FLIP IT! A Guide to Flipping Your Company to the U.S.

What is a Flip? A flip (the “Flip”) is a legal mechanism by which all of the equity interests of one company (the “Foreign Co”) are transferred to another company (the “US Corp”) and all of the former equity interest holders in the Foreign Co receive proportionate equity interests in the US Corp instead. As a result of a Flip, the Foreign Co becomes a wholly-owned subsidiary of the US Corp. The Foreign Co continues to exist and often continues its operations. The only difference is that it now has a single owner, the US Corp.

How Does It Work? Let’s see how a Flip works using a fictional company, Mobilka Rus Ltd.

Background. Mobilka Rus is a limited liability company formed under the laws of the Russian Federation. It has created and owns intellectual property and released a mobile app. It has raised seed capital from an investor in Russia, and has hired a few employees in Russia as well. Mobilka Rus is owned by its two founders, Dima and Sergey, who each hold 40% of Mobilka Rus, and by their investor, Dengami Investments, which owns 20%.

Step 1. The first step to performing a Flip is to incorporate a brand new corporation in the U.S. Our friends at Mobilka Rus incorporate Mobilka US Corporation in Delaware. Mobilka US gets a set of bylaws, a board of directors that Dima, Sergey and Dengami Investments all agree on (composed of 3 members, one for each of Mobilka’s owners) and is ready to go.

Step 2. Next, Dima, Sergey and Dengami Investments enter into a Share Exchange Agreement with Mobilka US, pursuant to which they transfer their entire ownership interest in Mobilka Rus to Mobilka US, such that Mobilka US becomes the 100% owner of Mobilka Rus. In exchange, Mobilka US issues shares of its stock to Dima, Sergey, and Dengami Investments based on their ownership interest in Mobilka Rus. Therefore, Dima and Sergey get 4,000,000 shares of Common Stock of Mobilka US each, and Dengami Investments gets 2,000,000 shares of Series Seed Preferred Stock. The ownership percentages are preserved, only now, instead of sharing ownership of Mobilka Rus, Dima, Sergey and Dengami Investments are holders of 100% of the issued shares of Mobilka US, which, in turn, is the holder of 100% of the ownership interest in Mobilka Rus.

Step 3. Then the ownership of Mobilka Rus must be changed on the official share register of Mobilka Rus, which requires several administrative steps.

Step 4. Having completed the Flip, Mobilka US approaches VCs in the US to raise money. The investment will be into the “business” of Mobilka Rus, since Mobilka US doesn’t have any operational business, but they will make the investment by purchasing Preferred Stock in Mobilka US, which is a Delaware corporation with a familiar structure and feel.

Why Do Companies Flip? Companies interested in orchestrating a Flip generally share the following characteristics:

• they are organized in a foreign jurisdiction;
• they are operational and may already have raised capital, created intellectual property, hired employees, and/or begun selling products; and
• they are interested in creating a U.S. presence that will allow them to (a) raise capital in the U.S. and/or (b) to move some of the operations to the U.S.

Following a Flip, the Foreign Co will continue its operations in the foreign jurisdiction without interruption, while the US Corp will either become a fully-operational U.S. headquarters or merely a holding company, depending on the Foreign Co, its business, and plans.

In our example above, Mobilka Rus can continue to operate in Russia, hire more Russian employees, and continue to develop intellectual property by building out its existing app or creating new ones. The only difference is that Mobilka Rus is now owned by Mobilka US. This enables U.S. investors, who are conservative and usually reluctant to invest in a Russian (or almost any other foreign) company directly, to invest in Mobilka US, which is a U.S. corporation, and to have the comfort that they are investing in the business of Mobilka Rus.

Happy company making!

Inna

Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Roadmap to Finding Venture Capital Investors

Many of our clients begin working with us when they are raising capital. Often they have raised some initial capital from angel investors in their country and are now looking to raise their next round from institutional investors in the United States.

