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Startup Law for Entrepreneurs: Formation: Adam Dinow/General Assembly
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Startup Law for Entrepreneurs: Formation: Adam Dinow/General Assembly

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Legal mistakes can doom even the best startup concepts and founding teams. In this class, you’ll learn about essential legal issues that startups face in the formation stage. We will explore the …

Legal mistakes can doom even the best startup concepts and founding teams. In this class, you’ll learn about essential legal issues that startups face in the formation stage. We will explore the decision-making process in forming a startup — including form, timing, documentation, and issues determining the capital structure. We’ll also dive into the the process to issue founder stock as well as tax consequences and vesting considerations. Compensation of equity structures will also be reviewed.

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  • 1. STARTUP LAW FOR ENTREPRENEURS: FORMATION Adam Dinow, Partner Wilson Sonsini Goodrich & Rosati, PC
  • 2. GET THE FULL EXPERIENCE: LEARN WHAT YOU WANT, WHEN YOU WANT Unlimited access to all upcoming live streams On-demand streaming classes taught by top practitioners A growing video library, updated weekly Get access for only $25 USD/month. No risk—you can cancel at any time! START 14-DAY FREE TRIAL
  • 3. AGENDA ‣ Forming and Organizing the Startup ‣ Founders Stock ‣ Equity Incentives
  • 4. STARTUP LAW FOR ENTREPRENEURS: FORMATION CHOOSING THE FORM OF BUSINESS ENTITY LIMITED LIABILITY COMPANY S CORPORATION C CORPORATION
  • 5. STARTUP LAW FOR ENTREPRENEURS: FORMATION LIMITED LIABILITY COMPANY (LLC) ‣ Combines features of both corporations and limited partnerships ‣ Corporate features: LLC members can operate as managers; all owners have limited liability (i.e., only the amount of their investment) ‣ Limited partnership tax features: No entitylevel tax—taxes pass through to LLC members ‣ Ownership interests of “members” are defined and established in LLC operating agreement LLC CORPORATIONS LIMITED PARTNERSHIPS
  • 6. STARTUP LAW FOR ENTREPRENEURS: FORMATION Why doesn’t an LLC work for a VC-backed startup?
  • 7. STARTUP LAW FOR ENTREPRENEURS: FORMATION S CORPORATION ‣ S corporation has board members/ shareholders, etc.; but— ‣ Tax benefits and losses passed through to the individual shareholders (i.e., a single level of taxation) ‣ Early stage start-ups will sometimes take advantage of “S Corporation” status: losses get passed through to the owners
  • 8. STARTUP LAW FOR ENTREPRENEURS: FORMATION Why doesn’t an S corporation structure work for a VCbacked startup?
  • 9. STARTUP LAW FOR ENTREPRENEURS: FORMATION C CORPORATION Shareholders Investors Employees Others Board of Directors CEO Optionees VP VP VP VP Other Employees VP
  • 10. STARTUP LAW FOR ENTREPRENEURS: FORMATION ATTRIBUTES OF A C CORPORATION ‣ Attributes of a C corporation ‣ Corporate governance ‣ No pass through of tax benefits ‣ VCs can invest in it; employees can understand stock incentives
  • 11. STARTUP LAW FOR ENTREPRENEURS: FORMATION Where to incorporate?
  • 12. STARTUP LAW FOR ENTREPRENEURS: FORMATION START-UP DOCUMENTS – 4 BUCKETS 1 2 3 4 Incorporation documents Founder documents Employee documents Basic third party agreements
  • 13. STARTUP LAW FOR ENTREPRENEURS: FORMATION INCORPORATION DOCUMENTS Certificate of Incorporation By-laws Organizational minutes and resolutions
  • 14. STARTUP LAW FOR ENTREPRENEURS: FORMATION FOUNDER DOCUMENTS IP Assignment Confidentiality Non-compete?
  • 15. STARTUP LAW FOR ENTREPRENEURS: FORMATION FOUNDER DOCUMENTS – FOUNDERS’ STOCK ‣ Restricted Stock Purchase Agreement ‣ Basic Tax Principles ‣ Vesting ‣ Acceleration Terms ‣ 83(b) Elections
  • 16. STARTUP LAW FOR ENTREPRENEURS: FORMATION FOUNDER DOCUMENTS – FOUNDERS’ STOCK ‣ The first step in capitalizing the startup ‣ Always common stock ‣ Typically issued in exchange for technology, past services or nominal cash ‣ Usually issued at low value
  • 17. STARTUP LAW FOR ENTREPRENEURS: FORMATION FOUNDER DOCUMENTS – VESTING – WHAT IS IT? ‣ Concept that recipient does not “own” all shares when issued ‣ Vesting also can, and typically does, apply to Options ‣ Mechanics depend on type of grant (Restricted Stock versus Options) ‣ What are typical vesting provisions? ‣ Founders ‣ Employees
  • 18. STARTUP LAW FOR ENTREPRENEURS: FORMATION FOUNDER DOCUMENTS – ACCELERATION TERMS OF FOUNDERS’ STOCK ‣ Termination of employment ‣ “Cause” and “Good reason” ‣ Change of control ‣ Single trigger vs. double trigger ‣ Also can apply to options
