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.
ABOUT WHITE SUMMERS AND WORKING WITH LEGAL COUNSEL
Please tell me a little bit about yourself, your background, and what you do now?
I obtained my JD from Berkeley Law in 2005 (it was then still called Boalt Hall). After law school I joined the Venture Law Group at Heller Ehrman, where I focused on documenting venture capital investments and working with startups. Heller Ehrman imploded in 2008, and my group joined the emerging companies group at Cooley. After Cooley, I worked briefly for Electronics for Imaging. However, I realized that in-house counsel work – only supporting one client, is not for me. I enjoy working with a number of clients at the same time. I hung out my own shingle, but quickly realized that solo practice did not provide the kind of scale that was needed to support my practice. To get better clients, I needed a bigger platform. Two years ago, I took my practice to White Summers, a boutique corporate and transactional law firm, with 10 attorneys. White Summers has offices in the Silicon Valley (Redwood City, California) and in the Pacific Northwest (Portland, Oregon) and specializes on structuring and formation of legal entities, financings, mergers and acquisitions, and commercial contracts.
Do you represent only U.S.-based startups?
Incorporation. When a startup consists of a single founder programming away in his proverbial garage without involving others, it can wait to talk to an attorney. But at a certain point, as the sole founder attracts team members and starts to actually do business, it becomes beneficial to form an entity with limited liability (usually a corporation). Of course, It is possible, even easy, to incorporate without working with a startup attorney, but will it be done right, in a manner most beneficial to the startup given its long- and short-term goals? At the point when a company is ready to form an entity for doing business, it is best to speak to an attorney to get advice on the best jurisdiction and time to incorporate as well as to get the other formation in place, such as stock issuance and transfer of intellectual property.
Commercial Agreements. Another time to seek legal counsel is when the startup is negotiating and about to enter into a commercial relationship. Whether this is a license of technology to or from the startup, a bank loan, or even an agreement with a consultant, it is best to consult a professional, who can review the contract terms, explain the risks associated with the particular agreement, and help to negotiate the best terms for the startup.
Term Sheet. Very frequently I am engaged by a startup that has been presented with a term sheet from an interested investor and needs advice on how to proceed. I provide an analysis of the term sheet and offer a negotiation strategy. My role is to identify the terms that do not conform to best practices in a way detrimental to the startup or the founder, and to review those with the startup. In most of these cases, the founders did not work with legal counsel previously, and are missing important documents. In those situations, I will do corporate cleanup, in other words, generate proper documentation that the investors’ legal counsel will require when they conduct diligence review.
Financing. Finally, sometimes I am engaged at a stage when the term sheet with investors has been signed and the company needs representation for documenting the financing itself.
What is the best jurisdiction for a startup to incorporate?
That said, not every startup intends to raise funding in the United States. A startup based outside the United States may look to investors locally or in other jurisdictions, such as Europe or Asia, where investors’ jurisdictional requirements are very different from those of U.S. investors.
If there is a desire to enter the American market or to work with American investors, then at least one of the companies in the family of companies that constitutes the business must be incorporated in the United States, preferably in Delaware. In fact, the vast majority of startups that are incorporated in the United States, are incorporated in Delaware.
But that’s history. Bottom line is that investors are familiar with Delaware. They understand how the Delaware laws affect their rights are shareholders. For investors who have large portfolios, investments in 30 to 50 companies or more, it would be an impossible task, having to track their rights across 15 or 20 jurisdictions. Delaware is the industry-standard, and while you don’t have to always adhere to the industry-standard, if you don’t, you should have a very good reason for swimming against the current.
Are there any benefits to incorporating in a local jurisdiction (outside the U.S.)?
When we are talking about global business, we have to talk about families of companies. Thus, having a legal entity in the jurisdiction where a company is actually located can be very convenient for its operations. For example, it is easier for a company incorporated locally to enter into contracts with employees or to obtain a lease for office space.
For foreign startups that are targeting the U.S. for investment, the local company will typically be a wholly-owned subsidiary of a U.S. corporation. For startups that are looking to U.S. as a market for its products or services, the U.S. company may be a subsidiary or a sister-company. In either case, the relationships between the family of companies that constitute a business can (and should) be documented by commercial agreements.
