How to Split the Pie, Raise Money and Reward Contributors

© 2020 Haynes and Boone, LLP
Idea to IPO
How to Split the Pie, Raise Money
and Reward Contributors
#startup #ideatoipo
1
Roger Royse
@rroyse00

Disclaimer
No information contained in this presentation is to be construed as legal advice.
No information contained in this presentation is intended or related to any
particular factual situation. Nothing herein forms an attorney-client relationship. If
legal advice or other expert assistance is required, the services of a competent
professional should be sought.
2

4
The Stakeholders
Founders
Service
Providers
Investors

Founder’s Equity
5
 Vesting
 Equal Percentages
 Subjective
 Formula

How many founders?
 One is rarely the right answer
 Two is deadlock potential
 Three will always be 2 against 1
 Four is deadlock potential
 Five is too many
6

Splitting Founders Equity
 The founder’s first decision
 The case of Zipcar:
 50/50 handshake deal
 Co-Founder 1 (Robin) built the startup, crafted its business
plan, and cold-called customers
 Co-Founder 2 didn’t even quit her day job, and contributed
little
 Her rushed negotiation had compromised her team’s longer-
term effectiveness by causing her “a huge amount of angst
over the next year and a half.”
7

Equal Split
 An exit may be 10 years away
 Contribution in year 1 may not reflect total contribution to the group
 The real work is in the future
 Adjust through vesting and additional grants
8

Dynamic Split Models – General Concept
Traditional fixed-split model: Equity given based on anticipated contributions
DYNAMIC-SPLIT MODEL: Equity given based on actual contributions
9
Inputs:
The dynamic model assigns a relative
FMV weight to various contributions from
each participant and contributions put into
model:
Outputs:
Depending on the relative weighted
contributions of each team member, that
member is allocated a corresponding
percentage of outstanding equity.
On “split,” members could return old
equity, or be given new equity, to ensure
each member gets appropriate percentage
of company.
 Time spent working
 Intellectual property
 Commissions
 Cash
 Facilities
 Equipment and
Supplies

The Founders’ Pie Calculator
 Created by Frank Demmler, professor, Tepper School of Business at Carnegie
Mellon University
 A founder’s value add is divided into 5 categories:
1. Idea
2. Business Plan Preparation
3. Domain Expertise
4. Commitment and Risk
5. Responsibilities
 Each category is given a value on a scale of 0 to 10
 The value is multiplied by the founder’s score to come up with a weighted
score
10

Founders’ Pie Calculator Example
Frank Demmler, professor, Tepper School of Business at Carnegie Mellon University
11
Founder 1 Founder 2
Idea 70 21
Business Plan 10 2
Domain Expertise 15 30
Commitment &
Risk
28 42
Responsibilities 12 18
Total Points 135 113
% of Total Founder
Equity Pool
54.43% 45.57% 100%

Grunt Fund
Source: http://www.slicingpie.com/the-grunt-fund-calculator/
12

Grunt Fund Detail
Source: http://www.slicingpie.com/the-grunt-fund-calculator/
13

Royse Subjective Method
 Full time or part time
 Technical or Non-technical
 Industry expertise
 Size and Stage
 Cash compensation
 Other contributions
 Pressure valves – vesting, option pool, phantom plans
14

Later Hires
 Paul Graham 1/(1-n) formula (how much can the employee improve the
outcome)
 Fred Wilson option pool formula = Cumulative salaries between rounds/post
money valuation = option pool
 Leo Polovets, AngelList job postings
 Hire #1: 2% – 3% of equity
 Hires #2 through #5: 1% – 2%
 Hires #6 and #7: 0.5% – 1%
 Hires #8 through #14: 0.4% – 0.8%
 Hires #15 through #19: 0.3% – 0.7%
 Hires #21 through #27: 0.25% – 0.6%
 Hires #28 through #34: 0.25% – 0.5%
15

Advisors
16
FAST Model
Valuation
Stock v.
Options
Milestones and
Deliverables
Vesting

Currency
 Options
 NSOs
 ISOs
 Extended NSOs
 RSUs
 Restricted Stock
 Phantom Plan Units
17

Partial Recourse Debt Sale
 Partial Recourse Promissory Note
 Less capital to purchase the shares at the outset
 Commercially reasonable repayment terms
 Adequate stated interest
 Partial Recourse to Maker
 51% recourse for stock sale
 Section 83(b) election
 Capital gains treatment on restricted stock
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Vesting
 Who should vest?
 How long?
 Acceleration?
 Change of control
 Termination without cause
 Double and single triggers
19

