The Low Down Start-Ups on By Jonathan D. Gworek MORSE BARNES-BROWN mbbp.com 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 mechanics. 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. 31 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- son); 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- plan. 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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