Acceleration: What All Entrepreneurs Must Know About Startup Law
By Ryan Roberts
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About this ebook
But now there's help. In Acceleration, corporate attorney Ryan Roberts guides you through the often confusing early legal decisions critical to getting a startup going. In plain, comprehensible English, he offers expert advice, best practices, strategies, and all the information you need to incorporate, issue and divide equity, decipher seed and venture capital investments, and much more.
Startup law doesn't have to be a confusing maze. The practical knowledge in this invaluable volume will help you make the smart decisions to protect your company and its future.
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Book preview
Acceleration - Ryan Roberts
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Copyright © 2019 Ryan Roberts
All rights reserved.
ISBN: 978-1-5445-1340-9
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To all entrepreneurs, in the words of Tupac Amaru Shakur and/or Alfred Adler, Follow your heart, but take your brain with you.
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Contents
Disclaimer
Introduction
Part One: Entity
1. Forming a Startup Company
Why Incorporate?
When to Incorporate?
Which Is the Best Legal Entity for a Startup?
What about Double Taxation?
Which State Should My Startup Incorporate In?
How to Incorporate?
What Documents Are Included in the Incorporation Process for a True
Startup?
Naming the Corporation
What Is a Registered Agent?
What Is a Foreign Registration?
2. Structuring Your Company
Bylaws
The Board of Directors
The Officers
Officer Titles
Authorized Shares
Par Value
Equity
Types of Stock at Incorporation
Dual-Class Common Stock
Series FF Preferred Stock
How Many Shares to Issue at Incorporation
Initial Board Consent
Should a Startup Have a Shareholders’ Agreement?
Should Founders License Their IP to the Startup?
Special Issues with CIIAAs
3. Equity Issues
Vesting
Vesting Schedules
Acceleration of Vesting Schedules
What Is the Repurchase Price of Unvested Stock?
The Difference between Vesting Options and Vesting Stock
Dividing Equity among Cofounders
Is the Majority Shareholder the King
of the Startup?
What Should Be the Purchase Price of the Founder’s Stock?
How Should Additional Cash Contributions by Founder(s) Be Captured?
Part Two: People
4. Founder Dynamics
What Makes a Good Cofounder?
Verify Credentials
Verify Existing Obligations
Family and Friends (as Cofounders)
Difficult Conversations
Cofounders and Co-Contributions
The Runway
Navigating Cofounder Breakups
Can Startups Outsource Founder Talent?
5. First Hires
Employees vs. Contractors
Avoiding the Employee Nightmare Situation
Hiring Family
What to Include in Employment Contracts
Employees and Equity
How Much Equity Should Employees Receive?
Employee Vesting Schedules
Types of Equity Incentives
The Option Pool
ISOs or NSOs
Selected Issues in a Stock Plan
When Is Stock or Stock Options Used?
Equity Incentive Agreements
Terminating Employees
6. Mentors and Advisors
The Advisor Relationship
What to Look for When Selecting an Advisor
Forget Closing Investment Deals
Red Flags with Advisors/Mentors
Creating an Advisory Board
Size of the Advisory Board
Board of Advisors vs. Board of Directors
Advisor Agreement
Granting Stock or Options to Advisors
Additional Provisions in an Advisor Agreement
Advisors as Investors
Finders Are Losers
Advisor Exit Strategies
Part Three: Investment
7. Accelerators
Finding the Right Accelerator Fit
Evaluate Equity
Reviewing Documents
How an Accelerator Is like a Startup Gym
Caution: Accelerators Triggering Cofounder Breakups
Raising Money before Pitch Day
8. Seed Round
When Should the Seed Round Take Place?
What Should the Financing Round Be Called?
How Much Should Your Startup Raise?
How Many Seed Investors Should a Startup Have?
Investors and Nondisclosure Agreements
Seed Round Structures
Convertible Note
The Discount
The Price Cap
Convertible Equity
What Happens If Your Startup Raises an Equity Round That Doesn’t Qualify as a QEF and Your Startup Has Convertible Debt or Convertible Equity Outstanding?
What Happens at the Maturity Date of a Convertible Note?
What Happens if You Sell Your Startup with Outstanding Convertible Notes or Convertible Equity?
How Many Convertible Rounds Should a Startup Have?
