Start-up lawyer, CFO Blog

Are your business assets protected? Free legal check-up, business audit from California business lawyer Chris Barsness

Wed, 27 Jun 2012 19:25:39 -0400

With the recent economic turmoil of the last few years, more and more businesses of all sizes have faced tough choices when it comes to the future operations of their company. Some have gone out of business and others have cut costs down to the bone to survive. Typically, the large corporations have their assets and business structure planned properly to provide as much protection as possible. However, many small to mid-sized businesses may have not worried too much about planning for the future, they are just worried about making payroll for the month.

Obviously a best practice would be to get everything structure properly when the company is formed and setup, then maintained and kept up to date. Most start-up or small businesses don’t have the resources to do this, despite the fact that it would save them tons of time and money down the road, not to mention assuring that their personal assets aren’t at risk.

The problem is that the owners or management don’t realize the major risks to their own assets and personal livelihood can be in jeopardy. Just because you have a LLC or corporation formed doesn’t mean there are not any major landmines. I have seen many business owners come to me having to file for personal bankruptcy because their lives and their families lives were ruined by a business failure in which they thought they were protected. Some lose their homes or personal assets, like savings accounts as well.

Some examples of how this can happen are failure to keep adequate workers compensation insurance in California or properly withhold and deposit enough payroll taxes for your employees. The owners, directors, officers, and management can face personal liability for all of these liabilities, even if the company is a corporation and no personal guarantees were signed by those individuals.

There are ways to protect yourself personally and your assets from business issues, but the best way to handle this before it ever gets to your personal assets is to be sure your business and business assets are properly protected and structured. This can be done at any time, but if you wait until after the fire starts, it will be much more difficult to put it out the longer you wait.

There are many ways to protect your business and assure it is being properly run. One of the best ways to see how healthy your business is would be to get a business check-up, sometimes called a legal check-up or business legal audit.

We provide a free initial consultation to take a look at your current business structure, operations, finances, assets, liabilities, insurance, record keeping, and risks. We can devise a plan of action and strategies on how to improve the health of your business. This is even more important if the business is not doing well financially, because that is usually when the problems are going to start or get worse.

Contact me, your California business attorney, to give you a free consultation and check-up for your business. I can give you a no obligation review and idea on what steps you should take and any costs or fees involved to get the business back up to speed and protect not only the company, but your personal assets.

Litigation in California is big business for plaintiffs’ lawyers and state agencies take no mercy on shutting down companies and taking the owner or management’s assets.

Entrepreneurs Suffer Credit Problems In Economic Hard Times

Thu, 03 May 2012 17:21:05 -0400

Many small business owners or other entrepreneurs start out with a great idea for a new product or service. They start a business and focus on doing whatever it takes to make the company successful. Many don’t take the steps necessary to properly protect the business from creditors or don’t really pay much attention to what they sign when they are making deals. The ones who do read the fine print may just have the attitude that they are so confident in the business’ success, who cares if they use their own personal credit to get some working capital. With the economic downturn over the last few years, many business owners have had to close their doors because they couldn’t get the funds they needed to even cover the simple things like payroll or rent.

Use of Personal Credit

Many entrepreneurs feel that they should put some ‘skin in the game’ by contributing some of their own money into the business. In fact, the Small Business Administration backed loans often require the founders to contribute at least a certain percent of their own assets or some other major contribution in order to qualify for a business loan. When the owner doesn’t have available cash, they look to other sources to get the money to contribute. That can lead to things like taking out a home equity line of credit or using personal credit cards to help fund the business. Obviously that is pretty risky, but often necessary to get early access to this seed money to start and grow. The banks that issued the credit did so based upon the owner’s personal credit rating. Just because the credit card may have the business’ name on it doesn’t mean the bank hasn’t covered their bases by making sure they can sue the owner personally if the business defaults in payment.

The other area where founders often don’t take the time to understand the agreements they are making is in the area of personal guarantees. In the majority of start-up or new business loans or other forms of credit, the bank or whoever is granting credit will require a personal guarantee. Within the stack of forms the founder signs, it will clearly state that the founder is responsible for payment if the company cannot pay. Forming a corporation or LLC does not protect you from a personal guarantee. The contract or agreement for the personal guarantee is between the bank and the founder, not the company. If the founder signed and the agreement is enforceable, they are stuck with paying it. Also, the one signing the personal guarantee or using their own personal credit cards will be the one with negative credit being reported on their credit report.

