Start-ups and Venture Capital Investments ©

By Catharina Yoosun MinPartner

Reed Smith LLP

Types of Start-ups

• Sole Proprietorship

• Partnerships

• Limited Liability Company

• Corporation

• Most choose Corporation in Delaware

How to form a corporation

• File Articles or Certificate of Incorporation• Bylaws• Appoint directors• Directors appoint officers, sell initial stock,

fix fiscal year, etc.• Obtain Employer ID Number from the IRS• Open a bank account

Initial Funding• Founders stock – simple and cheap since

low or no valuation

• Friends and Family – simple and cheap since low valuation. Usually a bit higher than founders stock

Securities Laws• Need to comply with federal and state

laws where the investor resides

• Cannot sell stock to just anybody

• Can usually only sell to people who are related to the founders/officers or who have net assets of over $1 million

Employee Issues

• All employees are “at-will” and can be terminated anytime. Cannot terminate based on unlawful reasons (race, nationality, sex, etc.)

• All employees need to assign any and all IP to the company

• All employees/consultants to sign Proprietary Rights and Confidentiality Agreement

• Employment agreement not common but sometime for key officers

Next Funding

• Convertible Debt- Automatically converts to the next financing of a certain amount- Usually has warrants attached to the convertible note (around 10-30% warrant coverage)- Friends and family or angel investors

Series A Preferred Round• Need to create preferred stock with

preferences by filing a revised Articles of Incorporation

• Need shareholder and board approval

• Mainly angel investors or VC investors

• Looking for exit in around 5 years so the terms support this timeframe

Rights of a shareholder • Common Stock – residual rights after preferred stock• Preferred Stock

– dividends– liquidation– director seat– voting, veto and protective provisions– right to sell stock and co-sell with founders– right of first refusal when others sell– drag along rights – registration rights – timing of exit– Stock option pool

Series B Preferred Round• Will need consent from the board and the

holders of common stock and Series A preferred stock

• Rights of shareholders are either pari passu with Series A or in preference to Series A or a combination.

• Down-round or up-round depending on the valuation of the company

• If down-round, will trigger anti-dilution protection

Exit Options

• Licensing out of all material technology

• Initial Public Offering

• Mergers & Acquisitions

• Dissolution or bankruptcy

IPO

• Usually have underwriters who are investment banks

• IPO under the Securities Act of 1933 – registration statement is filed and declared effective

• NASDAQ or NYSE; AIM and other jurisdictions too

• Costly process and after IPO

M&A

• Stock vs. asset acquisition – depends on many things, e.g. contingent liabilities

• Tax consideration

• Representations and warranties

• Indemnification and escrow

• Purchase price adjustment

7 Procedural Issues:

1. Get the right local professionals and partners early in the process (bankers, lawyers, accountants, tax professionals)

2. LOI stage - obtain exclusivity, binding/non-binding, confidentiality, build in flexibility on the structure if needed

3. Do due diligence right and early

• What are we investing in and who owns it

• Any issues on change in control (IP, contracts, employees)

• Following the ownership chain, especially on IP

• Infringement, lawsuits, contingent liabilities

4. Think ahead of post-investment and plan ahead – capital needs, other infrastructure.

• Bring the team who will be there post closing and have them participate in the deal

5. Employee/Management team

• Employee retention - Who is important and necessary to the business Severance arrangements

• Non-competition, trade secrets

• Management team compensation – go with local market

6. Foreign Corrupt Practices Act

• Bribes and illegal payoffs to government officials

• US very aggressive – recent conviction of 2 senior officers

• UK Bribery Act of 2010 – encompasses more than government officials and no grease money

7. Attention to the local corporate governance laws –

• Have board and shareholder meetings

• Danger of piercing the corporate veil and having shareholder liability

Thank you.

Catharina Yoosun Min

Reed Smith LLP

Silicon Valley, California

CMin@ReedSmith.com

415-794-8314