And while some of the companies we work with are founded by very savvy business people, who could teach all of us a few things about raising capital, others are started by brilliant engineers with ground-breaking technology, but who don’t know how to approach the search for investment capital, in a new country in some cases. If you think you might be in that second category, here’s a roadmap that we’ve seen work well.

Build First. You should build as much as you can, and go as far as you can go with your company, using bootstrap funds or angel investment before you try to raise venture capital.

• Likelihood of Success. If you have a product and some initial traction, you will have a far better story to tell the investors than if you just have a great idea or you are several months into developing a prototype. As you may have heard, there are many great ideas, some of them very similar even, and what makes a difference is execution. The better that you are able to demonstrate the ability of your team to execute, the more likely it is that you will get venture funding. Also, if you have skin in the game (bootstrap funds) and have attracted angel funding (friend and family), there is a greater chance that the investors will take you seriously than someone who can’t even convince those close to him to invest and who isn’t willing to risk any of his own money.

• Valuation. The earlier that an entrepreneur brings in outside investment, the lower a valuation he can expect to receive, and therefore, the higher a percentage of his company he will have to give up for the same investment amount. Certainly a founder shouldn’t get obsessive about his ownership stake in the company in a way that will impede his ability to attract a strong team or investors. And certainly it is better to have a smaller percent of a larger (more valuable) pie than a greater percentage of a smaller pie. But if the founder has the resources to get more done prior to going out for capital, it is the smart thing to do in term of maximizing both control and ownership.

Get Organized. In preparation for raising capital, you should get your corporate house in order.

• Why? Being organized will show the investors that you are serious about your venture and you understand the rules of engagement. It will avoid conflicts about ownership of intellectual property and equity, which can destroy a young company and the prospects of getting funding. Finally, it will streamline the investment process and the investors’ due diligence review when you do find those willing investors, because you won’t have to do last minute corporate clean-up, scrambling to organize at the last minute.

• What to Do. If you haven’t already done so, you should (1) incorporate your company, (2) distribute equity interests in accordance with promises you made to your existing team and early investors, and (3) make sure that all intellectual property belongs to the company (and not individually to members of the team). An attorney experienced in working with startups will be able to walk you through everything that you need.

Research & Presentation Materials. To secure VC meetings and to succeed in them you have to be prepared. If a VC knows more about your space than you do, he will never invest. So make sure you do the research.

• What should I research? For sure, know the size of your market. Know who the players are, both as far as your competition goes and your potential strategic partners. Know what market share your competitors hold, exits your competitors have had, what funding they have raised, and at what valuations. Know your monetization model (even if you pivot later as many companies do). And finally, know the investors in your space, their strengths, their specializations, their reputation, and the stage at which they like to invest. When you meet with investors, they will invariably ask why you are interested in getting funded by their fund, and you had better have a good, very specific answer!

• Materials. Once your research is done, prepare an executive summary, a slide deck to take into meetings, and if you have the resources, a short video that demos your product. The video is to send together with your executive summary to investors. In this day and age of information overload, it will be hard to get an investor to read any materials you send with any amount of attention. Videos have a way of engaging the viewer and elicit an emotional response. Once thus engaged, there is a good chance that your executive summary will get a more thorough review.

Introductions. To get meetings with VCs, try to obtain warm introductions to the investors who invest in your space and in companies at your stage from your network. If your network doesn’t have the right contacts, don’t be shy and grow your network. Go to industry events. Read articles by industry savants and try to engage with them by commenting on their posts or sending them emails. Perhaps you will even be able to bring a few of them on as advisors. Talk to your lawyers, your accountants, your bankers. Utilize tools available to you, like alumni network groups, LinkedIn, or Facebook. Sometimes cold emails to a fund work, but that is the exception rather than the rule. Note that the best-regarded and most effective intros are from entrepreneurs that the VC has already funded. VCs are very busy people with a lot of noise being directed their way. So do what you can to make sure your executive summary gets placed at the top of the pile to the folks that you want to see it.

