You are on page 1of 45

Startup Law 101 How To Structure

Startup for Growth
Presentation to

September 2015

About Sheppard Mullin
 Full-service Global 100 law firm handling
corporate and technology matters, high stakes
litigation and complex financial transactions
 Over 700 lawyers in 15 offices in
North America, Europe and Asia
 150+ lawyer corporate group is very strong in
– Startup representation (on the company side)
– Venture capital and other private financings
– Liquidity transactions (M&A and IPOs)


About Sheppard Mullin
 120+ lawyer IP group has specialists in every
technical field, handling

Patent prosecution
Trademark prosecution
Copyright prosecution

 Representative clients include

Northrop Grumman
Samsung & Samsung Ventures

About Joe Daniels
 Partner in the Corporate & Capital Markets Groups and
Member of Emerging Company and Venture Capital
Practice at SheppardMullin
 For 19 years (including 8 in CA during days)
has represented
– Startup to mature public companies (e.g., Atmel, Autodesk,
Informatica, Polycom, Monster Worldwide)
– Private equity and venture capital firms
(e.g., Alpha Prime, Sorrento, Walden, Oxford, Third Wave)
– Investment banks (e.g., Credit Suisse, Morgan Stanley)

 Involved in high-growth sectors, such as technology,
life sciences and consumer

About Joe Daniels (Cont.)
 Areas of focus have been
– Getting companies funded in angel, VC and other private
rounds of financing
– IPOs and other public offerings of equity and debt
– All sorts of mergers, acquisitions, partnerships and joint
– Other business deals from formation to liquidity, like
licensing or joint development
– Acting as outside general counsel to companies
– Currently represent 50-60 startups and venture funds

 Independent
– Mostly company-side work, and not owned by VCs

About James Gatto
 James?

 Avi Yaschin – founder & CEO of CleanEdison
 Essential formation, equity and IP documents
– Type of entity (corporation vs. LLC)
– Equity documentation
– Protecting IP when adding personnel

 Raising Capital

Typical Note and Seed Round Terms
What is the A Round?
VC fundraising process overview
Typical Series A preferred stock term sheet terms

 Questions and answers

Avi Yashchin – Founder & CEO of
CleanEdison (Acquired by Kaplan)
 Introduction of Avi
 What does a new Founder need to know about
the law to launch a successful startup?
 How do you pick a law firm to work with?
 How do lawyers help set up a company and help
with financings and exits?
 What are some common legal mistakes?

Corporation vs. LLC
 C Corporation
(best choice for venture model company)
– Preferred by VCs and most angels, who do not want
pass-through gain/loss
– Easy to use equity for service providers and acquisitions
– Laws governing C Corps are much clearer than LLC law
– Fast growth companies do not pay dividends and
instead reinvest, so the tax benefit of LLC and SCorporation is not relevant
– Tax loss benefits of LLC or S Corporation usually
exceeded by higher legal costs from operating
agreement to equity grants and converting to a C
Corporation for financing

Corporation vs. LLC (Cont.)
 S Corporation
– Same type of entity - just an election for pass-through
– May make sense to elect S Corporation status in
loss years
– Not eligible for S Corporation status when you have
any other entity or a foreign person as stockholder or
have more than one class of stock or >100 SH

 Delaware (the 1st state) is the state in which to
– People most trust DE
– Many investors will force a switch

Limited Liability Company (LLC)
 Limited Liability Company (LLC)
– Good for lifestyle businesses that will make periodic
distributions of profits
(instead of reinvesting in the business)
– “Pass-through” or single-level tax
– Venture capital firms and some angels may require
conversion to C Corporation for funding
– Cumbersome for granting equity to service providers
– More complex to use LLC equity as
currency for acquisitions
– Delaware is the state for any LLC formation

Equity Documentation
 Doing the paperwork showing equity grants early
is important
1. Tax issue – if you paper grants too close to an equity
round, you create potential ordinary income taxes for
the grantee and the company
2. Founder disputes – when equity is not adequately
papered, and founders no longer get along, it can lead
to drawn out disputes that hinder the company
3. Investors will require all equity to be correctly papered
prior to the closing of any financing

Equity Documentation (Cont.)
4. Vesting – all founders’ shares should vest, because any
could leave any time

Typical founder vesting is 3 year 1 year cliff from the time
you start working on the company

. Prior to your first equity round, papering equity
grants is simple
– This just requires a board consent, restricted stock
purchase agreements and filing 83(b) elections, or option
agreement after you’ve done a seed rounds
– Most law firms that practice in this area, including
Sheppard, offer a package deal to form companies,
including the equity grants, that is totally

Intellectual Property – Jim Gatto
 Mr. G?

