I have tried to provide on my blog answers to most frequently asked questions relating to company formation and obtaining investment. If there are other general interest topics that you would like to see covered, please make a note of it in the comments section and maybe sometime soon you will see an answer posted on this blog!
General
Company Formation & Corporate Maintenance
Fundraising Process
Investment Terms
Investors' Perspective
Who Should Have Vesting. Every contributor’s shares in a venture should be subject to vesting. I use the term “contributor” here because these concepts apply not just to the founders, or the early employees, or the consultants, but to anyone in a startup who is incentivized by a grant of shares, or the right to purchase shares (known as a stock option).
Vesting Definition. Vesting is the process, whereby shares or stock options granted to a contributor are, in effect, earned over a period of time, such that they may be repurchased or cancelled, as applicable, in whole or in part, from the contributor if his involvement with the venture does not continue for the entirety of the vesting term.
Vesting Term. Vesting should be imposed over a term, typically calculated in months, that is the shorter of (a) the period over which the contributor is expected to meaningfully contribute to the venture, or (b) 48 months.
No Cliff on Founder Shares. There is usually no cliff on founders’ shares—their shares vest monthly from the beginning and frequently they get “credited” in their vesting for the number of months that they worked on the project prior to getting their shares. For example, if a founder worked on his startup for a year before he was issued shares, it is not uncommon for his shares to be 1/4th vested up front, and the remaining shares to vest monthly over 36 months.
Cliff on Shares by Other Contributors. By contrast, non-founder contributors typically have what is known as a “cliff” on their vesting—a block of time up-front, during which they are tested to make sure they are a good fit. At the end of the cliff, which is usually a year for full-time hires and may be shorter for other contributors, a portion of the contributor’s total share grant, usually proportionate to the ratio of the cliff period to the entire vesting period, vests at once. However, if the contributor’s services to the company are terminated before the cliff runs out, none of the shares vest.
Vesting Acceleration. Sometimes the vesting of founders’ shares or the shares of other top contributors, accelerates in full or in part upon the happening of certain events. Most typically, vesting accelerates, if at all, either on a single trigger (which can be termination of the contributor or acquisition of the company), or on a double-trigger (termination of the contributor in connection with an acquisition of the company). Vesting acceleration is a heavily negotiated term whether with investors, new hires, or an acquirer of the company.
Why Do We Need Vesting. There are several good reasons why it is a very good idea to impose vesting on the founders’ shares.
First of all, investors insist that the founders’ and other contributors’ shares be subject to vesting. So if the founders do not subject their own shares to vesting in the beginning, when they engage with investors, imposing vesting on founder shares will almost invariably be one of the conditions to the investment. Founders who impose vesting on their own shares may get better terms than those that investors will require of them. But as long as those terms are reasonable, investors will typically not require founders to amend their vesting terms.
But even if investors are not in the picture, as long as there is more than one founder, imposing vesting on all founders protects the company and its viability. Let’s consider an example to see why vesting can make or break a company. All names, characters and specifics are completely made up, but situations like this in an assortment of variations come up all the time.
At a gaming conference, Jim and Rhonda meet Pete. Pete has an MBA from Stanford and did a summer internship at a venture fund. Pete is a gamer and after spending several long weekends talking to Pete about their vision, they decide that they would benefit from Pete’s business expertise in getting GameFriends off the ground. Pete agrees to join the company for a 20% stake, but insists that they need to incorporate the venture and formally issue shares. Everyone agrees. The founders incorporate the venture with 10,000,000 authorized shares of Common Stock, of which Jim and Rhonda hold 4,000,000 each and Pete holds another 2,000,000.
Jim and Rhonda trust each other, so they decide they don’t need vesting on their own shares. Since Pete is new, they decide to have his shares vest monthly over one year.
In the meantime, Rhonda’s sister, who is working on a children’s book, asks Rhonda to help with illustrations. Rhonda can’t say ‘no’ to her sister, she’s always really liked doing children’s books illustrations, and her sister promised to pay her! She decides she can help her sister, while continuing her role with GameFriends.