Limiting Liability Problems

Many founders come to me asking about filing bankruptcy for their small business or themselves. If the company filed bankruptcy (won’t get into discussion of Chapter 11 reorganization), any assets of the company are liquidated to pay off existing creditors. Any remaining debts are discharged. The business can probably get out of paying, but the company will no longer cease to exist. If you file bankruptcy, in most cases, you can’t take some of its assets (even if you contributed them) and go start another business. That would be defrauding the company’s creditors. Also, filing bankruptcy for the company will not get rid of any personal liability for credit cards or personal guarantees, even if they were used to benefit the company. Now the owner could file a personal bankruptcy to get rid of personally guaranteed debt, but they can’t just discharge the business debt, they have to include all their personal assets and liabilities in the case. In 2005, the bankruptcy code was amended to make it more difficult to use a chapter 7 liquidation which discharges debts. People with any significant recent income usually end up having to use Chapter 13 which is essentially a partial repayment plan over up to 5 years. I have personally had clients who started a business, signed personal guarantees for loans, and owed hundreds of thousands of dollars when the company failed. Even in a personal bankruptcy, if the creditor shows the owner was obtaining credit recklessly or using the money improperly to create some form of fraud on the creditor, the debt cannot be discharged even if done for a business.

The discussion to this point has assumed that the owner formed some form of business entity, such as a corporation or limited liability company (LLC). If the owner did not form a business entity properly, it would be considered a sole proprietorship or possibly a partnership and they (and their partners if a general partnership) are personally liable for any debts. However, even if a corporation or LLC is formed to limit liability, there are times when a creditor can still get after the founder’s personal assets.

In what is known as “piercing the corporate veil,” attorneys can try to personally go after the founder, owner, officer, or director for the company’s debts. Many of the online discount incorporation services fail to properly advise founders of just how important it is to be sure to do everything properly in the future to keep the limited liability alive. An LLC generally has less formalities and requirements to keep it in good standing. The corporation has more requirements. Some of the things a court would look at may be whether the company is not a separate entity, but really nothing more than the ‘alter ego’ of the founder. So if the founder commingles their actions so much as to make it appear that they are the corporation, they could be found personally liable. Some of the other things a court looks at are the failure to properly keep records of meetings, failure to hold annual shareholder meetings, failure to hold board of director meetings, and failure to adopt resolutions approving corporate actions. Also, if the founder commingles their own personal funds with corporate funds, such as using a company card for their own personal gas or paying for their rent or house payment with a corporate bank account, this can increase the chance of personal liability. Essentially, the court wants to see that the company is a separate legal entity, is independent in its actions, and acts properly under the direction of the shareholders and board of directors. If the founder simply starts a corporation and recklessly starts using credit when he or she knows the company can’t repay, this could lead to a claim of fraud by the bank and possible personal liability.

In California, an officer, director, or other high level employee can be held personally responsible for failing to do things like deposit payroll tax withholding or failing to get workers compensation insurance, even if the business was a corporation.

Many of these problems can be avoided with proper planning and following simple rules. The difficulty founders, start-ups, and small business owners face is being able to obtain credit in this difficult economic environment without resorting to things like personal guarantees or using their own credit cards. If you are in that situation, there are things you can do to try to protect yourself, but ultimately, understand the ramifications of your actions. Ask yourself, “what happens to the liabilities if this company goes out of business?” There is nothing wrong with planning for success and having confidence in your idea, in fact, most investors require this in order to invest in the company. At the same time, you still need to understand the risks of each action you take.

Also, if you are low on cash and want to use a discount online incorporation service or do it yourself, be sure that you understand the go-forward requirements and shop around, you may be able to find a start-up lawyer who believes in your idea and is willing to work in exchange for stock in your new venture or at least give you some guidance and overview of the pitfalls to watch out for. We will have to wait and see if the new JOBS Act makes a difference in bringing available capital to start-ups and small businesses.

Good discussion of VC signaling in seed and series A rounds

Wed, 18 Apr 2012 11:34:38 -0400

Good discussion of VC signaling in seed and series A rounds

2012 US Compensation Policy FAQs from ISS

Tue, 17 Apr 2012 18:15:50 -0400

Back on January 25th, 2012, Institutional Shareholder Services, Inc. (ISS) released its report and frequently asked questions regarding corporate governance relating to policies on compensation and proxy solicitations. This helps provide guidance for companies preparing their proxies for 2012 and beyond in terms of disclosures and voting for say on pay, pay for performance, and equity plans.

