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           Low Down Start-Ups                              on

                                      By Jonathan D. Gworek

             PENDLETON PC
The law firm built for business. SM

Business | Technology & IP | Employment & Immigration | Taxation   781-622-5930
               The Lo w Do wn
               on St ar t-Ups

                          A company will never succeed without
                          a strong business vision. And it will
                                       never come into existence
                                       at all without careful
             Jonathan D. Gworek
                                       attention to start-up

A SUCCESSFUL COMPANY always starts                          This is, of course, a vast oversimplification of
with a good idea. Development teams then                 what really happens. Before any business gets
take the idea and work on proposals for start-           to the start-up phase, the developers have to an-
up. After careful deliberation, the best start-up        swer quite a few questions: When is the right
plan is put into action, and a successful busi-          time to form the company? What is the best
ness is born.                                            choice of entity? Where should the entity be or-

Jonathan D. Gworek is a partner with Morse, Barnes-Brown & Pendleton, P.C., in Waltham, Massachusetts.

32     The Practical Lawyer                                                             September 2001

ganized? How should the company be capital-           themselves stock at the time of formation for
ized? Is an equity incentive plan a good idea for     one cent per share (for example), and then with-
this particular business? Would there be any ad-      in a short period of time outside investors pay
vantage in trying to get “angel” financing? And       $1 or more per share (for example), it might ap-
how should the company go about hiring its            pear upon an IRS audit that the founders issued
staff? This article discusses some of the basic an-   themselves stock at significantly below the fair
swers to these and the other questions that are       market value per share. The difference between
critical to a successful start-up.                    what the founders paid for their stock, and the
                                                      fair market value of that stock based on the sale
WHEN TO FORM THE COMPANY • Busi-                      to outside investors, may be characterized as
ness development teams are often somewhat             compensation income resulting in what could
fluid, and likely to change before the company        be significant tax liability to the founders. If on
is actually launched. There may even be some          the other hand founders’ stock is issued with
question about whether the company will be            some lead time before investor commitment,
launched at all. As a result, the team members        and certain significant milestones are achieved
may not be ready to incur the costs of forming        in the interim, this risk decreases substantially.
the company, and even if they were willing to
do that, they might not be comfortable making         Ability To Contract
decisions regarding equity allocation among the          The founders may want to establish certain
founders at such an early stage. While these are      relationships with third parties that require con-
legitimate concerns, there are several good rea-      tracts. As an example, there may be an indepen-
sons to form the company as early as possible.        dent contractor that is going to be developing
                                                      some software code. For the company to own
Holding Periods                                       this code, it needs to enter into a work for hire
   The earlier the company is formed, the soon-       agreement with the contractor. This obviously
er the stock can be issued and the capital gains      cannot be done until the company is formed.
holding period begins to run. Upon a liquidity        Non-disclosure agreements, or NDAs, raise a
event, stock that has been held for one year or       similar issue. Founders are often in contact with
more will be taxed at the long-term capital gains     potential strategic partners, advisors, employ-
rate, which is generally 20 per cent. Gains on        ees, and others at the very earliest stages.
stock held for less than one year are taxable at      Although the individual founders could, and
an individual’s ordinary income tax rate which        often do, enter into these types of agreements
can be significantly higher than the long-term        with third parties before the formation of the
capital gains tax rate.                               company, this arrangement is not ideal, and
                                                      raises issues regarding enforceability and per-
Cheap Stock Issues                                    sonal liability for the founders.
  Founders of companies often make the mis-
take of waiting until they have received a strong     Limited Liability
indication of interest from an investor before           Perhaps the most fundamental benefit of in-
they decide that it is time to incorporate. Form-     corporating is the protection of the corporate
ing a company so close in time to raising capital     shield. Individual stockholders are generally not
can create a significant tax issue. This issue may    liable for the liabilities of the company in which
be summarized as follows. If founders issue           they hold stock. Until a company is formed, the
                                                                         Low Down on Start-Ups         33