Founder Vesting
 Term, milestones, commencement
 Acceleration
 Single and double triggers
 Fire the Founder
20

The VC’s View of Vesting
 VC will require unvesting shares, so vesting period could be 8 years
 Fund life can be 7-10 years
 Most exits are M&A – fewer and longer IPOs
 Extended Option exercise periods
21

Class F Super-Voting Stock
 Special class of common that has super-voting rights
 Facebook, Google Snap
 May be negotiated away in institutional round
22

Transfer Restrictions
 Right of First Refusal (ROFR)
 Carveouts
 Company and then investor
 Lock Ups
 Co-sale Rights
 Drag Along
 Buy Sell
 Rule 144
23

Cap Table
 Common Stock
 Options
 Warrants
 Convertibles
 Preferred Stock
24

Cap Table
 Cap Table.xls
25

Capitalization
26
Founders 5,000,000 38% 5,000,000 45%
Stock Pool 2,000,000 15% n/a
Series A 3,000,000 23% 3,000,000 27%
Series B 3,000,000 23% 3,000,000 27%
total 13,000,000 100% 11,000,000 100%
Fully Diluted % Issued %

Effect of Valuation Caps
Company that sells a $1,000,000 SAFE with a $4,000,000 pre-money valuation cap
That means that the SAFE will take 20% of the capitalization ($1,000,000/$5,000,000)
27
Founders 4,000,000 100% 4,000,000 100%
Stock Pool 0 0% n/a
total 4,000,000 100% 4,000,000 100%
Fully Diluted % Issued %

Pre-Money vs. Post-Money SAFEs
 Pre-Money – cap based on value of the company before SAFE ( and other
SAFEs) and option pool
 Company friendly
 SAFE holders share option pool and other SAFEs dilution
 Cannot predict what percent SAFE will get until conversion
 Post-Money – based on value after financing
 Y Combinator form
 Parties have certainty as to percentages
 Founders take option pool dilution
 SAFEs do not dilute each other
28

Cap Tables – Series Seed Example
 ..FormsSeed Financing Spreadsheet.xlsx
29

Liquidation Preference
Who gets paid first and how much?
30

Example of Liquidation Preference
 1x non-participating convertible preferred
 $1,000,000 invested for 10%
 Ex 1: Exit (sale) of company for $5,000,00
 Ex 2: Sale for $20,000,000
31

Management Incentive Plans
 Sale at or below preferences
 Percentage of proceeds off the top for management
 Tax
 Corporate
 Securities
 Fiduciary
32

Carve Out Plans – Share of sales proceeds
 Pool or earnout
 Are shares subject to vesting?
 What if someone leaves – who gets forfeitures?
 Are incentives aligned?
 Earnouts
33

In re Trados Inc. Shareholder Litigation
 Board adopted a management incentive plan (MIP) that was structured so
that once an offered sale price for Trados exceeded the venture capitalists’
liquidation preference, compensation to the preferred stockholders would
increase substantially at the expense of common stockholders.
 Preferred received most of their preferences, MIP got $7.8 million, common
got nothing
 Interested director transaction
 Entire fairness standard
 Fair process
 Fair price
34

Taxation for Compensatory Partnership Interests
 Tax allocation issues
 Capital shift
 Taxable event for the member receiving capital.
 Profits interests
 Share of future income and appreciation – like an option
35

Incorporation of an LLC
Start-ups started as LLCs may want to or need to convert into a corporate form at
a later point because:
 Venture capital investors more comfortable with corporate form
 Potential IPO (but UP-C increasingly popular alternative)
 Availability of Section 368 reorganization on exit
 ISOs
 General increased liquidity
 Qualified Small Business Stock exemption
 Issuance of stock in a C corporation on incorporation of an LLC may qualify as
QSB stock
 Stock held in C Corp following termination of S Corp election does not qualify
because stock was not issued in a qualifying corporation
36

Additional Considerations
 Employee vs Independent Contractor
 Wage & Hour Laws
 Intellectual Property Issues
 Prior Employer’s Facilities
 Invention Assignments
37

Employee vs. Independent Contractor Issues
 The Differences in Tax Treatment
 Employee
 Business Owner
 Independent Contractor
38

