When launching a startup, you want to make and keep your startup as valuable as possible. In order to do that, you must ensure that
The following documents will accomplish this.
A Charter, which sets the number of stocks the startup authorizes and par value (the minimum amount of money stock can be sold for). Par value needs to be set very low so it's affordable for the founders and so you don't receive a huge tax bill from Delaware. More details on that in another blog post, but suffice it to say that it can be the difference between an annual tax bill in the hundreds or tens of thousands.
Bylaws, a legal document that determines the rules and regulations for the startup's internal management. Who gets to vote? How are board resolutions passed? How are officers elected? Startups often fail to draft bylaws, as they do not have to be submitted to the secretary of state, but they should not be overlooked. I've seen these seemingly small details lead to major disputes down the line.
Stock Purchase Agreements, which issue equity shares to the founders and should include a vesting schedule. I'll detail why and how shares should be vested in another post, but it's basically to keep founders with the company and motivated. VCs don't like to invest in companies who've lost a substantial number of shares.
Shareholders Agreement, which covers a shareholder’s right to transfer his or her shares, rights of first refusal, and redemptions upon death or disability. This is another document that's often overlooked but is vital to avoid disputes in the future.
Technology Assignment Agreements, which transfer ownership of intellectual property that was developed before incorporation to the startup.
Confidential Information and Inventions Assignment Agreements, which broadly assigns anything related to the venture to the company (domain names, business plans, etc.) and contains nondisclosure obligations and non-solicit obligations.
Employment Letters, which set the terms of employment for each co-founder. Again, often overlooked, but important to set the tone and manage expectations of each co-founder.
The first meeting of your corporation! Equity shares will be issued and the Board will be elected.
This meeting should take place soon after the effective date of your certificate of incorporation. Important things to cover include
Prepare forms for minutes and share certificates before the meeting so they can be signed.
The share certificates are usually issued at the end of the meeting, but in some cases, such as when a prospective shareholder does not yet have money to pay for them, they are issued when paid for.
An inventions assignment is an agreement where a founder or developer assigns intellectual property created pre-incorporation over to the startup. In an inventions assignment, the founder or developer will acknowledge that all IP developed solely or jointly with the other co-founders or developers is the property of the startup and not owned by the individual.
Inventions Assignments should also be used when hiring to ensure that any IP developed is the property of the startup.
Preferred stock is most commonly issued when a startup receives VC funding. Preferred stock provides certain economic and control rights and protections not given to the holders of common stock. Founders may also be issued preferred stock, but it's not as common and may not be advisable.
Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with voting issues and electing the board of directors.
Other than the Capital Raised, Does the Startup Benefit from the Issuance of Preferred Stock?
Yes. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.
Preferred Stock For Founders: Dual Stock & Series FF
The usual method to create super-voting rights for a founder is to implement a dual class common stock structure, generally the “Class A” and the “Class B”. The Class A and Class B will be identical economically, but the Class A comes with 10 votes per share, whereas Class B is 1 vote per share. During formation, one or more of the founders would be issued Class A Common Stock, and everyone else such as employees, advisors, consultants would receive the Class B Common Stock.
Benefits of the Dual Class Structure
The Benefit of the dual class structure is that the founders can maintain control of the startup as the company grows while still holding a smaller percentage of the company. As you know, founders generally put their blood, sweat, and tears into their startup and the thought of losing control doesn't seem fair; however, the dual class structure can be a potential red flag to investors.
Potential Red Flag?
A dual class structure has a bit of a bad reputation in Silicon Valley. It signals ego and investors avoid startups where founders are perceived as having ego problems. We usually advise our clients not to implement a dual class structure unless they are a very “hot” startup or have a good track record with investors. If you've already implemented dual stock, don't worry it can be amended.
An option pool is an amount of a startup’s common stock reserved to issue in the future to employees, directors, advisors, and consultants.
Via a written plan, a startup pre-authorizes a certain amount of the company’s common stock which will be issued by the plan’s administrator (usually the startup’s board of directors or a committee selected by the board). For example, if the startup has 5 million shares of common stock outstanding, it may elect to authorize 1 million shares to be issued pursuant to the plan.
Keep in mind that a startup’s original option pool will likely not be the last option pool the startup creates. The size of the option pool is typically negotiated at each round of financing, since at that time, the startup will likely need additional equity options to attract and motivate future hires.
A buy-sell agreement, also known as a buyout agreement, sets forth what will happen if one of the co-owners of a company leaves the company for any reason, including death. There are two main types of buy-sell agreements: the cross-purchase plan and the stock redemption plan. I generally recommend a stock redemption plan.
Every company with more than one owner needs a buy-sell agreement. These agreements set a strike price in advance for the departing shareholder’s stock, create a market for the business interest (which can be difficult with closely held corporations) and assure business continuity for the remaining active owners, employees, customers, and creditors.
The two main types of buy-sell agreements are the cross-purchase plan and the stock redemption plan. Under a cross-purchase plan, each company shareholder agrees in advance to buy the shares of the withdrawing shareholder while the withdrawing shareholder agrees to sell his or her shares to the remaining shareholders. The corporation is not involved in the transaction.
Under a stock redemption plan, the corporation redeems the shares of the withdrawing stockholder.
Both types of plans cover:
Both cross-purchase and stock redemption plans are generally funded by life insurance policies. In a stock redemption plan, the corporation purchases one policy for each shareholder. In a cross-purchase, plan each shareholder buys a life insurance policy on the life of every other shareholder, pays the premiums out of their own pocket and is the policy’s beneficiary. For example, if a company had 7 shareholders, 42 life insurance policies would need to be purchased.