A link to their answers and the link to their white paper and the methodologies used in adopting its policies can be found at:

http://www.issgovernance.com/policy/2012/USCompensationFAQ

http://lawprofessors.typepad.com/securities/2012/04/sec-report-examines-significance-of-reg-d-offerings-in-raising-capital.html

Thu, 12 Apr 2012 14:28:09 -0400

http://lawprofessors.typepad.com/securities/2012/04/sec-report-examines-significance-of-reg-d-offerings-in-raising-capital.html:

SEC report on Reg D offerings

What do I look for in a business or startup attorney?

Wed, 11 Apr 2012 20:21:25 -0400

One of the biggest questions small business owners or founders have when it comes to early stage business issues is when do they need to hire an attorney and how do they pick one. I will explain what I think are important qualities and how an attorney can be invaluable, even before the company is formed.

A good startup or business attorney needs to be able to see a wide variety of potential issues the company may face and be able to address those with the company or founders. If they simply form a corporation and provide some initial shareholder agreements, bylaws, resolutions, or other initial documentation, that is a valuable service, but there is much more to be examined and addressed in an early stage business. There are many legal or business issues, such as what intellectual property protection is or needs to be in place (e.g. patents, trademarks, non-disclosure agreements), advise the founders about securities laws relating to issuing stock or raising money, preparing for human resources and hiring (e.g. explaining that you can’t just call someone an independent contractor or 1099 and avoid payroll tax withholding obligations), and when to get someone involved in drafting or reviewing contracts. While it is true that “startup law” is really mostly about basic formation and protection of business entities and possibly help with closing initial rounds of funding, the attorney should have a wide general knowledge of many aspects of business and law.

I boil it down to having a good business sense to be able discuss the company, its plans, evolution, and future. I feel that the best startup or small business attorneys provide quality legal services plus the business judgment to know what questions to ask and advice on guiding the company. That is where the advisor role comes into play. If someone brings me a contract and says to review it, I can read it and tell them if it is legal and if any additional clauses need to be added to protect the client; however, the better approach is to not only review it for contractual legal issues, but to find out about the transaction and business relationship. In my opinion, if you don’t know what your client intends to do with the contract or the interplay between the two parties or any other parties that could become involved, you can’t foresee future problems and properly advise the client. Having an enforceable contract is helpful, but it doesn’t do you any good if the business relationship is not feasible.

I feel that many attorneys get bogged down in the details of following the law and forget about the role as advisor. Part of this can be due to the attorney not having any actual business experience or not having enough experience with business transactions and startup issues. The best startup attorney will get back to you quickly and understand exactly what you are going through. They may not know the solution, but they can guide you to the right resources if they can’t help. They should have good connections for those resources. I know that all of these qualities can be difficult at times to find, but I feel that it is critical.

I understand that the costs of attorneys are not cheap, so to go over all your business decisions with one is not something you can do either. So when do you hire one? A good consultation in the early stages or pre-formation can be invaluable to put together the relationship between founders, shareholders, and protect the assets (such as intellectual property like ideas or developments) of the company. Many people have to hire an attorney because a dispute has arisen between founders about who owns what idea or development or something goes wrong; however, proper planning in the early stage can avoid many of these situations or at least have a plan in place for how to handle the issue if it comes up. The founders should get a good quality consultation to see what possible things need to be addressed and maybe get some early documents to use in protecting the company and then bring the attorney back in as money is being raised, contracts are being negotiated, or employees are being hired.

If you call a business attorney and they don’t ask you about what your business does or details about the development of the company to this point and your future plans, they are doing you a disservice. That doesn’t have to be in the first call, but discussing your business plan and model can help see future problems.

Most businesses think they can just use an online website to form their corporation and they will be set without any need for an attorney, but the consultation should be part of business planning for the future. They are not told that they need to keep accurate books and records, need to have regular board and shareholder meetings, pass resolutions, file securities law exemption notices when issuing stock, and many other items. Failure to do this even from the company’s inception can lead to personal liability for the founders, officers, and directors. Also, if you don’t clearly transfer or separate developed intellectual property, such as an app or other code, there will probably be disputes down the road about who owns what.

Hopefully this gives a small amount of insight into what to look for. Get a quality consultation early on and bring them back in when you can for major events (raising money, signing contracts, hiring) or on regular intervals to be sure you are on track. You can also negotiate flat fees for certain projects to keep your budget in line.