If a startup has not incorporated and does not have a corporate bank account, how is it going to take money from investors? It is, of course, always possible to shake hands and accept a suitcase full of cash under the table. However, this is not a good business practice. If something goes very wrong, the founders will be subject to personal liability because they will be found to have been operating as a common law partnership. To minimize liability and make it easier to conduct business, ventures should be incorporated when they business outgrow the embryonic state and begin to have relationships with the outside world, whether it’s taking investment, uploading a mobile application to the AppStore, or hiring engineers.
As I mentioned in the discussion about engaging counsel, if a startup consists of a single founder, that founder can exist for quite a while on his own, without incorporating. However, if there are multiple founders involved and the company is not incorporated, the company structure becomes volatile.
By way of example, let’s say that five founders are working together on a startup without documenting their relationship. By the time an investor enters the scene, only three founders are still working on the project and the remaining founders incorporate the business.
But what about the two founders who left? Because of the lack of proper documentation, we are faced with many questions the answers to which depend on who you ask. Do the founders who left own a share of the company? If so, is it clear what their share is? Is it proportionate to their contribution? Is intellectual property that they created being used by the company? If so, does the company actually have the right to use it? Do the founders have the right to use it as well in a competing venture?
More often than not, an investor will not want to get involved in this type of situation because the risks are too high. Investors require that the cap table and IP ownership be clear and unambiguous. And this kind of a situation is exactly the type of issue that investors worry about uncovering when they conduct legal due diligence of a company.
This is why, the more people that are involved in a project, the more important it is to structure and document everything correctly and in a timely manner. Then, if something does not go according to plan, which is often the case, it’s a minor hiccup that does not derail the entire venture.
GETTING READY TO TAKE INVESTMENT
What types of documents should an entrepreneur have in place before talking to investors?
That can happen even when we are talking about savvy investors. For example, about six months ago we closed a deal in which our client received funding from Khosla Ventures, a top-tier venture fund. Vinod Khosla met the founder at a conference and he believed in the team and the technology. At that time, the company was formed as an LLC. There was nothing else done; it was an empty shell company. The client received a term sheet and we prepared the proper formation and financing documents.
In other words, there is no minimum set of documents that a startup is required to have to engage with investors, if there is a sufficiently high level of interest from the investors. But some investors might see a complete lack of corporate documentation as evidence of a lack of commitment by the founders. After all, if the founders have not been willing to invest even the small amount of their own funds necessary to properly set up the company, they must not have a lot of faith in the success of the project. But, ultimately, the importance that is placed on proper corporate documentation pre- first investment is going to be individual to the investor and to his interest in the company.
If you were to do things “by the book” so to speak, you would form a Delaware corporation, distribute Common Stock to the founding team, impose vesting on the shares, transfer all technology and other intellectual property created by the founders pre-incorporation to the corporation, and enter into agreements with everyone generating intellectual property for the company that make this intellectual property the property of the corporation from the time of creation. That’s the basics. Of course, if the company has any operations, you would properly document those as well.
Legal services can come with a hefty price tag. If the investors are performing due diligence, who pays the bill?
Of course, if we are talking about a very small investment amount, we work with the company to create minimalistic (yet sufficient) documentation, where the legal fees will make sense in the context of the transaction. Usually, a small investment can be documented as a bridge financing using a convertible promissory note that we’ll prepare for the company, based on the investment terms that it would like to offer to its investors. (For more information about convertible promissory notes, see my blog post on the topic.)
On the other hand, if we are talking about a financing in excess of $500,000, U.S. investors will expect the startup to pay their legal fees. Depending on the transaction, the cost of services of an attorney from the investor side is usually limited to $10,000 -$35,000. Since the attorney for the startup performs the majority of the work in an investment transaction, the cost for company counsel’s fees averages 1.5 to 2 times the cost of legal services for the investor (assuming comparable law firms with comparable rates on both sides of the transaction).
LEGAL PITFALLS
What are some legal difficulties that a startup might face at different stages of its life?
Legal difficulties often arise when something that needs to be documented is put off for later. Then suddenly it becomes too late, and it’s no longer an item at the bottom of a long to-do list, but a mistake which carries a cost and needs to be fixed. Some mistakes can be fixed afterwards, but it is typically more expensive than doing it right the first time.
