Legal services for early-stage startups made

EASY!!

• Incorporation

• Founders Agreements :

– Restricted Stock Purchase Agreements

– Shareholders Agreement

• Basic IP protection :

– NDAs and Innovation Assignment Agreements

– Contractor Agreements

• Option Plan

• To raise money from friends and family

What early-stage startups may need

• A new business, based on an idea, an app., a product. . .

• One or more founders who: – want to work together to exploit the idea and bring it to fruition

– want to do business with legal protections in place

– want to offer consultants or employees options as well as cash

– maybe want to raise money from friends and family

• Believe in what they’re doing!

What is an “early-stage” startup?

• A corporation limits founders’ and other shareholders’ liability to the amount of their investment – so long as they don’t mingle their funds with the corporation’s

(e.g. founder and corp. use the same bank account).

• A shareholder’s other assets, e.g the family home, are not at risk, even if the corporation goes bankrupt!

• Where to incorporate? Delaware! Why?

Incorporation: the first step I

• Delaware corporations have become the Silicon Valley norm

• The corporation is incorporated in Delaware, rarely domiciled there

• Delaware offers the most developed system of corporate law in the US, giving shareholders and Board members greater predictability and security

• Professional investors require Delaware, if the founders are lucky enough to attract them, because Delaware law protects investors who serve on the startup’s Board

Incorporation: the first step II

• A Corporation is the preferred choice of entity unless you are a consulting business or other business limited to a few participants in the long term, when an LLC or partnership may be appropriate

• If your startup will need additional participants (e.g. employees, independent contractors), the corporation is the best form of entity for offering them options.

Incorporation: the first step III

• The reason that many advisers recommend LLCs for startups is to avoid “double taxation,” taxation of corporate income and then of shareholder income when that same corporate income is distributed to shareholders

• Why then do professional investors prefer Delaware corporations? These are not people who enjoy paying taxes!

• Because ALMOST NO STARTUPS make money at first (true: don’t feel bad!!)

• Thus startups rarely pay any taxes either at the entity or shareholder level

Incorporation: the first step IV

• One downside for an early-stage startup incorporated in Delaware: two franchise taxes (taxes payable for the privilege of doing business in the corporate form) are payable, one in Delaware and the other in the State where the startup does business

• If the startup’s business is in e.g. California and it is incorporated in California, then there is only one franchise tax

• BUT if the California startup later attracts professional investors, they will likely require “reincorporation” in Delaware, which is very expensive to do

Incorporation: the first step V

• Startup A La Carte™ incorporation covers the key basics, and explains them to you if needed

• Includes the basic documents needed to incorporate: Certificate of Incorporation, Bylaws, First Board Meeting Minutes, etc.

• Includes advice on your choices as to Board members and officers (how many, who, who should hold which office, etc.), initial share issuances (how many to each founder? how many shares to be authorized in total?), etc.

Incorporation: the first step VI

Founders Agreements I• On day one, it all looks great! Three founders

with complementary skills enthusiastically pool their resources.

• In a spirit of democracy, they decide to issue each other one third of the startup’s shares

• Risk: Among any three founders, within six months one will likely get bored / find another project / fall in love

Founders Agreements II

Solution: each founder’s shares vest over time only so long as s/he continues full participation in the startup

• This simple goal can only be accomplished by a complex contract called a “Restricted Stock Purchase Agreement” between each Founder and the startup

• If one Founder leaves after six months, most of his / her shares revert to the corporation, and are available to whoever replaces the departed founder

Founders Agreements III“Shareholders Agreement”•The founders made a deal with each other, and no-one else.•They will not want to discover a new co-founder, after a transfer of one founder’s shares to a third party without the agreement of all •Transfer procedures carefully set out to include rights of first refusal for the company and the co-founders to buy the shares being sold

Founders Agreements IV• if the Company and other founders do not have

the resources to exercise their first refusal rights, Shareholders Agreements also provide for a “cosale” right

• This prohibits transfer of one founder’s shares to a third party unless the buyer also buys all of the other founders’ shares

• This avoids one founder making money out of his shares while his co-founders do not

Basic IP Protection I• Innovation Assignment Agreements, Contractor

Agreements: you own all IP invented or generated on your behalf by employees, strategic partners, consultants, other service providers

• Without these agreements, the service providers inventing or generating the IP may own it, even though you’re paying them for it!

