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STARTUP LAW FOR ENTREPRENEURS: FORMATIONAdam Dinow, PartnerWilson Sonsini Goodrich & Rosati, PC
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AGENDA
‣Forming and Organizing the Startup‣Founders Stock‣Equity Incentives
STARTUP LAW FOR ENTREPRENEURS: FORMATION
CHOOSING THE FORM OF BUSINESS ENTITY
LIMITED LIABILITY COMPANY
S CORPORATION C CORPORATION
‣Combines features of both corporations and limited partnerships‣Corporate features: LLC members can
operate as managers; all owners have limited liability (i.e., only the amount of their investment) ‣Limited partnership tax features: No entity-
level tax—taxes pass through to LLC members‣Ownership interests of “members” are defined
and established in LLC operating agreement
STARTUP LAW FOR ENTREPRENEURS: FORMATION
LIMITED LIABILITY COMPANY (LLC)
CORPORATIONS LIMITED PARTNERSHIPS
LLC
STARTUP LAW FOR ENTREPRENEURS: FORMATION
Why doesn’t an LLC work for a VC-backed startup?
‣S corporation has board members/shareholders, etc.; but—‣Tax benefits and losses passed
through to the individual shareholders (i.e., a single level of taxation)‣Early stage start-ups will sometimes
take advantage of “S Corporation” status: losses get passed through to the owners
STARTUP LAW FOR ENTREPRENEURS: FORMATION
S CORPORATION
STARTUP LAW FOR ENTREPRENEURS: FORMATION
Why doesn’t an S corporation structure work for a VC-backed startup?
STARTUP LAW FOR ENTREPRENEURS: FORMATION
C CORPORATION
Investors Employees Others
Optionees
CEO
VP VP VP VP VP
Other Employees
Shareholders
Board of Directors
STARTUP LAW FOR ENTREPRENEURS: FORMATION
ATTRIBUTES OF A C CORPORATION‣Attributes of a C corporation‣Corporate governance‣No pass through of tax benefits‣VCs can invest in it; employees
can understand stock incentives
STARTUP LAW FOR ENTREPRENEURS: FORMATION
Where to incorporate?
STARTUP LAW FOR ENTREPRENEURS: FORMATION
START-UP DOCUMENTS – 4 BUCKETS
1
Incorporation documents
2 3 4
Founder documents
Employee documents
Basic third party agreements
STARTUP LAW FOR ENTREPRENEURS: FORMATION
INCORPORATION DOCUMENTS
Certificate of Incorporation
By-laws Organizational minutes and resolutions
STARTUP LAW FOR ENTREPRENEURS: FORMATION
FOUNDER DOCUMENTS
IP Assignment Confidentiality Non-compete?
STARTUP LAW FOR ENTREPRENEURS: FORMATION
‣Restricted Stock Purchase Agreement‣Basic Tax Principles‣Vesting‣Acceleration Terms‣83(b) Elections
FOUNDER DOCUMENTS – FOUNDERS’ STOCK
STARTUP LAW FOR ENTREPRENEURS: FORMATION
FOUNDER DOCUMENTS – FOUNDERS’ STOCK‣The first step in capitalizing
the startup‣Always common stock‣Typically issued in exchange
for technology, past services or nominal cash‣Usually issued at low value
STARTUP LAW FOR ENTREPRENEURS: FORMATION
FOUNDER DOCUMENTS – VESTING – WHAT IS IT?‣Concept that recipient does not “own” all shares when issued‣Vesting also can, and typically does, apply to Options‣Mechanics depend on type of grant (Restricted Stock versus Options)‣What are typical vesting provisions?‣Founders‣Employees
STARTUP LAW FOR ENTREPRENEURS: FORMATION
FOUNDER DOCUMENTS – ACCELERATION TERMS OF FOUNDERS’ STOCK‣Termination of employment‣“Cause” and “Good reason”‣Change of control ‣Single trigger vs. double trigger‣Also can apply to options
STARTUP LAW FOR ENTREPRENEURS: FORMATION
FOUNDER DOCUMENTS – 83(B) ELECTIONS FOR FOUNDERS’ STOCK‣General Rule — Founders are taxed on FMV of shares as they vest‣Exception ‣File 83(b)!