individuals are acting in their personal capacity,     deduct early losses from the business and pre-
and may be personally liable. To enjoy the ben-        serve their ability to take advantage of Code
efit of the corporate shield, certain corporate for-   section 1202, they may be better off forming the
malities must be adhered to, including the             business as an LLC and then converting it to a
maintenance of separate corporate records and          C corporation at the time of the VC investment.
accounts, the holding of annual meetings of the        Of course, certain Code provisions may limit
stockholders and directors, and the execution of       the founders’ and investors’ abilities to use their
documents in the name of the company.                  shares of the company’s losses anyway. In addi-
                                                       tion, LLCs can be cumbersome when it comes
CHOICE OF ENTITY • One of the initial deci-            to awarding equity participations to employees
sions founders must make is the form of entity         and consultants.
to use for their new company. On the whole, C
corporations tend to be the entity of choice for       STATE OF INCORPORATION • There are ba-
most startups that plan to raise money from the        sically two states of incorporation that startups
venture capital (“VC”) community.                      based in Massachusetts consider—Massachu-
                                                       setts and Delaware. Although some founders
C Corporation                                          feel a connection to Massachusetts, and will in-
   For a company that is going the traditional         corporate in Massachusetts for that reason, in-
VC route, it may make the most sense to simply         corporating in Delaware is the more common
form the company as a C corporation because C          practice, for two primary reasons: maturity of
corporations are generally preferred by VCs. In        Delaware corporate law, and relative ease of
addition, by forming the business as a C corpo-        taking stockholder actions.
ration, the founders position themselves best to
take advantage of Internal Revenue Code                Maturity of Delaware Corporate Law
(“Code”) section 1202, which permits the exclu-           First, VCs tend to be comfortable with Dela-
sion of up to 50 percent of the gain on sales of       ware corporations, regardless of where the ven-
stock in certain types of C corporations held for      ture capital is based. This is because the corpo-
more than five years.                                  rate law of the State of Delaware is generally
                                                       considered to be the most sophisticated, com-
Limited Liability Company                              prehensive, and well defined. For this reason,
   If the founders or investors want to be able to     many Fortune 500 companies are incorporated
deduct early losses from the business on their         in Delaware, even though their primary office
personal tax returns, however, they might be           location is in another state. Since VCs serve on
tempted to organize the business as an S corpo-        the board of directors of their portfolio compa-
ration or limited liability company (“LLC”). S         nies, they generally prefer Delaware because
corporations have very strict limitations on who       the laws regarding fiduciary duties and other
can be stockholders (for example, non-resident         matters involving directors are well understood
aliens, corporations, and partnerships cannot be       and delineated.
stockholders in S corporations). Perhaps more
significantly, stock issued while the corporation      Stockholder Actions
was an S corporation can not qualify for the fa-         The second benefit to incorporating in Dela-
vorable treatment of Code section 1202. Thus, if       ware as opposed to Massachusetts has to do
the founders or investors want to be able to           with the legal mechanics of stockholder actions.
34     The Practical Lawyer                                                             September 2001

In both Delaware and Massachusetts, stock-            common stock that are issued and outstanding
holder action can be taken either at a meeting at     at any time, plus that total number of shares of
which a quorum of the stockholders vote in per-       common stock that the issued and outstanding
son or by proxy, or by circulating what is called     preferred stock (and other convertible securi-
a written consent that is signed by the stock-        ties) would convert into at that point in time
holders. It is generally preferable to take actions   were it to convert;
by written consent if possible because stock-         • Issued and outstanding common stock on an as-
holders’ meetings typically require prior writ-       converted, fully diluted basis is the total number
ten notice of at least seven days. The Delaware       of shares of issued and outstanding common
laws generally authorize action by consent with       stock on an as-converted basis, plus the total ad-
a simple majority of the stockholders’ signa-         ditional number of shares that would be issued
tures. However, in Massachusetts consents can         and outstanding if all options and warrants
only be accomplished with the signatures of all       were exercised.
of the stockholders. As a result, it is often much
easier to obtain stockholder approval if the          Capitalization at Time of Formation
company is based in Delaware. In fact,                   The total number of authorized shares, and
Massachusetts companies often later reincorpo-        the total number of issued and outstanding
rate in Delaware for precisely this reason.           shares, at the time of formation of the company
                                                      is largely arbitrary; and in the end not of high
FOUNDERS’ EQUITY • The subject of found-              importance. What really matters is the relative
er’s equity is one of the more involved aspects of    allocation of the equity among the founders.
organizing a start-up. Matters to consider in-        The numbers of shares authorized and out-
clude capitalization at time of formation, divi-      standing can, and often are, adjusted upward
sion of shares among founders, stock restriction      through stock splits. Notwithstanding this,
agreements, the dilutive effect of the employee       there are a couple of guiding factors.
pool required by the VCs, and equity budgeting.
                                                      Ability To Make Awards
                                                      of Large Blocks of Shares
Basic Definitions
                                                         Prospective hires often focus more on the
   Basic definitions for understanding the choic-
                                                      total number of shares awarded to them (either
es facing the founders include the following:
                                                      outright as restricted stock or by the grant to
• Authorized stock is the total number of shares      them of options to purchase the shares) rather
of capital stock, whether common or preferred,        than the percentage of the company that such
that the company is authorized to issue at any        shares represent. As a result, the company
given time;                                           should consider putting in place an equity in-
• Issued and outstanding stock is the total num-      centive plan that has a significant number of
ber of shares of capital stock that have actually     shares, often between one million and two mil-
been issued pursuant to financings, stock op-         lion shares. At the high end of the range, this
tions or otherwise, and that are still owned          will allow the company to make awards in the
based on the corporate records of the company         market range in terms of both percentage and
at any time;                                          raw numbers (i.e. two percent to three percent
• Issued and outstanding common stock on an as-       for a VP of Business Development, at 50,000 to
converted basis is the total number of shares of      70,000 shares). In addition, this allows the com-
                                                                      Low Down on Start-Ups         35