Misunderstandings between counterparties also potentially create legal difficulties. If an agreement was rushed, it is possible that it was not thought through fully. After the fact, it may turn out that one party had meant one thing, and the other something else. Sometimes, when documentation wasn’t sufficiently well thought through, the plain text of the contract may not be enough to provide guidance on a point of contention.
Bottom line, good communication between the parties about their expectations with respect to their relationship will help to minimize many potential conflicts and legal difficulties.
What we do see sometimes are trademark disputes. Here’s how that usually goes:
These days, it can be difficult to invent a relevant and interesting company name for which a domain name is still available. But entrepreneurs are creative people, and eventually find a name and a domain. During the name selection process, they will usually run a Google search for their desired name to see if it’s already being used. If the search does not produce relevant hits, or if the only relevant hit is a chicken farm in New Zealand, they proceed with the name.
The problem is that trademark infringement is broader than using the exact name that another company is using in the same space. The test is “likelihood of confusion” so a company with a similar, not identical name, may have a legitimate claim against a newcomer. Without conducting a thorough trademark search, it is hard to catch those similar but not identical names.
Proceeding with our example, sometimes it turns out that there is, in fact, another company, with a similar but not identical name, that has the resources to do trademark policing. This company will start a cease and desist letter campaign against what they perceive as a violator of their trademark.
The first letter is generally from the company that owns the trademark, and reads something like, “We’ve invested a lot of money in our trademark and you are violating our rights! Stop it, immediately.” Then the “offending” company has to go to their attorney and the attorney will write a response explaining how there is actually no trademark violation and that the marks are sufficiently dissimilar that there could be no likelihood of confusion.
The next letter will typically come from a heavy-hitter law firm hired by the trademark holder. It will say something like “You are violating the rights of our client. Stop immediately or we will sue you.”
Whether there truly is infringement, is largely a matter of opinion and interpretation, and any question of opinion or interpretation can be resolved in court – that’s what courts do. But that’s a very expensive way to get an answer. If the dispute is between a small startup and an established company with a budget allocated specifically towards IP rights enforcement, the startup will have a difficult decision to make. One option is for the startup to change its name. But that means they would have to come up with another, non-infringing name that’s just as good, find a domain name that’s available, and wave goodbye to the time and money spent on developing this brand. Another option is to continue the letter exchange and hope that the other company is bluffing when they say they’ll sue. That’s a big risk, calling their bluff!
To reduce the risk of facing this situation, prior to definitively committing to a name, (1) have your attorneys conduct a thorough trademark search for it, and, if it comes back clear (2) register a trademark for it.
What advice can you give to new/novice entrepreneurs?
Second, you need to be running a continuous assessment of what you bring to the venture. You have to keep track of the components you need for success and be honest about what’s missing. Sometimes, entrepreneurs will start a project on their own and develop a strong personal attachment to it. It is theirs and theirs alone. They don’t want to bring on additional founding team members because they don’t want to share the equity or have to listen to other opinions. That kind of an approach can work for some founders, but it can backfire as well. Two heads are better than one and it is good to be challenged, even if it’s not as comfortable as being king in your own little kingdom. Working alone results in a skewed, one-sided vision.
Founders should seek out other talented like-minded people who will also become obsessed with the project. The more people that are excited about your idea, the more chances you have of persuading clients, customers, investors and business partners to be excited about it as well.
Don’t be paranoid that someone will steal your idea. Don’t be reluctant to seek advice from experts or to issue an equity stake to your partners. Running a startup is a collaborative process. All successful companies are developed by a team. No matter how brilliant an entrepreneur is, he cannot run a successful startup without a team. There will inevitably be gaps, and a strong team can fill those gaps. Every successful entrepreneur I have talked to has said “hire people smarter than yourself to be on your team”!
Lastly, I would say, constantly check and recheck whether the project you are working on is relevant! Does it provide a solution to a real problem? Solving a fictional problem is truly a thankless task.
Happy company making!
Inna
I am a corporate and securities attorney based in Silicon Valley, California, specializing in representing startups and startup investors.
