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General Corporate Overviewfor Early-Stage StartupsPresented by: Inna Efimchik
Topics
• When is the right time to incorporate and
why
• What do investors look at in diligence
• Funding term sheets: vocabulary and trends
Incorporating Your Business
When is the right time to incorporate?• Co-founders
• Commitment
• Risk of liability
• VC or angel funding
What can happen if you don’t incorporate?Let’s Suppose:• you start with 2 other co-founders• you are saving $, so you don’t hire an attorney• you write out the terms of your “partnership” and everyone signs it
Personal Liability
Let’s Suppose:• you start with 2 other co-founders• you are saving $, so you don’t hire an attorney• you write out the terms of your “partnership” and everyone signs it
Scenario 1: on the way to aprospective customer meetinga co-founder is in a serious caraccident & injures a pedestrian
IP in Limbo
Let’s Suppose:• you start with 2 other co-founders• you are saving $, so you don’t hire an attorney• you write out the terms of your “partnership” and everyone signs it
Scenario 2: a co-founder takesa job at another company & plansto use the technology he has beendeveloping for that company
IP &/or Equity in Limbo
Let’s Suppose:• you start with 2 other co-founders• you are saving $, so you don’t hire an attorney• you write out the terms of your “partnership” and everyone signs it
Scenario 3: a co-founder decidesnot to pursue the venture any more;has a falling out with other co-founders
Corporate Advantage• Scenario 1: injured pedestrian could sue only the corporation, but not the co-founders personally
• Scenario 2: co-founder’s IP belongs to company
• Scenario 3: co-founder’s IP assigned to company; will keep small amount of vested shares; unvested shares repurchased for nominal $
Investors’ Due Diligence
Why is it important?• Sophisticated investors (VCs & super angels) take investing
seriously
• Their lawyers will conduct thorough legal due diligence
• Investors don’t like surprises
• They are conservative pattern-recognition experts
• Legal diligence review that unveils red flags can slow down or even jeopardize a financing altogether
What can be a “red flag”?• Founder equity not subject to vesting
• Founder equity vesting subject to acceleration
• Founder equity improperly granted (e.g. w/out board
approval)
• Biggest red flag: problems with IP (ownership/proper
assignment)
What do investors like to see in first-round legal diligence?• Delaware corporations – it’s a deep-seated bias of the VC
community
• Detailed cap table with a small number of stockholders
with properly issued shares subject to vesting; minimal dilution from other sources
• Board and stockholder actions that support the company’s
cap table
• Executed invention assignment agreements
• Clean ownership of core IP
Preparing for Diligence Review• If you maintain proper corporate records easy
• If you don’t maintain proper corporate records nightmare
• Corporate records are like health: much easier & cheaper to maintain than to “repair” later
• You can task your law firm with keeping your corporate records and responding to diligence requests
Term Sheets
Equity vs. Debt FinancingPreferred Stock Financing (Series A, Series B, etc.) – equity
• sell shares of the company to investors
• investors set valuation, which determines price per share
of Preferred Stock
Convertible Promissory Note Financing – debt (bridge
loan)
• company takes on debt
• debt converts into equity upon a funding event
Equity Financing Terms• Pre-Money Valuation – (arbitrary) $-amount set by the
investor based on similar companies & on % of company investor wishes to buy
• Post-Money Valuation – sum of pre-money valuation &
investment
• Dividends — usually 8%, non-cumulative, when, as and if
declared
• Liquidation Preference — investors’ proceeds on a sale of the company; can be 1x, 2x, etc., participating or non-participating
Equity Financing Terms• Redemption – investors’ option to require the company to
repurchase their shares after some number of years
• Qualified IPO – an IPO with aggregate proceeds & pre-
money valuation agreeable to investors; triggers automatic conversion of Preferred Stock into Common Stock
• Pay-to-Play — a mechanism whereby investors failing to participate in future rounds are penalized (by loss of rights)
Equity Financing Terms• Antidilution – a protection for investors in down-rounds,
which adjusts the number of shares of Common Stock into which their Preferred Stock convert; there are exclusions to this & it can be waived
• Protective Provisions – a category of matters deemed
especially significant by the investors, which requires a separate vote by Class or by Series
• Board of Directors — governing body of the company; investors will usually request a seat
Equity Financing Terms• Stock Option Pool – usually between 15 and 20% of the
company on a post-money basis; the reserve for employee equity compensation that investors request; delays dilution to investors as the company grows
• Right of First Refusal – one of two things: - right of Company to buy shares offered for sale by any founder; or - right of investors to buy any new shares offered by Company
• Co-Sale Right — right of investors to sell their shares when founders shares with the SEC (going public)
Debt Financing Terms• Interest rate – promissory notes bear interest because they
are debt instruments; interest can be converted or paid when shares convert
• Maturity date – usually the drop dead date; parties expect
that company will either raise equity funding or will go under prior to this date; no real expectation that the note will be repaid
• Security interest — protection for worst case scenario; debt holders with a security interest take priority for spoils over other debt holders in a bankruptcy or dissolution
Debt Financing Terms• Qualified financing – equity funding round with aggregate
proceeds agreeable to investors; note automatically converts into Preferred Stock
• Events of default – certain predefined events which will
cause the note to mature immediately (e.g., sale of the company); may have special repayment terms attached in event of sale of company
• Cap — maximum pre-money valuation at which note will convert into Preferred Stock; a reward for early-stage risk-taking
Summary• Incorporate when you are ready (with counsel that
understands startups)
• Maintain organized corporate records (or have counsel do it for
you)
• When the time comes to talk to investors, dazzle them with
your technology and streamline the financing by being on top of your game
• Understand the term sheet and, if you don’t, ask your lawyer
Thank you!