Preferred Stock
Economic Terms
Valuation
Determining Valuation
Liquidation Preference
Anti-Dilution Protection
Dividends
Redemption
Control Terms
Board Seats
Protective Provisions
Covenants
How Does a Startup Analyze Investment Structures?
Investor’s Perspective
Legal Documents Typically Used for the Seed Round
Bad Terms to Watch for in a Seed Round
Don’t Agree to Non-Dilution Rights
Don’t Agree to Pay Dividends
Don’t Agree to Give Up Control
Don’t Make a Personal Guarantee
Don’t Agree to a Multiple Liquidation Preference (Unless The Lights Are About to Go Off)
Accepting Bad Terms
Who Drafts the Term Sheet and Documents for the Seed Round?
When Investors Back Out by Adding Draconian Terms
9. Venture Capital
When to Actively Pursue a VC Round
Always Be in VC Mode
Time to Close: Seed Rounds vs. Venture Capital Rounds
What Is Due Diligence?
What Happens to Investors from Your Seed Round?
Assessing Multiple VC Offers
Check the Deal Flow
Who Drafts the Term Sheet and the Deal Documents?
What Is Term-Sheet Purgatory and How Does a Startup Get Out?
Receiving a Term Sheet
If a Term Sheet Is Nonbinding, Why Can’t We Renegotiate the Terms?
The Pro Forma
What Documents Comprise the Entire Venture Capital Financing Process?
Main Transaction Documents
Ancillary Documents
PDF Closing Binder
Stock Certificates
The Composition of the Board: Seed Rounds vs. Venture Capital Rounds
Protective Provisions: Seed Rounds vs. Venture Capital Rounds
Covenants: Seed Rounds vs. Venture Capital Rounds
Introduction of the Right of First Refusal and Right of Co-Sale Agreement
Economic Terms: Seed Rounds vs. Venture Capital Rounds
Control Terms: Seed Rounds vs. Venture Capital Rounds
A Special Note on Pro Rata Rights
Corporate VCs: When an Investor Could Become a Competitor
10. Securities Law Overview
The Securities Act of 1933
Consequences of Not Complying with the Securities Laws
What Is a Security?
Exemptions from Registration
Section 4(a)(2)
Regulation D
Rule 506(b)
Rule 506(c)
Rule 504
Rule 701
Regulation S
Regulation Crowdfunding
Regulation A+
Blue Sky Laws
Integration
Bad Actor
Disqualification
Resale of Restricted Securities
Conclusion
About the Author
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Disclaimer
The material in this book is for educational purposes only. This book is sold to you with the understanding that neither the author nor publisher of this book is rendering legal, accounting, tax, or investment advice and services of any kind. The author and publisher, including any and all of their affiliates, do not assume any liability for damages of any kind, including loss of profit or any type of special, incidental, consequential or other damages, any errors or omissions or for any consequences resulting indirectly from your use of this book, nor do they make any representations or warranties with respect to the accuracy of completeness of the material contained in this book. For legal, accounting, tax, or investment advice, please consult with the appropriate professional about your particular situation, as the content may not be suitable for your particular situation. The views expressed by the author of this book may not reflect the views shared by the company or firm the author is employed by at the time of publishing or in the future.
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Introduction
Let’s face it, founding a startup is a totally irrational decision. Most people opt to start a career, climb the corporate ladder, then stay as high as they can be eking out a comfortable and rather stable existence. When you choose the startup path, you’re making a commitment to low pay, all-nighters, and doing whatever it takes to achieve success against all odds. As a founder, you’re bombarded by an ever-growing list of to-dos while trying to accomplish an insane number of tasks, all simultaneously. From building a product or prototype to snagging those first few customers to hustling to cobble together financing, who has time for the legal aspects, right?
Just the founders who want to be successful or cross the finish line, that’s who.
The legal aspects impact all your decisions, and if you get those decisions wrong, it creates a headache over lost revenue or time, or worse, a heartbreak over lost venture capital financings or acquisitions. Some founders believe there is no such thing as a shortcut; they must sacrifice and endure the pain of making the wrong legal decisions. That’s how we learn, isn’t it, through trial and error?
What if I told you there’s another way to learn? That you do not have to make potential million-dollar mistakes in order to understand the legal ins and outs of starting a business? Not only does this path exist, but I’m also going to show you how to avoid the common legal pitfalls that ensnare many founders.