"Emerging Growth Companies"- JOBS Act May Provide Eased Regulations

Mon, 02 Apr 2012 13:25:00 -0400

With H.R. 3606, or most commonly referred to as the “JOBS” Act (Bill Summary | Bill Text PDF), likely to be signed into law this week by President Obama, there are some new changes that may be of help to startup and small companies. In addition to the so-called crowdfunding exemption from securities registration which allows pooling of small amounts from investors to fund a company, the JOBS Act puts in place regulations that carve out a category called “emerging growth companies” which have an intermediate level of reporting obligations with the SEC. It is between the level of disclosures required for a fully reporting large company and a private, non-reporting company. This could be a very good help for these small to middle market companies to ease the burden of time and expense in being a fully reporting company.

An emerging growth company is defined as a company with less than $1 billion in annual gross revenue; however, the company loses that status upon hitting certain targets related to the amount of debt securities issued, after 5 years of first having sold stock per an effective registration statement, or upon being declared a large accelerated filer under SEC rules.

The new rules for an emerging growth company (EGC) is to exclude it from some of the restrictions imposed under the Sarbanes-Oxley Act or Dodd-Frank Act. EGCs are excluded from the requirements of say-on pay executive compensation disclosures and other proxy disclosures under Dodd-Frank. EGCs are also not required to comply with the internal controls audit requirements of SOX. The JOBS Act also requires the SEC to review Regulation S-K and make any changes to make it easier and less costly for companies to register their securities under that regulation. It is not required to implement those, but the SEC must transmit its recommendations for streamlining registration of EGC securities within 180 days of implementation of the JOBS Act. An EGC need not provide more than the last 2 years audited financial statements in an IPO registration statement and further reporting obligations do not need to include the selected financial data normally required under Section 229.301 of the Code of Federal Regulations under Regulation S-K. However, smaller reporting companies were already excluded from this requirement under Section 229.10(f)(1) for those companies that meet the$75 million in public float or $50 million in annual revenue test.

It is hard to tell how much actual impact this will have or what the SEC will propose for further ways to reduce the burden on these small to middle-market companies. The EGCs still have to hire auditors and law firms, even though they may not have to fully comply with all of the SOX or Dodd-Frank requirements at first. The cost and time to prepare more than 2 years audited financials, disclose compensation ratios, or providing selected financial data may not be a large incremental increase versus standard disclosures and audit requirements. It will probably end up being a recommended best practice to simply get used to going through those corporate governance motions and disclosures just to be prepared for the future anyways.

To Stagger or Not to Stagger Your Board of Directors, That is the Question

Fri, 23 Mar 2012 12:11:00 -0400

One question faced by companies from startup through Fortune 500 status is whether they should stagger or classify their board of directors. Staggering or classifying occurs when the corporation sets up voting for election of only a minority of members of the board every year, so it often takes several years to replace an entire board. This is viewed as a good takeover defense and also argued to be good for the corporation because frequent changes of directors can result in corporate policy and corporate governance changing more often or more dramatically. Those against it feel that it doesn’t give shareholders the ability to make major changes when problems arise with the current board’s decisions and it entrenches existing corporate policy and management to not as easily allow for necessary change. Although some would downplay trying to make this about shareholder rights versus management or existing structure, that is a major factor of the argument.

Originally, corporations would implement a simple once a year vote of shareholders for either current or new directors. These types of corporate governance decisions are put into articles of incorporation, bylaws, or state corporate law, although most commonly in the company’s bylaws. The idea of staggered boards was implemented within the last several decades as essentially a takeover defense, although they are now common for corporate stability. There is no right answer at this point, although legislative changes like SOX and Dodd-Frank continue to expand shareholder protections and rights to deal with things like “Too Big to Fail,” the Madoff Scam, and other shakeups.

The battle continues with a war of words between Harvard Law’s Shareholders Rights Project and law firm Wachtell, Lipton, Rosen, & Katz. The firm continues to argue for staggering and that it is not just about takeover defense. Harvard’s project argues that staggering needs to be eliminated to get rid of low valuations and bad corporate decision-making. Wachtell says there is no correlation between staggered boards and bad decision-making or lower company valuations. The project has gotten about a third of the Fortune 500 companies to agree to bring forward proposals to get rid of staggered boards. In addition, Dodd-Frank is implementing shareholders ability to weigh in on corporate governance and ways to provide nominations for the board of directors (instead of current management simply proposing who they recommend you vote for on their annual proxy), so the trend is definitely heading towards shareholder rights.