Protecting IP When Adding Personnel
 Essential to lock up all IP in the company as
people join with Service Agreements
– IP includes inventions
(e.g., a new and useful business processes),

Copyrights (e.g., webpages)
Trademarks (brands)
Trade secrets

– All founders/other personnel should agree to assign
existing and to-be-developed IP relevant to the

Protecting IP When
Adding Personnel (Cont.)
– Use a consulting agreement that maintains
confidentiality, assigns inventions & has nonsolicitation provisions (so someone leaving can’t
solicit company personnel/customers/suppliers)
– The duties in the services agreement can also be tied
to vesting
– After you start a payroll all employees should sign an
offer letter and confidentiality, invention
assignment and non-solicit agreement

 A round Investors will want all current and former
consultants and employees to have signed such

First Seed Round Terms – Notes &
Series Seed
 Prerequisites
– Often just strong founders and initial product plan

 Purpose of Capital:

figure out product,
determine the market and user base,
scale past the initial founders, and
build an early product

 $250k- $2MM for 5%-33% of the company
 Investors are Angels and early stage VCs
(company-led, so the company proposes terms)
 Work with counsel to create a term sheet

Convertible Notes
 Always better / cheaper for the Company than any
Preferred Stock, as long as the terms are right – why?
 Note converts automatically when minimum raised, why?
 Ideal: lowest possible discount, no cap, or high cap
 Its better to fix the conversion price than agree to a cap,
because with a cap, if you raise at less (after discount),
investors get lower price
 Must convert at acquisition, and ideally at maturity too
 Try to use one-off notes so you can change terms for
each investor (i.e., no note purchase agreement)
 Consider setting low interest (e.g., 2%) and paying it
instead of converting it to give away less stock

Series Seed Preferred Stock
– Series Seed is light preferred stock with minimum
favorable rights
– Most important term is the pre-money valuation
(same tricks with equity pool & note conversions as
discussed below under Ser. A)
– Company typically creates a 2 page term sheet and
rounds up the early-stage VCs and angels
– Do not use SAFE because it creates too many
separate series and new investors or you may not
want SAFE round investors to have the same rights
– Do not use seed preferred that converts into the
A round for the same reason

Series Seed Preferred Stock
– What is light preferred stock
• Simple non-participating preferred
• No board seat rights (or at least not control)
• Limited investor blocking rights (maybe allowing for
equity raises and acquisitions over certain valuation
• Very limited registration and investor rights and regular rights

 After term sheets are signed: work with counsel
to draft note or seed preferred documents &
close the financing.

What Is The A Round?
 The A round is usually the first institutional equity
– Different prereqs vs. seed round: product and
userbase are defined plus you show significant
traction – what are traction ex.s?
• Social media app: lots of users plus user growth
• Transaction platform: number of deals and dollar
volume plus margin
• Enterprise software: big customers paying big fees, lots
of and growing number of SMEs paying small fees, etc.
• Can not figure it out – try revenue and EBITDA

What Is The A Round? (Cont.)
– Purpose: scale distribution, scale geographically and
perfect the business model
(meaning determine how to actually make money)
– Amounts: $2 – 15MM (or more…)
– Investors: Hopefully one lead VC with angels
tagging along

The VC Funding Process
 Goal is to get an acceptable term sheet
1. Target top 10-20 A round VCs based on industry
2. Share list with all advisors and get/schedule meetings
with in two weeks – why
a) Creates buzz – VCs all talk to each other
b) Auction dynamic – with everyone talking about you, they
will move/cave quicker
c) Helps you refine the pitch
d) You will not get a term sheet weeks/months before the
next one – if you do you will have nothing to compare
against and the first VC will get pissed & withdraw

The VC Funding Process (Cont.)
3. Create an auction
a) Focus on getting a term sheet from each individual VC
b) Never tell one VC which others you are talking to or the
terms they are offering – just say the usual suspects, or
they may literally collude to lower the valuation
c) Do not let VCs create a syndicate, or you will likely end
up more diluted
d) Entertain all term sheets (keeping backups), compare
with laywers & advisors and choose

4. If at first you don’t succeed, go back to a convertible
note or seed round
5. Sign the term sheet, finalize transaction documents,
and close