Relationship. Once you have had an initial meeting with a VC, don’t expect him to send you a term sheet. Remember that investors are in it for the long-haul. Would you expect a woman to decide to marry you after your first date? Before an investor commits millions of dollars to your venture and before he commits to supporting your company over the next 6, 8, or 10 years, he will want to get to know you as a person. You should want this as well! So treat each meeting as adding valuable connections to your network, connections that you should be willing to work to maintain. Don’t just ask for money. Ask for advice. Even if a VC does not invest in your company in your initial financing round, maintaining a relationship can pay dividends down the road when he invests in the second round or makes a valuable introduction because you’ve been keeping him updated on your progress.

A final note, to keep in mind that only a very, very small number of companies, generally believed to be between 0.1% and 0.2% of the companies that look for VC funding, actually secure an investment. So do the best you can, but have a contingency plan in case it does not pan out. Remember, that many highly successful companies were considered “unfundable” by the venture capital community!

Happy company making!

Inna

Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

US Incorporation and Flips FAQs

I am frequently speaking with foreign-based businesses about forming their company in the United States. They see the U.S. as a major market for their products or services and as a hub for investment capital, and they typically fall into one of two categories: (1) already seed-funded by angel or venture investors in their home countries or (2) no formal form of organization in their country, and interested in forming the entity directly in the United States.

Below are some of the most frequently asked questions in this context and my answers to them.

Do I Have to be a US Citizen or Resident to Form a Company in the US?

There are no nationality or residency requirements in the United States for either the members of the board of directors of a company or for its shareholders. This is a major advantage to incorporating in the United States, as it avoids the hassle of having to engage resident nominee directors as may be required in certain other jurisdictions.

However, the issue of ownership, or control, of a US corporation is not to be confused with the question of who can be employed by such a corporation in the United States. All employees a US corporation who will be employed in the United States must be work-authorized - in other words, they must be citizens, permanent residents, or have a visa which permits their employment by any employer or this employer in particular. Offshore employees may be employed directly by the US corporation or by a foreign-based subsidiary of such corporation, the latter being more typical.

How Quickly Can I Form a Company in the US?

If you are ready to go--in other words, if you have filled out our formation questionnaire, signed our engagement letter, and sent in a retainer--and assuming that we are forming a Delaware corporation, we can usually get a company formed for you within 24 hours. After the certificate of incorporation is filed in Delaware, it will take another one to two weeks, depending on whether there is urgency, to prepare the other documentation necessary to set up the company for operations.

On our end, this includes preparation of the following, as necessary and applicable:

• a capitalization table;
• bylaws;
• action by incorporator (appointing directors);
• organizational board consent (authorizing initial stock issuances, among other things);
• stock purchase agreements for founders and early employees;
• assignment of intellectual property to the newly formed company by the founders;
• documentation of investments into the company which precede or are contemporaneous with formation;
• indemnification agreements for officers and directors;
• application for employer identification number (necessary to open a US bank account);
• state qualification to do business; and
• form of confidential information and inventions assignment agreement.

Will You Help Us Open a Bank Account?

We work with several startup-friendly local banks, and will be happy to assist with opening your business checking account. Note, however, that to open a bank account, someone from your company will need to come here to meet with a bank representative in person, and while we can assist, we cannot open the account on your behalf.

What's the Minimum Capitalization Amount for a US Corporation to Meet the Statutory Requirements?

There is no statutory minimum for investment into or capitalization of the newly formed company. However, you should plan to provide sufficient capital for startup expenses, taxes, etc. to maintain the company in good standing under federal and state laws. Note also that your bank may impose a minimum monthly balance that it requires you to keep in the account to waive fees.

What Are the Annual Corporate Maintenance Obligations Associated with a US Corporation?

