of an impact on the bank
           (3) Banks protect themselves by
               (a) Assessing the company
               (b) Asking for personal guaranties
           (4) Loans are usually given to
               (a) Company w/ wealthy founders
               (b) Company w/ hard assets
                   (i) Real estate
                   (ii) Clothing industry – people will place orders if they like your design but you have to
                        pay for the cost of making the orders upfront – you need to get a factor – factors
                        are lenders but not bankers (tend to lend money at really high rates) – if you have a
                        K w/ Nordstroms for instance – the factor will give you money, you will assign
                        your rights under the K to the factor & while the order is being processed you pay
                        interest on the money that has been advanced as well as a fee for advancing the
                        money – finally after Nordstrom‟s receives the finished product, they will pay the
                        1. Not the most profitable way to do business but it allows you to monetize the K
                            – similar to accounts receivable financing
                        2. Factoring depends less on the creditworthiness of me the seller, than on the
                            creditworthiness of the person who placed the order (Nordstroms)
                   (iii)Glen Ivy – one of the first time share companies – if you buy a time share you buy
                        the right to use a condo for one week a year (represents an interest in property so I
                        can get a mortgage to pay off that lease)
                        1. To make their real profit Glen Ivy would bundle hundreds of mortgages into a
                            group (mortgage backed security) & they would sell these (someone would
                            have a guaranteed stream of income and they could get money upfront.
                        2. Example of how borrowing allowed the business to thrive – they were able to
                            take this money and build more properties and reap more profits
               (c) Banks don‟t tend to be flexible w/ respect to changing their loan agreements
           (5) Startup companies be wary:
               (a) Need to be wary of loans from bigger companies in the same industry & terms of loans
                   b/c if smaller company falters the big company can declare a default and seize the
                   technology of the smaller company
               (b) What happens if I stumble?
   e) Types of Lenders
      i) Commercial Banks
      ii) Commercial Finance Lenders
           (1) Specialized by industry
               (a) Ex – equipment lending, factor financing (clothing)
      iii) Insurance Companies
      iv) Other Sources
      v) Exemption from Usury Laws for Certain Business Loans
   a) Affirmative Covenants
      i) Balance Sheet
           (1) When banks start putting limits on things – they will tend to look towards the assets and
           (2) Assets are usually listed in terms of liquidity (cash ----- real estate) & banks may look to
               the liquidity of the company
               (a) Want to see a ratio of current assets to current liabilities that is relatively high
                   (i) When that ratio drops that tends to be a sign of problems
              (b) Debt/equity ratio
                  (i) How much you owe compared to how much is a surplus for the owners
                  (ii) Banks care about your total debt & one problem w/ borrowing money is that it
                       limits your ability to borrow money in the future
                  (iii)Total borrowing can interfere w/ success so some agreements may limit total
                       borrowing (not just borrowing that comes ahead of the bank)
     ii) Insurance
          (1) Bank wants to ensure that if something happens to the company the assets of the company
              are insured so there can be some claim there
     iii) Compensating Balances
          (1) Sometimes a bank will allow you to borrow money provided you keep a certain amount of
              money in the bank – may make sense when you have funds that you aren‟t allowed to use
              until next year for instance
     iv) Sinking Fund
          (1) Bank doesn‟t require you to keep $ in the bank – more of a forced savings w/ the intent
              that the money saved by the company will go towards paying off the loan. It is a devoted
              account intended to save to pay off something or buy something
b)   Negative Covenants
     i) No dividends w/o banks consent
     ii) No repurchase of shares
     iii) No money coming out of company to pay someone else other than the bank
     iv) Catch All Default – failure to perform any provision of the agreement . . . borrower will be
          held in default
     v) Cross default – if you default on any related agreement then it is a default on all of the
c)   Restrictions
     i) Many restrictions are financial in nature
          (1) Less about what the company can do business wise and more about financial terms
              (a) debt to equity ratio must be ___ etc
     ii) Lender liability suits
          (1) Usually the result of a bank taking enough control to have some responsibility for the
              failure/success of the business – bank will have become a principal by taking control of the
          (2) Bank needs to be careful about playing too big a role in managing the company – limits on
              what a company can do are broader (don‟t want to be seen as managing the company) –
              lender liability and principal agent
d)   Schedule
     i) Time frame that declares when the principal of the loan will be repaid
     ii) Schedule may require payment of the loan if the business takes certain actions
          (1) Selling equipment etc, selling parts of the company
     iii) Problem w/ pass through entity
          (1) Phantom income – if you have a company w/ 4 people making $1M a year, A will have
              income of $250K and have to pay taxes on the $250K. If you have to pay down a loan for
              the bank, there isn‟t money to distribute to the members, but they still have to pay tax on
              the $250K that they supposedly made. When you pay back principal this does not reduce
              your income for taxable purposes.
e)   Subordination
     i) Ordinarily a bank will be first in line to be paid and will always be ahead of the insiders
          (1) Question becomes if you have a situation where the bank is owed $5M – you might have a
              situation where the founders won‟t put more money into the company b/c they will be
              worried that their claims won‟t be ahead of the bank‟s claim – they may have to say to the
              bank we want your rights to be subordinated to new capital coming into the company –
              sometimes banks will do it, sometimes they won‟t
          (2) If bank does not allow subsequent financing to come in ahead of their claim they may
              cause the business to fail
   f) Reps and Warranties
      i) Especially w/ revolving loans, banks will ask you to reaffirm the reps and warranties each time
          you take money out
      ii) There‟s nothing w/in the company documents that prevents this loan from occurring (b/c
          sometimes there are provisions stating that loans can‟t be sought w/o approval of preferred
3) REVOLVING LOAN (aka line of credit)
   a) Represents a pool of money on which you can draw (for seasonal businesses for example) – you
      don‟t pay interest until you borrow the money
   b) Time period for repayment – usually short
   c) Fee – there is almost always a fee just for having access to the money
   d) Conversion into term loan – attempt to negotiate a right to convert the revolving loan to a term
      loan that has a maturity date and payment schedule that the borrower can comply with.

                              VIII. AGREEMENTS AMONG FOUNDERS

   a) Founders
      i) Put together the idea to form a business – often the founders are the first people w/ whom the
           lawyer interacts
           (1) tend to work hard;
           (2) be somewhat naïve about really happens (need the lawyer to protect them from themselves
               while recognizing that you will probably represent the company and not the individuals)
           (3) driven;
           (4) enthusiastic
   b) Lawyer
      i) Protects founders from themselves while recognizing that the client is the company
           (1) Difficult balance b/c at first the founders are the company
           (2) Need to make it clear to founders that you represent their business
      ii) Deals w/ potential conflicts among the founders
      iii) Deals w/ 3rd parties coming in after the company has already been founded – must make it
           clear to third parties that they should seek independent counsel b/c lawyer‟s client is the
   c) New Company (esp. w/ technology companies)
      i) Intellectual Property (assignment of IP)
           (1) Typical scenario – you have founders A, B, C who invented a cure for baldness – typically
               founders will assign their rights to the company
               (a) It‟s in the best interests of the company to own all the rights outright
               (b) It‟s not necessarily in the best interests of the founders to assign all their rights
           (2) Clause – for valuable consideration transferor transfers and assigns entire right, title, and
               interest in ____ property to ____ entity, including any and all confidential, proprietary, or
               trade secret rights, patent and patent rights . . . and rights to all copyrighted and
               copyrightable material, to the extent any such rights or information exist now, or may
               hereafter come into existence.
      ii) Company’s Interests
           (1) Wants entire right assigned to it or if this is not possible an exclusive license
           (2) Investors want entire right or exclusive license
               (a) It will be hard to value the company and harder to get financing from outsiders if the
                    company doesn‟t own the rights outright
           (3) If the founder wants a significant share of the company – they have to give up more of
               their rights
           (4) Company may even say that the founder should assign all their rights to it and then the
               company will license the technology back to the founder for use in other areas
      iii) Founder’s Interests
           (1) May want to license the technology to the company (for unlimited use) rather than assign it
               in exchange for payments for the right to use the technology and a percentage of the
           (2) May want to restrict the right to use the technology for the thing the company was started
               for (in this case baldness), but if the medicine could be used for something else, you may
               want to retain the right to use it in this new way.
