Setting up a tech business in the US: considerations on incorporation, equity and financing

Incorporating in the U.S., financing, and equity considerations A founder / CEO perspective Benoit Bergeret Slacker Hill Strategies ben.bergeret@gmail.com FACCSF/BusinessBooster September 12, 2012 San FranciscoSlacker Hill Strategies (c) Benoit Bergeret 2012 1and FACCSF – 09/2012

Purpose and Context This presentation has been given to attendees ofthe Business Booster training program of the French American Chamber of Commerce in San Francisco (www.faccsf.com) It is aimed at technology leaders from Europe (with a focus on France) who are thinking about opening a presence in the US , either a new company or a subsidiary of an existing company For more information contact the author: Ben (Benoit) Bergeret Slacker Hill StrategiesSlacker Hill Strategies and ben.bergeret@gmail.com (c) Ben Bergeret 2012 2FACCSF

DisclaimerThis document presents my personal view of the subject matter based on my (limited) experience and acquired knowledge. It is aimed at being comprehensive or complete, and might even contains errors, for which I will assume no liability whatsoever. All information contained herein is subject to correction / modification and does not constitute legal or financial advice; neither does it establish an attorney- or advisor-client relationship with the reader.Slacker Hill Strategies and (c) Ben Bergeret 2012 3FACCSF

Contents• Introduction• Deep dive: CA incorporation 101• Financing sources• Startup equity considerations – Preferred stock – Convertible notes – Equity splitSlacker Hill Strategies and (c) Ben Bergeret 2012 4FACCSF

Slacker Hill Strategies and (c) Ben Bergeret 2012 5FACCSF

First things first: why are we here?• Expand a foreign presence into the US?• Start a business from scratch?NewCo vs. Subsidiary• What are we in the market with / for? – Product vs. Service – Growth towards dividends vs. Exit? Corporate structure / equity, financing type, etc.Slacker Hill Strategies and (c) Ben Bergeret 2012 6FACCSF

Whatever your plan is… (1)• Choose form wisely – C-Corp often preferred for foreign companies subsidiaries • Customers here prefer to do business with a U.S., rather than overseas, entity. • Provides legal firewall protecting mothership • Low cost & capital requirements – Most common option is to incorporate in Delaware and register in CA• Budget beyond the obvious – Average employee cost in SF Bay Area $150k-$180k p.a. (fully loaded) – Benefits & Employee Taxes; local taxes – Office Brokers & Equipment – Property & Casualty Insurance – Trademarks & DomainsSlacker Hill Strategies and (c) Ben Bergeret 2012 7FACCSF

LLC vs. C Corp vs. S Corp• LLC = Limited Partnership – Limited financial liability for partners (limited to their investment) – Free-form governance (LLC Operating Agreement = how investors relate to each other, their respective financial rights and obligations, how the LLC is governed) – Best suited for companies that are limited in purpose or which otherwise do not wish to become full-blown corporations. – “Check the box" under U.S. federal tax law: LLC can elect to be treated as a partnership or a corporation for U.S. federal tax purposes. – Typically receives "pass through" tax treatment (income is only taxed when distributed to the partners vs. "double taxation" for corporations)• C Corp = true corporation – Incorporated under the laws of one of the states (i.e. Delaware) – Subject to the rules of corporate governance determined by the statute under which it is organized: meetings of the board of directors, annual filings, board/officers structure – The rights and obligations of the shareholders, directors and officers are typically defined by statute and court precedent and are harder to vary by contract (it is still done, by means of Shareholders Agreements, but generally less freedom is available than is the case with an LLC). – Subject to "double taxation”: income earned by the corp is taxed twice: when earned by the corp and then at the shareholder level, if/when distributed as income – Best choice for tech startup or US sub of foreign company• S Corp = C corp without double taxation – But major restriction = 100 shareholders maximum, must be natural persons (not corporate entities) who are U.S. citizens or residents. – Inadapted to sub of foreign entity – Poorly suited for tech startupSlacker Hill Strategies and (c) Ben Bergeret 2012 8FACCSF

Whatever your plan is… (2)• Understand CA employment law – Employees benefit from high protection – Hire at will does not mean absence of obligations and liabilities – Harassment (incl. futile) and discrimination (gender, age, family obligations, health, etc.) – Contractor (1099) vs. employee (w-2)• Be aware of local tax obligations and amounts – SF payroll tax (1.5%) – County / state taxes (Franchise tax: 8.84%) – Property taxes – And more… Check this: the ‘Amazon Tax’ http://sanfrancisco.cbslocal.com/2012/09/11/bay- area-congresswoman-online-sales-tax-for-all-50-states/• Contract mandatory insurance policies – Business liability – Workers’ compensation insurance – Key men insurance as neededSlacker Hill Strategies and (c) Ben Bergeret 2012 9FACCSF

