Tcn -structuring founder relationships and equity -oct 2012

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October 24, 2012
Structuring Founder Relationships
Paul Sweeney, Foley Hoag LLP

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Tcn -structuring founder relationships and equity -oct 2012

  1. 1. Structuring Founder Equity And Relationships The Capital Network - Expert Lunch Series Paul G. Sweeney, Esq. October 24, 2012© 2012 Foley Hoag LLP. All Rights Reserved.
  2. 2. The presentation of these materials does not establish any form of attorney- client relationship with the author or Foley Hoag LLP. Specific legal issues should be addressed through consultation with your own counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. These materials have been prepared solely for educational purposes. These materials may contain works of others that are protected or protectable under applicable copyright and/or trademark law, and such works are included here pursuant to the fair use doctrine. © Foley Hoag LLP 2012. United States Treasury Regulations require us to disclose the following: Any tax advice included in this document and its attachments was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 2
  3. 3. Introductions Paul Sweeney, Esq. – Partner in Foley Hoag’s Business Department – Named one of “Top 20 Startup Lawyers in Boston” and “Top 10 Most Innovative Lawyers in America” by the American Bar Association Journal – Practice focuses on angel and venture capital financings, mergers and acquisitions, strategic alliances and related business transactions. – Clients range from start-up and venture-backed portfolio companies to well-established public companies operating in a wide array of industries, including mobile, networking, computer security, information technology, and high tech. – Helped clients raise hundreds of millions of dollars in angel and venture capital, and advised clients through several dozen acquisitions in the aggregate amount of over $2.8 billion.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 3
  4. 4. Overview Cutting up the pie; dividing without being divisive “Restricted Shares” The Founders’ Agreement; getting it down on paper© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 4
  5. 5. Picking a Great Co-Founder Complimentary Skills The Three “I”s - intelligence, intensity and integrity Ideal team is comprised of people with a history of working together, of similar age, life state and financial picture, where some are great at building things, some are great at managing things and some are great at selling things. 4 things early-stage investors care most about = PIMM (People, Idea, Model, Market)© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 5
  6. 6. Choosing Your Co-Founders Use care in who you choose; founders are to a startup as location is to real estate. Ability is important, but character and commitment are even more so. Work hard to maintain the relationship; your co- founder is more than just a co-worker. You haven’t seen someone’s true colors unless you’ve worked with them on a startup. The success of a startup is almost always a function of its founders.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 6
  7. 7. Critical Questions Facing Co-Founders Definition: Who should my co-founders be? Equity Distribution: How will we divide the equity among ourselves? Control: How will decisions be made, and who will make them? Succession: What happens when one of us leaves? Forced Departure: Can one of us be fired? By whom, and for what reasons? Cash Contributions: Will any of us be investing cash in the company? How will this be treated?© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 7
  8. 8. Dividing The Pie“Why not just split everything equally?”X= total number of founders, and each founder gets 1/X of equity. It’s simple and quick We’re all equals, so our equity stake should be too There’s no “right” answer, so might as well divide it equally We want everyone to have skin in the game Debating over equity will kill the company If future events require, we can always adjust later© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 8
  9. 9. Dividing The PieConsider reasonable metrics for dividing equity: Past contributions Future contributions Opportunity cost Your relationship with co-founders –(Note: Don’t confuse equity with income)© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 9
  10. 10. What do I pay for my Founders’ Stock? Address this EARLY! Everyone should pay “fair market value” for the stock. Cash is sometimes augmented by contribution of intellectual property, but this is tricky: - Difficult to define scope of transfer - Difficult to properly perfect the transfer - Difficult to value the assets assigned - Potential tax ramifications (Section 351 of IRC)© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 10
  11. 11. What if I paid “more” than FMV? Need to balance control over company (relative percentage of company held) with company’s need for capital. In extreme cases, consider issuing junior preferred stock with a liquidation preference.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 11
  12. 12. Equity - take aways Address the “splitting the pie” issue as early as possible Pay attention to tax issues (get appropriate advisors) Dividing equally is often sub-optimal Choose metrics that are appropriate for your business Co-Founder’s equity position should reflect his/her true value “Skin in the game” means different things to different people Don’t avoid the issue; this only gets harder (and more expensive) over time© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 12