If a company has no physical presence in the United States, the following are the annual maintenance obligations of which it needs to be aware:

• Registered Agent. A US corporation must have a registered agent for service of process in the state of its incorporation. This is an annual subscription service, which receives "official" mail on behalf of the corporation and forwards it to its real address (in another US state or abroad, as specified).
• Franchise Tax. Delaware and most of the other states have an annual franchise tax requirement.
• Information Statement. Delaware and most of the other states have an annual information statement requirement. In some states this is combined with the franchise tax payment and in others it is separate.
• Tax Return. As a separate legal entity for IRS purposes, a US corporation must file federal and state tax returns. For this, it is advisable to retain a CPA or a tax accountant, who can streamline the process.
• Annual Meeting of the Board of Directors. To maintain the limited liability protection offered by the corporate form, it is advisable for a corporation to hold a meeting of the board of directors at least once annually (though for an operating company the practice is quarterly meetings). These meetings should be documented with board meetings prepared either by the company's secretary or your attorneys.
• Survey of Foreign Investment. Bureau of Economic Analysis requires all U.S. businesses that are owned 10% or more by foreign persons (individuals or corporations) to file a Survey of Foreign Direct Investment in the United States

This list is not exhaustive. And there may be other maintenance obligations with respect to a company in a special regulated industry.

What is the Difference between a Flip and a New Company Formation in the US?

If you look back to the first paragraph of this post, companies in category (1) that are looking to create a US parent company to their preexisting foreign-formed company need to "flip" their foreign company to the United States. Conversely, companies in category (2) of that paragraph will typically need a simple US company formation. Flips, as you can imagine, are more complex animals, as they involve structuring inter-company relationships that affect revenue flow, IP creation and ownership, and customer relationships in addition to simple US company formation. Generally, we see flips arise in the context of a significant financing round from a US venture fund that requires the company to be a US corporation. (More information on flips.)

Happy company making!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Antidilution Protection FAQs

"Dilution" is a very frequently heard word in startup circles. And I think most people have a pretty good general sense of what dilution is--it's when you have a piece of the pie and something happens which decreases your piece.

What I think is less understood, are (1) the implications of something happening which results in dilution to existing equity holders, and (2) the rights to protect against the resulting dilution (also known as "antidilution protection").

What Triggers a Dilutive Event.

So what has to happen to decrease your piece? Let's run through the simple algebraic analysis first. You (the founder or the investor) have x shares and the company has a total of y shares outstanding. So your piece is x/y. Then the company issues more shares so that it has y+n total shares outstanding, but you still have only x shares. x/y > x/(y+n), so you had a higher percentage of the company before the dilutive issuance.

But now let's see what's happening from a business perspective. Why is the company issuing more shares? Not every dilutive issuance is equal in its impact on the company. If the issuance serves to increase the value of the company, your smaller piece of the pie might in fact have a higher value than the bigger piece of the smaller pie that you had before.

Example: Suppose you are a 10% equity holder in a company valued at $5,000,000. The company subsequently raises another $5,000,000 at a $15,000,000 pre-money valuation--a dilutive event. Prior to the financing you have 10% of $5,000,000, which is $500,000, and post financing you have 7.5% of a $20,000,000 company, which is $1,500,000. Your stake decreased, and your percent ownership was diluted, but you are doing ok!

The example above demonstrates that what you should watch out for is not securities issuances which dilute your percentage interest, but securities issuances that decrease your total value. The latter are the instances where equity is being issued without a corresponding increase in the value of the company. Examples of those might be (a) warrants with a low exercise price that are issued as part of a loan transaction, (b) shares issued to investors at a discount or a price lower than the company's last valuation, or (c) shares issued to employees.

Protection Against Antidilution.

Now that we know how to distinguish between different kinds of dilution, how do we protect against the bad kind, the kind that dectracts from your value?

As disappointing as this may be for founders and other holders of common stock to hear, really the only equity holders who ever get antidilution protection are the investors (holders of preferred stock). I am sure there are exceptions to this rule, in the way that there are exceptions to every rule. But 99.99% of the time this holds true.