The Story of Homejoy
 Used an algorithm to connect homeowners with contract-for-hire cleaners and
schedule visits
 Raised $40 million in venture funding
 Treated its cleaners as independent contractors, and not employees
 CEO said the “deciding factor” in failure to raise money and failure was
worker classification lawsuits (ReCode July 17, 2015)
39

Employment Status: The Law
 The presumption is that the worker is an Employee (Cal. Lab. Code §3357)
 Different agencies/jurisdictions have different tests
 IRS
 DOL/FLSA
 CA Common Law and EDD
 Statutory Employees
40

Employment Status: The Law
 IRS: The Control Test
 Behavioral Control
 Financial Control
 Type of Relationship
 DOL/FLSA: Economic Realities Test/Silk Factors
 Focus is on the degree of control the Company has over the worker performing the
service. The key inquiry is the right to control not whether the Company actually
exercises the control.
 In July 2015 DOL issued administrative guidance and explained that the test
focuses on whether the worker is economically dependent on the hiring entity or is
in business for herself/himself.
 CA Common Law/EDD: S. G. Borello & Sons, Inc. v Dept. of Industrial
Relations (1989) 48 Cal.3d 341
 This is a multi-factored test with the most significant factor considered is whether
the principal has control or the right to control the worker as to the work done and
the manner and means in which it is performed.
 Statutory Employees
41

What if I’m Still Not Sure?
File Form SS-8 with IRS:
Determination of Work
Statutes for Purpose of
Federal Employment Taxes
and Income Tax Withholding
42

Dynamex Decision
 Dynamex Operations West, Inc. v. Superior Court of Los Angeles adopts a
three factor ABC test, which presumes a worker is an employee unless all of
the following tests are satisfied
 Worker is free from control and direction of hiring authority
 Worker performs work outside the usual course of the hiring entity’s business, AND
 Worker is engaged in an independently established trade, occupation of business
of the same nature
43

AB-5
California Assembly Bill 5 codified Dynamex in the Labor Code and the
Unemployment Insurance Code “For purposes of the provisions of this code and
the Unemployment Insurance Code, and for the wage orders of the Industrial
Welfare Commission…”
 Assembly Bill 2257 exempts a long list of job categories from AB5
 video photographers and editors, freelance writers, content contributors, editors,
translators, fine artists, and musicians
 broadens the business-to-business exemption of AB5
 creates an exemption for individual business people who contract with each other
 California Trucking Association challenged the constitutionality of AB5 in federal
court
CA AG sued rideshare companies seeking to enjoin compliance; CA appeals
court upheld ruling that Uber and Lyft must classify drivers as employees
44

AB-5
 Proposition 22 would consider app-based drivers to be independent
contractors and not employees or agents
 Uber, Lyft and DoorDash spent more than $220 million on Prop 22 (San Jose
Mercury News Oct 24, 2020)
 California Labor Federation, representing 1,200 unions with 2.1 million
members, vowed to defeat the effort (LA Times August 30, 2019)
45

Failing To Protect IP
Protect your intellectual property from claims of ownership by employers,
employees, consultants and competitors
 PIAIA or CIAIA
 Broadly Drafted Invention Assignments
 Federal Defend Trade Secrets Act
 Cal Labor Code
46

California Labor Code § 2870
 Employee’s Time
 No Employer Facilities
 Not Related to Employer’s Business
 Doesn’t Result from Work Performed for Employer
47

The Exit
48
Taking Money
Off the Table
Earnouts and
Contingencies
Acqui-Hires

Taking Money Off the Table
1. Investor buys preferred shares from company and common shares from
founders
2. Alternatively, investor buys preferred from company and redeems common
from founder
3. Founders common priced at above market
4. Tax issues for founder
49
Target
Target
Shareholders
PEG
Cash
Cash
Target
Shares

Series FF Stock
1. Common stock that is convertible to preferred on financing
2. Converts to common on IPO or at holder’s election
3. Pricing issues
4. Tax issues for founder
5. Later investors may not accept it
50
Target
Target
Shareholders
PEG
Cash
Cash
FF
Shares
FF stock

Earnouts and Contingencies
 Purchase price based on performance (earnouts) should be baked into
formation documents
 Can structure for capital gains tax instead of ordinary income
51