  13. 13. Should Founders’ Stock be Restricted? “Restricted Stock” –shares subject to forfeiture The company has the right to repurchase the shares if the founder leaves the company for any reason. Vesting Acceleration Determining repurchase price Critical Tax Considerations – 83(b) election Timing- When to impose restrictions© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 13
  14. 14. What is “Vesting” At the beginning, Company has the right to repurchaes your shares (called “Restricted Shares”) Vesting = Company’s right to repurchase shares lapses over time or upon certain events “Vested Shares” – shares that are no longer subject to repurchase right. “Unvested Shares” - shares that are still subject to repurchase right. Note: Time based vesting vs. Performance based vesting© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 14
  15. 15. Vesting Schedule Standard Vesting Schedule: Four year total, with 25% vesting after one year (“cliff vesting”), remaining 75% vesting monthly over next three years. Vesting commencement date – credit for past service? “Re-vesting” at a financing event© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 15
  16. 16. Timing: Restrictions on Day 1? Primary reasons for imposing vesting even before VC financing: 1. If multiple co-founders, each is benefited if company is able to repurchase unvested shares of a departing co-founder. 2. If the terms are reasonable, they might survive the venture financing.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 16
  17. 17. Acceleration Upon Change of Control Standard Approach - allow some amount of accelerated vesting (6-12 mos.) upon Change of Control “Double Trigger” - acceleration tied to the termination of the founder (usually without “cause”) within a certain period of time (12 mos.) after the Change of Control. - Difficult to implement if cash only consideration. Note: Founders and Investors have adverse interests© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 17
  18. 18. Acceleration Upon Termination Accelerate upon termination without “cause” or “constructive termination”? - Difficult to define “cause” and “constructive termination” - Difficult to implement - Usually results in regret (except for the departing founder). Consider treating acceleration like severance (3-6-12 mos.)© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 18
  19. 19. Repurchase Price Two Approaches: - 1) Company repurchases unvested shares at the nominal price paid by the founder. (Most common approach) - 2) Company repurchases unvested shares at a price equal to the fair market value (FMV) at the time of the repurchase. •Board usually determines FMV •Problem #1- Investors often view the founders as having not yet “earned” the stock, and so they resist allowing founder to benefit from an increase in equity value. •Problem #2- the Company might not have the $. •Possible Compromise: Differentiate the purchase price based upon the reason for the departure.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 19
  20. 20. 83(b) Election General Rule: If service-based vesting is imposed up on founder’s stock, founder recognizes income (the difference between fair market value and the price paid) as the stock vests. 83(b) Election: If founder elects within 30 days of the issuance of the stock to be taxed on the value of the stock at the time of issuance (less anything paid for the stock, which can include the value of IP contributed to the business), then no income recognized upon vesting. 30 Day Limit – Strictly Enforced. (Being close doesn’t count.) Election is voluntary - Can’t unwind if shares are© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 20 forfeited.
  21. 21. 83(b) Election Example: Founder purchases stock for $0.01 per share (fair market value is $0.01). Stock is subject to four year vesting with a one year cliff. –If founder does not make 83(b) election, then at each vesting date founder recognizes income based on difference between $0.01 and FMV. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax. –If the founder had made 83(b) election, the founder would not recognize any income as the stock vests.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 21
  22. 22. The Founders’ Agreement Some Do’s and Don’ts: –Don’t confuse equity issues with management issues –Don’t assume everyone will always be agreeable –Don’t get bogged down in legalese – decide what you want, then have your attorney put it into proper legal form –Do make sure everyone’s objectives/visions/risk profiles are compatible –Do talk to others who have had experience in these matters –Do understand what is in the agreement© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 22
  23. 23. When do I involve the Lawyers? As early as possible! Organization of company (charter, bylaws, stock incentive plans) Founders’ Agreement, or any other agreement containing equity feature or right of first refusal Financing transactions (both debt and equity)© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 23
  24. 24. Take Aways Choose your co-founders wisely. Choose your attorney wisely, and early! Always involve an attorney before issuing equity or entering into agreements among co-founders.© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 24
  25. 25. Sources and References www.onstartups.com www.founderresearch.blogspot.com “Founders at Work” by Jessica Livingston “Startups that Work” by Joel Kurtzman “Business Basics for Engineers” by Michael Volker© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Presentation Title | 25
  26. 26. Questions? Paul Sweeney (617) 832-1296 psweeney@foleyhoag.com© 2007 Foley Hoag LLP. All Rights Reserved. 2012 Proposal or event name (optional) Presentation Title | 26

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