Startup Voice

Monday, November 12, 2012

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.

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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).

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.

Thursday, November 8, 2012

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 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?

cumulative voting

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?

cumulative voting

How does the Board vote?

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

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Thursday, October 25, 2012

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:

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.
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.
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

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Friday, October 19, 2012

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

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Thursday, August 30, 2012

Convertible Promissory Notes: Investor’s Perspective

Unlike venture capitalists, who commonly dictate their own terms and present their own term sheet, angel investors are typically on the receiving end of a term sheet from the company in which they have expressed an interest. Sometimes even, there is no term sheet and the angel investor is presented directly with transaction document(s) (e.g., a convertible promissory note or a convertible promissory note and note purchase agreement).

Of course, as you will hear me repeat again and again, I would discourage anyone from making an investment without the help of legal counsel in navigating the negotiation and review of the documentation for it. Attorneys that specialize in financing work will be able to point out underwater rocks and provide invaluable negotiation advice. In this post, we’ll discuss five points that you should pay attention to in your transaction documents:

Preferred Preferences and Privileges. When purchasing a note, you are postponing the negotiation of the rights, preferences and privileges of the shares of preferred stock into which your note will convert and deferring it to investors who come after you. This saves everyone time and money and allows a bridge financing to be completed in short order using just a few short documents. However, that also means that you, as a bridge investor, have to be comfortable that you are leaving the negotiation of your rights in good hands. The typical way to control this is by setting the amount which must be raised by the company in its “Qualified Financing” high enough that the investors in such Qualified Financing will be serious market players, most likely venture capitalists. On the other hand, the threshold should not be so high, that your note never converts. Striking a healthy balance is key. (Mechanics of note conversion are covered in detail in another post.)
Maturity. As a debt instrument, a note should always specify a maturity date—in other words, a final date by which the note must be repaid. The probability is high that, if there has not been a Qualified Financing forcing conversion of the note prior to the maturity date, on maturity the company will not have the necessary funds to repay the note. I recommend a contingency plan, which provides that if there has not been a Qualified Financing prior to maturity, on maturity the note converts into [fill in the blank] based on a [fill in the blank] formula. For instance, the note can convert into common stock, such that the note holder holds 55% of all common stock and takes over the company. That’s aggressive and really only works with one larger investor, but I’ve seen it done (by east coast investors). Or, more typically, the note can convert into preferred stock with a pre-negotiated (and likely punitive) valuation. The conversion can be automatic or at the discretion of the investor. There are many ways that a contingency plan can be structured, but I do believe it wise to negotiate this up-front, rather than waiting for the note to mature and for the company to default on repayment.
Amendment of the Note. You should know and care about who can amend the terms of your note. Will your consent be required, or will a “majority-in-interest” of the notes (which you may not control) be able to approve amendments? If only a majority-in-interest is required, is there a provision that protects you as a minority holder against changes which impact you in an adverse and disparate manner from the other note holders? Relatedly, what other decisions can be made by a majority-in-interest? Finally, are you able to determine, based on the information provided to you, whether you will control a majority-in-interest vote and if not, which investors or what combination of investors will control it?
Prepayment. You should also pay attention to whether your note be prepaid without your consent. Seems like a minor point, but it can be very important. You may have negotiated the best conversion terms or the most lucrative multiplier in the event of a change of control, but if your note can be prepaid without your express approval, you stand to lose your negotiated upside and have to settle for accrued interest instead, which is certainly not why you entered this high risk game in the first place.
Negative Covenants; Notice Rights. Do you have the right to weigh in on or veto certain acts of the company? For instance, if the company raises money at a low valuation or a small amount that does not trigger conversion, will you have a vote? What about if the company wants to acquire assets of another company (thus spending a lot of the cash it raised in the bridge financing)? Whether you should be entitled to consent rights depends on your investment amount. If you can’t negotiate for negative covenants, you may at least wish to ask to be notified prior to an action being taken. At least you will not be left out of the loop entirely. Unlike a company’s shareholders, note holders are not entitled to statutory notice rights. Therefore, bridge investors have to negotiate for their own notice rights, if those are important to them.

Of course, what we’ve covered here just brushes the tip of the iceberg, but I do hope you find it helpful.

Happy investing!

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.

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Tuesday, August 28, 2012

Legal Due Diligence: Investor’s Perspective

In the perfect world, anyone making an investment should retain highly qualified and specialized legal counsel to assist with the transaction. Attorneys that work on financings every day will know exactly how to approach the legal due diligence process and will be invaluable guides, scouring the company’s legal documents to protect the investor’s rights and pointing out to the investor any red flags and fixes.

However, we do not live in the perfect world, and some angel investors out there will consider their investment amount too small to engage legal counsel, and will venture out on their own.

