What Type of Entity Should I Choose for My New Company?
Choosing the structure of your new Company involves an analysis of many factors, including tax structures and implications, ownership restrictions, attractiveness to investors and structural complexity. The biggest advantage to incorporating as a C-corporation is its attractiveness to investors, namely venture capitalists and angel investors. Additionally, it allows for a great deal of flexibility in terms of the ownership and capital structure. A limited liability company (“LLC”) on the other hand, is not attractive to investors; in fact many investors will require an LLC to convert to a C-corporation prior to making their investment. An S-corporation can provide many of the same benefits as that of a C-corporation; however it is very restrictive in terms of its ownership and capital structure. Click here for a further discussion on choice of entity.
Where Should I Incorporate?
A Company can incorporate in any state it chooses, provided it satisfies the procedures established by that state. However, absent highly unusual circumstances, a Company should incorporate in either Delaware or the state in which its headquarters are located. Delaware has always been at the forefront of corporate law and incorporating in Delaware provides a comfort in knowing that most legal issues that arise will likely have solid legal precedent. Additionally, Delaware has a very responsive Secretary of State’s office. The disadvantage of incorporating in Delaware is that the combined franchise fees can be very expensive, sometimes exceeding tens of thousands of dollars annually.
States other than Delaware vary widely in the modernity of their corporate statutes. Recent amendments to the Wisconsin Business Corporation Law have made the Wisconsin statutes very modern and flexible. For many early-stage Wisconsin companies, we recommend incorporating in Wisconsin, as the lower costs will usually outweigh the advantages of the more developed Delaware law.
What is a Certificate of Incorporation (Articles of Incorporation)?
The Certificate of Incorporation (referred to as the “Articles of Incorporation” in some jurisdictions) is a document which contains many of the basic pieces of information required to be filed with the state of incorporation, such as the name of the Company, an official address, the name of a registered agent and the classes and number of authorized shares of stock. The Certificate of Incorporation is filed with the state along with a filing fee, after which the state will certify the Company’s existence.
What are Bylaws?
A Company’s bylaws are the organizational rules by which the Company is governed. While the Certificate of Incorporation generally contains no more than what the state of incorporation specifically requires, the bylaws describe in much more detail how the Company will run on a day to day basis. Bylaws generally contain details such as the number of directors on the board, how such directors will be elected, the officer positions and specific powers associated with them and rules for both board meetings and stockholder meetings.
What is the Difference between Authorized, Issued and Outstanding Shares of Stock?
A Company will authorize a certain number of shares of stock from which shares will be issued to its stockholders (referred to as “shareholders” in some jurisdictions). The authorized number of shares is the maximum number of shares which can be issued without amending the Company’s Certificate of Incorporation. Issued shares are those authorized shares actually issued to a founder, employee or consultant of the Company. The number of currently issued shares must always be less than or equal to the number of authorized shares. The outstanding shares of stock are those shares of the Company’s stock which have been previously issued and still remain issued. To the extent a Company repurchases shares of stock, those shares would no longer be outstanding.
What is Par Value?
Par value is a dollar amount assigned to a security, though it has no relation to the security’s fair market value. The par value on a share of common stock is usually a nominal value (such as $0.001) and represents the price below which the Company cannot issue shares of the same class. Typically, the par value on shares of a Company’s preferred stock will mirror that of its common stock.
Stock Options / Compensation:
What is the difference between Stock Options and Restricted Stock?
Stock Options and Restricted Stock are quite similar in that both provide a way for the Company to issue shares of its common stock to founders or other employees or consultants. Additionally, the right to purchase those shares (Stock Option Agreement) or actual ownership of the shares (Restricted Stock) will likely be subject to a vesting schedule. The main difference between these two types of agreements is whether the founder or employee will have to pay anything for the shares of common stock. Under a typical Stock Option Agreement, the employee will be granted a right, after a certain period of time, to purchase the shares of common stock for a set purchase price. The purchase price will typically be significantly less than fair market value so as to operate as an incentive for the employee to make the Company successful. Restricted Stock Agreements, on the other hand, actually provide the employee with the shares of common stock after the vesting period has expired. There is no additional purchase required. Employees who receive restricted stock should also consider filing an 83(b) election.
What is an 83(b) Election?