Series A Preferred Stock Terms 1
 Valuation Issues
– Most important term: the pre-money valuation, determines
percentage of the company sold (e.g., $5MM on $20MM =
5/25 = 20%)
– 2 major terms effect the effective valuation, or price per share
• Equity plan increases: you want a nice post-money pool,
because you hopefully have complete discretion to grant options
from that pool, but do not take all the dilution on it
– CF: all included in the post-money capitalization, so it does not
effect per share price
» E.g., per share = valuation/outstanding pre-money shares, so
the price is down if the shares are up
– N: split the plan half pre and half post, or some other compromise
– IF: all included in the pre-money calculation, substantial decreasing
the per share price

Series A Preferred Stock Terms 2
– How to convert the convertible notes / SAFE / “convertible
equity”? -- 3 ways (and investors will game it):
• CF: pre-money method: calculate the price per share based
on pre-money (e.g., $20MM pre / 20MM outstanding = $1.00)
and then divide principal (and maybe interest) by this price
• IF: percentage-ownership method: calculate the percentage
the cash investors should own based on the pre-money and
work back from there – takes points away from the founders
• N: dollars-invested method: calculate how much the cash
investors + noteholders should get based on the pre-money
and work back, so founders only take dilution on any
discount noteholders get (not as bad & arguably more fair)

Series A Preferred Stock Terms 3
 Liquidation preference on sale of company or
dissolution/winding up)
– Why is this important?
• One major benefit of preferred stock is it gets paid first
on liquidation
• Depending on the sales price, preferred will either take
their liquidation preference or convert if they make
more converting (1-for-1 for common stock)
• So for a range of sales prices up to a certain amount,
the liquidation preference of the preferred determines
how much money is left for you and the other common

Series A Preferred Stock Terms 4
– CF (market): non-participating, meaning if not
converted, preferred gets 1x pref. + declared &
unpaid dividends
• Basically this is getting their money back
– So even in a low price sale they get that

– IF (reject): fully participating, meaning investors get
1x + full as-converted payout
– N (reject): participation with a cap. E.g., 1x + up to 2x
based on as-converted payout
 Most VCs are OK with non-participating in an A round
because they don’t want future preferred investors to get
participating on top

Series A Preferred Stock Terms 5
 Board Seats
– The board hires/fires CEO & other C-levels, issues
stock/option and approves other major co. action
– So, do whatever you can to control the Board
• You may still be vesting, and board can fire you
• You built it and run it day-to-day, they invested in you,
so keep control over strategy and hiring

– How to control – outnumber the investors (1, 2/1, 3/2)
• You need a completely unified group on your side
• Seats should be owned by specific individuals and not
common stock as a whole, because preferred can
convert to common at any time in their discretion.

Series A Preferred Stock Terms 6
 Board Seats (Cont’d)
– What to watch out for:
• 2 founders, 2 investors, and one independent –
problem: independent can vote with investors
• 2 founders, 2 investors, but one of the founder seats is
for the CEO. So if the board replaces you as CEO, the
founders lose control.
• 2 founders, 2 investors, and you’re still deadlocked.

– Market: founders control after A. If investors aren’t
buying 50% of the company, why should they control
or even have equal representation on the board?

Series A Preferred Stock Terms 7
 Dividend Preference
– Generally not relevant because startups don’t pay
dividends, BUT mentioned 4th because VCs will
sometimes ask for cumulative dividends, and you
need to know to fight it
– CF: dividends paid on preferred on as-converted
basis when, as, and if paid on common stock
• i.e., preferred stock gets the same $ as common stock

Series A Preferred Stock Terms 8
Dividend Preference Cont’d
– N (market): non-cumulative dividends in an fixed amount
per share (e.g., 4-8% of the price per share) paid on
preferred when and if a dividend is paid on common
• This can also be participating (i.e., after preferred gets the
minimum per share, it also gets the dividend the common is

– IF: (reject) Cumulative dividends (e.g., 4-8% per annum) +
participation in any dividends on Common Stock
– The accrued dividend is usually payable upon the sale of
the company or IPO
• The problem with this is that it increases the amount of the
company the investors own on a daily basis
• Its especially bad if the accrued dividend compounds

Series A Preferred Stock Terms 9
 “Protective Provisions” or Blocking Rights – requires holders
of a majority or supermajority of the A for the Company to take
major actions
– Sell/merge, liquidate/dissolve/windup the Company
• This is included in almost every deal
• You can sometimes negotiate that investors can’t block
a sale over a certain $ amount
• …especially where a strategic investor holds a large
percentage of the preferred

Series A Preferred Stock Terms 10
Protective provisions cont’d
– Amend, alter, or repeal any provision of the Certificate of
Incorporation or Bylaws [in a manner adverse to the
preferred stock]
• CF = bracketed included (market), does not block senior
• N/IF = not included

