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SFFI - Spring 2018 - Legal - Michael Gorback


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Michael's presentation on legal concerns for early stage startups.

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SFFI - Spring 2018 - Legal - Michael Gorback

  1. 1. STARTUP LAW 101 Founder Institute May 8, 2018 Click icon to add picture Mike Gorback, Partner at Hanson Bridgett LLP Corporate Group Chair (415) 995-5100
  2. 2. WHICH ENTITY DO I CHOOSE? • Why an entity in the first place? • C Corps, S Corps, LLCs…. • Tax treatment, among other considerations: – S Corps and LLCs utilize “pass-through” taxation; i.e. the entities themselves are not taxed on income. They simply pass the company’s income or loss on to their members or shareholders. – C Corps are taxed in their own right at the corporate level, and then the dividends they pay to their shareholders are taxed as income. This is commonly referred to as “double taxation.” • So why not an S Corp or LLC? Because S Corps can’t issue preferred stock and LLCs are too wishy-washy. These are deal killers for VCs and sophisticated angels. Also, some venture funds are not even permitted to invest in LLCs. 2
  3. 3. WHERE SHOULD I INCORPORATE? • Delaware is by far the most preferred state of incorporation. • Why? – The most well-established body of corporate law. – More deferential to the board of directors (California is more shareholder- focused). – Delaware is more streamlined. Can often file and close on same day. CA can take weeks. – Venture capital investors routinely insist on non-Delaware corporations re- incorporating in Delaware as a condition to closing. Doing so costs time and money, so may as well start in Delaware. • Is there a downside to incorporating in Delaware? Not really… – You pay tax in two states. BUT, Delaware franchise tax for early-stage companies is typically between $350-$500/yr, or about one of several hours of legal fees to reincorporate later. Franchise tax goes up as a company grows, but pros typically outweigh the cons. – Need a registered agent for service of process in DE (around $300/yr) 3
  4. 4. CHOOSING A NAME • Make sure the name is available in the first place in BOTH Delaware and California (assuming you’ll be doing business in CA). Even if incorporating in DE, you’ll still need to qualify to do business in California if you are located here, and CA won’t qualify you if your name is being used already. • Even if the name is available, you must assess whether it is likely to infringe another company’s trademark. • Finally, even if the name isn’t likely to infringe, consider the strength of the mark itself– i.e, how well you can protect it against infringement by others. Generally: – Descriptive = weak (OnlineShoestore, WebSearch, DisappearingMessage, – Arbitrary = strong (Zappos, Google, SnapChat, Indeed) • Trademark analysis usually runs around $1,500. Do it. 4
  5. 5. BASIC FORMATION DOCUMENTS • Certificate of Incorporation • Bylaws • Action by Incorporator • Initial Board Consent in Lieu of First Meeting • Initial Stockholder Consent • Founder Stock Purchase Agreements – Founders purchase their shares partially in exchange for assigning all of their IP rights to the company. IP MUST be assigned. – Shares are typically subject to vesting. • Stock Option Plan and Form of Option Agmt • Forms of NDA • Indemnification Agreements • Advisory/Consulting Agreements • Employment, Proprietary Information and Invention Assignment Agreements 5
  6. 6. WHAT IS MY CAP TABLE? HOW MANY SHARES SHOULD I ISSUE? • Hint: aim for an initial “fully-diluted” capitalization of 10M shares: 6 # of Shares % (Outstanding) % (Fully-diluted) Common Stock 7,600,000 100.00% 76.00% Founder 1 2,533,334 33.33% 25.33% Founder 2 2,533,333 33.33% 25.33% Founder 3 2,533,333 33.33% 25.33% Option Pool 2,000,000 -- 20.00% Outstanding 0 -- 0.00% Available 2,000,000 -- 20.00% Warrants 400,000 -- 4.00% Founder Institute 400,000 -- 4.00% Totals: 10,000,000 100.00% 100.00%
  7. 7. PAYING FOR YOUR FOUNDER SHARES • Founders typically pay for founders’ shares with a combination of cash and a contribution of IP. Best practice is to pay for at least half in cash. • The purchase price per share for founders’ shares is usually $0.001 or $0.0001 per share. At the latter, a founder stake of 2,000,000 shares would cost $200. 7
  8. 8. HOW FAILING TO MAKE A SECTION 83(b) ELECTION CAN RUIN YOUR DAY. • Assume on Day 1 of NewCo, Founder Joe pays $0.0001 per share for 1,000,000 shares for a total of $100. The shares vest 25% after Year 1, 25% after Year 2, 25% after Year 3 and 25% after Year 4. • Year 1 is a decent year, and when the first 25% vests, the fair value of the stock is $0.10. That’s 250,000 shares at $0.10 per share = $25,000. But Joe only paid $0.0001 per share, for those 250,000 shares = $25. The IRS treats that as taxable income of $24,975 for year 1, even though Joe has seen no real income. • Year 2 is even better. So when his next tranche vests, the stock is worth $1 per share = 250,000 x $1 = $250,000. Since Joe paid only $25, that’s taxable income of $249,975 in year 2. And so on… • Section 83(b) allows founders to avoid this by electing to treat the entire purchase as final, even though the shares are subject to vesting and may ultimately be lost. Since the price paid ($100) is the value of the shares ($100), there is no taxable income. • BUT THE ELECTION MUST BE MADE WITHIN 30 DAYS OF PURCHASE OR IT IS LOST FOREVER. DO NOT FORGET TO MAKE THE ELECTION. 8
  9. 9. HOW MANY SHARES SHOULD ADVISORS RECEIVE? • Founder Institute model (from the FAST): 9 Idea Stage Startup Stage Growth Stage Standard (monthly meetings) 0.25% 0.15% 0.10% Strategic (plus recruiting) 0.50% 0.40% 0.30% Expert (plus projects) 1.00% 0.80% 0.60% • These are just guidelines. Evaluate what a big-name advisor brings to the table and determine if going outside the guidelines is in the company’s best interest.
  10. 10. FUNDRAISING BASICS • Most sophisticated investors (VCs and angels) want to invest in preferred stock because of the bells and whistles that typically accompany preferred stock, including: – Liquidation preference. This means the preferred shares get paid first in the event of a liquidation or acquisition. It’s key. – Preferred dividends. – Special veto rights. – Registration rights. – Rights to maintain proportionate ownership in future offerings. – Many others…. • However, preferred stock financings are expensive and typically involve a lot of documentation. • Therefore, early stage companies will often accept early investments in the form of convertible debt (and more recently, “convertible equity” as well (such as the SAFE)). Convertible notes are just that: notes (i.e. loans) that convert later in a preferred stock financing, often at some discount to what the new investors are paying. They are simple, inexpensive, and flexible. Convertible equity (ie the SAFE) is similar but with no maturity date or interest rate. • Tip: limit investments to “accredited investors.” 10
  11. 11. Questions? 11