               (a) This only really happens when the technology is valuable enough that the inventor has
                    tremendous bargaining power
           (3) The larger the share of the company that the founder owns, the more willing the founder
               will be to do what‟s in the best interests of the company and not in their own best interests.
           (4) Royalty Payments
               (a) Stream of payments – founder may want some income from the company in addition to
                    their ownership share in the company
   a) Founders – usually work for the company
      i) What protection are we entitled to?
   b) Investors
      i) If necessary, when can I get rid of the founders?
   c) Generally, founders are not the people who can take the company and make it into a Fortune 500
      i) Founders never believe that this applies to them
   d) Definitions
      i) Disabled – condition continues for a period of ___ years from the date initially determined or
           for an aggregate of ___ years during any continuous ___ year period.
           (1) Whether or not someone is disabled and unable to continue working for the company is not
               as clear (not like death for instance) – for example, woman gets pregnant and is on bed-rest
               this counts as a disability – it may be critical for the company to be able to move on even
               when it‟s not the fault of the founder and the company will fail w/o that people there
      ii) To what is the disabled founder entitled?
   e) Purchase on Death, Termination of Employment, or Disability
      i) Events Triggering Purchase
           (1) Shareholder’s death;
               (a) Investor – likes provision, wants company to retain control of stock but wants the
                    option to buy it back
                    (i) Ideal provision - company shall have the right but not the obligation to repurchase
                        the stock should any of the events occur
               (b) Founder – may want the shares to pass to their family so they want the option to sell it
                    (i) Ideal provision - company shall, at the shareholder‟s election repurchase the stock
                        upon the occurrence of any of these events
           (c) Any fixed position – could be bad or good – don‟t want to lock yourself into having to
               buy back the stock or sell back the stock – what you always want is choice.
               (i) On balance, it‟s probably better for the company to repurchase the stock on the
                    founder‟s death assuming you can truly establish a FMV for the stock b/c the
                    founder‟s family will probably need the cash and the company will probably need
                    the equity to attract someone to replace the founder
           (d) Another way to hedge
               (i) Pick a fixed percentage that the company will be entitled to repurchase
       (2) Shareholder’s disability;
           (a) Disability clause is hugely important – b/c if a disable SH can have their stock
               repurchased, the definition becomes hugely important
       (3) An employed shareholder becoming a terminated shareholder (fired);
           (a) Under what circumstances can you be terminated?
               (i) Felonies, crime, gross negligence, intentional misconduct
               (ii) Doing a bad job
               (iii)Board can fire officers, especially if they are doing a bad job
               (iv) Can the Board fire you if you own stock in the company as they could w/ regular
                    1. Depends on percentage of company owned – 52% would control the board so
                        probably not, but 20% you can be fired – the only protection would be through
                    2. Big battle is whether you should be treated differently than other employees –
                        you can make the termination payment so high that it‟s not practical to fire the
           (b) Founder – what should be the triggering events for being fired?
               (i) Gross negligence
               (ii) Can make the termination salary so high that there‟s a disincentive to fire you
           (c) Investor – what should be the triggering events for firing someone?
               (i) If you do something for which you could be prosecuted for, then you could be fired
                    (may limit it to felonies)
               (ii) Simple negligence
           (d) What happens to the founder’s stock when the founder is terminated?
               (i) In this example they treat a founder‟s firing as a trigger for the repurchase of the
                    founder‟s stock
               (ii) With respect to repurchase of stock – important questions
                    1. Is the right assignable?
                        a. Company gets to repurchase but can assign it to SHs
                    2. How the price is calculated
                    3. How much can be repurchased
   ii) Note
       (1) You don‟t have to use the same standards for death, termination of employment or
           disability – you can have certain set percentages bought back for disability as opposed to
           death for instance – these categories don‟t all have to have the same consequences.
f) Terms to Know
   i) Key Man Life Insurance
       (1) When a company is set up to repurchase the stock of a founder who dies, but there is
           concern that there might not be enough cash on hand to buy it back, the company will take
           out a life insurance policy on the key founders – when the founder dies, the insurance
           policy is paid to the founder‟s estate in exchange for he founder‟s shares – the company
               does need to come up w/ the premiums for the life insurance but this is cheaper than
               having to buy out a dead founder‟s stock
           (2) Founder – needs the ability to ensure that the company continues to pay the premiums b/c
               when cash gets low this is usually the first thing to go
      ii) Disability Insurance
           (1) Can be purchased for the same thing
   a) In this agreement buyouts come up under 2 different scenarios
   b) Questions
      i) How do you determine FMV?
           (1) Parties will come to an agreement or go to arbitration
           (2) Appraisal method
               (a) Parties will agree upon an appraiser or the parties will each pick an appraiser who will
                    pick another appraiser and the two closest will split their appraisals – there are a ton of
                    different appraisal methods
               (b) Chasalow prefers appraisals
               (c) Have an appraisal w/ guidelines
           (3) You can have a set formula
               (a) Chasalow doesn‟t like these b/c you have to revisit them over time and they can be
                    totally arbitrary
           (4) Minority Discount and Control Premium
               (a) Sometimes the company is willing to pay more or less depending on the % of the
                    company they are repurchasing
           (5) Multiplier
               (a) Usually determined by the industry
      ii) Payment Terms (almost as important as price)
           (1) Lump-Sum or Spread Out Payments?
               (a) Company - Better for the company to pay over time
               (b) Family - Better for the family to have all the money upfront
                    (i) Long term payment has risk if the company goes under further down the line, but
                        you can secure the payment
           (2) What’s a fair interest rate?
               (a) If the payoff takes a long time, the right to payment is secured by the stock that is being
                    repurchased – so if you don‟t pay me money, the only thing I have is the right to get
                    my stock back
                    (i) This is bad for the founder‟s family b/c they are turned into a lender – they have the
                        risk of the company failing but none of the upside. There isn‟t really any way to fix
                        this – usually a standard provision b/c most people anticipate they will be on the
                        buying end not the selling end
      iii) Penalty Clause
           (1) If the buyout isn‟t done after the clause is activated there should be some sort of penalty
               (a) Other party might get the right to the buyout at a lower price
               (b) Creates incentive to actually follow through w/ the deal
   a) One SH can repurchase the other‟s shares (can become a kind of chess game w/ people trying to
      figure out how they can get control of each other‟s shares)
5) Pass Through Entities
   a) At a minimum, you have to ensure that the company pays enough dividends so the SHs don‟t have
      to pay the taxes out of their own pockets – for S-corporations especially
6) Voting Covenants; Optional Order of Purchase; Personal Guaranty
   a) If SHs holding the required majority vote to accept a tender offer . . . then each SH will vote w/ the
      majority in order that the offer may be accepted unanimously by the Corporation‟s SHs.