The majority, though not all of our clients, are incorporated in the United States. Where they are physically located, however, is another matter. About half of my clients are headquartered in the CIS countries. One of my partners, Mark White, represents clients from Spain, and throughout Europe. An attorney is joining us, who will be developing the firm’s China practice. Even though many of our clients are located outside of the United States, they all inevitably have some to the U.S. jurisdiction – either they are incorporated in the United States, or they are raising money here, or their products and services target the U.S. market. A common characteristic among our clients is that they must face questions which require answers from a U.S. attorney.
When is the right time for a startup to engage legal counsel?
The best time to seek legal counsel is when the startup begins interacting with the outside world. There are four primary entry points:
The United States legal system is based on precedent. So the more that cases of a certain type are adjudicated in a jurisdiction, the more established and clear the law is relating to those kinds of cases in that jurisdiction. Historically, Delaware was the state of choice for large corporations and remains the state of choice for publicly-trading companies in the United States. Perhaps this was because of the business-oriented administrative system in place, or because Delaware has a separate court, the Chancery Court, that specializes in corporate and securities matters. Regardless of the original causes, the fact remains that over many years Delaware has acquired a very established body of corporate law and a judicial system that is competent in these matters and reasonably predictable.
I would say that waiting to incorporate until a business generates revenue is waiting too long and exposing the founders to too many risks and potential liability. Many startups don’t begin generating revenue for one to two years, or even longer. During that time, they have developers working on valuable intellectual property, officers are meeting with prospective customers, and presumably there is investment being made into the company that is supporting its operations.
Technically, you don’t need anything to talk. It is always possible that the investor will be so excited about the investment opportunity that he will offer you a term sheet even when the startup is not incorporated or does not have all the right documents in place.
It depends on how familiar the founder is with the terminology. I would say that on the whole, investors aren’t trying to purposefully mislead the founders or hide something unpalatable in the term sheet. Investors will include those terms and conditions in the term sheet that are important to them. Founders are expected to understand each term (whether on their own or with the help of an attorney). It is not enough to look at the company valuation, though that is certainly an important term. If a founder is experienced, understands common industry practices and terminology, and has already sold three companies, he can probably handle negotiations with the investor himself. But these types of founders are the exception.
Often in an investment transaction, the startup pays not only for its own attorney, but also for counsel for the investors. This is a very standard practice in the U.S. Sometimes if the investment amount is fairly small ($25,000-$100,000) both parties will agree to pay for their own counsel, or more likely, the investor will not engage counsel in the first place.
We do not run into this problem very frequently. In my practice, I have yet to see a single contract that I’ve drafted litigated. Generally speaking, the documents that we generate are meant to set expectations between counterparties. Even if things don’t go according to plan and one of the parties is dissatisfied with the performance of the other, it does not make a lot of sense to go to court for resolution. Litigation is both a very expensive endeavor and a disruptive one for business. The majority of my clients are not yet at a stage where it makes sense for someone to sue them or where they have the resources to sue someone.
Fortunately, patent infringement claims have not been brought against my clients either. Possibly for the same reasons listed above, but also because, even if their technology potentially infringes a patent, the patent holder simply wouldn’t know about it. Since my clients’ products and services aren’t household names quite yet, someone has to look pretty hard to find them. And then again, there are no deep pockets, so what will a lawsuit, even a successful one, get them? The company will shut down and everyone loses.
The most important piece of advice that I can give is to do what you love! The right motivation to become an entrepreneur is that you cannot do anything else, not because you don’t have the skills, but because you have identified an important problem, and have a solution to that problem that is far superior to what’s out there now. Being an entrepreneur, running a startup, you’ll work harder than you ever have in your life. It's certainly not for everyone, and if you’re going to take the plunge and go for it, be sure you are ready and that this is right for you.
| 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.
What does it mean for shares to be authorized?
Amending the Certificate of Incorporation to increase the authorized number of shares requires a vote of the stockholders of the corporation. It also requires a state filing and associated fees. This is somewhat tedious. When thinking about the number of shares that you need to authorize, plan so that number of shares initially authorized is sufficient for your purposes for the foreseeable future, until a significant event in the life of the corporation, such as a financing, for example, when you will go through the trouble of amending the Certificate of Incorporation.
While online searches for sample Certificates of Incorporation may return some Certificates of Incorporation with "blank check" Preferred Stock, the best practice for a startup is not to include it. Investors keep a close eye on the company's authorized and unissued shares of each class and series, allowing only a very small cushion.