pany to establish a low issuance (in the case of    Founder Status
restricted stock) or exercise (in the case of op-      There is much confusion over what makes
tions) price.                                       someone a founder, and whether it has any
                                                    legal significance. “Founder” is really nothing
Venture Capital Ranges                              more than a designation that the original pro-
   VCs often have an opinion about what num-        moters of an idea bestow on one another to
ber of shares of common stock should be issued      identify to the outside world who is credited
and outstanding at the time of their investment.    with getting the company off the ground. A key
They usually run numbers based on an as-            hire may come in well after the company has
sumed purchase price in the range of $1 per         been formed, and in the end be described as a
share for a first or “Series A” round. Some VCs     founder. The expression has no legal signifi-
are more concerned about the initial purchase       cance per se.
price than others, and will dictate what the cap-      However, VCs do distinguish founders from
ital structure of the company will look like be-    other employees for certain reasons. For exam-
fore funding. For the sake of discussion, if we     ple, VCs often require the founders to make cer-
assume that a VC firm is going to put $5 million    tain representations and warranties individual-
into a company with a pre-money valuation of        ly at the time of the first round of investment. In
$5 million in exchange for 50 percent of the        addition, VCs might want to impose certain
stock of the company, and require that 20 per-      vesting restrictions on the stock of founders, but
cent of the stock be allocated to an employee       might not be so concerned with the other em-
pool, the founders would need to own three          ployees on the theory that the founders really
million shares in aggregate for the purchase        constitute the brain trust. (Nonetheless, late
price in the Series A round to be $1.               hires, especially late executive management
                                                    hires, are often treated like founders by VCs for
Division of Shares Among Founders                   such purposes).
  The issuance of stock among the founding
group is for the founders to determine, and is      Allocations Based on Relative Contributions
typically based on relative contributions to the       If three people jointly conceive of an idea that
formation of the company, including:                is based on a business model rather than a tech-
• The conception of the business idea;              nology, it would not be surprising for them to
• Leadership in promoting the idea;                 split the company evenly at formation. How-
• Assumption of risk to launch the company;         ever, if one person conceived of the idea, wrote
                                                    the business plan, and assembled the team, a 50-
• Sweat equity;
                                                    25-25 percent split might be more appropriate.
• Writing the business plan; and                    In addition, it is often the case that when the
• The development of any underlying technol-        business plan is based on a proprietary technol-
ogy.                                                ogy, the developer of the technology receives a
In addition to pre-formation contributions, the     significantly higher percentage of the company.
potential for future success in commercializing     However, if the technologist is fortunate to at-
the business idea may also be a factor, including   tract as a co-founder a CEO with established in-
the background and experience that each per-        dustry credentials and connections, the busi-
son brings to the task.                             ness experience of this person might level the
36     The Practical Lawyer                                                              September 2001

playing field and suggest a more equal split of        ceipt exceeds the amount paid for the shares. If
founders’ equity.                                      it is expected that the founder’s shares will ap-
                                                       preciate significantly in value, therefore, it may
Importance of Team Cohesiveness                        be a good idea to make a section 83(b) election.
   If you are the lead promoter of an idea, and
are faced with making the initial proposal re-         Basic Elements Regarding Vesting
garding the division of equity, keep in mind that
                                                          There are five essential elements to address in
nibbling around the edges of a prospective co-
                                                       a stock restriction agreement regarding vesting:
founders’ equity position may not inspire the
level of trust and cohesiveness so essential           • Duration of vesting schedule;
among the members of a founding team. The              • Up-front vesting;
objective is to reach an allocation that is per-
                                                       • Cliff vesting;
ceived to be fair and that leaves all of the found-
ers feeling properly motivated to do what is           • Acceleration upon termination; and
necessary to make the business a success.              • Acceleration upon change of control.
                                                       VCs have established certain acceptable ranges
Stock Restriction Agreements                           for these elements, and they serve as the best
   To ensure that stock issued to founders is          guide for determining what vesting should be
properly “earned” by each founding stockhold-
                                                       self-imposed by the founders. By self-imposing
er, it is advisable for each founder to sign a stock
                                                       restrictions before VC funding, the VCs might
restriction agreement. The primary purpose of
                                                       satisfy themselves that what is in place is ac-
this agreement is to give the company a right to
                                                       ceptable, and as a result, the founders may end
purchase shares held by a founder in the event
                                                       up with slightly more favorable terms than they
that the founder leaves the company for any rea-
                                                       otherwise would receive. The following are
son. This purchase option generally applies only
                                                       some ranges for these elements, which tend to
to shares that are unvested at any given point in
                                                       change from time to time due to the labor mar-
time, with shares becoming vested over a pre-
                                                       ket and can vary by industry.
determined, usually time-based, schedule.

                                                       Vesting Period
Tax Consequences of
                                                          Founders stock generally vests over three to
Stock Restriction Agreements
   Stock restriction agreements can have signifi-      five years. You rarely see five-year vesting re-
cant tax consequences. The founder must make           quirements any more. Founders with signifi-
an election under Code section 83(b) within 30         cant bargaining leverage may be able to get a
days after receiving shares subject to the restric-    three-year vesting schedule. Four-year vesting
tion agreement. If not, the founder is subject to      seems to be the most common.
tax as the shares vest on the amount by which
the value of the vested shares at the time they        Up-Front Vesting
vest exceeds the amount paid by the founder for           It is fairly common in VC transactions for
the vested shares. If the founder makes a section      founders to have some percentage of their stock
83(b) election upon receiving the shares, he is        vested up front. VCs will often agree to this if
taxed upon receiving the shares on the amount          there has been a significant amount of effort put
by which the value of the shares at the time of re-    into the company before funding. The range of
                                                                       Low Down on Start-Ups         37