      i) Voting agreement that eliminates dissenters‟ rights
7) Covenant not to compete
   a) Enforceable when the person signing them has an ownership interest in the entity (not enforceable
      in CA w/ respect to regular employment Ks)
8) Hitting a Bump
   a) When companies hit a bump, they will usually restructure and force the original investors to take a
      position that is not really in their best interests – a founder could be subject to the same sort of
      restructuring if they are no longer useful – so the founder must either remain useful or insert
      provisions protecting themselves from this sort of restructuring

                                         IX.     STOCK OPTIONS

   a) An option is the right to purchase at a specified price
      i) Probably the most widely publicized device used in a start-up
   b) How it works
      i) You are given a piece of paper that says you have the right to buy stock in this company at a
           certain price
   c) Private Start-Up Company
      i) Your price at which you can buy is usually very low
      ii) Usually given as incentives to employees, directors, officers etc. – to align the goals of the
           people running the company w/ the goals of the people invested in the company (if the stock
           price goes up everyone benefits)
   d) Limits on Stock Options
      i) Expiration date – you can only buy stock up to a certain point before the option expires
      ii) Vesting of Option – options usually vest over a period of years
      iii) What happens when you leave the company?
      iv) Transferability – might not be transferable
      v) Stock – that is ultimately purchased might be restricted in various ways
      i) Adopted by company, usually w/ broad parameters – plan outlines the parameters of the
           specific stock option grants
      ii) Specific, differing plans may be developed for various people in the company
      iii) Approved by board of directors
      iv) May be something that a venture capitalist (investors) will have veto power over
           (1) Will use words like “no longer than” “no more than”
           (2) You can let one group vest more quickly than another
      v) Set number of options granted & can be allocated by committee in several ways
      vi) Dilution provisions – options will be adjusted for stock splits, recapitalization etc. – does not
           get adjusted when the company issues more shares
   f) Potential Issues Raised w/ Stock Options
      i) Taxation
           (1) Usually raised from the employee‟s standpoint b/c ordinarily compensation given by a
               company is taxed – the question is how will they be taxed? Often it‟s very hard to value an
               option absent a market system (not present in start-ups)
           (2) Two types of stock options
               (a) ISO (Incentive Stock Option)
                    (i) If you know the value of the option at the time you get it you have to pay taxes on
                         it (can be priced in a market system where the options are traded)
                    (ii) Tax-Free Plan – you‟re only taxed when you sell the stock.
                    (iii)AMT - BUT under the Alternative Minimum Tax (AMT), the value of stock
                         options that you‟ve exercised but not sold is counted, so you may still have to pay
                         taxes on it
                    (iv) There is no deduction for the company
               (b) Non-Qualified Stock Option (NQSO)
                    (i) You must pay tax on your gain when you exercise the option (actually purchase the
                         stock) – taxed as ordinary income.
                    (ii) The gain is the difference b/w the amount paid for the shares under the option and
                         the purchase price of the shares at the time you actually buy the shares.
                         1. How do you come up w/ the $ to pay the tax?
                         2. If the stock goes down, your tax on the stock may be more than what the stock
                              is worth
                              a. Chasalow says – always sell the stock when you exercise the option
                    (iv) Company gets a deduction for the tax the employee paid as though the company
                         has paid the employee actual compensation
      ii) Not a Shareholder
           (1) When you hold stock options, you are not a shareholder in the company - you become a
               SH when you exercise the right
      iii) Short Expiration Periods
           (1) People may be forced to decide if you want to exercise your option before the company
               goes public – can take 5-7 years before a company goes public
           (2) Some plans say that if you leave the company your options expire 30 days after you leave
               the company and you may need to decide whether to exercise the option
      iv) Transferability
   a) Expensing Stock Options
      i) For a long time, stock options were not put on the book as an expense – for a long time stock
           options were not considered to be liabilities when doing the books of a company – it was
           looked at as changing the ownership interest in the company (reducing the percentage of
           ownership held by people) but not reducing the actual value of the company
           (1) Debate is shifting in the opposite direction now
      ii) Counter-argument – people thought this was deceptive b/c even though the company was
           worth the same thing on paper, the value to the individual SH was less b/c their shares of the
           company were being reduced, and this was being used as compensation – if you didn‟t give the
           options you would have to pay employees more in salary in order to attract them – the
           valuation of the company was less that what it seemed b/c the stock options were essentially a
           liability that the company would have to pay out in the future.
      iii) Companies don‟t like expensing options so they‟ve tried to think of alternatives to
           compensation (see below)
   a) Stock Options to be Purchased Immediately
      i) You would have to buy the stock right away and instead of having the shares vest over time,
           the company would have a right to repurchase the stock and the company‟s right to repurchase
           the stock would lapse over time, exactly as if the shares were vesting over time
   b) Restricted Stock
      i) Bigger companies would just give stock rather than options to the employees, but the company
          would give less stock
          (1) If the stock stays flat or goes down somewhat it‟s a much better deal but if the stock goes
              up a lot it‟s a much worse deal (b/c options are worth a lot more when the stock price is
              rising fast)
   c) Phantom Stock
      i) Company doesn‟t want to issue more stock to its employees so it gives them some certificate
          that they can redeem for money down the road based on an increase in the stock price
   d) Stock Appreciation Rights (SARs)
      i) Basically the same deal as phantom stock – as stock goes up you will receive a bonus (but you
          don‟t have the actual stock)
4) Alpha Toys Stock Option Plan (Handout)
   a) Both ISOs and NQSOs have been authorized
   b) Exercise Price
      i) Option shall not be less than 85% of the FMV of shares on the date the Option is granted –
          allowed under law to discount the shares slightly
   c) Exercise period
   d) Exercise of Options
      i) §6.2 Payment
          (1) Cashless exercise – you are allowed to buy the stock and simultaneously sell enough of it
              in order to purchase the stock
              (a) “through a „same day sale‟ commitment from Optionee and a broker-dealer . . .
                   whereby Optionee irrevocably elects to exercise the Option and to sell a portion of the
                   Shares so purchased to pay for a exercise price and whereby the NASD Dealer
                   irrevocably commits upon receipt of-such Shares to forward the exercise price directly
                   to the Company
   e) Limitations on Exercise
      i) If Optionee leaves company, he must exercise the right w/in 90 days
          (1) §6.4.1 – if Optionee ceases to provide services as an employee . . . Optionee may exercise
              such Optionee‟s Options to the extent that they would have been exercisable upon the date
              that Optionee ceased to provide such services, w/in 90 days after the date that Optionee
              ceased to provide such services, but in no event later than the expiration date of the Option
      ii) §6.4.4 --- deals w/ military leave
          (1) Good example of things that may come up, that are unforeseeable
   f) Escrow: Pledge of Shares
5) Alpha Toys Stock Option Grant
   a) Note – usually drafted by lawyers of company – not equal negotiating power – employees usually
      accept them as they are – usually one-sided documents
      i) Company wants to be covered on all bases
   b) Grant of Option
   c) Exercise Period
      i) Vesting date – 20% after the first year, thereafter exercisable at an additional 2.083% per
          month (works out to 20% per year) –
          (1) Vests month by month so that company will not have an employee who doesn‟t want to be
              there hang around so they can exercise the option
   d) Termination of Option
      i) Termination generally – if Optionee ceases to be employed . . . for any reason . . Option is
          may be exercised within 30 days after the Termination Date . . .