So what should you choose for your board? I still think staggered boards have a purpose and are not directly correlated to bad decision-making, but they are often used, whether intentionally or indirectly, to entrench current policy and management. With a startup or emerging growth company, you will be making major changes in the direction of the company on a frequent basis and need to add, remove, or change directors on the fly. This can be done with provisions in the bylaws that allow for removal or change in directors or adding directors to increase the number on the board, not having to wait for the annual shareholder meeting and proxy process. Founders should realize that as the company increases in number of shareholders during fund raising and growth that it often becomes more difficult to make major changes in things like how corporate governance is handled. For now you have the ability to stagger your board, so it is probably okay to still use them, but provide for provisions to more easily make changes in the board within your bylaws and realize that the current trend may require you to switch to annual elections for all directors.

Crowdfunding Passed Senate but Reduced By Bill Amendment

Thu, 22 Mar 2012 18:25:00 -0400

H.R. 2930, one part of the multi-bill JOBS Act being pushed through Congress, was to allow more eased securities regulation of so-called crowdfunding. Some have argued that sites like Kickstarter or others could change their business model (currently only accepts gifts or donations, called pledges, to raise money) to help companies raise money for companies in exchange for stock in that company. Currently, that model would be prohibited under securities laws as general advertising and public sales of stock are not allowed, especially through an intermediary, with certain exceptions like using a registered broker-dealer or registering the stock with the SEC.

H.R. 2930 passed the U.S. House last year, but was stuck in the Senate until today. The Senate passed the JOBS Act, including H.R. 2930, but in amended form so that it must go back to the House for another vote. The prevailing thought is that it will easily pass, even with this amendment, and become law soon.

The amendment puts more limitations on how crowdfunding can be used. Previously, a company could get up to $10,000 per investor to raise a total of $1 million in a 12 month period, or up to $2 million if audited financial statements are provided to investors. Now the total raised would be capped at $1 million and certain financial disclosures to investors would be required in all cases, such as financial statements certified by the CEO and other descriptions of the business. Also, intermediaries used to help bring in this money would now need to be registered with the SEC as a broker-dealer or funding portal, as before they would not need to be a registered broker-dealer.

The term funding portal will start to be heard much more as it will be used by intermediaries to help raise money and the newly proposed definition is:

Definition.—Section 3(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)) is amended by adding at the end the following:

“(80) FUNDING PORTAL.—The term `funding portal’ means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act of 1933 (15 U.S.C. 77d(6)), that does not—

“(A) offer investment advice or recommendations;

“(B) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;

“(C) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;

“(D) hold, manage, possess, or otherwise handle investor funds or securities; or

“(E) engage in such other activities as the Commission, by rule, determines appropriate.”.

It sounds like funding portal will be a less stringent bar to overcome than registering as a broker-dealer; however, it is a step in the right direction to cut down on the potential for scam artists stepping unregulated in to raising money through websites. It may reduce the amount of people and situations previously described by Columbia Law Professor Coffey Jr. as “every barroom in America might come to be populated by a character, looking something like Danny DeVito, obnoxiously trying to sell securities to his fellow patrons. He could provide each fellow patron with a business card that noted that the securities carried high risk, but would need to provide no other disclosure.”

There are also some changes in calculating how much each individual investor can put towards a crowdfunding investment based upon their net worth or annual income. The amendments are listed here, but should be more succinctly summarized in the near future.

Exits- What are the common forms?

Wed, 21 Mar 2012 18:45:07 -0400

Many people start companies because they are passionate about their idea, product, or vision. Investors love to see that passion in a founder, but they are obviously wanting a return on their investment. This is where exit strategies come into play, sometimes referred to as a liquidity event. You could lump things like a dividend distribution or repayment on a note in as a form of exit for the investor to recoup their investment and gain their return; however, most early investors in startups are willing to take the very high risk of failure for that investment in return for a potentially large return on their investment and dividends are not usually as sexy of a return.

Mergers & Acquisitions

Common forms of exit are to merge with another company or be acquired (i.e. bought) by another company. Of course, a startup could also seek out acquisition targets to obtain their intellectual property or their management team and be the one doing the buying, but we will look at M&A from an exit strategy point of view for the selling company.

Acquisitions typically come in one of two forms, a stock purchase or an asset purchase. They are pretty self explanatory, in one the acquiring company buys all the outstanding stock to acquire control of the seller, the other the buyer simply purchase all of the selling company’s assets and the selling company simply dissolves. There are a number of factors involved in making the decision of whether to utilize an asset sale or stock sale as the preferred method for the transaction, such as taxes, accounting, anti-trust, securities laws, liabilities, contract rights, and practical or logistical considerations.