Basic IP Protection II• NDAs are the basic protection of your startup’s

ideas and trade secrets. Use them!• Build your own NDA: free service on website!

Form clauses, with EXPLANATIONS of what they do!

• Go ahead! Feel free to use the template!• http://startupalacarte.com/nda-works-form-n

da-basic-explanations/

Contractors / Consultants• A startup does not want to be treated as a consultant’s

employer by the tax authorities, and become liable for unemployment and other social charges

• Unlike employees, consultants do not benefit from State unemployment payments after they are terminated

• Contractor Agreements help assure that (1) independent contractors cannot claim to be employees, and (2) the IP invented or generated is owned by the startup

Option Plan I• KEY PART OF THE SILICON VALLEY MODEL:• Options enable the startup to conserve cash, by paying

its employees and consultants / contractors (“service providers”) less in cash

• Instead, the startup grants service providers a possible share in the startup’s equity upside in the form of options

• Options vest over time, meaning become exercisable over time, encouraging service providers to remain with the startup

Option Plan II: Exercise Price• When a service provider exercises an option, she

buys a share at the exercise price established when the startup granted her the option

• If the value of the startup has increased, the value of each share in the startup has increased, and the exercise price is less than the new share value

• Options are only worth money if the value of the startup increases

Option Plan III: Vesting • The startup wants its service providers to stay, even if

their cash earnings are below market• Each option grant has a vesting schedule designed to

encourage service providers to stay, and over time the service provider receives the possible benefits of more and more vested (exercisable) options

• If the startup is doing well, later vesting options are likely worth more to the service provider, because the value of each share should increase over time with the startup’s success (yet the exercise price remains the same)

Option Plan IV: Limits• A service provider only realizes the potential

profit on her options if:– she continues working for the startup until an Exit

occurs (see next slides) or – if she exercises the option and buys the shares when

she leaves the startup, even though they cannot be resold

• Very risky to buy the shares when they cannot be resold! Their value may always drop before resale is possible.

Option Plan V: Exits I• In order to be able to resell the shares purchased

by exercising her options, a service provider needs her startup to experience an “Exit”

• There are normally only two types of exit, the startup having an initial public offering (IPO), or being acquired by another company (M&A)

• Absent an Exit, US securities laws make it VERY difficult to privately sell shares obtained on the exercise of options (unless your startup is called Facebook or something similar!)

Option Plan VI: Exits II• If the Exit is a sale of the startup (M&A), all outstanding

options need to be bought by, or exchanged into options in, the acquiring corporation in order for service providers to fully benefit from the sale

• Check this in any Option Plan you benefit from as a service provider, or have your lawyer do it! Some Plans (not ours!) almost encourage the acquirer to avoid giving proper consideration for options

• If the acquiring corporation is publicly quoted, its shares or options are readily resellable

Option Plan VII: Exits III• If the exit is an IPO, vested options can be exercised

and the resulting shares freely sold six months after the IPO (the bankers managing the IPO typically require a six-month delay before option shares come onto the public market)

• When a service provider’s other options vest after that date, the shares obtained on option exercises can be resold immediately

Option Plan VIII• A startup’s Option Plan should be approved by the

startup’s shareholders because it will dilute outstanding shares

• If approved, typically 10 – 20% of total shares go into the “option pool,” to be granted over time

• As well as service providers, Board members and Advisory Board members are typically granted options

Advisory Board I• Strategic advisors are invited by the founder(s) for

the guidance or relationships that they can offer• They are typically offered a seat on the Advisory

Board with option grants again substituting for cash • Sometimes a time commitment is made upfront by

the Advisory Board member. More often, an informal telephone relationship is built up over time

Advisory Board II• Why Advisory Board membership rather than Board

membership? • The Board has fiduciary duties to the shareholders

and is responsible for overseeing management• An Advisory Board member has minimal duties, if

any, and no oversight responsibility• Advisory Board members, unlike Board members,

thus have minimal legal risks arising out of their service for the startup

Friends and Family Investors I

• “Bootstrapping” is the founders’ ideal: they only answer to themselves and their customers

• BUT, a little help from friends and family can give any startup a major boost

• Convertible notes, rather than shares of stock, are often sold to friends and family