           (1) Note that the stock option plan gives the company the discretion to allow the employee to
               exercise the option as late as 90 days past termination but this agreement limits the time to
               exercise to 30 days
      ii) Death or Disability
           (1) Employee has 6 months to exercise the option
   e) No Right to Employment
      i) Nothing in the Plan . . . shall limit in any way the right of the Company . . . to terminate
           Optionee‟s employment or other relationship at any time, w/ or w/o cause, and w/ or w/o
   f) Tax Withholding
      i) Prior to issuance of Shares upon exercise of Option, Optionee must pay or provide for any
           applicable withholding obligations of the Company
   g) Non-Transferability of Option
   h) Tax Consequences
   i) Acceptance
      i) Optionee has reviewed the Plan and this Option in their entirety, has been advised and had an
           opportunity to obtain the advice of counsel prior to execution . . .
      ii) This is NOT equal negotiation
   j) Consent of Spouse
      i) CA is a community property state and this counts as income & spouse has a right to it
6) Alpha Toys Stock Option Exercise
   a) When employee is ready to act, this is the form they need to fill out
      i) Purchase of Shares
           (1) How they will be paid for
      ii) Representations of Purchaser
      iii) Compliance w/ Securities Laws
      iv) Affirms certain things
           (1) Restrictions on stock
               (a) Right to repurchase and right of first refusal
               (b) Restrictions apply to stock and not just options
           (2) Stock options are securities
7) Note
   a) Stock options themselves are securities – need an exemption from securities law for issuing stock

                                 X.      EMPLOYMENT AGREEMENTS

   a) Every company needs to hire people & make various arrangements w/ them for compensation etc.
   b) Biggest Issue
      i) At will employees vs. For term employees
          (1) There is no right answer to this – there‟s always a right answer after the fact
          (2) If for term, worst case scenario is that you buy out their K
      ii) What do employers prefer?
          (1) It depends but they tend towards at-will Ks b/c they don‟t think that term Ks get them that
              (a) Some prefer at will b/c they want the option of being able to fire at any point
              (b) Some prefer Ks b/c they want to lock in good talent and they can always buy out the K
                   if necessary (big companies)
           (2) If you can prevent someone from taking a job elsewhere this clause starts to take on new
      iii) What do employees prefer?
           (1) It depends
               (a) Some employees prefer a term K b/c it gives them stability and job security;
               (b) Others (some especially law students) prefer the flexibility that comes w/ being able to
                   change jobs at any time they wish
   c) Golden Parachute
      i) Usually not at start-up stage, usually during a restructuring phase of a company, but it can be
           put in if you‟re worried that the company may be taken over
      ii) Provision – if the company gets taken over (and I get fired), I will get a ton of money
      iii) Take-Over defense
           (1) Can be used as a take-over defense - may dissuade purchasers if they have to pay a ton of $
           (2) Down-Side
               (a) In a public company it seems as though you‟re stealing $ from the SHs but if you‟re a
                   key employee and key SH it doesn‟t seem that outrageous
   d) Golden Handcuffs
      i) Usually discussed in the context of people leaving their job at a law firm – not a device that‟s
           used, but more of “I’m making so much money right now that I can’t afford to leave or
           I’ve started living a lifestyle that makes it impossible for me to leave my current job” –
           some big firms start a line of credit for their employees which can lock employees in.
      ii) When your compensation in a start-up is all going to come later on down the road, this is
           another form of tying up your employees
2) AGREEMENTS Regarding Employment Relationship
   a) K for at-will employment
      i) Purpose
           (1) K is necessary so employees can‟t claim it‟s term employment (can‟t say you promised
               them orally that they could stay at the company until it started to pay off)
           (2) K is also necessary b/c start-up companies absolutely cannot afford to defend a lawsuit,
               especially employment suits.
               (a) Most of the issues in a suit like this are questions of fact b/c much of the controversy is
                   he said/she said so the chances are good that a suit like this will go to trial.
      ii) Provisions
           (1) Employee‟s future salary rate, bonus, position(s), conditions, terms and benefits of
               employment, if any, shall be determined by the Company in its sole and absolute
           (2) Employee agrees to abide by the Company‟s rules, regulations, policies and practices as
               revised from time to time by the Company in its sole and absolute discretion.
           (3) Notwithstanding any other term or provision contained in this Agreement, or in any
               Company rules, regulations, policies and practices, Employee‟s employment with the
               Company is not for any specified term and may be terminated by Employee or by the
               Company at any time (i.e. “at will”) with or without cause and with or without any notice.
           (4) With the sole exception of the Mutual Agreement To Arbitrate, if applicable, this
               Agreement constitutes the complete agreement and understanding between Employee and
               the Company . . . . Employee understands that no representative of the Company has been
               or is authorized to enter into any agreement or commitment with Employee which is
               inconsistent in any way with the terms of this Agreement.
               (a) Courts felt that it was coercive to force someone to give up their right to a jury trial in
                   exchange for a job, so mandatory agreements to arbitrate were held unenforceable
           (5) The terms set forth in this Agreement may not be modified in any way except by a written
               agreement signed by Employee and by Bill Jones, the Company‟s President, which
               expressly states the intention of the Employee and the Company to modify the terms of this
      iii) Note
           (1) Even though an employee is at will you can‟t fire them for a bad reason (legally prohibited
   a) Agreement is sometimes given to employees, sometimes given to independent contractorss
      i) Two important aspects
           (1) Keep our Secrets Secret
               (a) You need to ensure that when someone works for you, what they create is your
                   property. This is true if you have a company where your employees are creating things
                   that can be owned
                   (i) ("Employee") agrees to assign . . .all his right title and interest in all ideas, inventions, discoveries,
                           concepts, information and improvements, whether patentable or not, made, developed or conceived
                           by Employee, solely or jointly with others, during the term of his or her employment with the
                           Company . . . except for any idea or invention for which no equipment, supplies, facility, trade
                           secret information or Confidential Information of the Company was used and which was developed
                           entirely on the Employee's own time and (a) which does not relate either to the business or potential
                           business of the Company or to the Company's actual or demonstrably anticipated research or
                           development, and (b) which does not result from any work performed by the Employee for the
                           Company. Employee shall not be obligated to assign any invention which is wholly conceived by
                           Employee after he or she leaves the Company, unless such invention involves the utilization of
                           Confidential Information. Nothing contained in this Paragraph 1. shall prevent Employee from
                           utilizing knowledge and experience of a general nature acquired in the performance of services for
                           the Company. (Last sentence makes the employee feel better although it‟s fairly obvious that the
                           statement is not necessary).
                     (ii) This was a big problem at universities where professors were going to technology
                          firms where they would get paid for their inventions – now universities use revenue
                          sharing programs
                     (iii)Provision is extremely broad and covers anything created in the context of
                          1. So if the employee comes in at night and uses the lab to create something
                              entirely on their own it would still belong to the employer – broad provisions
                              are legal under CA law
                 (b) Non-Disclosure
                     (i) I won‟t tell anyone what I know unless it gets into the public domain & I promise
                          not to use what I know (this is important b/c how a company does business can be a
                          huge competitive edge – it might be why someone wants to hire away an
         ii) Non-Compete Agreements -You can‟t go out and work for other people
             (1) Unenforceable in CA w/ very limited exceptions
             (2) Exceptions
                 (a) If someone has an equity in a business or ownership of the company and is selling the
                 (b) If there is a real specific expertise that you have developed it may be enforceable
                 (c) Mostly not enforceable
             (3) Provision
                 (a) During Employee‟s employment with the Company and for a period of one (1) year thereafter Employee
                      agrees not to, directly or indirectly, whether as an employee, agent, consultant, representative, officer,
                     director, investor or otherwise . . . perform for any Client any services which are the same, similar or
                     comparable with any services performed by the Company for any individual or entity at the time of
                     termination of this Agreement or within the twelve (12) months prior to the termination of this
               (b)   Under no circumstances shall the provisions of this Agreement be construed to create any restriction on
                     Employee that would violate any applicable law, including California Business & Professions Code
                     Section 16600.