As a startup lawyer, I work as a hands-on advisor to my clients, helping them understand and navigate all phases of the growth process from incorporation to seed financing to venture capital financing to a liquidity event such as an acquisition. In the last decade, I’ve helped my clients, which include high-growth companies and venture capitalists, close more than $500 million in transactions from seed rounds to Series A, B, C, and D rounds. I’ve represented more than 1,000 clients in places like California, Texas, New York, India, Australia, the European Union, and the Middle East.
Statistically, I have most likely seen everything.
I know, you may roll your eyes when you read the word lawyer. It likely dredges up images of someone wearing an expensive suit, sitting behind a big desk in a stuffy-looking office, and speaking in legalese that only other lawyers can decipher—in-between squash games with other similar lawyers, of course.
Take that image and burn it. I’m not that type of lawyer, and while this book gives you an inside look at how to protect your company, and yourself, from unintentional, self-inflicted legal wounds, my goal is to do it in a way that anyone without a law degree can understand. While this book is geared toward first- and second-time startup entrepreneurs, it’s a great refresher for seasoned entrepreneurs, too.
No Two Startups Are the Same, but Their Legal Paths Are
Before prospective clients even step into my office, I already know a few things about them and their startups. I know that they have a tight budget, that they’ve worked hard to get where they are and will continue to work hard, and that they have to make a lot of important decisions relatively quickly.
I also know that success, and its definition, varies from founder to founder.
Some measure it in the monetary heights they climb. For others, it’s about impact and influence. The founders I work with have different personalities and aspirations. Some founders like forging their own path and being their own boss. Others want to see how far their technology can take them, or how far they can take their technology.
Some are trying to give back to their communities or the people who have supported them throughout the years. I remember working with one cofounding team at the very beginning of their startup’s founding, at a time when they had no money. I’m talking dead broke. Four years later, the cofounders sold the company, and the first thing one of them did was pay off his mother’s house and other debts.
While no two prospective clients and their companies are alike, they do share one similarity—the legal path they will tend to follow. The vast majority of startups should follow the same legal path, unless there is a compelling reason to deviate from what some might call market
or standard
approaches. But it’s tough to know when your startup has to deviate. Thus, a standard approach is where to start and also where to fall back on when you aren’t sure.
What You Will Find in This Book
In the dynamic startup environment, founders have to make rapid decisions, yet simultaneously have the patience to await the results. In my work, I’ve observed three types of founders. There’s the founder who doesn’t care that much about the legal decisions, so he makes rash ones for the sake of speed. He makes decisions so fast, without contemplating any consequences that he hurts the company in the process.
Then there’s the founder who cares so much that he obsesses over any legal decision. He needs as much information as possible; he needs to talk to everyone he can to get their input, and then he has to sit and think through all his options. This takes so long that he puts his startup in a literal holding pattern. He puts off making decisions for weeks, sometimes months. He too, hurts his company in the process.
Both of these founders display what I call analysis paralysis.
One cares too little; the other cares too much, and both put off making critical decisions for their startups.
There is the third type of founder, though. This person has attained a balance. She cares about the legal decisions, but not so much that she cannot decide. She makes decisions at a prudent pace, while understanding their short- and long-term implications.
Guess which type of founder this book encourages? If you guessed the third type, you’re spot-on. I want you to care about the legal decisions you must make for your company but without becoming paralyzed from making them. I want you to be thoughtful and to understand the choices you will be asked to make. I want to help you understand the why that you’ll face. I’ve found that when founders understand the why behind their decisions, then they can make those decisions faster and with more confidence, benefiting their startup with a solid legal foundation.
Think of this book as your practical legal guide that will give you the basic information you need to navigate the thorny issues of creating and then protecting your startup. In the coming chapters, my goal is to offer insight into some of the big legal milestone events that many startups share at the very earliest stage. The early days of a startup are where the wild, wild west occurs. Many founders shrug off following the prescribed legal path to blaze their own trail—only to find later that their mistakes cost them dearly. The early decisions, such as what state to incorporate, how to divide equity, attracting top talent, choosing a board of directors, and even selecting mentors, are critical to getting you to the bright lights of a Series A financing round and, perhaps, to the holy grail of a liquidity event.
