Startup Law for Entrepreneurs: Formation: Adam Dinow/General Assembly

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


LIMITED LIABILITY COMPANY (LLC)

CORPORATIONS LIMITED PARTNERSHIPS

LLC


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


S CORPORATION


Why doesn’t an S corporation structure work for a VC-backed startup?


C CORPORATION

Investors Employees Others

Optionees

CEO

VP VP VP VP VP

Other Employees

Shareholders

Board of Directors


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


Where to incorporate?


START-UP DOCUMENTS – 4 BUCKETS

1

Incorporation documents

2 3 4

Founder documents

Employee documents

Basic third party agreements


INCORPORATION DOCUMENTS

Certificate of Incorporation

By-laws Organizational minutes and resolutions


FOUNDER DOCUMENTS

IP Assignment Confidentiality Non-compete?


‣Restricted Stock Purchase Agreement‣Basic Tax Principles‣Vesting‣Acceleration Terms‣83(b) Elections

FOUNDER DOCUMENTS – FOUNDERS’ STOCK


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


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


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


FOUNDER DOCUMENTS – 83(B) ELECTIONS FOR FOUNDERS’ STOCK‣General Rule — Founders are taxed on FMV of shares as they vest‣Exception ‣File 83(b)!


EMPLOYEE DOCUMENTS

Offer letter Invention Assignment Agreement

Options


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”


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.


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)


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!


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”


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


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


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


EMPLOYEE DOCUMENTS – OPTIONS – NONSTATUTORY STOCK OPTIONS (NSOS)‣An NSO is any option that does not qualify as an ISO


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


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


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


CAPITALIZATION: PRACTICAL TIPS

2. Anticipate up to 50% dilution for first/second rounds‣Set aside approximately 20% for future employees in the early stage



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




‣[email protected]

ADAM DINOW

mailto:[email protected]



Startup Law for Entrepreneurs: Formation: Adam Dinow/General Assembly

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