                   (i) Note – this is not a non-compete agreement exactly, they are just agreeing not to
                        work for a client of the firm – this may be enforceable according to Chasalow.
                        Additionally, the last clause is to save the agreement from any challenge stating
                        that it‟s overly broad and does not comply w/ CA law
           (4) Why put in a non-compete agreement even if it‟s unenforceable?
               (a) It‟s the illusion of a boundary and sometimes employees won‟t fight it if they think it‟s
                   enforceable – even if told it‟s unenforceable they might still comply w/ it or they won‟t
                   leave b/c they don‟t want a fight
                   (i) Chasalow thinks this is an unethical way of behaving
           (5) What are you allowed to do?
               (a) Protect your information – keep people from contacting your clients – prevent
                   interference w/ your established interests
                   (i) They can put out a new business flyer or something along those natures
               (b) Can prevent an employee from recruiting other employees out of the company
   a) Key Provisions
      i) “As much time as is reasonable and necessary which shall not be less than her full
           business time, attention, skill and efforts to the performance of her duty . . “
           (1) Employee – what does business time mean exactly? Concerned that it will be too much
               (a) Additionally the employee may want to engage in a business that does not compete
                   (such as teaching or serving on a Board of Directors)
               (b) Does not want to have to seek approval every time they want to engage in something
                   that may not be related to the business.
               (c) Managing personal investments – maybe even engaging in a non-competing business –
                   a person of this stature probably has businesses or investments on the side
           (2) Employer – views “business time” as whatever it takes, but no less than full-time
               (a) All the employee‟s waking hours?
               (b) Your full professional efforts (any time spent in the business world).
                   (i) This it to protect against CEO doing a fantastic job in 2 hours and taking off – you
                        want them to be at the office thinking about what‟s good for the company and what
                        they can do to help the company.
               (c) Want to lay specific parameters for side activities like teaching (perhaps 4 hours a
                   week) – parties must set boundaries ahead of time as to what is ok and what must be
               (d) Want to approve everything on a case by case basis
      ii) Salary
      iii) Vacation & Vacation Pay
           (1) Some Ks have use it or lose it provisions – CA does not look favorably on this policy
      iv) Non-Compete Section
      v) Termination Provisions
           (1) Death or Disability
               (a) What is a disability and when does someone lose their job?
           (2) For Cause
               (a) Incompetence
               (b) Continual failure by employee to perform her duties (as described by the company)
               (c) Fraud – stealing by the employee
               (d) Material breach of the employment agreement
                   (i) Cure period – material breach of the agreement which the employee fails to correct
                        after written warning
               (e) Unable to perform job – losing a license
               (f) Illegal conduct (felony convictions or some crime of moral turpitude)
                   (i) Problem w/ convictions is that sometimes people will plead to a lesser offense or
                        plead no lo contendere – language usually states that the act happened which could
                        lead to a felony conviction even if it doesn‟t ultimately.
                   (ii) Employee in the reasonable judgment of the employer has committed an act which
                        is felonious
       vi) Buy-Out Price
           (1) If company terminates the employee for any reason other than cause, they will have to pay
               the employee __ months compensation (limits the term provisions of an agreement) – your
               term will actually be limited to the # of months they have to pay out in actuality

                                               XI.     LEASES

   a) Terms to Pay Attention To
      i) Rent – comes in a lot of different forms
           (1) Can be a dollar figure that you pay or it can be a percentage (usually sales) to the landlord
               – almost makes the landlord an investor in the company – in shopping centers for instance
               % rents are common
      ii) Term of lease – usually involves locking in a rent for a certain period of time – ordinarily
           landlords want longer leases – it‟s a gamble based on what you think the real estate market
           will be like
           (1) Option to Extend – want the option to extend to be the client‟s not the landlord‟s
      iii) Tenant Improvements (TIs) – things that the landlord does to a space in order to get it ready
           for a tenant – sometimes involves out of pocket expenses for a landlord
      iv) Pass-Throughs – things you pay on top of your rent
           (1) You have a base rent then you pay costs that the landlord has that are passed through to the
               (a) Utilities
               (b) Maintenance costs
               (c) Taxes
      v) Personal Guarantee
           (1) If the company is an LLC, the landlord may want personal guarantees b/c they know that
               the individuals are not personally liable and they are worried about the limited liability
               aspect of the company
           (2) Alternatives to Personal Guarantees
               (a) Post letter of credit – promise by the bank to pay a certain amount of money or up to a
                    certain amount of money – like a security deposit but you don‟t have to come up w/ the
                    cash – pay a fee 1-2% to the bank, but sometimes the bank will ask for a personal
                    (i) Provides some protection to landlord and some security to the tenant
               (b) Limit to guarantee – provide a guarantee for 3 months rent or $50K – the guarantee
                    has a cap on it
               (c) Fade-Away Guarantee – goes away after a year, or goes away gradually
                    (i) Landlords may agree to these fade away clauses b/c landlords have a duty to
                        mitigate even if you breach your lease
      vi) Unamortized Commissions and TI’s
           (1) These are actual costs to the landlord of bringing in a new tenant (commissions to the
               broker and improvements made) – as time goes by, the landlord earns back these costs
               which are amortized over the course of the lease
           (2) If tenant has some bargaining power, they may not agree to an outright guarantee for the
               entire lease, but may agree to a personal guarantee of the unamortized commissions and
               TIs – if the landlord has an empty space they may prefer to accept this than to simply let
               the space sit.
                    (i) Note – although the tenant is of value to the landlord, usually the tenant has a lot
                        less bargaining power than the landlord
           (2) Note - Anything you can do w/ a guarantee you can do w/ a letter of credit
      vii) Triple Net Lease
           (1) Most Leases
           (2) You pay your base rent and every expense that the landlord has is passed through to you
           (3) Must be careful of these b/c sometimes unexpected costs are passed through
               (a) After 9/11 for instance insurance premiums went up a lot and these costs were passed
                    along to the tenants who had these clauses
               (b) Proposition 13 CA – when you buy property, the taxes are based on how much you
                    paid for the property at the time of purchase w/ small increases – property is not
                    reassessed until it‟s sold
                    (i) If building is sold while you are a tenant, the property will be reassessed and if the
                        increase in value is huge, the property taxes owed will be huge and passed along to
                        the tenant – ask when the building was sold and when it may be sold in the future -
                        may also want to try and put a cap on the taxes that are passed through.
   a) Terms/Commencement Date
   b) Rental
      i) Increase in Direct Costs
           (1) Tax provisions – there is a provision stating that taxes will ratchet up as property values
               increase, but if taxes fall below what they were during your base year, this benefit isn‟t
               passed on to the tenant – one way ratchet clause – you must still pay the base amount
      ii) Landlords do NOT usually accept stock in lieu of rent
           (1) Landlords should stick to being landlords, should not try to be investors
           (2) Company, likewise should be careful about giving away equity
   c) Holding Over
      i) What happens after the lease is over but you don‟t leave the premises?