up-front vesting typically falls between 10 per-     Change of Control
cent and 25 percent.                                    VCs will generally permit either an addition-
                                                     al one-year vesting or 50 percent vesting upon a
Cliff Vesting                                        change of control. A founder can make certain
  Vesting is said to be on a “cliff” basis when a    assumptions about when the change of control
                                                     for the company would be most likely to occur,
certain minimum period of time must elapse
                                                     and determine which of these two options ap-
before any additional shares of stock vest. Six
                                                     pears preferable. For example, if the vesting du-
and 12-month cliff vesting is fairly common,
                                                     ration is three years, and the founders anticipate
with the current trend toward the shorter end of
                                                     a sale of the business after the first year, the
that range.                                          founder would be better off with one-year ac-
                                                     celeration, as it would always result in more ac-
Termination                                          celeration than 50 percent after the first year.
  Any number of circumstances could lead to             Occasionally founders are able to obtain full
the termination of a founder’s employment.           acceleration upon change of control, and it is
VCs often take the position that the equity must     not always an unreasonable starting point for
be earned, and that if the founder leaves for any    negotiation. After all, if the company is sold, the
or no reason, no additional stock vests. There       founders who are still with the company likely
are four basic circumstances in which a founder      made significant contributions to put the com-
might leave the company:                             pany in a position to be bought. VCs, however,
• Resignation (for no reason and for good rea-       are very reluctant to allow for full acceleration
                                                     upon change of control. Their primary argu-
                                                     ment is that the value of the company dimin-
• Termination (for cause and without cause);         ishes if the founders stock vests fully upon
• Death; and                                         change of control because the founders have
• Disability.                                        less incentive to work for the acquirer after the
                                                     acquisition. If the VCs do not permit for full ac-
   In the event the employee resigns voluntarily
                                                     celeration, an alternative is to request that they
or is terminated for cause, no additional stock
                                                     agree to provide for full acceleration if the
vests. However, an argument can be made that
                                                     founder is let go or resigns for good reason
if the founder is terminated without cause, or
                                                     within one year following a change of control.
resigns for good reason (in other words, is          This is sometimes called “double trigger” accel-
“forced out”), there should be some compensa-        eration. However, this compromise position is
tion to the founder; both out of fairness and as a   only appropriate when the change of control
means of keeping the board of directors honest.      calls for the founders to receive “replacement”
While VCs resist any acceleration under these        equity. The double trigger concept does not
circumstances, occasionally founders are able to     make sense in a cash-out merger.
negotiate for partial or even full acceleration,
with an additional six to 12 month’s accelera-       Dilutive Impact of Employee
tion being the most common. In the event of a        Pool Required by VCs
founder’s death or disability, six-month acceler-       Every VC term sheet includes a requirement
ation is fairly common, presumably as a good         that the company put in place an equity incen-
will gesture in a time of hardship.                  tive plan equal to between 15 percent and 25
38     The Practical Lawyer                                                             September 2001

percent (sometimes higher) of the common             • VCs own 5 million shares of preferred stock
stock of the company on an as converted, fully       (convertible one-to-one into common stock);
diluted basis, including for this purpose the en-    • Founders own 3 million shares of common
tire employee pool even though no awards may         stock; and
have been made at the time of the closing of the
                                                     • There are 2 million shares of common stock
venture investment. The more key hires the VCs
                                                     reserved for issuance under the equity incentive
perceive will be necessary to fill out the execu-
tive management team, the higher will be the
proposed employee pool. Very few first- time         The point of the illustration is to show that the
founders understand the important implication        shares that fund the employee pool come di-
that this percentage has for their equity stake in   rectly out of the founders’ ownership, and the
the company. A brief description of the pricing      VCs are not diluted at all by issuance from the
of equity in VC deals illustrates the point.         pool. In this example, the founders are diluted
                                                     50 percent after the first round, assuming that
                                                     all of the shares in the employee pool are put to
Pre-Money Valuation
                                                     use, and even more if not all of the shares are
  VCs place a pre-money valuation on the com-
                                                     put to use.
pany, which is the negotiated value of the com-
pany before putting their money in. For sake of
discussion, let’s assume that this number is $5      Recent Increases in Employee Pool Sizes
million. The VCs then specify how much they             There seems to be a trend to increase in the
are willing to invest, which number, when add-       size of the employee pool required by the VCs.
ed to the pre-money valuation, yields the post-      This is in part a result of upward pressure on the
money valuation.                                     amount of shares available for issuance from
                                                     the pool resulting from the labor shortage in the
   Let’s assume that the amount of the invest-
                                                     startup community.
ment is $5 million, yielding a post-money valu-
ation of $10 million. For this $5 million, the VCs      Another explanation might be that the VCs
will demand 50 percent of the company, on an         are trying to reduce the net effect of escalating
as-converted, fully diluted basis, including for     pre-money valuations by requiring larger em-
this purpose the entire employee pool specified      ployee pools. The dilutive effect of the employee
in the term sheet. Let’s assume that the term        pool as described in the previous paragraph is,
sheet requires an employee pool of 20 percent.       after all, less well understood than the relatively
Assume further a $1 price per share for the VCs’     simple notion of pre-money valuation. The size
50 percent of the company, for a total of 5 mil-     of the employee pool is very much a pricing
lion shares. For these 5 million shares to equal     term, and should be thought about as such.
50 percent of the company on an as-converted,
fully diluted basis, including for this purpose      Effective Valuation
the employee pool, the founders must own 3           Assigned to Founders Stock
million shares immediately before the closing,         One useful tool for sorting all of this out in the
and the employee pool must have 2 million            context of reviewing a VC term sheet is the cal-
shares reserved for issuance. Immediately after      culation of the effective pre-money valuation
the closing of the financing, the capitalization     being assigned to the founders’ shares. Using
will be as follows:                                  the numbers in the example above, the effective
                                                                        Low Down on Start-Ups         39