If you are in that boat, you should at least conduct your own due diligence. At a bare minimum, there are 3 things you should request from the company in which you are investing, before you sign on the dotted line and before you initiate the wire (or write that check):

Charter Documents. A company’s charter documents are, depending on its jurisdiction of incorporation, its articles or certificate of incorporation and its bylaws. It is important to see charter documents to make sure that you are investing in a real corporation, not a corporation that the founders are planning on forming, and not in a general partnership or a limited liability company.
Cap Table. The cap table that you request should contain, in addition to the obvious, founder vesting schedules and all other convertible notes (or other convertible securities) of the company. (I’ve written about cap tables more extensively in a prior post.) If you are not sure how your convertible note converts into shares of the company’s stock and what percent of the company you stand to own, I would urge you even more strongly to consult an attorney.
IP Assignment. There are two types of inventions assignment agreements to looks for: one for pre- and one for post- formation.
- Most founders will begin generating intellectual property for their company before it is incorporated. Unless there is an agreement assigning all their inventions to the company, the inventions belong to the founders personally. Therefore, the first type of IP assignment agreement to look for is one assigning pre-formation IP to the company. Relatedly, if the company claims to have any patents and trademarks, check to see that they are registered in the name of the company. Many founders will forget to effectuate the transfer with the patent and trademark office, and this is something that should be done before your money goes in.
- Once a corporation is formed, there should be in place an inventions assignment agreement with each founder which covers all inventions developed by such founder during the life of the company. Usually, this is an agreement that goes with a consulting agreement or an offer letter, but because many companies are unfunded at the time of incorporation and the founders do not enter into consulting agreements or offer letters with themselves, at the very least a free-standing inventions assignment agreement should be in place.

Beyond the documents mentioned above, if the amount that you are investing is upwards of $100,000, I would strongly recommend having your counsel conduct full legal diligence review.

Happy investing!

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Sunday, August 26, 2012

Seed Financing: Equity or Debt?

Many early-stage companies that have succeeded in finding one or more interested seed investors are faced with a pleasant dilemma: should they document the initial investment as a bridge financing (or sale of convertible debt) or as an equity financing (or sale of shares in the company)? Let’s discuss some important factors to consider in making this decision. For more information about promissory notes, read my post dedicated to this topic.

Cost and Timing. The cost of documenting a middle-of-the-road bridge financing is generally going to be significantly lower than the cost of documenting a middle-of-the road equity financing.

The reason is that bridge financings, as the name suggests, are designed to tide a company over until it raises an equity round, and therefore, it leaves much of the negotiation and documentation of material terms to be done at the time of such equity round.

A very simple note financing (for $10,000 to $50,000) might entail just one document – a promissory note. On the other hand, in a preferred stock equity financing, at the very least an amended and restated certificate of incorporation is required, as well as a stock purchase agreement, and usually a shareholders agreement (or some combination of investors rights agreement, right of first refusal and co-sale agreement, and voting agreement).

A financing that requires less negotiation and fewer documents, can be completed on a shorter timeline. Therefore, on average, a bridge financing allows a company to take in money faster than an equity financing.

Control. Depending on the investor and the amount of the investment, a company may have to give up a measure of control when taking in capital. Control comes in several forms: control by equity holders and control at the board of directors level. A venture capitalist purchasing a significant stake in a company will usually require both, a board seat and special protective provisions that give him veto power as a shareholder over important company decisions. Even if special protective provisions are not negotiated, by law shareholders must approve certain decisions, which adds an administrative burden on the company.

A bridge financing for a small investment amount will generally allow a company to keep the most control. The founders will continue to control the entire board of directors, without having to add the bridge investor to the board. In addition, because a promissory note does not constitute a direct equity ownership and the holders of a promissory note do not become shareholders until the note converts, a company does not have to submit matters which require shareholder approval to the note holders.

Note, however, that a more sophisticated bridge financing, might include negative covenants, which would specify company acts or decisions which expressly require approval of the bridge investors irrespective of the fact that they are not shareholders. Bridge financings with a lower investment amount (< $100,000) will usually not include negative covenants.

Dilution. Before the first outside investment, founders amongst themselves own 100% of the company. With investment comes dilution—by issuing shares to the investors the founders’ share in the company decreases.

In the best-case scenario, using promissory notes will result in less dilution to the founders long-term than selling equity. In the worst, it will be the same. The determining factor, of course, is the company valuation. External factors like market conditions aside, and speaking for companies in the first several years from their formation, the later that a company is valued, the higher generally its valuation will be. In an equity financing, investors purchase shares based on a company’s valuation at the time of their investment. If the company isn’t very far along, doesn’t yet have a product, or has a product in beta and has not demonstrated traction, chances are its valuation will be low ($1,000,000 to $2,000,000) and even a small investment will significantly dilute the founders.

On the other hand, bridge investors are not purchasing shares at the time of their investment, and the number of shares that their investment will convert into will be determined based on the formula specified in the note. If a company can negotiate for the note principal and interest to convert into shares of the company’s preferred stock at a discount (of 15%-30%) of the price for such stock in the company’s next equity round, that will result in the least dilution for the company.

Many investors, however, will ask to cap the maximum valuation at which their notes will convert. In other words, even if a company’s first preferred stock financing is at a valuation of $10,000,000, if the bridge investors negotiated a valuation cap of $5,000,000 in their notes, their notes will convert into the number of shares equal to the (a) principal and accrued interest on the note, divided by (b) a price per share determined as (i) $5,000,000, divided by (ii) all of the shares of the Company outstanding at the time of the conversion.

The conversion cap has become an industry standard for even the smallest bridge financings. However, in my experience, the conversion cap does not generally reflect a company’s valuation at the time of the financing, but rather a valuation that’s somewhere midway between the valuation today and the expected valuation at the next equity financing. Therefore, even a promissory note with cap is frequently less dilutive than a priced seed equity round.

Is it any wonder that given how all these factors play out, convertible notes have become the standard investment tool for low-value seed-stage investments?!

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