VENTURE CAPITAL AND START-UP PROFFITT SPRING 2016
CREATING THE STARTUP COMPANY
Corporate Organizations:
(1) Sole Proprietorships à Not good for startup
No legal entity exists (liability against owner’s assets)
No financing available (business must rely solely on revenue)
(2) Partnerships à Not good for startup
Good for service providers (venture capital firms)
Joint and several liability (each partner is liable for the others’ actions)
Pass through taxation (partners report income on own tax returns)
(3) Limited Liability Company (LLC) à Good for startups that do not need to raise funding (venture capitalist do not invest in LLCs)
Functions like a corporation
Super flexible
(4) Corporation (“C” Corporation/”S” Corporation) à Good for startups
Incorporate in Delaware à Incorporator files a Certificate of Incorporation/Articles of Incorporation with Secretary of State
When should a company incorporate:
(1) Company starts interacting with the outside world
(2) Sharing the company (co-founders or bringing in a coder)
(3) When there is IP to protect
Separate legal entity exists (a “legal” person with the ability to own property and enter into contracts) à Liability stops attaching to owners/shareholders and attaches to company
Board governs the entity à Serves the shareholders
Board hires CEO à CEO hires management (govern day-to-day)
C Corporation à Flexible capital structure
No pass through taxation benefit (corporate level tax)
S Corporation à Treated like a partnership for tax purposes (pass through taxation benefit)
Heavily restricted:
No more than 100 shareholders
Shareholders can only be individuals
Only one class of stock (no class of preferred stock) à Venture capitalist do not invest in S corporation
State of Incorporation Factors (Delaware v. California):
Pro-management/pro-company corporate law (Delaware)
Cost of reincorporation and IPO/exit objectives
Ability to attract outside directors
Cost/Filing services in Delaware/California
Ability of counsel to offer legal opinions (most familiar with Delaware law)
Corporate Name à Name can be changed later on
Availability of the name:
Location of incorporation (check with Secretary of State)
Location of doing businesses
As a trademark (USPTO)
As a domain name (purchase domain name)
Marketability of the name
Startup Documents:
(1) Incorporation Documents à Certificate of Incorporation
(2) Founder Documents à Founders gives IP to company in exchange for stock
Restricted Stock Purchase Agreement (vesting schedule for stock)
Invention Assignment Agreement (IP assignment to the company; confidentiality; non-compete)
(3) Employee Documents
Non-compete clauses are not enforceable in CA (exception for sale of the company)
Invention Assignment Agreement
Does an employee’s invention belong to the company? à Grey area
Did the employee work on the invention during company time?
Did the employee use company resources for the invention?
Non-solicit Clause à Unable to solicit other employees once employee leaves
Anti-moonlighting Clause à Unable to do anything but work for the company
(4) Basic Third Party Documents à Non-disclosure agreement
Practical Tips:
(1) Founders’ stock arrangements must be correct
Founder must be comfortable with allocation of IP to the company in exchange for stock
Establish vesting schedule (VCs may alter the schedule later on)
“Buy/Sell” Agreements are not necessary
(2) Anticipate up to 50% dilution for 1st/2nd rounds of financing
20% of shares goes to the employee option pool
(3) Establish financing strategy
Incentive matrix for all positions (incentivize employees to work)
Determine when to raise financing and the amount needed
Establish milestones that demonstrate progress
CORPORATE ORGA
TION) à Begins capital gains holding period (taxes shares at election as if the shares are fully vested)
Must file election within 30 days of stock transfer
No § 83(b) Election à Taxed on each vesting date (costly)
Equity incentives for later stage employees à Stock Options (right to buy a fixed number of shares at a fixed price)
Regular Stock Option Procedure:
(1) Grant of option à Board action required to grant an option
(2) Vesting of option à Once the option vests (vests monthly), the holder is able to exercise the option
(3) Exercise option à Once the option is exercise, the option holder becomes a shareholder
Option is exercisable for 10-years or until termination
Option holder is not a stockholder (no vote) until exercised
Capital gains holding period beings only when exercised
Early Exercise Stock Option à Option is exercisable on date of grant
(option is not subject to monthly vesting)
Option holder receives common stock after exercise (stock received is subject to vesting) à Must file § 83(b) election
NSOs v. ISOs:
Nonqualified Stock Options (NSOs) à Public companies
No tax at grant
Gain before exercising the option à Taxed as ordinary income (higher tax rate than capital gain tax)
Gain after exercising the option à Taxed as capital gain
Stock held for more than one year à Long-term capital gain tax applies
Stock held for less than one year à Short-term capital gain tax applies (similar to ordinary income tax)
Incentive Stock Options (ISOs) à Private Companies (only grantable to employees)