pre-money valuation assigned to the founders’         Stock options come in two forms—incentive
shares is $3 million, determined by subtracting       stock options and non-qualified stock options.
from the pre-money valuation the per share            These basic forms of incentives differ primarily
price paid for the preferred multiplied by the        in the tax consequences to the recipient.
number of shares required for the employee
pool. This calculation can be very useful in com-     Stock Options Generally
paring two VC offers, when one is at a higher            A stock option is a contract between the com-
valuation than the other, but requires a larger       pany and the recipient that gives the recipient,
employee pool.                                        usually an employee, the right to purchase a
   For example, a pre-money valuation of              certain number of shares of common stock at an
$5,500,000 on its face sounds better than $5 mil-     exercise price per share specified in the option
lion. However, if the employee pool require-          grant agreement. This right to “exercise” the op-
ment for the $5,500,000 valuation is 25 percent,      tion applies only to that portion of the stock
the effective pre-money valuation is $2,875,000       subject to the option that has vested, and the
($5 million - ($1 X (.25 X 10,500,000)). While this   underlying stock typically vests over a period of
calculation may be useful for drawing compar-         time—three or four years, usually in equal
                                                      monthly or quarterly installments, although
isons, founders should not place too much of an
                                                      often there is an initial “cliff” of six months to
emphasis on it. It is always of prime importance
                                                      one year.
to consider the other things that a VC can bring
to the company, and a perceived preoccupation
with valuation and ownership tends to drive           Incentive Stock Options
VCs off.                                                 Incentive stock options (“ISOs”) are a com-
                                                      mon type of equity currency used by start-up
                                                      companies. Only employees are eligible to re-
Equity Budgeting
                                                      ceive ISOs. ISOs must, among other things,
   Many companies find it useful to put togeth-
                                                      have an exercise price at least equal to the fair
er a spreadsheet that, based on certain assump-
                                                      market value of the stock at the time of grant (or
tions, projects out the founders’ stock owner-
                                                      110 percent of the fair market value if the
ship in the company through several rounds of
                                                      grantee is a 10 percent owner). In addition, the
financing. Such a budget can be a helpful tool
for thinking about the dilutive effect that fi-       value of shares (as of the date of grant) for which
nancings will have on the founders’ equity            an ISO may first become exercisable in any year
stakes. Statistics show that founders as a group      may not exceed $100,000. The advantage to an
have done well if they retain between 15 and 20       ISO is that the employee is not taxed until he
percent of the company at IPO. This statistic         sells the shares acquired upon exercising the op-
suggests that founders should expect 80 percent       tion. Upon sale, if the requisite holding periods
dilution at minimum before going public. The          have been met, the amount by which the sale
first round of financing itself often results in 50   price of the shares exceeds the exercise price of
percent or more dilution when the employee            the ISO is taxed as a long-term capital gain. This
pool is factored in.                                  is, however, subject to two caveats:
                                                      • The first caveat is that the exercise of an ISO
EQUITY INCENTIVE PLANS • There are two                can have an alternative minimum tax (or
basic types of equity incentives used by start-up     “AMT”) consequence (A discussion of this is be-
companies—stock options and restricted stock.         yond the scope of this article);
40     The Practical Lawyer                                                              September 2001