  • 19. STARTUP LAW FOR ENTREPRENEURS: FORMATION FOUNDER DOCUMENTS – 83(B) ELECTIONS FOR FOUNDERS’ STOCK ‣ General Rule — Founders are taxed on FMV of shares as they vest ‣ Exception ‣ File 83(b)!
  • 20. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS Offer letter Invention Assignment Agreement Options
  • 21. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – WHAT IS AN OPTION? ‣ Right to buy Stock at a set price ‣ Typically granted to employees, board members, advisors and consultants ‣ Issued through an “option plan”
  • 22. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – STOCK PLANS ‣ “Stock plan” or “stock option plan” (these are synonymous) ‣ A stock plan is a formal written document approved by the board of directors and the shareholders. ‣ The stock plan establishes a “reserve” of stock.
  • 23. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – ISSUING OPTIONS ‣ How boards have traditionally priced common stock in connection with option grants/stock grants ‣ Every option grant/restricted stock grant has to be approved by the board, and the board has to establish the stock price (i.e., FMV)
  • 24. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – PROCESS FOR GRANTING OPTIONS ‣ Certificate of Incorporation and Bylaws ‣ Restrictions in other constituent documents (e.g. pre-emptive rights) ‣ Stock Plan ‣ Securities Laws consideration ‣ Corporate process ‣ Issuing the agreement and maintaining good records ‣ Clean-up is costly so better to get it right the first time!
  • 25. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – INCENTIVE STOCK OPTIONS (ISOS) ‣ An ISO is eligible for favorable tax treatment ‣ Key Concepts: ‣ No tax at grant ‣ No tax at exercise (purchase) ‣ Unless alternative minimum tax (AMT) applies ‣ Sale or other disposition triggers income ‣ Tax consequences differ depending on whether disposition is “qualifying” or “disqualifying”
  • 26. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – ISOS ‣ Applicable Holding Periods ‣ 2 years from ISO grant AND ‣ 1 year from ISO exercise (purchase) ‣ Meeting both of these holding periods results in a qualifying disposition ‣ Failure to meet either of these holding periods results in a disqualifying disposition
  • 27. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – ISOS — ALTERNATIVE MINIMUM TAX ‣ Exercise of ISOs may trigger AMT ‣ General Rule — “spread” at exercise is included in the calculation of AMT ‣ Paying AMT may generate tax credit against future years’ income tax (as long as not subject to AMT) ‣ Goal to accelerate tax, not double tax
  • 28. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – CHARACTERISTICS OF ISOS ‣ ISOs must be granted pursuant to a written plan that: ‣ sets forth number of shares, ‣ states class of employees, and ‣ is approved by majority of S/Hs within 12 months of Board Adoption
  • 29. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – NONSTATUTORY STOCK OPTIONS (NSOS) ‣ An NSO is any option that does not qualify as an ISO
  • 30. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – SECTION 409A ‣ Discount stock options are treated as a deferral of compensation under Section 409A ‣ Stock options covering other than “service recipient stock” provide for a deferral of compensation ‣ Only includes common stock (i.e., does not include preferred stock) ‣ Options in subsidiary stock potentially problematic
  • 31. STARTUP LAW FOR ENTREPRENEURS: FORMATION EMPLOYEE DOCUMENTS – OPTIONS – SECTION 409A ‣ Tax at time of vesting, not date of exercise ‣ Potential interest penalty ‣ Employers have reporting and withholding requirements
  • 32. STARTUP LAW FOR ENTREPRENEURS: FORMATION THIRD PARTY DOCUMENTS ‣ Form NDA ‣ Consulting Agreement
  • 33. STARTUP LAW FOR ENTREPRENEURS: FORMATION CAPITALIZATION: PRACTICAL TIPS 1. Get the founders’ stock arrangements right! ‣ Make sure the founders are ok with their allocation ‣ Establish vesting schedule although the VCs may reverse it later ‣ “Buy/sell” arrangements are generally not necessary
  • 34. STARTUP LAW FOR ENTREPRENEURS: FORMATION CAPITALIZATION: PRACTICAL TIPS 2. Anticipate up to 50% dilution for first/second rounds ‣ Set aside approximately 20% for future employees in the early stage
  • 35. STARTUP LAW FOR ENTREPRENEURS: FORMATION CAPITALIZATION: PRACTICAL TIPS 3. Establish an overall financing strategy ‣ Create an incentive matrix for all positions in the organization ‣ Determine when you need to raise financing and how much ‣ Establish milestones that demonstrate viability/progress ‣ Expect 4-6 months process from beginning to receipt of funds
  • 36. STARTUP LAW FOR ENTREPRENEURS: FORMATION ADAM DINOW ‣ adinow@wsgr.com