Ready to incorporate?Slacker Hill Strategies and (c) Ben Bergeret 2012 10FACCSF

Incorporating a NewCo• OK to go with LLC (even sole proprietorship w/dba initially) BUT• Incorporate as soon as you are not alone anymore• Most important decision is equity split – Impacts ability to manage, grow, sell company – Should reflect leadership structure through hard assets contributions – Sets the stage for future funding / exit discussions – See last slide• Next = I.P. assignment & tangible assets transfers• While at the same time securing early stage financingSlacker Hill Strategies and (c) Ben Bergeret 2012 11FACCSF

Opening a US subsidiaryExample 1: Foreign company, has US sub, major US clients & multi-million USD revenues but no employeesExample 2: Foreign company does business in the US without a US subsidiary (business trips, local suppliers contracts with mothership, invoicing from abroad) Why open a US sub? – Local market proximity – if your customers are real people based here – Marketing value of US presence – key in some tech markets – Local staff• Incorporate in time for first payroll employee or any contract that cannot be entered by mothershipSlacker Hill Strategies and (c) Ben Bergeret 2012 12FACCSF

Financing sourcesSlacker Hill Strategies and (c) Ben Bergeret 2012 13FACCSF

Available funding sourcesfor a startup• The usual suspects: – Friends and family (cash loans) – Business angels (stock or convertible notes) – Venture capital (preferred stock)• The little-known gems: – Crowd-funding (i.e. Kickstarter) – Local (US) public funding (SBIR grants) – Asset-backed loans (venture loans) (less often applicable but worth a look)Slacker Hill Strategies and (c) Ben Bergeret 2012 15FACCSF

Kickstarter? Seriously?10 most successful fundraisers to date (09/2012)Project Seeked RaisedPebble e-paper watch $100k >$10m DeviceOuya video game console $875k $8.6m Device / gamingDouble Fine advanture game $400k $3.3m GamingWasteland 2 game $900k $2.9m GamingShadowrun Returns $400k $1.8m GamingElevation Dock $75k $1.45m DeviceThe Order of the Stick (comic) $57.75k $1.255 BookAmanda Palmer & The Grand Theft $100k $1.2m RecordOrchestra albumSedation Wars: Battle for Alabaster $20k $950k GamingTikTok+LunaTik Multi-Touch Watch Kits $15k $940k DeviceSlacker Hill Strategies and (c) Ben Bergeret 2012 16FACCSF

Available funding sourcesfor a Subsidiary• Good ideas: – Funding by holding company • Independence + flexibility • Requires appropriate cash flow or mothership financing – Dedicated “international expansion” VC round – COFACE export insurance – Local venture • Co-investment with partner (product / sales / etc.) • Control? Exit? Proceeds? • More often than not: problematic / conflictual down the road – Distribution agreements • Manages local distribution / partnerships • Lightweight (could have no US employees) – Grants & loans • Coface insurance • Small Business Innovation Research (SBIR) grants – For R&D-heavy organizations – Restrictions apply; plan sub structure accordingly • Local bank loans: if you can get them… take them!• Bad ideas (most of the time): – VC investment in sub (they simply won’t do it) – Asset-backed venture loans (too hard to enforce on foreign assets)Slacker Hill Strategies and (c) Ben Bergeret 2012 17FACCSF

Drill-down: VC financing termsSlacker Hill Strategies and (c) Ben Bergeret 2012 18FACCSF

Stock / capital funding considerationsfor a startup (1)• Angels vs. VCs – Different objectives / expectations / roles • Short vs. long term investment • Returns expectations lower vs. higher • Bridge money vs. growth advisor – Different culture • Hands off vs. ‘domain experts’ • Opportunity vs. trend• Most commonly used tools (see dedicated sections) – Fully-priced preferred stock – Convertible notesSlacker Hill Strategies and (c) Ben Bergeret 2012 19FACCSF

“Were in a bubble, right ? Who knows how much this funding bonanza will last, how long before the hapless VCs run like lemmings in the other direction to lick their wounds, demonstrating once again their fundamental lack of appetite for risk. Better take as much as you can on the balance sheet right now, for who knows what will happen when the Wall gets breached ?” – Fred Destin (http://freddestin.com/2012/09/penis-envy-why-you-too-should-raise-a-massive-series-a.html)Slacker Hill Strategies and (c) Ben Bergeret 2012 20FACCSF