Since these types of transactions usually require some form of majority vote of the shareholders, there are considerations such as dissenting shareholders’ rights or accounting rights if the shareholder refuses to vote for the M&A transaction.

All of the above considerations also go into whether to choose a merger instead of stock or asset sale. A forward merger is treated similar to an asset sale and reverse merger treated similar to a stock sale. A merger, stock sale, or asset sale can result in a liquidity event for investors, but not all the time. The major factor for an investor is obviously the valuation of either the stock or assets of the company to see what their return will be.

IPO or “Going Public”

Many people don’t understand exactly what it means to “IPO.” An initial public offering (IPO) is when a company registers their stock with the SEC and also sells some or all of the stock they are registering to the public to create a public marketplace for the purchase and sale of their stock. Various federal and state securities laws place significant restrictions on transfer of private stock, but allow stock to be publicly traded between individuals once the stock is registered with the SEC. The registered stock is then listed for sale on some form of exchange, such as NASDAQ or NYSE, or electronic marketplace, such as what are referred to as “Pink Sheets” or “Over the Counter Bulletin Board” marketplaces. This provides a marketplace for average people to buy and sell that company’s stock. In the IPO typically an investment bank comes in to sort of pre-market the company’s stock before it is actually publicly traded to get a sense for what the right price is and how much stock would be bought once it hits the market. So not only does the IPO process register the company’s stock, it creates a public marketplace for resale, and raises money for the company. Prior investors typically have registration rights before the IPO so that their stock is registered in the process and able to be sold, thus recognizing an exit.

Until the shares are registered, it is difficult for someone owning shares in a startup to be able to easily sell their stock due to restrictions on transfer and the fact that there is no public market to sell the stock in. They have to try to do private sales and comply with securities laws or exemptions to allow the sale. In many cases under Rule 144, they have to own their stock for a period of years before they can sell it.

So why doesn’t every company simply pursue an IPO right away? The IPO process involves filing a registration statement, typically an S-1, with the SEC. This document gives all kinds of explanations about the company, its financial performance, management team, and business plans for the future. It also provided financial statements and other required disclosures. In order to produce an S-1, auditors and lawyers need to be hired to audit financial statements, provide legal opinions, and assist with drafting the S-1 (See my discussion and links to Facebook’s S-1 as an example). The SEC then will often have comments or request further information regarding the S-1 requiring the company to amend their S-1. Often after several months, the SEC then declares the registration effective and the stock is registered. The expense and time involved in this process can be tremendous, often costing from several hundred thousand dollars to several million dollars.

The other factor involved is the actual sale of the stock. Many investment banks will enter into fee agreements that are a percentage based on money they raise, so it may not cost the company anything up front. However, any major investment bank is not going to simply take on the IPO process for a no-name company because they want to know that there will be buyers out there willing to pay their asking price. The market, investment bankers, and company want to be sure there will be enough liquidity (purchase and sales) in the marketplace to create a regular market. Many stocks have gone public only to see the market for their stock drop to where there is so little volume (no buyers) that the stock price drops into the pennies per share. These so-called “penny stocks” end up on the OTCBB or Pink Sheets with very little trading volume, so no current shareholders can even sell their stock on that public market.

Reverse Merger

There was a time when the new method to avoid the costs of going public was to do a reverse merger where the company merges into an already publicly traded company and takes over that company. The private company exchanges its stock for the public company’s stock and like that, it is a publicly traded company without the need for the traditional IPO. The shareholders go from shares in a private company to shares in a public company in a very short time. This process sometimes involved cash changing hands, but was usually simply a transaction used to go public, not necessarily raise money. The SEC cracked down over the last several years on the practice of using so-called “shell companies” that would go public by registering shares with the SEC and then simply not conducting any business and sell their “shell” to a reverse merger candidate who wants to quickly go public. The reverse merger process is still something that can be used to create liquidity, but the limitations placed by the SEC place some obstacles to using this as a legitimate form of going public. Essentially, the public company should not just be a shell formed for the purpose of avoiding the initial share registration process. If it was actually an operating company that simply failed, but was still publicly listed, it still could be used for a legitimate reverse merger.

So a reverse merger can be included as a “going public” type of transaction to get liquidity or an exit for existing investors, but the more traditional forms of exits are IPO, traditional mergers, and acquisitions. There are other creative ways to provide an investor an exit that can be examined such as new investment rounds purchasing some of the prior investors shares, company repurchases of shares, and others. The bottom line is that every founder should analyze and be ready to discuss a proposed exit with investors; however, investors want to hear your passion for your idea and execution on it, not that you can’t wait to go public or be acquired and get rich.