Unfortunately, she isn’t able to do both well. She takes longer to respond to Jim’s emails and lets his calls go to voicemail because she feels bad about not having her deliverables ready when she promised.
After a couple of months, Jim and Rhonda have a heated discussion, where Jim accuses Rhonda of not being dedicated to the project and Rhonda defends herself and finds fault with Jim’s own coding efficiency, which she thinks is to blame for their first game not being ready yet. Rhonda is upset and decides to leave the project. She has 40% of the company at this time.
In order to finish the project, Jim needs to bring on another graphical artist. At a high school reunion, Jim runs into a good friend of his, Kevin, who would be perfect to replace Rhonda. Jim wants to bring him on and offers him 4,000,000 shares in the company, the same number of shares that Rhonda received. Kevin is interested, until he realizes that a large percent of the company belongs to a former co-founder, who is no longer involved.
Here is what the capitalization looks like: Jim and Rhonda each have 4,000,000 shares, Pete has 2,000,000 shares and Jim would like to offer Kevin 4,000,000. If Kevin accepts, he will have approximately 28.5% of the company, but so will Rhonda, who invested only a few months of her life into the project.
Kevin turns down the offer. When Pete realizes that there is not anyone to replace Rhonda, he leaves as well. At this point, 6 months have passed since he joined the company. Because his shares are subject to vesting over 12 months, half of his shares have vested. The company repurchases the remaining shares.
Jim is now the only one left, trying to salvage the business. Rhonda and Pete together hold 5,000,000 shares and Jim holds the remaining 4,000,000, or roughly 44.5%. It is very difficult for Jim to bring on either a new graphic artist or a new business person because such a large percent of the company is owned by people, who are not contributing to the business. Jim closes the company and accepts a job at Zynga.
GameFriends could have avoided this untimely demise, if Jim and Rhonda had not made critical mistakes at the formation stage. Had Jim and Rhonda’s shares had vesting on them, then, when Rhonda left, GameFriends could have repurchased most of her shares, which could have gone to Kevin instead. Pete’s shares were subject to vesting, but the vesting period was too short, which is why he ended up with over 10% of the company when he left 6 months later.
When shares are granted to contributors, the expectation is that they will continue to contribute for some significant period of time. If they don’t, their shares have to be made available to other contributors, who will be brought in to take their place. Otherwise, those who stay with the company suffer dilution, when additional shares have to be issued to attract replacement contributors, and the recruiting process itself becomes very difficult.
For this reason, to improve a venture’s chances for success, it is the industry practice for the founders’ shares to be subject to vesting.
Happy company making!
InnaGameFriends is a startup developing a new social gaming application. Jim does the coding and Rhonda does the graphics. Jim and Rhonda have known one another since college and came up with the idea over coffee one day. They started working on GameFriends a few months ago and agreed that everything would be split fifty-fifty between them. They have not incorporated the business yet, waiting to complete a game first.
 | 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. |
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.
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:
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. |
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.
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:
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:
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. |
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.
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:
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. |
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.
You can see that the level of detail and complexity of this agreement can be quite high. If it is not, how valuable will this agreement be in settling disputes among cofounders? If it is, how much time and expense will it take to put together the agreement? Bottom line is, unless there is a really good reason for you to put off incorporating once you've embarked with your cofounders on an entrepreneurial venture, skip the preincorporation agreement and take the plunge by incorporating.
And, my shameless plug at the end: whichever course you choose, or to discuss the best course for your company, Emergence Law Group is available to help.
Inna Efimchik
 | Emergence Law Group, specializing in assisting emerging technology companies in Silicon Valley and beyond, provides incorporation, financing, and licensing services as well as general corporate counseling. |
| | Emergence Law Group, specializing in assisting emerging technology companies in Silicon Valley and beyond, provides incorporation, financing, and licensing services as well as general corporate counseling. |