Due to the extra administrative burden of cross-purchase plans, the out of pocket cost for shareholders, and the potential for unequal insurance costs due to individual health and age, I generally recommend a stock redemption plan. But as always, this is general advice. Each company’s situation is going to be unique and there is no one-size-fits-all method. Factors such as the number of shareholders, their relative ages, available personal funds, company valuation, insurability, taxation and the events that mandate shareholder withdrawal must all be considered in crafting your company’s buy-sell agreement.
Convertible equity is similar to a convertible note, but convertible equity is not debt. Like convertible debt, convertible equity usually has the terms of a price cap and a discount, but there’s no interest or maturity date. The most common form of convertible equity is the “SAFE”.
The SAFE (Simple Agreement for Future Equity) was originated by Y Combinator and tends to be one of the most startup-favorable ways to finance a seed round.
Convertible debt is a type of security frequently issued by startups when raising capital in their seed round. The debt converts to equity at the Series A round, where the seed investors receive equity at a discounted rate.
With convertible debt, the startup issues the seed investor a promissory note, for the investment amount, that contains a conversion feature. The conversion feature is the mechanism by which the debt (the promissory note) will convert to equity (new shares for the investor) upon various future events.
Most (if not all) convertible promissory notes contain an automatic conversion clause that dictates the automatic conversion of the convertible debt upon a “qualified financing.” The qualified financing is typically defined as an equity financing by the startup, in which $1,000,000 is raised. (The exact amount can vary by deal, but its typically 1 million.) Thus, the qualified financing event is the trigger by which the convertible debt will automatically convert to equity. The conversion is considered automatic because it does not require the vote of either the startup or the investor.
The convertible debt held by the investor will convert to qualified securities in the Series A round. The amount of shares of the qualified securities issued to the convertible debt investor is dependent on the conversion discount per the terms of the convertible promissory note.
The Discount or Price Cap
Because investors at the seed round are making a riskier investment, convertible promissory notes have a conversion discount feature by which the convertible debt holder will exchange the debt for qualified securities at a price per share equal to 80% (this amount can also vary per deal) of the price per share paid by the qualified financing investors (the Series A investors).
Angel invests $100,000 in Startup.
Startup issues Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 with a conversion discount equal to 20%.
Startup closes $1,000,000 Series A Preferred Stock round by a VC at a Series A Preferred Stock price of $1.00 per share.
Since the Automatic Conversion feature in Angel’s convertible promissory note is triggered by the Series A round, Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.
Startup issues Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is canceled.
Alternatively, convertible notes offer the seed investor a “price cap” which is the maximum valuation that their investment will convert into shares.
For example, if a price cap is set at $5,000,000, no matter how high the startup's valuation grows between the time of investment and qualified financing, the money invested will convert into shares at no higher than a $5,00,000 valuation. This often results in a savings of more than 20% for the original investors.
* Since this post was written, there have been laws enacted in several states strictly limiting who can be classified as an Independent Contractor. *
You should have a written agreement with everyone who works for you to avoid disputes regarding service terms, IP ownership, equity shares, and other matters.
The classification of employee, contractor, or intern comes with significant tax and liability ramifications. While an agreement alone will not eliminate the risk of misclassification, it can help. Therefore, it is important to use forms appropriately. For example, using a standard employee confidentiality and inventions assignment agreement for an intern or an independent contractor could support a determination that the service provider was misclassified and should have been provided the benefits of an employee.
All employees, including founders and other executives, should sign some sort of employment agreement. Most start-ups use two-page offer letters – as long as all key terms are included. For more complex hires, these same form letters can be tailored to include more detailed terms.
Confidentiality and Inventions Assignment Agreements
It is essential that every employee (including founders and other executives) sign a Confidential Information and Inventions Assignment Agreement (also known as Proprietary Information and Inventions Assignment Agreements). One form of this agreement can be used for all employee hires in each state. Companies might need or want to modify the forms for employees in different states, based on those states’ laws and regulations. For example, some states require very specific language in order for an employer to have an effective assignment of IP rights. In addition, certain states allow broad post-employment restrictive covenants, such as non-competition and/or non-solicitation provisions, while others do not. Note, these regulations are based upon the state where the employee is working, not the state where the company is incorporated.
For Independent Contractors
All contractors and consultants should sign independent contractor agreements. The agreement is different from, and often more complex then, the employee offer letter, and should include confidential information and invention assignment provisions similar to those used with employees. We recommend that companies have different forms of such agreements for different types of contractors (for example, technical versus non-technical consultants) in order to avoid complicated legal agreements for those consultants or advisors who will not play a role in creating intellectual property.
Whether paid or unpaid, interns should also sign a service agreement. If they are working on intellectual property, the agreement must include confidential information and inventions assignment provisions.
Minimum Wage Laws
Startups often do not pay cash to founders and early executives and such arrangements generally violate state and federal minimum wage laws. The liability can be significant and can affect funding down the line.
A non-disclosure agreement (NDA) is an agreement where a third-party agrees to protect your startup’s confidential information from disclosure to other parties. Anyone working on your startup's IP should sign one. It is not common practice for investors to be presented with an NDA.
If an investor maintained the practice of signing an NDA for each submission they received, they would have to retain a team of lawyers to keep track of them. This would increase transaction costs greatly and potentially prevent an investor from even hearing your pitch.
Non-Disclosure Agreements can be mutual or unilateral. A Mutual NDA protects the confidential information of both parties to the contract, while a Unilateral NDA only protects one party.
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