• The second caveat is that the employee must         Equity Incentive Ranges
hold the stock received upon exercising the ISO          Companies often ask us to comment on what
for at least a year after exercising (and until the   percentage ownership interest would be appro-
date that is at least two years after being grant-    priate for an executive hire. Although there are
ed the ISO). A disposition that is made before        ranges that can be helpful as points of reference,
the required holding periods have expired is re-      the amount of equity that a person can com-
ferred to as a “disqualifying disposition.” A dis-    mand as a condition of employment is a very
qualifying disposition generally results in ordi-     fact-specific question. The answer depends in
nary income to the employee at the time of the        part on how much risk the prospective employ-
disposition. Disqualifying dispositions are very      ee is being asked to take, and what the individ-
common upon liquidity events for emerging             ual’s background is. In determining the level of
technology companies.                                 risk, relevant considerations include whether:
                                                      • The company has been venture funded;
Non-qualified Stock Options                           • The prospective employee is being asked to
  Non-qualified Stock Options (or “non-               forgo salary in exchange for equity;
quals”) are often used when ISOs are unavail-
                                                      • The company is far along in validating its
able, such as when the grantee is not an em-
                                                      product, service, or technology (i.e. are there
ployee. The grantee of a non-qual recognizes or-
                                                      any customers or partners lined up); and
dinary income upon exercising the non-qual in
the amount by which the value of the shares re-       • The management team is largely in place.
ceived upon exercise (measured at the time of         As is always the case in a hiring situation, the in-
exercise) exceeds the exercise price of the non-      dividual’s credentials, and the resultant supply
qual. The grantee then takes a fair market value      and demand forces for such individual’s ser-
basis in the stock, and his holding period for tax    vices, are major factors. In addition, the nature
purposes begins, upon exercising the non-qual.        of the company and its hiring needs weigh
                                                      heavily into the equation, as a technology com-
Restricted Stock                                      pany may pay more in equity for a technology
   Restricted stock, as already explained in con-     officer than a marketing person, whereas a con-
cept above, is stock that is held outright, but       sumer product business idea may be the other
subject to the company’s option to buy back un-       way around. Finally, the size of the opportunity
vested stock at the time the employee leaves the      is also relevant, as the greater the potential for
company. Restricted stock is desirable to the re-     the company, the less the company may have to
cipient because, if the recipient makes an elec-      pay the individual in equity.
tion under Code section 83(b) upon receiving             Although these and other factors make it dif-
the stock, any appreciation in the value of the       ficult to generalize about equity participation
stock after receipt is taxable at long-term capital   levels, there are certain ranges that are recog-
gain rates when the stock is sold if the recipient    nized as “market”:
has held the stock for more than one year. Thus,      • CEO—six to 10 percent;
the tax issues generally associated with options
                                                      • VP Technology—two to six percent;
are avoided. Restricted stock also entitles the
holder to voting rights, a benefit that may make      • VP Marketing—one to three percent;
a key employee feel more involved in the own-         • VP Business Development—one to three per-
ership of the company.                                cent; and
                                                                       Low Down on Start-Ups        41

• VP Finance and Operations one-half of one           demanding on the company than might other-
percent to two percent.                               wise result.
These numbers are determined as of the closing
of the first VC round, and are not subject to di-
lution by the grant of options out of the em-         Type of Security Sold
ployee pool. For example, if there is a 20 percent       Angels will typically be expecting one of two
employee pool, a CTO receiving five percent           types of securities in exchange for their
would be granted options or receive restricted        money—preferred stock or debt convertible
stock for 25 percent of the shares in the employ-     into preferred stock. Preferred stock gives the
ee pool.                                              holder certain preferences and privileges rela-
                                                      tive to the holders of common stock.
   If offers are being extended to prospective
hires before VC funding but after the founders’
interests are established, the company might          Preferred Stock
offer one of these key persons an amount                 Preferred stock was the standard vehicle until
which, after the first round, would bring the         it was supplanted by convertible notes as the in-
person into the appropriate range. For example,       strument of choice over the last several years.
the VP of Business Development might be of-           The preferences associated with preferred stock
fered six percent before the first round, which       purchased by angels are, these days with a more
would result in three percent after first round,      sophisticated angel investor base, essentially
assuming a 50 percent dilution.                       the same that VCs would obtain.

ANGEL FINANCINGS • As a company gets                  Liquidation Preference
into initial fund-raising efforts, it may find that      Most fundamental to preferred stock is what
it either needs to or prefers to raise money from     is called a liquidation preference. A liquidation
“angel” investors rather than through tradition-      preference gives the holder of the stock the
al venture capital firms. An angel is generally a     right to receive its original investment back
wealthy individual who invests in his or her in-      upon liquidation or dissolution of the company
dividual capacity. Recently, groups of angels         before any distributions to holders of common
have gotten together and formed alliances. Ex-        stock. Once the preferred stockholders have
amples of these are the Band of Angels in Silicon     gotten their original investment back, the com-
Valley, and the Common Angels and the Walnut          mon stockholders typically get whatever is re-
Group in the Boston area. By aligning, angels         maining. The liquidation preference typically
are able to pool their resources for purposes of      includes declared or accrued but unpaid divi-
screening suitable investments. These alliances       dends. In today’s financing climate, the liqui-
can also benefit the company seeking to raise         dation preference is often a multiple (two or
money, because once one angel in one of these         three times) of the original investment.
groups has decided to invest, others may be
more inclined to follow.                              Dividend
  One potentially significant downside of               Some preferred stock may also have a divi-
working with a group of angels is that because        dend associated with it, which is usually a fixed
they pool their collective knowledge base, they       annual percentage return on the original pur-
tend to be more sophisticated than individual         chase price—much the way interest works on a
angels. This can result in terms that are more        loan. This dividend may be:
42     The Practical Lawyer                                                              September 2001