Under certain tax laws, the vesting schedule of a Restricted Stock Agreement will be treated as a substantial risk of forfeiture. In layman’s terms, the employee may lose his or her job before the vesting schedule lapses, meaning all shares of common stock subject to a Restricted Stock Agreement may not completely vest. The Internal Revenue Service therefore, does not tax the initial issuance of a Restricted Stock Agreement. Instead, the shares of common stock will only be taxable to the holder when they have vested. Although this means the holder of a Restricted Stock Agreement will not be taxed upon receipt of that agreement, it does mean that the holder will be taxed when the shares vest (presumably when the shares of stock are much more valuable). To prevent this higher taxation at a later date, the Internal Revenue Service gives you thirty days from the date any vesting restrictions are imposed on the stock, to file an 83(b) election. This election will allow you to pay taxes on the stock at the time of its issuance: when it likely has very little value, for tax purposes. When the stock actually vests, you will not need to pay any additional amount. As an added bonus, you can start your capital gains period on the date the stock is issued, as opposed to the date the stock vests, giving you a jump start on the one-year holding period for capital gains treatment.
What is Section 409A?
Section 409A of the Internal Revenue Code governs the federal income tax treatment of a variety of non-qualified deferred compensation arrangements (e.g., stock options (other than Incentive Stock Options), restricted stock, phantom stock and certain severance and change-in-control agreements). It applies to non-qualified deferred compensation given to employees, consultants, directors, service providers and other independent contractors. Non-qualified deferred compensation plans must comply with various regulations regarding timing of deferrals and distributions. Failure to comply with Section 409A can lead to severe penalties, including early taxation of certain deferred amounts and penalty taxes.
What is an Option Pool?
An option pool is a certain number of authorized and unissued shares of a Company’s common stock which are set aside for issuance to future employees, namely key executives. Due to a lack of capital, most start-ups do not have the funds necessary to pay their key executives an annual salary, or at least not an annual salary on par with market rates for other operating companies. Instead, many executives will be compensated through a mix of an annual salary and shares of common stock, typically issued by a Stock Option Agreement or a Restricted Stock Agreement. For the Company, it lowers the amount of actual cash needed to hire the key executive. For the key executive, it should serve as an incentive to make the Company a successful one. Additionally, outside investors like to see a Company’s key executives with so called “skin in the game.” Click here to read more on the employee incentive pool.
Should Founder’s Shares be Subject to Vesting?
The answer to this question clearly depends on who you ask. In the Midwest, it is less common to have the founder’s shares be subject to vesting than it is on the West Coast. Every situation is unique, but best practices often dictate that a significant portion of the founder’s shares be subject to vesting during the initial two to three years of the Company. During this critical time, subjecting the founder’s shares to vesting will allow the Company to free up some shares of its stock to raise money for, or to provide equity as, a replacement. To the extent a founder’s shares are not initially subject to a vesting schedule, an investor may require that as a condition to the investment, at least a portion of the founder’s stock be subject to vesting.
What is the Difference between an Incentive Stock Option and a Non-Qualified Stock Option?
Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs) are the two most widely used forms of stock options issued by start-up companies. ISOs offer certain tax advantages over NQSOs, but do so at the price of flexibility. ISOs can only be issued to employees and must be granted at fair market value. These options are non-transferable, must be granted within ten years of approval by the board / stockholders and must be exercised within ten years of the date of grant. They are taxed on the sale of the stock (as opposed to the issuance or exercise of the options). Additionally, if they meet the holding period requirements, ISOs can receive long-term capital gain tax treatment.
Alternatively, NQSOs can be issued to anyone (i.e., consultants, board members, employees, etc). They can be priced below, or even above, the current fair market value. They will typically be taxed upon the exercise of the options and will be taxed at the ordinary income tax rates. In some situations, NQSOs may be taxed upon the issuance of the actual option agreement.
Convertible Promissory Notes:
What is a Convertible Promissory Note?
Like an ordinary promissory note, a convertible promissory note is evidence of indebtedness. It proves that its holder has loaned money to the Company, and that the Company is legally obligated to pay back the loan. Convertible notes differ from ordinary promissory notes in that one way the note can be paid back is in stock of the Company (typically, promissory notes are paid back in cash). When that happens, the note is considered “converted” into equity of the Company.
What is a Conversion Price?
A conversion price is the factor that determines the number of equity shares that a convertible promissory note is converted into. The number of converted equity shares is determined by taking the outstanding balance of the note and dividing it by the conversion price. For example, a convertible note with an outstanding balance of $100 and a conversion price of $2 would be converted into 50 equity shares ($100/$2 = 50) of the Company.