           (1) In this instance the rent is increased 3 times
               (a) Could happen if you‟re negotiating a new lease (does not seem fair)
           (2) Attorney‟s Role
               (a) Must communicate this clause to the client and have them remember it b/c it would be
                    too unwieldy to insert a clause saying that it doesn‟t apply if they‟re engaged in good
                    faith negotiations
               (b) Also remind tenant to renegotiate new lease before old one runs out
   d) Use Section – Article 7
      i) If you want to do something non-traditional w/ the space you need to be approved
      ii) You need to know what your client‟s business is and what it involves
   e) Conditions of Premises
     i) Tenant agrees that premises shall be taken "as is", "with all faults", "without any
          representations or warranties"
          (1) Tenant is basically waiving a host of guarantees that are provided by the law
          (2) Tenant needs some guarantee or representation that the premises have not changes since
              they were first inspected
     ii) Taking of possession of the Premises by Tenant shall conclusively establish that the Premises
          and the Project were at such time in satisfactory condition
          (1) If it‟s not in satisfactory condition the tenant has to decide if they want to move in anyway
              and waive their right – this is a tough decision b/c at that point the tenant is usually packed
              and ready to move in. Once you go ahead and move in, it‟s a lot more difficult to compel
              the LL to do the work
f)   Repairs and Alterations
     i) Landlord has right to use their own people or require you to use their own people
          (1) LL is worried about tenant‟s people screwing up their building
          (2) Tenant is worried that LL‟s people won‟t do it right or the way they need it done
     ii) Approval of repairs should be done before signing the lease
g)   Project Services
     i) Landlords provide certain maintenance (heating and air conditioning) and this clause explains
          when they‟ll have to do it
          (1) You may have to pay extra if you want to work on the weekend and need heating etc.
h)   Excess Usage
     i) Tenant will not, without the prior written consent of Landlord, use any apparatus or device in
          the Premises which will in any way increase the amount of electricity or water usually
          furnished or supplied for use of the Premises as general office space; nor connect any
          apparatus, machine or device with water pipes or electric current (except through existing
          electrical outlets in the Premises), for the purpose of using electric current or water
          (1) This clause was added before computers became ubiquitous - they were a huge drain on
              the rest of the tenants when one tenant would use them a lot b/c the electricity bill would
              be split amongst all the tenants (so it didn‟t matter to L)
i)   Landlord is the sole electrical representative
     i) You can‟t have your own generator or use your own power company
j)   Right of Inspection
     i) Landlord can come in whenever they want to inspect – as the client‟s representative you want
          to make sure they will agree not to interrupt business meetings etc
     ii) Non-Disclosure Agreement
          (1) If the landlord has a right to inspect whenever he wants you should ensure that they sign an
              non-disclosure agreement to protect your client‟s interests
k)   Insurance Requirements
     i) Put in to require the tenant to have insurance so if something goes wrong they are covered by
          insurance – landlord wants to ensure that if something happens the client will still be able to
          pay the rent
     ii) If LL is supposed to pay and T‟s insurance will cover it, LL doesn‟t have to pay
l)   Assignment and Subletting
     i) Most leases allow for this – the only question is what are the conditions
          (1) In this particular lease you have to pay the landlord $3K and the incoming tenant must be a
              reasonable person that the landlord occurs
     ii) Additionally the original tenant is usually not let off the hook
     iii) Additionally, if the space is being subleased for a profit (b/c rents have gone up) there may be
          a provision that the landlord collect 50% of the profit from the sublease – in this case the
          landlord wants 75% which seems a little greedy
      iv) If 25% of the company is sold, this is deemed a transfer
           (1) What happens if you are taking on investors or introducing a new class of stock – this
               shouldn‟t be deemed a transfer but you will need to carve it out
   m) Default Section
      i) Tenant Side – you get 3 days grace period of late rent w/ 30 days opportunity to cure after any
           default after notice
      ii) Landlord Side – landlord is not in default unless the landlord fails to perform after notice and
           60 days has passed – opportunity to cure provision
   n) Estoppel Certificate
      i) Document that landlord requests of tenant that says – there are no defaults on behalf on the
           landlord as of the date of this certificate or if there are, they are listed below – thereafter the
           date of the certificate the tenant is estoppel from raiding any complaints hat happened prior to
           the date of the estoppel certificate
      ii) Sometimes used when the bank is refinancing a building and want to make sure that none of
           the tenants have a claim against he landlord
      iii) Can be used defensively if there‟s the possibility of a dispute b/w the landlord and tenant
   o) Liability of landlord
      i) Landlord is only liable for a maximum of 10% of the value of the property – can be less if they
           have a bank loan and have mortgaged more than 90% of the property – they are only liable to
           the extent of their equity in the property but in any event no more than 10%
           (1) This is a way of making recourse debt non-recourse
   a) Arrange the lease so if favors your client on certain critical points
      i) This is why it‟s important to know your client‟s business
      ii) Much of this is minute, but the importance is in the details
   b) Ex – Sheraton Deal In Dubai
      i) One of Chasalow‟s friends now puts in a provision stating that the rent for ___ hotel will
           decrease by ___ amount if the property on which the hotel stands ever ceases to be beachfront
           property – started putting this clause in after the government filled in some of the beach to
           make room for new developments effectively cutting of beachfront property that was already
           in place
      ii) Some stuff you will not be able to anticipate but you should try to anticipate what you can
      iii) Technology may affect people‟s rights and may affect what you can do
   c) Things to Remember
      i) Most standard leases are very one-sided – it doesn‟t mean you are stuck w/ them but it does
           mean you should expect it to be one-sided. Most lawyers represent LLs

                                                       XII.     LICENSING

   a) License
      i) Definition - the right to use something.
      ii) Usually license something instead of selling it.
          (1) Instead of detaching ownership rights, you retain them and let someone else use it to make
              money for them and for yourself.
   b) IP law
      i) Huge component of IP law here, but we won‟t address it.

 Chas likes this topic b/c it‟s actual business. It‟s one of the places where business strategy and legal practice coincide. The
document directly impact business strategy
      ii) Question in IP is
           (1) Can you protect it?
      iii) Question is NOT
           (1) How you can make money from this product/process/invention?
      iv) For this class, assume it can be protected (assume they already have the license).
   c) When do you want to do a licensing deal?
      i) There are things you want to keep and sell in a different direction.
           (1) Ex – drug can be used for multiple purposes
      ii) Control over trade secrets
      iii) You want to keep the reversion interest.
           (1) You only license it for a period of time.
      iv) You can license to a bunch of different people.
      v) Ability and Reach
           (1) Your business might not have the ability or expertise to maximize the benefit of the
               (a) Your reach might be further by licensing the product out
               (b) When you have a product you‟re not quite sure what to do w/, licensing it allows
                    someone w/ expertise to exploit it, while you still retain some benefits
      vi) Franchises – pricing
           (1) If it‟s too expensive to buy in, can just start your own business
      vii) You can avoid competition.
      viii) Can‟t reach the market
           (1) Example: car dealers get licenses for satellite radio.
               (a) If you don‟t have a K w/ the car companies, how are you going to get the product into
                    the car?
           (2) Allows word of mouth to spread the word about your product
           (3) Allows all parties to be in a place they otherwise would not be in
               (a) All parties can make $ from a deal being reached b/w the 2 parties
           (4) More common & useful in the global economy
      ix) Way to extend the life of your patent
           (1) Velcro story – Velcro trademarked the name Velcro then licensed it to companies – there is
               a product out there that is exactly the same as Velcro but goes by some weird name (hook
               and loop tape) – companies will pay the extra money to buy “Velcro” b/c it‟s such a well-
               known product that no one wants to use the generic version of it
           (2) Note – then you need to police the use of the trademark
   d) Goal (horizon)
      i) More volume, less money
           (1) When you license to a lot of people, those people can sell more than you could by yourself
   e) Drawbacks to Licensing
      i) When you license something you don‟t get as much as if you sell it
           (1) When you sell the product you give away all the rights so you get more $
           (2) When you license the product you retain some of the rights and this is not worth as much
               to purchasers
   a) Exclusive
      i) Can be granted based upon:
           (1) Time – i.e., a 6 month exclusive license
               (a) But if it does well the license can be extended
               (b) Ex – Guru-Net & Yahoo
           (2) Geography – i.e., you have the license in the Northeast
        (3) Scope – i.e., you have the right to sell the product as it applies to children‟s toys, but not
            for adults - also, Adidas licensing the manufacturing of caps to a company but no other
            articles of clothing
            (a) But if you do well, then you can extend to other markets/areas/regions
   ii) Is it a good thing?