It may not seem fair to someone who has earned his sweat equity with... well, sweat and hard work. But investors are the ones that pay the full market price for their shares (usually 3x or more the price of Common Stock), and they are the ones who are more typically able to successfully negotiate some protection for themselves. Note, however, that even their protection does not lock their initially purchased percentage for perpetuity. Generally speaking, with each new sale of securities, their percentage, too, will be effected. However, they will get an adjustment (the conversion rate at which they Preferred Stock converts into Common Stock will increase, such that the same number of Preferred shares will be convertible into more shares of Common Stock) for issuances made at a price below their entry point, with certain exceptions. The list of exceptions to investors' antidilution protection is frequently the subject to heavy negotiation between company and investors' counsel.

Happy company making!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Private Company Board of Directors FAQs

Inevitably, the best topics for my posts come from questions I get from my clients. Hot off the press, these questions (and answers) came up on a seed round financing that I am working on this week!

Who makes the final decision on the number of Board members?

In Delaware, a Company's bylaws will typically allow the Board of Directors to fix the total number of directors, provided that any decrease in the total authorized number of directors will not remove from office any incumbent director. The bylaws may also fix a specific number of directors or specify a range (e.g., like in California), such that changing the number of directors from such specific number or to a number outside the range will require amendment of the bylaws.

In financings, the total number of directors that constitute the entire board will be negotiated with the investors, who will often insist that the number of directors may not be changed without their consent. (For those who like the technical details, in equity financings you will usually find this in the protective provisions of the certificate of incorporation and in debt financings, in the negative covenants.)

What are the qualifications for Board membership?

There are no special requirements as to who can be a Board member, so long as it’s an individual (and not a corporation). A Board member may, but does not have to be, a stakeholder of the Company.

What percent ownership of the Company entitles a stakeholder to designate a Board member?

Unlike certain foreign jurisdictions, in the US, there is no statutory right based on (a minority) percent ownership to nominate a Board member. Practically speaking, a majority stockholder will, in the absence of a voting agreement, be able to put his own designees on the Board. In certain states, like California, cumulative voting applies to election and removal of directors.

Normally, whether an investor gets a Board seat is negotiated at the term sheet stage and subsequently built into the charter (certificate/articles of incorporation) and voting agreement. The right to nominate an investor will usually be conditional on such investor maintaining some number or percent of shares initially purchased by such investor.

How long is the term of a Board member?

Normally, directors are elected to the Board to serve until they resign or are replaced by another director. It is possible to elect directors for a set term, e.g., for 3 years, but that is not usually done in small privately-held companies.

What is the process for removing a Board member?

A board member who does not voluntarily resign may be removed by the stockholders who had the right to appoint such Board member in the first place. In the absence of special provisions, a majority of the outstanding shares will be able to remove a director. If special rights have been negotiated, such that the preferred stock holders designate a director, the vote of the preferred stock holders will be required to remove the director designated by them. In certain states, like California, cumulative voting applies to election and removal of directors.

How does the Board vote?

The Board can vote (1) at a meeting, or (2) by unanimous written consent. There are no special rules about which type of vote needs to be obtained for which type of action. This is at the discretion of the Company. But there are some differences in the mechanics:
• Meetings of the Board can be held by teleconference, so everyone does not have to be in the same room. At a meeting, assuming notice requirements have been met, a majority of directors will usually constitute quorum (which means that it’s enough to start the meeting and vote on matters before the Board), unless a higher threshold is set in the bylaws. A majority of the directors present at the meeting (in person or otherwise) is required to pass a resolution. So, technically, in a board of 5 members, if 3 members attend and only 2 vote on a particular matter, that will be sufficient, though less than the actual majority of the whole Board. Practically, however, Boards that are not dysfunctional try to vote on matters unanimously, and if 2 of 5 directors can’t make it, they will probably reschedule the meeting.

• Actions by written consent have to be signed by every director. When the Board is small--one or two co-founders--written consents are the typical way to approve matters, so that there is a written record of Board action.

Happy company making!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Negotiating with Investors: How far is too far?