Under What Circumstances Should a Convertible Promissory Note be Used?
A convertible promissory note should be used when there is significant uncertainty or disagreement about the valuation of the Company, making it impossible to determine the price per share at which stock should be issued. A convertible promissory note may also be issued if the Company needs interim funds to achieve a milestone or close on the next round of equity funding. A convertible promissory note’s conversion price is usually defined to be the price per share at which equity is issued in the subsequent round of financing. Therefore, investors in a convertible note round are essentially agreeing to defer the question of valuation until the next financing, at which time they would convert their notes at a conversion price equal to the price per share at which stock is sold in that subsequent round. This allows convertible note round investors to invest based upon the price per share in the next round, usually with some discount or warrant coverage to compensate for the additional risk. For this reason, convertible notes are often referred to as “bridge” loans, because they bridge the gap between the time of the investment and the Company’s next financing round.
What is Warrant Coverage?
Warrant coverage refers to the warrants (essentially, rights to purchase equity shares) that may be issued to convertible note holders at no extra charge to compensate them for the additional risk they take by investing at an early stage relative to other investors. You may have heard of warrants referred to as “Equity Kickers.” Because convertible notes are typically converted into equity shares at a conversion price equal to the price per share at which equity is sold in a subsequent financing round, the convertible note investors get the same deal as the investors in the subsequent round, all things being equal. This is considered unfair to the convertible note investors, who invested at an earlier time when the investment was more risky. To compensate the convertible note investors for the added risk they take, warrants to purchase equity shares at a predetermined price are issued to the note holders at the time they purchase their convertible notes. These warrants are the notes’ “warrant coverage,” which is usually expressed as a percentage of the initial principal of the notes. For example, 20% warrant coverage implies that if a convertible note is issued with an initial principal amount of $100, the note purchaser would also receive a warrant to purchase 20 equity shares of the Company at a predetermined price.
When are Convertible Notes Converted?
Convertible notes are usually intended to be converted at the time of the next financing round. However, convertible notes are drafted to convert upon other events as well. For example, if the next financing round does not occur before the stated maturity date, the convertible notes might convert – either automatically or at the option of the Company, the individual noteholder or a majority of the noteholders – into equity shares at a predefined conversion price. Similarly, a convertible note might be convertible into equity shares upon a “change of control” transaction, such as a merger of the Company.
What Should be the Maturity Date of the Notes?
Convertible notes will typically become convertible (either automatically or at the option of one or more parties) upon maturity – and usually at an investor-friendly “default” conversion price. Because of this fact, the Company will typically want the maturity date to be as far in the future as possible in order to maximize the amount of time it has to close on a subsequent round of financing. This makes it more likely that the notes will convert at a conversion price equal to the price per share of equity sold in that round, as opposed to at a default conversion price that would apply to conversions at or after maturity. Conversely, investors will generally want a shorter maturity in order to maximize the likelihood that their notes will convert at the investor-friendly default conversion price.
What are Typical Interest Rates for Convertible Promissory Notes?
Interest rates on convertible promissory notes are almost always substantially higher than most ordinary promissory notes. This is because the investors who purchase convertible promissory notes are taking a substantial risk, for which the interest rate (together with the warrant coverage) is intended to compensate. Therefore, the Company should expect to issue convertible notes at interest rates comparable to notes issued in most mezzanine financing transactions. For example, if the prime interest rate is 3.25%, the Company should expect to issue convertible notes with an interest rate in the range of 8% to 12%. Of course, interest accrued on a convertible note is almost always added to the note’s balance and converted into equity shares (as opposed to paid in cash); but even so, the interest rate is important as it determines in part the number of equity shares into which the note will ultimately be converted. As an additional note, keep in mind that the interest rate on the convertible note is a small portion of the overall value, with most of the economic value based upon the discount or warrant coverage provided.
Series AA / Angel Stage Financing:
When Should You Use Series AA Preferred Stock?
Series AA Preferred Stock is intended for use where an entrepreneur and angel investors or early-stage venture capital investors agree on terms that provide the investors with certain rights that are greater than those associated with common stock (e.g., liquidation preference, special voting rights, a designated board seat, etc.), but do not include all of the specific rights that a later round venture capital investor might require. The goal of the Series AA Preferred Stock is to lower the cost and simplify the capital structure of an angel-round financing.
What is the Typical Range of Investments in Series AA Financings?