I’ve broken the top legal aspects that you need to watch for into three parts: Entity, People, and Investments. You may not be at the beginning, but this is a typical chronological journey that most founders take and you can really jump in anywhere.
In part 1, Entity,
we look at why and how to officially create a corporate entity, what documents should be produced, how to structure the entity, and how to issue stock and create vesting schedules. Many founders place these tasks low on their to-do lists, but if you get them done sooner and right rather than later and wrong, then you’re setting up your company for a far smoother experience when you get to the first financing round.
In part 2, People,
we dive deeply into the founding team, the early hires, and the mentors and advisors whom you’ll likely encounter as you work to grow your startup. Many founders focus so hard on building a great product or service and getting it to their customers that they forget to pay close attention to the personal dynamics of their team—the engine that’s building the startup. But if you ignore the personal dynamics, it could haunt you down the road. From a legal perspective, there are absolutely steps you can take to reduce your risk and legal liabilities if these relationships don’t work out.
Finally, in part 3, Investment,
we look at the financing transactions that you may encounter on your quest to build a successful startup company. I’ll walk you through the different investors such as accelerators, and how seed and venture capital rounds work.
In many ways, the advice in this book is everything I wish I had known or had access to as a college student just starting my own fledging company. And it’s everything that I try to instill into my clients from the moment they walk into my office. While it is true that there are always exceptions to the rule, the general rules and guidelines I detail in this book are based on the experiences of thousands of clients.
This Is Your Journey
I love helping founders to navigate the pitfalls and peaks of starting a company, working to grow it, and making it to the hallowed grounds of financing rounds and, if they’re lucky, a successful exit. It is truly a wild and crazy journey, one where success is never guaranteed. Startup lawyers are not an almighty force, without whose guidance you will fail—nor with whom will your success be guaranteed. But legal work is an inevitable part of a startup’s life cycle—one you cannot ignore or obsess over.
When I started my company, I had no idea what to expect, and I see that same surprise, excitement, and trepidation in the eyes of the founders whom I work with today. Hopefully, the advice and anecdotes in this book will allow you to skip over having to learn the lessons yourself through pain and error. The legal side of running your company doesn’t have to be something you fear, ignore, or obsess over. With a little sound advice, you can avoid the common pitfalls that trip up many founders, and instead, give your startup a better chance to succeed.
As you read this book, it may be helpful to visit my blog, startuplawyer.com. It contains a startup law glossary with definitions and examples of some of the legal terms and other startup lingo you’ll find in coming chapters.
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Part One
Part One: Entity
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Chapter 1
1. Forming a Startup Company
Picture this. Five former coworkers from a major tech company decided to break off and launch their own startup. They dreamed of creating the next Instagram or Twitter. Much to their delight, the five founders gained momentum.
Maybe we should formally create a company. Who wants to take the lead on that?
a founder says.
Everyone demurs. People are too busy building and developing the product, finding customers, and trying to line up financing. Let’s talk about it next month,
someone finally volunteers.
Next month turns into three months, which turns into six months. Finally, after nine months, the founders—which started as a group of five but is now a group of three—move to make their company official. They form a C corporation and file in Delaware. A year later, the company is really humming along with a financing deal in the works. For the deal to go through, the founders need all inventions assignments and other corporate documents signed and delivered.
There’s just one problem: the two original founders who left the company before the company became a legal entity refuse to sign the inventions assignments and other related documents. Without their signatures, the investor backs out. It’s too risky for them: there’s nothing to prevent the former founders from turning around and suing the company and winning a tidy sum, and whether or not they win, they can keep the company in litigation for years.
Now the startup is in a real bind, because no investor worth partnering with will open themselves or their investment to such risk (and more importantly, the investor does not want their investment to go toward funding such litigation). Short of getting the former founders to sign the paperwork, the startup’s ability to raise capital has been severely damaged.
The sad truth is that this situation is all too common while being very easy to avoid.
Why Incorporate?
Some founders assume that the only reason to incorporate a business is for liability protection. If they were running a business with a physical storefront such as a restaurant or retail establishment, then yes, that would likely be the main reason. When you incorporate, the corporate veil
protects the corporation’s owners (i.e., the shareholders) from personal liability such as if an employee or customer slips and falls or otherwise injures themselves on the job. If this happens and the injured employee or customer sues, then they sue the