When an investor presents a company with a term sheet we enter the exciting realm of negotiation. Much can be, and I am sure has been, written on this topic. But perhaps not in our context. How far should a founder push the envelope with his investors on deal terms? I even posted a question on Quora to get testimonials about some wacky things that founders have tried and succeeded on.

In the meantime, I wanted to share my thoughts on this more generally:

1. Being Reasonable. During the term sheet negotiation process, the investors are watching the founder. After all, an investment into a company is the beginning of a long road. The investors will have much interaction with the founder over the years after they invest, so at a basic level they have to like the founder enough to look forward to that interaction. And they must believe that the founder is someone capable of succeeding in making them a lot of money. Someone who is unreasonable, irrational, and who handles negotiation like a selfish five year old, is generally not likely to pass that test and get to a signed term sheet, though I am sure there are some exceptions.

   What is reasonable and rational, of course, varies by culture and context. But I would posit that being reasonable in a term sheet negotiation means picking one or two terms that are deal-breakers, and arguing calmly and persuasively for those terms, in a substantiated and thoughtful manner. If there are other terms that are more investor-friendly than is the market practice, a founder may use them as leverage, trading chips, to get the terms important to the founder. Investors respect an entrepreneur who has a solid grasp of the deal terms, who can evaluate the relative importance of those terms, and who is willing to engage in a give and take process during negotiation.

   Attorneys can actually be helpful here--a startup attorney who sees a lot of term sheets can work with an entrepreneur to help him assess which of the terms offered are "market" and which are not. Knowing industry standards, even when one is arguing for structuring deal terms differently, goes a long way to sounding reasonable in a negotiation.

2. Being Strategic. If you have to pick only one or two terms to really focus on, which ones would you pick? Frankly, there are only two important concepts in a financing -- price and control -- though these are expressed in a number of ways through a number of different terms.
   • Price. You could argue over price. For instance, you could try for something trite, like asking for a higher valuation than originally offered or for a smaller option pool reserve, which effectively gets you a higher price (less dilution for the founders). Or you could get creative. As an example, to bridge a wide gap in valuation you could set milestones and provide for warrant coverage to the investor in the event the milestones are not met. Or you could play with the conversion price of the Preferred Stock to overcome valuation differences. But frankly, unless you have a lot of leverage (e.g., competing term sheets and investors falling over themselves to invest in your hot company), there is unlikely to be much give here from the investors.

   • Control. Control is more promising. It can't be measured in dollars, so it is easier for the investors to give this, if they like and trust the founder. There are many control terms. I have seen a deal, for instance, where angel investors gave the founders a proxy to vote their Preferred shares. That's an outlier, but some of the more typical control terms that do get negotiated are (a) board control -- who the board seats are allocated to between the founders and the investors; and (b) stockholder control -- what blocking rights an investor, either alone or in concert with other investors, has on specific actions by the company.

     Since control and voting are intimately tied, a lot of thought (and negotiation) goes into whether voting will be done by class or by series and what the percentage threshold will be per such class or series. While the number of shares held by an investor or a group of investors is tied to the price, the law allows flexibility for unequal voting by different classes of shares. These mechanisms are not frequently invoked beyond protective provisions that run into several pages in length, but can be, and sometimes are, under the right circumstances.

3. Cost. Legal innovation is expensive. A road well-traveled, otherwise known as "market terms", is going to come with the lowest legal price tag because there will be established forms which need little customization and not a lot of negotiation. Your attorney will not need to conduct legal research to tell you the ramifications of a particular provision because they will be well-known to him or her.

   Conversely, be prepared that innovative legal solutions will be expensive. They will require more time to prepare and analyze by your attorney. They may require specialists (like tax or executive compensation attorneys) or senior partners to get involved, which will increase your legal bill. You will get pushback and arguments from the attorneys on the other side of the table, and your lawyers will have to convince the lawyers on the other side that your solution works. Negotiations, too, will add to your legal bill.

