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How to Split Founders' Equity

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Splitting equity among founders, team members, and other parties can often be a challenging process fraught with pitfalls for many startups.

The speaker will discuss the following issues:

1) the different types of shares available for issuance to founders and rights associated with such shares

2) the issues most commonly taken into account in connection with allocation of equity among the founding team

3) the common mistakes made by founders at the equity allocation stage and best practices for founders to follow at the entity formation stage

and more!

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How to Split Founders' Equity

  1. 1. © Copyright 2017 by K&L Gates LLP. All rights reserved. Presented by Stan Lewandowski stan.lewandowski@klgates.com 650.798.6743 February 16, 2017 Silicon Valley Startup: Idea to IPO How to Split Founders' Equity
  2. 2. These materials have been prepared solely for educational purposes. The presentation of these materials does not establish any form of attorney-client relationship with the author or K&L Gates. Particular legal issues should be addressed through consultation with your own legal counsel, not by reliance on this presentation or these materials. Attorney Advertising. Prior results do not guarantee a similar outcome. © K&L Gates LLP 2017. Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, please be advised that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed within. klgates.com 2
  3. 3. 3
  4. 4. INTRODUCTIONS § Stan Lewandowski, Esq., Partner (Emerging Growth/Corporate/Energy/M&A Lawyer) § Works primarily in the Silicon Valley and SF offices of K&L Gates in Palo Alto § Advises start-ups and emerging growth companies primiarily on optimal legal entity selection and initial structuring issues, angel and venture financings, licensing, strategic relationships and M&A matters klgates.com 4
  5. 5. OVERVIEW § Clean break from your current employer § Choice of legal entity § Why and where to incorporate § Conventional capital structure 5
  6. 6. OVERVIEW § Types of shares for founders and associated rights § Common issues considered by founders when allocating equity among the founding team § Common mistakes made at equity allocation stage and best practices for founders to follow at entity formation stage 6
  7. 7. AVOID AN INTELLECTUAL PROPERTY TAINT – CALIFORNIA LABOR CODE 2870 § “Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall NOT apply to an invention that the employee developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information EXCEPT for those inventions that either: 1. Relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or 2. Result from any work performed by the employee for the employer.” klgates.com 7
  8. 8. WHAT ARE THE IMPLICATIONS? § Will be tested in due diligence in a financing; employee has burden of proof § Covers employer’s scope of business not just your job scope § There is no time limit on the prohibition on using the employer’s trade secrets klgates.com 8
  9. 9. WHAT ARE THE IMPLICATIONS? § Working completely outside an employer’s premises and not using an employer’s resources is not enough to avoid a taint § Overlapping employment (“moonlighting”) by a founder § Does not apply to general skills or knowledge but issue is where is the dividing line klgates.com 9
  10. 10. AVOID DOING THE FOLLOWING (ASSUMING SAME SPACE) § Any overlap in employment § Filing a provisional (or utility) patent application a few days after you leave your old company § Assigning IP and technology to purchase your shares in the new company klgates.com 10
  11. 11. AVOID DOING THE FOLLOWING (ASSUMING SAME SPACE) § Reducing any ideas about a possible invention to any tangible medium while at your prior company § Developing the product in the new company at “super human” speed § Taking anything from your prior employer even paper clips klgates.com 11
  12. 12. CHOICE OF LEGAL ENTITY § Limited liability companies § Corporations § Tax status § Limitations for S-corporations klgates.com 12
  13. 13. WHY AND WHERE TO INCORPORATE § Most start-ups seeking investment incorporate § Investor requirement and comfort § Enables use of stock options for service providers § Corporation can be acquired tax-free with stock (LLC cannot) § Corporations are the best vehicle for going public klgates.com 13