– Raising equity - create or authorize the creation of or issue
any other security convertible into or exercisable for any
equity security, having rights, preferences or privileges
senior to [or on a parity with] the preferred
• CF = bracketed included
• N/IF (market) = not included
• Old money usually has to approve new money, but you can
occasionally negotiate a valuation cap, esp. with strategics

Series A Preferred Stock Terms 11
Protective Provisions cont’d
– Purchase or redeem or pay any dividend on any capital stock prior to the
preferred stock, except repurchases from departing service providers
• Usually included in every deal
• Investors do not want you spending money repurchasing stock
– Create or authorize the creation of any debt security [if the Company’s
aggregate indebtedness would exceed $[1,000,000][other than equipment
leases or bank lines of credit][unless such debt security has received the
prior approval of the Board of Directors, including the approval of
[________] Series A Director(s)

CF = exclude altogether, N (market) = include the 1st and 2nd bracketed
language so you can do bridge notes, and IF = include the 2nd and 3rd
bracketed language.

Increase or decrease the size of the Board of Directors. Market, because
both sides want to fix it.

Series A Preferred Stock Terms 12
 Conversion
– Most preferred stock starts out converting 1:1 into
common stock
– Classic preferred stock terms include anti-dilution
adjustments to the conversion price of the preferred stock
in any “down-round financing”
• CF: typical weighted average adjustments are most
common (market)
– This formula adjusts the conversion price down (so the
preferred converts into more shares)
– But not so far as the price of the dilutive issuance –
» Just to reflect the weighted average effect of the dilutive
issuance based on the price per share and amount of
money raised

Series A Preferred Stock Terms 13
Conversion cont’d:
• IF: a full-ratchet adjustment takes the preferred conversion
price down to the exact price per share at which the dilutive
round was made, no matter how much money was raised
• N: a compromise is the narrow weighted average
adjustment, which is more severe (investor favorable)
because options are excluded from the formula
• Carve-outs: for option grants (70% discount), bank and
vendor warrants, and other customary items

Series A Preferred Stock Terms 14
 Redemption Rights – investors’ right to make company
buy back their shares.
– CF/N (market) = No redemption rights
– IF = right to have shares redeemed 3-5 years out if a
majority or greater % of the preferred request it, including
any accrued & unpaid dividends

Series A Preferred Stock Terms 15
 Representations and warranties
– The company and not founders should give standard
– Be over-inclusive with disclosure schedule, and read it!

 Counsel and expenses
– Your (company) counsel should draft docs to limit unfavorable
– Expect to pay up to $15-25K for investors’ counsel’s fees
– The lower the cap, the less comments and diligence questions
you’ll get from investors’ counsel

Series A Preferred Stock Terms 16
 Registration rights
– These are seldom used, so no need to focus on the
investor ask too much – let company counsel handle it.
– Ideally, provide piggyback and S-3 but not demand.

 Management and Information Rights
– Expect to promise to deliver some unaudited financials on
an annual, quarterly, and even monthly basis, maybe with
a budget and reconciliation – so you’ll need acct. software
– CPA that files your tax returns can help you set it up
– Be careful that you don’t agree to deliver them too soon
after period end (120, 90 and 30 days)
– Try to avoid agreeing to audited financials, and limit
delivery obligation to major investors

Series A Preferred Stock Terms 17
 Participation rights
– Expect to provide major investors (e.g., $500K or more) the
right to buy a pro rata share of future financing rounds
• Pro rata share meaning the same percentage of fully-diluted that
they own after the A round

 Matters requiring investor director approval
– List of things that can’t be done without the investor director’s
– For the investors this is a second pass at blocking rights
– Try to eliminate or limit them as much as possible

Series A Preferred Stock Terms 18
 Rights of 1st Refusal, Co-Sale and Drag-Along
– Right of 1st refusal: right of company and then investors to
buy founders’ stock when you want to sell
• This is market so prepare to give it up
• You can also negotiate rights to buy a pro rata share when
other founders sell

– Right of Co-Sale: right of preferred holder to sell a pro rata
share with the founder if they sell
• Again this is market so just agree
• Again you can negotiate the right to sell a pro rata share with
other founders

Series A Preferred Stock Terms 19
– Drag Along: right of a majority of the preferred to
make all stockholders vote to sell the company
• Try to limit this right to when the founder(s) agree
• As a compromise agree to limit the right to when the
board approves (another reason to control the board)
• As a last resort require holders of a majority of common
stock to approve


Thank you!

Joseph F. Daniels
30 Rockefeller Plaza
New York, NY 10112
T: 212.653.8172
F: 212.655.1764