This is because a stockholder's share in a company is calculated as such stockholder's shares divided by the sum of all issued and outstanding shares of the company and the shares reserved under the company's stock plan. Note that a stockholder's share is not based on the company's authorized shares. Therefore, if a significant cushion exists, an investor's share can be easily diluted by the company issuing shares from the pool of authorized shares, without seeking the investor's consent.
While most investors expect to be diluted at some future time, for example, in connection with the next investment into the company, they try to structure their investment in a way to delay the dilution to a time when the value of the company has increased as well. To better understand dilution, read my blog post on dilution.
Typically, at a Series A stage, a startup is going to be valued between $2M and $12MM, broadly speaking. At the time of investment, the Series A price will be calculated as pre-money valuation divided by the total number of then issued and outstanding shares, plus the shares reserved under the company's stock plan (including an increase to the stock plan reserve for the Series A round). Simplistically, a $10MM pre-money valuation, divided by $10MM shares (which include shares already issued to the founding team and the unissued shares reserved under the stock plan), equals a Series A price of $1.00. Individual numbers will vary of course, but it makes it easy and convenient to stick to conventions, so that the Series A price per share isn't 1/100 of a dollar nor hundreds of dollars.
There is an additional consideration. When a startup is recruiting, optically, it is better to be offering 15K, 30K, or 75K shares to employees than 15, 30, or 75 shares. It requires an additional conversation with the recruits about the company's capital structure, about the number of shares that are authorized, and about why that is the case. Most likely, a company that starts out with a very small number of shares will end up doing a stock split at a future point. It's not particularly difficult, but it complicates matters. If you can authorize the "correct" number of shares from the start, the number that will make your life easier, why wouldn't you?
I recently heard from a company that was incorporated by their CPA, that they were advised to authorize no more than 5,000 shares. The logic behind this suggestion was to save the company money on Delaware franchise taxes. It is true that using the "authorized shares method" a company's franchise tax liability can be as low as $75.00 per year for so long as the company does not authorize more than 5,000 shares. And for a regular small business (not a startup), that's a perfectly acceptable logic to follow. But startups need room to grow. No VC will understand the logic behind keeping the authorized share number extremely low to save a couple hundred bucks. It will seem very short-sighted to them, not smart and frugal. A typical startup uses the "assumed par value capital" method to calculate its Delaware franchise tax liability. The minimum tax that may be owed under the assumed par value capital method of calculation is $350.00. The actual formula to calculate franchise tax liability using this method can be simplified to the following:
How many shares then should the founders issue to themselves initially?
Note that the share reserve needs to be sufficient for the company's hiring needs until the next time that the Certificate of Incorporation is amended, and as we've said before, a natural time for the Certificate of Incorporation to be amended is in connection with an equity financing.
Finally, just a reminder that for founder shares to be properly issued, the following formalities should be observed:
Inna
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.
Vocabulary is important here. The authorized number of shares that goes in the Certificate of Incorporation is the number of shares that the Board of Directors may issue without amending the Certificate of Incorporation. By contrast to authorized shares, issued shares are shares that have actually been sold and are outstanding.
Generally speaking, unless the company is being incorporated concurrently with taking an investment, only Common Stock needs to be authorized.
For my startup clients, I typically recommend that 10,000,000 shares of Common Stock be initially authorized. There is no magic to this number, but it tends to result in a Series A price per share that is of a familiar/standard magnitude.Total Gross Assets (as reported on the U.S. Form 1120, Schedule L) X (Authorized Shares / Issued Shares) X $0.00035.
Founders have a very natural inclination to want to issue amongst themselves all the shares that they authorize in the initial Certificate of Incorporation. However, if the company plans to use equity in the near-term to incentivize its consultants and employees, then a reserve of authorized but unissued shares should be left for this purpose. A typical reserve, even without a formal stock plan, is 10-30% depending on the company's hiring plans. So, in our typical scenario, the founder or the founders would be issued, in the aggregate between 7M and 9M shares of Common Stock, with 1M to 3M authorized and unissued shares remaining available for future issuance.
Happy company making!
LEGAL DISCLAIMER 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.
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.
Happy company-making to all!
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.
