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!
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
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5. OVERVIEW
§ Clean break from your current employer
§ Choice of legal entity
§ Why and where to incorporate
§ Conventional capital structure
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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
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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.”
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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
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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
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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
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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
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12. CHOICE OF LEGAL ENTITY
§ Limited liability companies
§ Corporations
§ Tax status
§ Limitations for S-corporations
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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
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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
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15. CONVENTIONAL CAPITAL STRUCTURE
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§ 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. 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
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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
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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)
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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
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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
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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
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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
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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
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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)
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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)
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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
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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
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28. THANK YOU
For Further Questions Please Contact:
Stan Lewandowski
Partner, K&L Gates LLP
(650) 798-6743
E-mail: stan.lewandowski@klgates.com
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