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!