  14. 14. WHY AND WHERE TO INCORPORATE § Incorporation requires more than filing certificate of incorporation § No one owns the corporation unless shares are purchased § When to incorporate? § Document founders ownership § Receive investment § Take actions that could create liability § Sign first customer contract or even a NDA § Grant stock options to “pay” for development services klgates.com 14
  15. 15. CONVENTIONAL CAPITAL STRUCTURE klgates.com 15 § Keep it simple and conventional § Fully diluted concept: outstanding shares + outstanding options + option reserve Outstanding Authorized or Reserved ______________________________________________ Common Stock 10M 3-5M Founders 1-2M Stock Option Plan
  16. 16. CONVENTIONAL CAPITAL STRUCTURE § Fully-diluted is 5M shares § Founders own 100% of the company on an outstanding share basis and 80% of the company on a fully-diluted basis klgates.com 16
  17. 17. TYPES OF SHARES FOR FOUNDERS § Types of common stock shares § Class A common stock (sometimes referred to as Class E, F, etc.) § Class B common stock klgates.com 17
  18. 18. TYPES OF SHARES FOR FOUNDERS § Class A common stock (sometimes referred to as Class E, F, etc.) § Voting privileges - more than 1 vote per share rights § Right to approve certain corporate acts § Amend the charter or bylaws § Change the size of the board of directors § Create new classes or series of capital stock § Liquidate, merge or consolidate the company § Right to elect board members (by separate vote) klgates.com 18
  19. 19. TYPES OF SHARES FOR FOUNDERS § Class B common stock § 1 vote per share § No “special” rights § Class A common stock converts into it at any time at hte option of the holder klgates.com 19
  20. 20. TYPES OF SHARES FOR FOUNDERS § Founder’s “Liquidity Shares” § What type of shares should be used? § Class A common or new series of preferred stock? § Regulatory issues for venture funds (NQ investments) § Redemption by company klgates.com 20
  21. 21. COMMON ISSUES CONSIDERED BY FOUNDERS WHEN ALLOCATING EQUITY § When to issue founders’ shares § What percentage of company equity will a founder receive § What consideration may be used to pay for such shares § What vesting schedule should be used for founders’ shares § 83(b) election notice § Accelerated vesting of founders’ shares klgates.com 21
  22. 22. FOUNDERS’ SHARES ALLOCATION AND PURCHASE § 3-5M shares of common stock § Number depends on number of founders § Common stock at a nominal price – timing § Payment is by cash, assignment of technology or other property. Need to purchase shares in order to own the company § Company must own its technology and intellectual property klgates.com 22
  23. 23. FOUNDERS’ VESTING ISSUES § What is stock vesting? § Right to repurchase shares, at original purchase price, on termination, that lapses over time § Right is exercisable if founder stops providing services to the company § 83(b) filing/consequences – within 30 days after purchase § Why impose vesting pre-financing? § Provides incentive for founder to continue to provide services to the company § Avoids “free-rider” problem if a founder leaves klgates.com 23
  24. 24. FOUNDERS’ VESTING ISSUES § How much vesting up front for founders? § Work done in past § Value of intellectual property/other contributions § Stickiness – most important factor § Time vesting § 3 or 4 years § Cliff, no cliff (cliff is more common) § Monthly, quarterly, annually after the cliff (monthly after the cliff is more common) klgates.com 24
  25. 25. FOUNDERS’ VESTING ISSUES § Vesting acceleration for founders – set up at founding in SPAs § Trigger events □ Upon termination without “cause” or for “good reason” (outside of an acquisition) □ Acquisition of the company with “double trigger” on acquisition – stickiness § What is a “double trigger”? □ Trigger One - Company acquired □ Trigger Two – Termination within 12 months (or other period) klgates.com 25
  26. 26. COMMON MISTAKES AT EQUITY ALLOCATION STAGE & BEST PRACTICES § Delaying issuance of founders stock after incorporation § Non-payment for founders’ shares § Lack of vesting § Non-compliance with applicable securities and tax laws § Oral rather than written agreements related to equity allocation klgates.com 26
  27. 27. COMMON MISTAKES AT EQUITY ALLOCATION STAGE & BEST PRACTICES § Issue founder’s stock early § Keep it cheap § Have vesting and vesting acceleration for founders § Get intellectual property into the company early on § Adopt a stock option plan at the time of incorporation § “Currency” for service providers § Compliance with federal and state securities and tax laws § 409A valuation klgates.com 27
  28. 28. THANK YOU For Further Questions Please Contact: Stan Lewandowski Partner, K&L Gates LLP (650) 798-6743 E-mail: stan.lewandowski@klgates.com klgates.com 28

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