Read more about startup and founder’s issues on my resource site and startup 101 at SiliconValleyStartupattorney.com

Shareholder Proxy Nomination No Action Rule By SEC

Wed, 14 Mar 2012 19:24:00 -0400

Shareholder Proxy Nomination No Action Rule By SEC:

Good brief overview of some of the implementation of Dodd-Frank when it comes to public companies wanting to limit what they are required to do to comply with allowing shareholders to add nominations in proxy materials.

Kickstarter and other crowdfunding platforms to grow in the very near future

Tue, 13 Mar 2012 20:12:00 -0400

Kickstarter is one of the main examples of a crowdfunding type of company. It solicits money to help fund new projects or companies. So is this general advertising, solicitation, and funding by a non-broker/dealer or intermediary that is not allowed by law? Yes and no.

Although their terms of use and other information on their website do not specifically state this, they are essentially relying upon the fact that the money used is in the form of a gift (or pledge as they call it) to the company. The person pledging the money does not get an ownership interest or much else in exchange for their contribution. Usually a company obtains funding by selling stock or getting a loan and enters into a sale of stock or sale of a promissory note. These are securities and are subject to federal and state law regarding their offering, purchase, and sale. Generally, a company cannot use general advertising or solicitation of the investment if they want to use the exemptions from registration available by law. Two examples: First, Facebook files for an IPO and the world knows they are selling stock. They have filed a registration statement, or S-1, with the SEC and this complies with laws to allow them to be able to publicly announce the sale. Second, Most startup or small companies do not have the resources or want to try to go through the process of filing with the SEC. They rely upon exemptions from registration to sell stock. The law puts certain requirements that need to be met to be able to use those exemptions, one of which is that they can’t go out and issue a press release or put on their website that they are trying to raise $1 million by the sale of their stock.

If Kickstarter or any other similar platform started selling an investment in the company where the investor gets something in return like a loan or stock, they could be guilty of federal securities law violations, especially if they took a percentage of the funding raised without being a licensed broker/dealer. However, here comes H.R. 2930.

There is a bill that is in the US Senate waiting for a vote that would allow a crowdfunding exemption and the use of intermediaries in connection with certain limited sales of securities, H.R. 2930, the so-called “crowdfunding exemption or bill.” (Actual Text & Bill Summary). It has already passed the US House and was part of a jobs bill pushed by both republicans, democrats, and the president. It sounds like that bill is going to be put for a vote in the Senate in the next few weeks. All conventional wisdom says that it should pass with flying colors, be signed by the president, and become law relatively quickly.

So how will this affect Kickstarter or other similar fund raising sites? If the company follows the intermediary limits in the law and future SEC rules, they could start helping companies raise money with a $10,000 cap and potentially get paid to assist, even though that would be selling a security. The $10,000 cap is technically listed as “per investor” so they could help raise up to the $1 million 12 month cap with only up to $10,000 per individual investor and take a cut on those rounds. Whether Kickstarter wants to change their model to include investments remains to be seen, but I am sure companies looking for money or those wanting to be the middle man will start popping up all over. They can publicly advertise and close deals; however, even the middle man can be prosecuted or sued if anything in the process could be seen as misleading, false, or inaccurate. That is a lot of liability to take on with major disclosure requirements for the company and intermediary.

We will see in the next few weeks when it will likely go into affect. In the end, I predict it really won’t provide a huge amount of “useful” capital to the market, but we will see probably a lot of new companies or websites trying to capitalize on this new small funding market.

I particularly like the statement by Columbia Law Professor John Coffee, Jr. when testifying about HR 2930 in front of the SEC, “every barroom in America might come to be populated by a character, looking something like Danny DeVito, obnoxiously trying to sell securities to his fellow patrons. He could provide each fellow patron with a business card that noted that the securities carried high risk, but would need to provide no other disclosure.”

Double-Edged Sword of Control for Startup Founders- "Isn't it MY company?"

Tue, 13 Mar 2012 13:20:00 -0400

When someone starts a company, they usually have an idea or vision and a passion to bring that idea or vision to market. Many founders get stuck in a difficult spot that most commonly comes up in the process of raising money. This is what I call a double-edged sword for startup founders, i.e. ownership and control of the company.