• Cumulative (which means that if it is not            ferred stock divided by the conversion price.
paid in one year, it will continue to build until it   Before any adjustment, the conversion price
is eventually paid); or                                usually equals the purchase price, and therefore
• Non-cumulative (which means the dividend             the original conversion rate is one share for one
does not carry over from one year to the next if       share. The conversion price, and as a result the
not declared by the company);                          number of shares into which each preferred
• Automatic (which means that the company              stock may be converted, changes when the
must declare it every year or at some other pre-       stock is sold at a price below the price per share
determined time such as on or before a sale of         paid by the preferred stockholder and an anti-
the company); or                                       dilution adjustment results. The calculation of
                                                       the “new conversion price” depends on the na-
• Discretionary (which means the dividend is
                                                       ture of the anti-dilution protection.
payable only if and when declared by the com-
pany’s board of directors); and
                                                       Full Ratchet
• Be subject to capitalizing (which means any             The most favorable kind of anti-dilution pro-
unpaid amount gets added to the total original         tection for a preferred stockholder is called “full
purchase price against which the dividend rate         ratchet” protection. In full ratchet protection,
is applied) or not.                                    the “conversion price” equals the most recent
In the event of a liquidation or dissolution, pre-     price per share of common stock sold by the
ferred stockholders are generally entitled to re-      company. To take a simple example, assume
ceive any dividends they are owed before the           there were 300 shares of common stock held by
common stockholders would be entitled to               the founders on January 1, 2001. Assume also
anything.                                              that the company sold 100 shares of preferred
                                                       stock to investors at $1 per share on that date,
Conversion and Anti-Dilution Protection                convertible one-to-one into 100 shares of com-
   Preferred stock is typically convertible into       mon stock, or 25 percent of all common stock.
common stock. Usually the conversion ratio at          Then assume that 100 shares of common stock
the time the preferred stock is issued is one-to-      were subsequently sold at 50 cents per share.
one—that is the preferred stockholder may con-         The new conversion ratio would be $1 divided
vert each share of preferred stock into one share      by fifty cents, or two, and the preferred stock
of common stock at any time. The preferred             would then be convertible into 200 shares of
stockholder typically has protection that results      common stock, which on an as converted basis
in an increase in the conversion ratio in the          would equal 33 percent of all common stock.
event that the company sells any of its stock at          Typically full ratchet anti-dilution protection
below the price paid for it by the preferred           is applied without regard to how many shares
stockholder—so-called anti-dilution protection.        of stock are subsequently sold at the lower
                                                       price. In the above example, if just one share of
Conversion Price                                       common stock were sold at 50 cents, the result
  The “conversion price” is a key concept for          would have been much more favorable to the
understanding the mechanics of anti-dilution           preferred stockholder, who would still have the
protection. Upon issuance, preferred stock typi-       benefit of the two-to-one conversion ratio. With
cally converts into a number of shares equal to        that ratio, the preferred stockholder would then
the original purchase price per share of the pre-      own stock convertible into 200 out of a total of
                                                                         Low Down on Start-Ups          43

501 shares of common stock, or nearly 40 per-         preference and the consideration that common
cent of the common stock!                             stockholders are entitled to. This is sometimes
                                                      referred to as “participating preferred”, and
Weighted Average                                      more disparagingly as the “double dip.”
   A type of anti-dilution protection more favor-
able to the company is called “weighted aver-         Issues Associated with Preferred Stock
age” protection. Weighted average protection             Although preferred stock is a widely accept-
gives effect to the dilutive effect that the subse-   ed security for early stage financings, relative to
quent issuance has, and typically results in a        convertible notes, it has certain shortcomings.
much less dramatic change in the conversion
ratio. To take a simple example, assume there         Fixing Fair Market Value
were 300 shares of common stock held by the              Issuing preferred stock to angel investors re-
founders on January 1, 2001. Also assume that         quires the company and the prospective in-
the company sold 100 shares of preferred stock        vestors to establish a pre-money valuation of
to investors at $1 per share on that date, con-       the company without the benefit of someone in
vertible one-to-one into 100 shares of common         the business of determining such valuations
stock, or 25 percent of all common stock. Then        (such as a VC). The company and the angel in-
assume that 100 shares of common stock were           vestors might not be entirely comfortable plac-
subsequently sold at 50 cents per share. The          ing a valuation on the company at this stage.
new conversion ratio would be $1 ÷ ((300 + 100)       They might fear that the valuation will turn out
÷ (300 + 200)), or 1.2, and the preferred stock       to be substantially different (even after taking
would then be convertible into 120 shares of          into account the development of the company
common stock, which on an as converted basis          between the two rounds of financing) than that
would equal 24 percent of all common stock.           established in the next, VC round of financing.

Conversion vs. Liquidation Preference                 Blocking Rights
   Often times preferred stockholders have one           Once a series of preferred stock has been is-
of two options upon the sale of the company in        sued, the company would typically need the
the form of an asset sale or a stock merger. The      consent of the holders of the preferred to ap-
preferred stockholder may opt either to:              prove future issuances of preferred stock, in-
                                                      cluding the issuance of stock to VCs. This can
• Treat such sale or merger as a liquidation,
                                                      occasionally result in problems with the angels,
and get the liquidation preference back before
                                                      who might, for example, disagree with the val-
the distribution of the proceeds to any of the        uation being offered to the VCs.
common stockholders; or
• Convert to common stock before the sale and         VC Concerns
be entitled to receive what the other stockhold-         Founders often ask whether having angels
ers are getting.                                      that hold preferred stock will somehow make it
A preferred stockholder has to decide which of        difficult to raise VC funding. There are two po-
these two options makes the most economic             tential causes of this concern. The first is that an-
sense. Under an alternative method of calculat-       gels typically have pre-emptive rights but often
ing the liquidation preference, a preferred stock-    do not participate in a the next round alongside
holder will be entitled to both the liquidation       VCs because:
44     The Practical Lawyer                                                            September 2001