        (1) Yes
            (a) Can build up the cache of a product – if a product is too widely disseminated it can lose
        (2) No
   iii) Apple v. Microsoft
        (1) Apple kept their operating system proprietary, forcing people to buy Apple computers to
            get their operating system. Microsoft allowed anyone to use their operating system, so all
            non-Apple computers used MS operating systems (MS basically gave it away).
        (2) Licensing is about
            (a) When you let people use your product
            (b) What to charge them
        (3) The best strategy is different for each product – depends on product and business strategy
            (a) Sometimes making less on each product, but having greater volume is a better deal –
                I‟d rather sell 1 billion products for $1 each than 100,000 products for $10 each
   iv) Problem of the Unproductive Licensee
        (1) More of a problem when they have an exclusive license (you care more)
b) Non-Exclusive
   i) Example – satellite radios in cars – 2 companies – (XM and Sirius)
        (1) Whether the car has the option of both companies or only one depends on whether the
            license is exclusive or non-exclusive
c) Concerns about licensing
   i) Volume – it is not always the case to have great volume.
        (1) Market can become too saturated.
            (a) The seller/licensee must sell at a volume consistent w/ your strategy.
            (b) You can control this through pricing controls
                (i) Charge them set amount per product sold instead of a percentage
                (ii) Set specific retail price for product
   ii) Make sure that the people do what you want to be done w/ the product (actually market
        (1) Make sure to require their best efforts to market the product. Some companies acquire
            licenses just to take the product off the market and reduce competition for their own
            (a) Ex – Parker Brothers would acquire games from inventors cheaply ($5) just to take
                them off the market – never used the games again & inventors never saw any real profit
        (2) Need some limits on what the parameters of the license are
            (a) Can‟t just pay me a certain amount of $ for the product and that‟s the end of it
                (i) Or if they do, you understand that‟s what they‟re going to do and you‟re ok w/ it
            (b) Want the right to pull the license if they don‟t distribute it
            (c) But some people are comfortable w/ a minimum licensing fee ($5K a year regardless of
                whether they sell any product)
   iii) Pricing
        (1) Focus on what behavior you are trying to incentivize and how your pricing leads to that or
            how it fails to lead to that.
        (2) The licensee should price the product consistent w/ your impression of what the market
            should be.
               (a) Must be consistent w/ my impression of the market
                   (i) High priced item vs. low priced item
                   (ii) Build quickly or slowly
                   (iii)Only sold through certain areas
               (b) Ways to accomplish this
                   (i) You can have shifting percentages. For first 10k you get 5%, for next 90k you get
                        4%, for next million you get 2.5%.
                        1. This creates discounts as people sell more and more – they pay less and less.
                            You incentivize strong sales.
      iv) Exposing Trade Secrets
           (1) Even though you can put limits on things, by allowing someone to sell your product you
               allow them to learn about your product and processes.
      v) Problem of the Unproductive Licensee
           (1) See above discussion
      vi) Underreporting or Dishonesty
           (1) How do you make sure the licensee isn‟t cheating you?
               (a) Get the right to inspect or get reports.
           (2) How easy is your formula to monitor?
               (a) A percentage of sales is easier than calculating a percentage of profit.
                   (i) Don‟t want to have to calculate what is profit & what goes into profit – do you
                        deduct overhead etc?
               (b) It is easier to sell someone a license based on a % of how much $ they saved as a result
                   of your license
                   (i) If the save nothing you get nothing, but this is hard to determine and monitor
      vii) Sublicensing
           (1) Do you allow your licensee to have other licensees?
           (2) In some situations it can be disastrous or it can be terrific.
               (a) Goal = high-volume
                   (i) Sublicensing is good
                   (ii) Don‟t care s long as they‟re making $ in the middle
                   (iii)Don‟t care as long as there are some price controls (either by the market or myself)
               (b) Goal – Keep a tight leash on who sells the product
                   (i) Sublicensing is bad
      viii) Story about Velcro.
           (1) The generic name is hook and loop tape. Velcro is a trademark. This was a patent. When
               their patent ran out, they began licensing the name Velcro.
   a) Description of product being licensed
      i) This is where you need to limit the use of the product
           (1) Exclusivity
           (2) Length
           (3) Terms of renewal
           (4) Territorial limits of the license
           (5) Limits on the use of the license
               (a) How people use it
               (b) How people promote it
   b) Trade Secret
      i) Does the license include trade secret info?
      ii) How is that info going to be protected?
   c) Payment structure.
        i) Fixed component and/or variable component.
             (1) Something up front (downpayment)
                 (a) Initial payment can be a minimum or a maximum
             (2) Variable components
                 (a) % sold
                 (b) Units sold
   d)   Audit Rights
        i) What rights does the licensor retain?
   e)   Improvements
        i) What if someone is using one of your products and they figure out a way to make it better?
             (1) Any improvements whether invented by licensor or licensees, belongs to licensor, but
                 licensee will be allowed to use the improvements. (pg 511)
             (2) Could be a big problem if the licensee makes improvements and the licensor doesn‟t have
                 the right to the improvement – then they only have the license to the original product
                 which is not as valuable w/o the improvement
   f)   Warranty and Indemnification
        i) What promises do you make about how the product is going to perform?
             (1) What happens if the product doesn‟t work?
             (2) What happens if someone is injured or damaged by the product?
        ii) Issue comes up when nobody is negligent or just a tiny bit negligent. Who bears the cost?
             (1) Licensor  Licensee is going to screw up and hurt someone they should cover all the costs
             (2) Licensee  injury is b/c of the product itself, then the licensor should cover the costs
                 (a) There‟s a big fight about it and it doesn‟t always come out the same way.
   g)   Right to Cancel
        i) Licensee
             (1) If the licensee is obligated to make payments over years and the product does not turn out
                 to sell that well, can he cancel?
             (2) If the venture is going well can I extend the license?
        ii) Licensor
             (1) If the licensee is unproductive can I cancel?
        iii) Note for client – must think of both outcomes, if venture is a success or a failure
             (1) Want to be protected on both sides

                                    XIII. TERMS AND CONDITIONS

   a) K w/ the consumer who purchases the product - when you have a product what do you include
      w/ the product as your terms and conditions
      i) W/ software
           (1) You can actually have people sign off on the terms and conditions before they use the
               product which makes it more enforceable
   b) What do you want to put in there to protect your client?
      i) Not really a negotiation – you can put in anything you want, BUT if you go too far no one will
           enforce it
           (1) You need to think about what is practical to put in the terms and conditions and what will
               be most helpful to your client
           (2) In some cases it‟s what you can fit on the back of a box
      ii) Indemnification
      iii) Release of Liability
      iv) Limits on Amount of Damages
       (1) Software licensing agreements
           (a) Our liability is limited to the cost of the product – what‟s really smart about this clause
               is that it‟s not overreaching – if you have a K that consumers have to sign that is totally
               one-sided, judges are less likely to enforce this – if there‟s a limit to your liability but
               you‟re willing to take some blame, then they are more likely to enforce the deal.
           (b) §10 - “[I]n no event shall the total liability of XYZ . . . for all damages, losses and causes of action
               whether in contract, tort (including negligence), product liability, or otherwise, either jointly or severally,
               exceed $500.00.