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS
Offer letter Invention Assignment Agreement
Options
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – WHAT IS AN OPTION?‣Right to buy Stock at a set price‣Typically granted to employees, board members, advisors and consultants‣ Issued through an “option plan”
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – STOCK PLANS‣“Stock plan” or “stock option plan” (these are synonymous)‣A stock plan is a formal written document approved by the board of directors
and the shareholders. ‣The stock plan establishes a “reserve” of stock.
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – ISSUING OPTIONS‣How boards have traditionally priced common stock in connection with
option grants/stock grants‣Every option grant/restricted stock grant has to be approved by the board,
and the board has to establish the stock price (i.e., FMV)
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – PROCESS FOR GRANTING OPTIONS‣Certificate of Incorporation and Bylaws‣Restrictions in other constituent documents (e.g. pre-emptive rights)‣Stock Plan‣Securities Laws consideration‣Corporate process‣ Issuing the agreement and maintaining good records‣Clean-up is costly so better to get it right the first time!
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – INCENTIVE STOCK OPTIONS (ISOS)‣An ISO is eligible for favorable tax treatment ‣Key Concepts:‣No tax at grant‣No tax at exercise (purchase)‣Unless alternative minimum tax (AMT) applies
‣Sale or other disposition triggers income‣Tax consequences differ depending on whether disposition is “qualifying” or
“disqualifying”
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – ISOS‣Applicable Holding Periods‣2 years from ISO grant AND‣1 year from ISO exercise (purchase)‣Meeting both of these holding periods results in a qualifying disposition‣Failure to meet either of these holding periods results in a disqualifying
disposition
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – ISOS — ALTERNATIVE MINIMUM TAX‣Exercise of ISOs may trigger AMT‣General Rule — “spread” at exercise is included in the calculation of AMT‣Paying AMT may generate tax credit against future years’ income tax
(as long as not subject to AMT)‣Goal to accelerate tax, not double tax
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – CHARACTERISTICS OF ISOS‣ ISOs must be granted pursuant to a written plan that:‣sets forth number of shares,‣states class of employees, and‣ is approved by majority of S/Hs within 12 months of Board Adoption
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – NONSTATUTORY STOCK OPTIONS (NSOS)‣An NSO is any option that does not qualify as an ISO
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – SECTION 409A‣Discount stock options are treated as a deferral of compensation under
Section 409A‣Stock options covering other than “service recipient stock” provide for a
deferral of compensation‣Only includes common stock (i.e., does not include preferred stock)‣Options in subsidiary stock potentially problematic
STARTUP LAW FOR ENTREPRENEURS: FORMATION
EMPLOYEE DOCUMENTS – OPTIONS – SECTION 409A‣Tax at time of vesting, not date of exercise‣ Potential interest penalty‣ Employers have reporting and withholding requirements
‣Form NDA‣Consulting Agreement
STARTUP LAW FOR ENTREPRENEURS: FORMATION
THIRD PARTY DOCUMENTS
1. Get the founders’ stock arrangements right!‣Make sure the founders are ok with their allocation‣Establish vesting schedule although the VCs may reverse it later‣“Buy/sell” arrangements are generally not necessary
STARTUP LAW FOR ENTREPRENEURS: FORMATION
CAPITALIZATION: PRACTICAL TIPS
2. Anticipate up to 50% dilution for first/second rounds‣Set aside approximately 20% for future employees in the early stage
STARTUP LAW FOR ENTREPRENEURS: FORMATION
CAPITALIZATION: PRACTICAL TIPS
3. Establish an overall financing strategy‣Create an incentive matrix for all positions in the organization‣Determine when you need to raise financing and how much‣Establish milestones that demonstrate viability/progress‣Expect 4-6 months process from beginning to receipt of funds
STARTUP LAW FOR ENTREPRENEURS: FORMATION
CAPITALIZATION: PRACTICAL TIPS
STARTUP LAW FOR ENTREPRENEURS: FORMATION
‣adinow@wsgr.com
ADAM DINOW
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