• The bump-up in value is significant enough         Promissory Note
to make further investment impractical from an          The security sold in a convertible debt offer-
economic perspective;                                ing is a promissory note that automatically con-
• The next round is large enough that it has be-     verts into preferred stock at some future time.
come too “rich” for angels, who frequently in-       The intent of the company and investors is that
vest $100,000 or less;                               the preferred stock into which the note will con-
                                                     vert will be whatever is negotiated between the
• The next round is a so-called down round,
                                                     company and the VCs in the first venture finan-
meaning that the value of preferred stock has
                                                     cing—typically Series A Preferred Stock. The
gone down as a result of slower-than-expected
progress in executing the company’s business         debt typically converts at some discount—usu-
plan.                                                ally in the 15 percent to 30 percent range from
                                                     the price paid by the VC investors. Companies
   The second potential cause of this concern is
                                                     occasionally try to come up with complicated
that angels can complicate votes and other deci-
                                                     discount matrixes in which the discount may
sions that are made by preferred stockholders
                                                     vary as a function of:
as a class. Feedback received from the VC com-
munity does not support these concerns, pro-         • The VC valuation. (The higher the valuation,
vided that the VCs will own a significant ma-        the steeper the discount in order to align the in-
jority of the preferred stock post-financing, and    terests of the note holder and the company); and
the angels do not have any preferential or block-    • The duration that elapses between the time of
ing rights (a fact VCs will make certain of before   the sale of the convertible note and the closing
investing). VCs may hesitate to invest in a com-     of the VC round. (The longer the duration, the
pany where there is known to be one or more          steeper the discount, on the theory that the ven-
difficult stockholders on the basis that “life is    ture must have been riskier at such an early
too short,” but as long as a company is working      stage).
with either passive or value-added angel in-         These complicated structures are something to
vestors, this should not be a problem.               avoid. They are very difficult to explain and
                                                     they confuse investors. Convertible debt financ-
Convertible Debt                                     ings seem to work best when they are kept clean
   Instead of issuing preferred stock to angels,     and simple.
early stage companies may issue notes that con-
vert into whatever the company issues in the fu-     Default Preferred
ture, presumably to VCs, but at a discount. The         In the event that there is no subsequent VC fi-
single most attractive benefit of this is that the   nancing within a certain period of time, the
valuation of the company can be deferred until       notes convert (usually automatically, but some-
the VCs, who are generally professional in-          times at the option of either the company or the
vestors, make their investment. The tax conse-       investors) into a pre-defined class of preferred
quences of an issuance of convertible debt may       stock, at a pre-determined pre-money valua-
be more complicated than those associated with       tion. This type of default conversion allows the
preferred stock financings, and should be con-       company to remove the debt from its books.
sidered carefully by the company and the in-
vestors. The basic terms of a convertible note of-   HIRING BASICS • Once the issues of forma-
fering are discussed below.                          tion and capitalization have been addressed, the
                                                                        Low Down on Start-Ups        45

founders can begin to think about filling per-         nies, it may be best to remove the non-compete
sonnel positions.                                      provision for lower level employees who will not
                                                       be privy to proprietary information.
Offer Letters                                             This agreement is not to be confused with an
   Offers of employment are typically extended         employment agreement, which provides pro-
to new hires using simple offer letters. These         tection for the employee, including severance,
simply serve to outline the key terms of the           acceleration of vesting upon termination, and
offer, including the position of employment, the       other similar provisions. Employment agree-
base pay, the options package and benefits.            ments are typically reserved for very senior
They also attach a form of employee agreement          management people who have significant ne-
that each new hire must sign as a condition            gotiation leverage coming into the company.
precedent to becoming an employee.
                                                       Personnel Resource Issues
Employee Agreement                                        With hiring comes a range of human resource
  An employee agreement is for the benefit of          issues, including payroll administration, health
the company, not the employee. It has four basic       insurance, 401k plans, and other benefits. Many
provisions:                                            start-up companies outsource these functions.
• A confidentiality agreement whereby the em-          The service providers for these functions,
ployee agrees not to disclose or misappropriate        through the aggregation of client employee
the confidential information of the company            bases, say they are able to buy benefits at group
during or after the period of employment;              discounts. This seems to be a very valuable ser-
                                                       vice, and one that a lot of our clients use.
• An assignment of rights provision, whereby
the employee agrees to assign any and all rights
                                                       CONCLUSION • Although a company will
in any work product resulting from or related to
                                                       never succeed without a strong business vision,
the employee’s services, to the company;
                                                       the return that founders ultimately realize on
• A non-solicitation provision whereby the em-         their investment in building the company de-
ployee agrees not to solicit the employees or          pends in part on certain key decisions that are
customers of the company for a period of time          made in the earliest days of the company, some
(usually one year) after the termination of em-        of which may seem mechanical and inconse-
ployment; and                                          quential at the time. From timing the formation
• A non-compete provision whereby the em-              of the company, through the complex choices of
ployee agrees not to compete with the company          capitalization, to the common-sense aspects of
for a period of time (again, usually one year) after   hiring personnel, the practical choices made at
the termination of the employee’s employment.          the beginning can be the most important. For the
   The company should require prospective hires        founders, and their advisors, there is good news:
to sign this agreement before they begin employ-       These things can be planned and controlled at
ment with the company; otherwise it may be dif-        the beginning. And the right choices can help to
ficult to enforce. In addition, in certain compa-      steer the business toward future success.

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