Stock / capital funding considerationsfor a startup (2)• Raise as little as possible in the early stages – To preserve % equity later – Pre-money value is key – Create value at each step – Stand your ground in negotiations• Carefully watch size of option pool – A required tool for hiring talent in the Bay Area – Contributes to founders dilution if not carefully managed – Plan early to grow it at later stages (don’t over allocate)Slacker Hill Strategies and (c) Ben Bergeret 2012 21FACCSF

Why preferred stock for investors?• The good: protection of their investment• The bad: risk of (bad) investors securing abusive rights• Founders need to hold their ground• While at the same time remembering this is a team adventureSlacker Hill Strategies and (c) Ben Bergeret 2012 22FACCSF

Typical preferred stock termsfor early stage investment• Most common: – Board seats / voting rights • A good way to secure founder’s prerogatives if negotiating power (i.e. Zuck @Facebook) • Caution with board size: too many members can be hard to manage – Protective provisions – Liquidation preference • Non-participating vs. full participating vs. capped participation • 1x most common these days (3x typical of pre-2008 now mostly gone) • NOT IMMUABLE – Conversion rate (usually 1) & mandatory conversion – Anti-dilution – Pay-to-play (or bust = lose anti-dilution rights) – Tag along – Drag along• Less common (these days) – Ratchet – Dividends – Redemption rightsSlacker Hill Strategies and (c) Ben Bergeret 2012 23FACCSF

What about Convertible Notes?Slacker Hill Strategies and (c) Ben Bergeret 2012 24FACCSF

Convertible Notesdemystified (1)• Highly popular in early stage rounds – Debt instrument, to be reimbursed at next financing round – Typical terms include caps, discounts, warrants, ratchets • Caps provide dilution protection to the investor (founder’s interest = highest cap or no cap) • Discounts provide investor bonus for investing early (founder’s interest = lowest discount or no discount) • (note: cap and discount are mutually exclusive. Only the most beneficial is used at funding series time) • Warrants (in lieu of a discount) • Ratchets transfer equity to the investor in case the note can’t be repaid• US vs. Europe – In continental Europe, the convertible note is looked at as debt with additional obligations investor has leverage to reclaim the money if no provision was made – In the US it’s the terms that matter by themselves. If they do not contain provisions in case the funding event does not take place, and if there is no alternative clause  investor might lose it allSlacker Hill Strategies and (c) Ben Bergeret 2012 25FACCSF

Convertible Notesdemystified (2)• Pros – Simple and inexpensive to implement – Defers valuation decision – Well adapted to ‘bridge’ financing (typically <$1m) – Unsecured (no IP or other assets attached) – Passive investor• Cons – Implications of cap, discount, warrants at next round can be lost to founders – The lower the pre-money at Series A, the more equity the angel investor gets – Beware of ratchets, damages obligations (rare but seen) clauses – If no round happens, note is only valued at its interest rate (not what angels want) – ”Notes are a promise/obligation for the future and things can change between now and then and investors have far fewer guarantees. Priced rounds give investors stock under certain terms.” – Daniel Levine, Accel – Passive investorSlacker Hill Strategies and (c) Ben Bergeret 2012 26FACCSF

Equity split between startup foundersSlacker Hill Strategies and (c) Ben Bergeret 2012 27FACCSF

Equity split between startup founders CONTROVERSYSlacker Hill Strategies and (c) Ben Bergeret 2012 28FACCSF

Equity split between startup founders• Forget equal split – Equal split means trouble down the line – Cash is king. Early cash mandates higher equity (as is any other form of tangible contribution i.e. I.P.) – If all bring same cash, remember that decisions will have to be made, not necessarily consensual: identify the leader – If already started on equal split basis, use stock options grant to clearly identify leadership• Protection among founders – Vesting: nobody wants a co-founder to walk away with 30% after 6 months of not doing much – Solid shareholder’s agreement among founders: tag-along, anti-dilution, etc.Slacker Hill Strategies and (c) Ben Bergeret 2012 29FACCSF

Slacker Hill Strategies Advisory services to early-stage tech startups• Founder & CEO mentoring / coaching• Corporate development, financing, equity structuring, go- to-market strategy, US implantation ben.bergeret@gmail.com (415) 370-5603Slacker Hill Strategies and (c) Ben Bergeret 2012 31FACCSF

Setting up a tech business in the US: considerations on incorporation, equity and financing

by Ben Bergeret on Sep 17, 2012

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Setting up a tech business in the US: considerations on incorporation, equity and financing Presentation Transcript