   It may be that your proposed terms, which require the innovation, will ultimately result in a significant financial benefit to you, to the tune of millions of dollars. It has certainly happened before. So by no means do I wish to discourage you--for me as an attorney it is a lot of fun to work on innovative solutions. But I do want to set your expectations--custom solutions come with a higher price tag, that's all.

Happy company making!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.

Startups: Choosing between an LLC and a Corporation

The first question that startup founders often ask a lawyer is "what is the right type of entity for my company." If you Google the subject, which you have probably already done bringing you here, you will see that there are a plethora of opinions. Most advice will be split into two campus: arguing in favor of either a corporation or a limited liability company (an LLC).

Almost everyone knows the core difference between a C-corporation and an LLC from a tax perspective -- LLCs get pass-through treatment (unless otherwise elected), such that all gains and losses of the LLC are recognized on the US tax returns of its owners (known as members). By contrast, C-corporations are treated as separate legal entities for tax purposes. Owners in corporations (known as shareholders) are not taxed on the corporation's gains and losses, though they are taxed individually if they receive a distribution (e.g., a dividend).

Very likely, you are reading this and thinking, "Yes, I know, but so what? I still don't know whether to form a corporation or an LLC." So let's see what this means for us.

I would posit that if you are a true startup (not a small business), the following will be very important to you: (a) being cost-efficient, and (b) obtaining funding from investors. If you agree with the premise and find yourself in that boat, read on.

Investors. Institutional investors (funds) will almost always require a company in which they are investing to be a C-corporation. There are several reasons for this:

• Administrative Burden. Investment funds are generally pass-through entities themselves, so their limited partners would be burdened with K-1 forms (the tax form which is issued to members in an LLC which allocates LLC's gains or losses to such member) for each investment by each investment fund in which such limited partner is participating.

• Tax Exempt Status. Some investment funds can't invest in LLCs because of their tax-exempt status or the tax exempt status of their limited partners.

• U.S. Tax Obligations for Foreign Funds. LLCs create a problem for foreign investors who may not otherwise be subject to US taxation or to US tax filing requirements.

• Structure. Investors like corporations because of the rigid time-tested structure that they provide. Corporations are owned by shareholders who vote for and elect a board of directors. The board of directors votes on important company decisions and, in turn, elects officers, who run the corporation day-to-day. The shareholders (among them the investors) have clear rights, among them, to remove the existing board and elect a new slate of directors if they feel that the corporation is getting derailed. LLCs are known for being more flexible. Rigidity can be built into them, at an extra cost, but is not inherent to this entity form.

Efficiency. In an LLC, the entirety of the understandings between the members as well as the ownership, management, and tax structures, are contained in a single agreement - the limited liability company operating agreement. This is a complex, difficult to understand, tax-heavy document, which requires much customization and deep tax expertise. This translates into many attorney hours and expensive tax counsel. On the other hand, corporate formation and financing use several smaller agreements, forms of which have become largely standardized over the years such that these agreements are actually faster and simpler to draft than the LLC operating agreement. Each corporate document has a narrow purpose, and because the corporation is a stand-alone legal entity, tax analysis for the members does not come in like it does in the LLC operating agreement. Faster, simpler, and no tax review all spell "cost-efficient".

Conclusion. For a typical startup that plans on raising capital, I think it's not worth spending a lot of time debating the pros and cons of different entity types. Bottom line is, forming a corporation will save you a lot of unpleasant discussions with investors down the road and, ultimately, the cost of converting your LLC to a corporation.

It goes without saying that there are exceptions to every rule. For instance, the founders may plan to bootstrap for several years and the LLC form would allow them to write-off operating losses during those years against their ordinary income from other sources. Or, a startup's capital may come from an angel investor who really likes the pass-through losses that he can take through his investment in an LLC. Or, friends and family investors may be providing capital with the idea of getting regular dividends, without double-taxation eating into the profits.

The above scenarios, however, are not typical startup issues, which is why typically, the right choice is to incorporate. But if you are in doubt or there is something unusual about your situation, you should consult a tax and/or legal advisor.

Happy company making!

Inna

Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.