Acceleration: What All Entrepreneurs Must Know About Startup Law

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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