      (2) Valid limitations are usually enforceable
          (a) Home inspectors – regularly limit their liability to the cost of the home inspection
              ($600) – amount of risk is really disproportionate to the amount of liability
          (b) Skydiving – they will take on the extra liability if you are willing to pay them extra (no
              one ever says yes b/c it‟s so expensive, but at least they give you the option which
              makes them look better)
   v) Limit Type of Damages
      (1) I am only liable for this product not working – not liable for anything else
          (a) §10.1 The foregoing shall constitute XYZ’s entire liability and Client’s exclusive remedy. In no event
               shall XYZ be liable for any direct, indirect, special, incidental, consequential or exemplary damages,
               (including, but not limited to, loss of use, revenue, profit or information (even if advised of the
               possibility thereof), or any claim, demand or actions by a third party) in connection with or arising in any
               way out of this Agreement or any of the Services or that result from mistakes, omissions, interruptions,
               deletion of files, data or e-mail, errors, defects, viruses, delays in operation, or transmission, or from any
               failure of performance, whether or not limited to acts of god, communications failure, non-deliveries,
               mis-deliveries, theft, destruction or unauthorized access to the Site or to XYZ’s records, programs or
        (2) Effectiveness – unclear whether this is effective or not, but the fact that it’s there provides
            more protection that if it weren’t in place, so it’s a good thing to put in.
   vi) Licensing Issues w/ Software
        (1) IP issue – deals w/ transferability of product
            (a) If you license software you can prohibit the sale of it later on, but if you sell it you
                can‟t limit the resale
            (b) Do you always want non-transferability?
                (i) Think of the ABC toy company – you might want people to keep passing the toy
                     around b/c if you make money from the manufacturer (end result are the toys) you
                     may want to encourage people to pass the software around and build more toys.
                (ii) It extends the life of the product and increases usage of the product
            (c) Issue may be very product specific
c) Wrinkles?
   i) What if person using product is a minor?
        (1) You can‟t enter into a binding K w/ a minor so how do you protect yourself
   ii) Protections for your client need to be balanced w/ marketing issues
        (1) If you have a good reputation for customer service people will be more likely to buy your
   iii) Waiver of Terms and Conditions More than Once Does NOT Invalidate Them
        (1) Important to remember that just b/c you have these brilliant protections in place, it might
            not be good for business to be a hardass about enforcing them so you could put in language
            that says – a waiver of these terms and conditions once does not mean that they are invalid
            – they remain in full force and effect even if the company waives the provision once or
            twice or a bunch of times
   iv) Participation Of Customer
          (1) The more participation you require from the customer in signing the waiver the more likely
              it will be to be enforced, but the more participation you require from the customer the more
              likely you are to lose the customer
          (2) Have them scroll all the way to the bottom of the agreement rather than just clicking on a
              box for instance
   a) Cashing Out
      i) Initial Public Offering (IPO) – stock will be listed on public exchange – there is a market for
          our stock
          (1) Drawbacks to IPOs
              (a) Shares are going public – you will probably be locked in for a while before selling your
                  shares so if the shares go down this isn‟t good for you
              (b) Shares may be sold publicly for less than what you invested in them – this isn‟t good
                  either – if the company is hugely overvalued (this happened a lot w/ the dotcom boom
                  and bust)
              (c) Company may go public in a different country – liquidity will vary from country to
                  country so it might not be easy to sell
              (d) Less flexibility b/c you are regulated on a higher level and by more entities
                  (i) SEC, Sarbanes Oaxley, increased scrutiny, rules of stock exchange may require
                       more of you, management might feel pressure to make decisions that affect the
                       short term value of the stock price – takes away from long-term investments and
                  (ii) Certain rules may require more shareholder approval than you needed before
              (e) Disclosure obligations – for company and investors
                  (i) Criminal and civil sanctions for non-disclosure
                  (ii) May have to disclose financial and competitive information that you would not
                       normally disclose to your competitors
              (f) Increased work by management
              (g) Increased legal accounting and printing expenses
              (h) Become more of a target
                  (i) Both by people looking to sue public companies and as an acquisition interest
                  (ii) Not such a terrible thing to be a private company if you don‟t need the quick exit
                       strategy – some investors now take public companies and make them private
          (2) Advantages of IPO
              (a) It‟s a good exit strategy
              (b) Company raises capital
              (c) Mere establishment of public market for a company‟s stock will increase it‟s value – a
                  liquid company is worth more than an illiquid company
              (d) Allows you to have a readily ascertainable market value
              (e) Provides you w/ more potential investors, corporate partners, status, and acquisition
                  (i) You can use your stock as currency if someone wants to take over your company –
                       you will be paid w/ publicly traded stock that is easier to use as currency
      ii) Acquisition by Another Company
          (1) Management issues
              (a) Will they still have jobs and control?
   b) Balance b/w wanting to monetize your success and continuing to run your company
      i) People who want to continue to run their company w/o selling it, they need to find a way to
          make the company liquid for their investors
           (1) There is no affirmative duty to provide liquidity for your investors absent an actual offer
               on the table
           (2) Duty can be defined by a K
      ii) As an investor you need to make sure you‟re not investing w/ someone who only wants to run
           their company – their baby – if this is their goal however, then maybe the founder can ensure
           that the investors are receiving dividends – perhaps form an LLC so that you don‟t have
           double taxation
   a) Expose us to highlights in various stages of representing a startup company
   b) Role as a transactional lawyer is not dependent upon your vast knowledge of a particular
      i) Should be familiar w/ a wide majority of documents that your client will encounter
      ii) Understand who you‟re representing and what their interests are
      iii) Your goal is not just to make an agreement or a provision in an agreement better
      iv) Your goal is to make sure they are protected and you have thought through any pitfalls in the
      v) How will my client be hurt by this provision or this provision interacting w/ another provision
           in the document – notify your client and have them make the ultimate decision
   Provision - Substitute Premises. Landlord shall have the right at any time during the Term
    hereof, upon giving Tenant not less than sixty (60) days prior notice, to provide and furnish
    Tenant with space elsewhere in the Project of approximately the same size as the Premises and
    remove and place Tenant in such space, with Landlord to pay all verified and previously approved
    costs and expenses incurred as a result of such movement to such new space. If Landlord moves
    Tenant to such new space, this Lease and each and all of its terms, covenants and conditions shall
    remain in full force and effect and shall be deemed applicable to such new space and such new
    space shall thereafter be deemed to be the "Premises" as though Landlord and Tenant had entered
    into an express written amendment of this Lease with respect thereto.
   Points to hit on the exam
        o Can‟t just be comparable size (must be comparable quality and location) – costs must be
            reasonable – option to terminate – limit the number of times the provision can be exercised
            – pay for direct and indirect costs (such as advertising to tell old clients where you‟ve
            moved etc) – option to expand or reduce the size of the space – adequate notice – one way
            ratchet provision for the pass through costs (so if the space is smaller you pay less but if
            it‟s bigger you pay the same pass through costs)
   What is wrong w/ this provision?
        o What are pre-approved costs? It should be reasonable actual costs.
        o You don‟t want just the same size, you also want a comparable location.
        o You want adequate notice. 60 days may not be adequate.
        o Option to break the lease.
        o Pay reduced rent as a penalty.
        o Limit the number of times this provision can be utilized.
        o Option to expand or decrease the size of the space.
        o Pass through elements of the lease are based on square footage. You want a one way
            ratchet that says your pass through expenses will not increase, but it can be decreased.
        o Key points – first limit the damage to your client, next get your client some rights.
                  Costs can‟t be up to the landlord.
                  Must be comparable location just not size.
                  Limit on number of times.
                  Option to terminate.
                  Reduced rent.
                  Adequate notice.

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