Series AA financings often occur after an entrepreneur has used up the funds available from bootstrapping and friends and family. At this point, angel investors may take a serious look at the business plan, business model and/or related technology that the entrepreneur intends to implement or further develop using the Series AA financing. While it is difficult to generalize, the amount of a Series AA financing will typically fall within the range of $100,000 to $2,000,000, give or take some on one side of the range or the other depending on the circumstances, the entrepreneur’s need for capital and the angel’s appetite for the deal.
What is the Difference Between a Series AA Financing and a Series A Financing?
Series A financings are more prominent among Companies that have lowered their risk portfolios, through securing a strong patent position, agreeing to terms in a license agreement, embarking on the path toward commercialization, etc. Series A financing is often funded by venture capitalists or angel investors who are funding at a level generally higher than most angel investments of $1,000,000 or more. Series A financings involve the issuance of preferred stock, which provides investors with many rights, preferences and privileges which are senior to those offered to a holder of the Company’s common stock. Investors in these types of financings anticipate some form of an exit, be it an IPO or a merger or other sale, within five to seven years of their investment.
Series AA financings on the other hand, are more typically used by a Company that has not yet reached that point of lower risk. For example, a Company that has perhaps been able to validate its business model with a successful prototype or is receiving positive market feedback from its beta test and needs capital to start production or kick off commercialization and marketing would be good candidate for Series AA financing. In many cases, Series AA financing might be sought at an even earlier stage. Additionally, Series AA preferred stock is less likely to include many of the same preferences and privileges as those associated with Series A preferred stock.
Series A / Venture Capital Financing:
The National Venture Capital Association (“NVCA”) can be a useful resource for “template” legal documents for venture capital investments. Click here to view the NVCA Term Sheet and Form Financing Documents.
Are Term Sheets Binding?
On the whole, term sheets are not binding. However, certain provisions of them, namely a No Shop provision will be. A “No Shop” provision will bar the Company for a period of time from going out in search of a better deal after the term sheet has been fully executed. The period of the ban will generally be short, no more than two to four weeks, but it will prevent the Company from looking for a better dance partner for that period of time. Click here to read more about no shop provisions.
What is Preferred Stock?
Preferred stock is an additional class of equity securities that a Company may issue for investments received. The preferred stock will typically have rights, preferences and privileges that are senior to those affiliated with shares of a Company’s common stock. Start-up companies will generally issue shares of its common stock to its founders and will reserve shares of its preferred stock for investors, namely venture capital groups.
How Do You Determine the Purchase Price Per Share?
The purchase price per share is a mathematical calculation equal to the pre-money valuation divided by the total number of shares outstanding. It is important to note that the total number of shares outstanding is calculated on a fully-diluted basis, meaning any outstanding options or other outstanding agreements will be included in that calculation.
What Does “Participating Preferred” Mean?
Participating preferred is a very investor-friendly provision. In essence it says that upon a liquidation event (which includes a sale or merger transaction) the holders of preferred stock can choose to (i) surrender their shares in exchange for an amount which will typically be equal to the amount paid per share plus any declared but yet unpaid or accumulated dividends, plus the number of shares of common stock that such holder would have been entitled to had it converted, and further “participate” pro rata with the common stockholders in any remaining proceeds from the liquidation event; or (ii) convert its preferred stock into shares of common stock and then share in the proceeds of the liquidation event pro rata with the other holders of the Company’s common stock. Many entrepreneurs view the participating preferred as “double dipping.”
What is Anti-Dilution Protection?
While there are several types of anti-dilution protection, the overarching concept is protection of the investors if the Company issues additional shares of stock (other than from the option pool) for a purchase price less than the previous price paid. The most common type of anti-dilution protection is what is known as the “broad-based weighted average anti-dilution.” This protection will consider not only the price the new shares are issued at, but also the number of new shares issued. If the Company only sells a small number of additional shares, the impact of the anti-dilution protection will be minimal. At the other end of the spectrum, the most investor friendly formula is known as “full ratchet.” If this type of anti-dilution protection is in place, and the Company issues even one additional share of stock for less than the previous price paid, the effective price of all shares held by protected investors will be reduced to that lower amount. Click here to read more on anit-dilution price protection.
What Does “Pay-to-Play” mean?
A pay-to-play provision will require investors to invest an amount equal to their current pro-rata percentage of ownership in the Company in future rounds of financing. Failure to do so can have a number of different consequences from loss of rights to participate in future rounds to conversion of all preferred shares into shares of common stock. Such a conversion would cost the investor any other privileges or benefits associated with holding shares of preferred stock. Click here to learn more about pay-to-play provisions.