Successful Exits
 IPO
 Sale or Acquisition
 SPAC
52

280G Parachute Payments
 20% excise tax and loss of deduction on Excess Parachute Payment
• “Excess Parachute Payment” means the amount by which the Parachute Payment exceeds the Base
Amount
• “Parachute Payment” means a payment, the present value of which, exceeds three times the Base
Amount
• “Base Amount” means the average annual compensation for past 5 years
• Must be paid to a disqualified individual (meaning employee, officer, shareholder, or highly
compensated individual)
• As compensation, AND
• Contingent on a change in control (50% change ownership or effective control, or ownership change
in a substantial portion of the company’s assets)
 Reduce Excess for reasonable compensation
 Exclude reasonable compensation for future services
 Exception for small business corporation and non publicly traded corporation
that has 75% uninterested shareholder approval
 Withholding requirement
53

280G Parachute Payments – other issues
 Non-Publicly Traded Stock
 Approval of 75% of shareholders after adequate disclosure
 Vote determines the right of the shareholder to the payment
 Ignore shares held by persons receiving the payment
 Reduction for Excess (299% of payments)
 Reduction for Reasonable Compensation
 Reduction for Future Services
54

Unsuccessful Exits
 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and creditors?
55

Other Unsuccessful Exit Issues
 Tax Liability
 Personal Liability
 Tax
 Employment
 Fiduciary Claims
 Securities Law Claims
 Contractual
 Pierce the veil and creditor claims
 Serial Entrepreneurs and failed companies
56

AUSTIN
600 Congress Avenue
Suite 1300
Austin, TX 78701
United States of America
T +1 512.867.8400
F +1 512.867.8470
CHARLOTTE
101 S. Tryon Street
Suite 2550
Charlotte, NC 28280
T +1 980.771.8200
F +1 980.771.8201
CHICAGO
180 N. LaSalle Street
Suite 2215
Chicago, IL 60601
T +1 312.216.1620
F +1 312.216.1621
DALLAS
2323 Victory Avenue
Suite 700
Dallas, TX 75219
T +1 214.651.5000
F +1 214.651.5940
DALLAS - NORTH
2505 North Plano Road
Suite 4000
Richardson, TX 75082
T +1 972.739.6900
F +1 972.680.7551
DENVER
1050 17th Street
Suite 1800
Denver, CO 80265
T +1 303.382.6200
F +1 303.382.6210
FORT WORTH
301 Commerce Street
Suite 2600
Fort Worth, TX 76102
T +1 817.347.6600
F +1 817.347.6650
HOUSTON
1221 McKinney Street
Suite 4000
Houston, TX 77010
T +1 713.547.2000
F +1 713.547.2600
LONDON
1 New Fetter Lane
London, EC4A 1AN
United Kingdom
T +44 (020) 8734 2800
F +44 (020) 8734 2820
MEXICO CITY
Torre Esmeralda I, Blvd.
Manuel Ávila Camacho #40
Despacho 1601
Col. Lomas de Chapultepec,
DF 11000
Mexico City, Mexico
T +52.55.5249.1800
F +52.55.5249.1801
NEW YORK
30 Rockefeller Plaza
26th Floor
New York, NY 10112
T +1 212.659.7300
F +1 212.918.8989
ORANGE COUNTY
600 Anton Boulevard
Suite 700
Costa Mesa, CA 92626
T +1 949.202.3000
F +1 949.202.3001
PALO ALTO
525 University Avenue
Suite 400
Palo Alto, CA 94301
T +1 650.687.8800
F +1 650.687.8801
SAN ANTONIO
112 East Pecan Street
Suite 1200
San Antonio, TX 78205
T +1 210.978.7000
F +1 210.978.7450
SAN FRANCISCO
201 Spear Street
Suite 1700
San Francisco, CA 94105
T +1 415.293.8900
F +1 415.293.8901
SHANGHAI
Shanghai International
Finance Center, Tower 2
Unit 3620, Level 36
8 Century Avenue, Pudong
Shanghai 200120, P.R. China
T +86.21.6062.6179
F +86.21.6062.6347
THE WOODLANDS
10001 Woodloch Forest Drive
Suite 200
The Woodlands, TX 77380
T +1 713.547.2100
F +1 713.547.2101
WASHINGTON, D.C.
800 17th Street NW
Suite 500
Washington, D.C. 20006
T +1 202.654.4500
F +1 202.654.4501
57
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