Friends and Family Investors II• Friends and family are relatively safe for startup

founders. They are unlikely to want to run the business

• Professional investors often do want to run the business, and believe that you’ll be better off if they do

• Professional investors typically receive some sort of Board role, and may request insertion of their own CEO

Friends and Family Investors III• WATCH OUT when you accept professional

investors!!• Make sure that they will let you run your startup,

unless of course you are looking for a CEO• If you are looking for a CEO, make sure that you’re

protected after he takes over (e.g. by having a majority of the Board seats)

Friends and Family Investors IV• Valuation is needed in all cases when shares are sold to

investors because it tells all parties how many shares the investors receive for their investment

• This applies to VCs as much as friends and family. In fact, it is a key issue in VC financing rounds

• If the investors invest $250,000, and the startup is worth $1,000,000, the investors receive 25% of the shares

• If the investors invest $250,000, and the startup is worth $2,000,000, the investors receive 12.5% of the shares

Friends and Family Investors V• Investors in convertible notes are making a loan to the

startup: nobody needs to value the startup• In an equity investment, where the startup sells shares of

stock to the investors, the startup must be valued• But who values the startup when friends and family are

involved? Founders would have to negotiate the startup’s value with friends and family, a sensitive task ripe for misunderstandings because of the obvious emotional dimension

• Also, no-one involved knows enough to arrive at a realistic market-driven valuation

Friends and Family Investors VI• The loan made by friends and family investors then

“converts” into equity in the startup if and when professionals (e.g. VCs, angels) invest

• Friends and family investors typically receive more equity than these later investors, because they took an earlier risk – say a 15 - 25% premium

• E.G., if the premium is 20%, and the shares are sold for 20 cents each to the VCs, then the loans are converted at a rate of 16 cents each to friends and family investors, giving them more shares for the same (earlier) investment

Friends and Family Investors VII• If professional investors are not found, the loans to the

startup are typically convertible into common stock or repayable, with accumulated interest, after two or three years

• As a practical matter, such repayment may be unlikely to occur if no additional investors come in

• If the startup is still doing well, it will likely prefer to convert the loans into equity rather than pay them back in cash.

TECH TRANSACTIONS 1: SUPPLIERS

• Product development often involves licensing in Intellectual Property, and adding to it

• Second sourcing helps assure continuity of supply: sole sourcing is always risky

• An early stage startup rarely needs a contract for a supplier, absent a real strategic value add from it

TECH TRANSACTIONS 2: CUSTOMERS

• Initial customers of a start-up often demand overbearing terms. Perhaps hard to resist

• No revenue with good risk protection is better than any price with no risk protection. In other words, an individual contract with no revenue is better than no contract with some revenue

• Terms and Conditions on the startup’s invoices offer some risk protection (between nothing and an individual contract). The customer may have its own conflicting Ts & Cs!

PHILOSOPHY I• Startup A La Carte™ : seeking to make the legal

aspects of starting a business transparent and understandable. There’s no need for mystery!

• That is the purpose of this Presentation. • For more detail, see www.startupalacarte.com

, and scroll down to the service descriptions. • Decide what services you need, and GO!

PHILOSOPHY II• Most Silicon Valley law firms cost a lot, and

won’t tell you how much to expect. “It all depends,” they will say, “on many things.” “But we will let you pay $ ___ later.”

• If a law firm offers to defer (postpone payment of) $20K in fees, it likely expects to earn a lot more from your business, say $60K or more.

PHILOSOPHY III• Startup A La Carte™ sets its prices in advance

for early-stage startups; you can see what you’re getting into, and budget accordingly

• Startup A La Carte™ sets its prices low for early-stage startups, because you are the least likely to be able to afford law firm prices

• Startup A La Carte™ legal services are transparent and affordable!

Disclaimer

• This presentation is not advertising or a solicitation, and is absolutely NOT legal advice.

• Think of it as a class giving a summary of some of the salient issues that early-stage startups meet. Like any class, its purpose is to increase general knowledge, not give specific guidance.

• If you need further legal clarification of any of the subjects presented, please ask a lawyer before taking any action. Thank you!

Ian J. Stock

Yale Law School, JD

Wilson Sonsini Goodrich & Rosati, Palo Alto CA

Kevorkian and Rawlings, Paris

Kronish Lieb Weiner & Hellman NY NY