What Does “Fully-Diluted” mean?
The number of fully-diluted shares in a Company is the total number of shares that would be outstanding if all possible sources of conversion were exercised. This would include conversion of shares of preferred stock into shares of common stock as well as the exercise of all issued stock options.
What are Redemption Rights?
Redemption rights allow investors to force the Company to repurchase their shares at a later date. This provision will be tied to a voting threshold, which will typically be the holders of at least a majority (or a higher percentage) of the preferred stock. Once the required holders provide the Company with notice, the Company will be required to purchase the shares of preferred stock back from the preferred investors. The purchase will generally be done in installments (usually 3 annual installments), and at each installment, the Company will purchase, on a pro rata basis, the shares of preferred stock from the investors. If the Company does not have sufficient funds to repurchase all shares of preferred stock, it will instead do so on a pro rata basis based on the total amount of funds available for the purchase.
What are Protective Provisions?
Protective provisions provide investors with the peace of mind that the Company can not take certain actions unless approval is received from a certain threshold of preferred stockholders. The typical voting requirement will be the holders of at least a majority (or a higher percentage) of the preferred stock. Some of the possible actions subject to such a provision include the right to liquidate, dissolve or wind-up the business and affairs of the Company, the right to amend, alter or repeal any provision of the Certificate of Incorporation (Articles of Incorporation), the right to create or authorize the creation of an additional series or class of stock with rights, preferences and privileges senior to those afforded to the holders of preferred stock or the right to increase or decrease the number of authorized directors constituting the board of directors.
What are Registration Rights?
Registration rights allow the investors to force the Company to register its shares of common stock (those issuable upon conversion of the preferred stock) with the Securities and Exchange Commission (the “SEC”). Shares which are not registered with the SEC are subject to transfer restrictions. Forcing the Company to register its shares would remove these transfer restrictions and would allow a venture capital fund to transfer and sell its shares of stock in the Company. Keep in mind that there will be a voting threshold needed to force the Company’s hand, which will typically be the holders of at least a majority (or a higher percentage) of the preferred stock.
What is an “Accredited Investor”?
An individual is currently considered “accredited” if he or she has a net worth of $1 million, or either an individual annual income in excess of $200,000, or a combined annual income together with his or her spouse of $300,000, in each case in each of the two most recent years. Sales of securities to such investors are largely unregulated at the federal level, and if such sales qualify under “Rule 506,” they are preempted from virtually all state regulation as well.
Why Should you use Venture-Experienced Counsel?
Yes, this question is self-serving but it also affects your business. For example, you would not ask the world’s best heart surgeon, much less a general practitioner, to do a liver transplant. Neither should you ask a lawyer that doesn’t regularly represent entrepreneurs and venture investors to handle your venture capital transaction. Lawyers who make venture capital transactions a regular part of their business are familiar with the current “state-of-the-art” documents on hand, and are aware of current market conditions. You can safely assume that a good corporate lawyer who has never handled a venture capital transaction before will, at least, double the expense of the transaction – and in the process will probably not do a very good job.
Will a Venture Capital Fund Sign a Non-Disclosure Agreement?
The answer is almost always no. The main reason being venture capitalists screen hundreds of business plans each year. Many venture capitalists only invest in a limited number of industries, and although every entrepreneur out there may think they have the next big idea, venture capitalists see overlap in business concepts with some regularity. Practically speaking, this is not as big of a deal as one would initially think. As a general rule, your business plan should not contain anything proprietary. Click here to read more on venture capitalists and non-disclosure agreements.
What is the Work-for-Hire Doctrine?
This is a legal doctrine which is intended to allow a Company to train, educate and share ideas with those working for it without fear of creating its next competitor. Under this doctrine, an employer is assumed to own the copyright of all work created by its employees within the scope of their job. Additionally, a Company will typically claim ownership of work created by independent contractors, assuming the work was specially ordered or commissioned by the Company, both parties expressly agreed in writing that the project was considered work for hire and the type of work fits within one of nine categories enumerated within the federal law. To read more on the work-for-hire doctrine, click here.
This Blog is a publication of Michael Best & Friedrich LLP and is intended to provide clients and friends with information on recent legal developments. This Blog should not be construed as legal advice or an opinion on specific situations. For further information, feel free to contact authors or other members of the firm. We welcome your comments and suggestions regarding this Blog. © 2010 Michael Best & Friedrich LLP. All rights reserved.