Many founders start to form a deep bond with their ideas and visions that are embodied in their new company. They take ownership of those ideas and the company. During the growth phase, they are asked to slowly give up some control of that company, usually through dilution of their ownership % by private sales of stock. One major identified reason that startups face major problems and may result in the company failing is the inability to give up control when the company starts to grow. New investors are coming in to get an ownership stake at a very risky stage in a pre-revenue company in exchange for potentially very high rewards. Part of what investors look for in investments are the ideas or vision, management team, and the passion of that team to drive the company to growth. If the founders are only focused on an exit where they go public or are acquired and retire early rich, investors will be put off by those founders who seem to care more about their own personal wealth than having a successful company. If Mark Zuckerberg would have pitched to investors that he was going to take Facebook public and make the company’s stock worth billions within two years, he would probably not have gotten many of those early investors, at least the experienced ones.

The most common example of investors slowly taking control away from the founders is when a venture capital firm comes in with an investment. Commonly venture capitalists take a large stake in the company, take seats on the board of directors, get certain voting and other preferential rights, and sometimes want to put some of their own trusted management team into the company at some point, such as a new CEO with years of business experience raising money, going public, or running a public company. Many technical founders don’t understand any of those aspects of the business, but feel like they are losing control of “their company.”

So whose company is it anyway? If the company uses the standard choice of entity by forming a corporation, technically the stockholders own the company. The board of directors are elected by the stockholders to manage the company at a high level and officers like CEO, CFO, CTO are put in place by the board to run the company day to day. The stockholders hold regular votes to exercise their ownership rights. In the early stages, the founders typically own 100% of the company and have complete control. Once the company starts giving out stock to investors, that percentage goes down substantially. This causes frustration and feelings that the founders are giving away their baby.

So how does a founder raise money and show passion for their long term vision without a quick exit, but also appeal to the investor that they will realize a return on their investment in a certain period of time? The biggest help can be an understanding of how corporate finance, corporate governance, venture capital, angel finance, exits, and other fund raising work. As long as the founders have a basic understanding of how control and dilution happen and that those things will eventually happen if they want to raise money to grow, they can better deal with it when they come up. That is not to say that a savvy founder can’t retain control and still raise money. In the example above with Facebook, Mr. Zuckerberg was able to retain a large amount of stock in the company (although less than a majority) and keep voting control through voting agreements and/or proxies.

In addition, although mostly applicable to public companies, regulations like Sarbanes-Oxley and Dodd-Frank are looking to force companies to provide more separation of control and other protections for investors. With attempts to separate the chairman of the board and CEO roles, the trend is to break up one person having too much control to avoid conflicts of interest.

Investors want to see your vision, so be passionate about that future and your company. You should also be able to discuss an exit for the investor so they can see the return, but hype up an IPO and 500x return within a year and you will probably find yourself without any investors except unsophisticated ones. Understand that it you want to keep it “your” company, you will probably have a difficult time with growth or fund raising.

For a basic understanding of items related to control, equity issuances, and fund raising, you can read my articles on my collection of resources for founders and startups at http://siliconvalleystartupattorney.com/wordpress/

SEC Proposes Rule To Protect Identity Theft under Dodd-Frank

Mon, 12 Mar 2012 18:09:04 -0400

The SEC published a proposed rule promulgated under Dodd-Frank to deal with issues of identity theft when dealing with broker/dealers, investment advisors, and other investment professionals. The rule would require SEC regulated entities to implement written identity theft policies and procedures to ensure investors’ identity remains confidential. It uses what they call a program of “red flags.”

There is a 60 day comment period before the rules would go into effect from the February 28, 2012 publish date.

The press release can be found here. The proposed rule can be found from the SEC website in pdf form.

Founders & Startup 101: Part VI) Internet & Tech Intellectual Property Protection

Tue, 06 Mar 2012 11:48:00 -0500

Part VI) Internet & Tech Company IP Protection

So you are working on the hottest new startup and want to know how to protect your ideas when you are out raising money and recruiting new engineers and designers. Here is a brief overview of the types of intellectual property (IP), ways to protect them, and tips for your startup. I will focus on some of the more common issues in internet and tech related companies, although some of these issues appear in other contexts. This information is meant to be an educational overview only and should not be used as a substitute for legal advice or considered an exhaustive discussion of all IP issues. Facts & circumstances can vary, as do laws and regulations by state or other territory, so you should consult with a local licensed attorney to be sure you are properly protected.

Copyrights

Copyright is a protection for original works of authorship that must be tangible. You can’t use copyright protection to protect an idea until that idea is put into a tangible form. The most common ideas people have of copyright is usually with authors who write film scripts or books where they often see the words “copyright” or a c with a circle around it and things like the name of the author and year next to it. The idea of the book is not protected by copyright law, it is when the book is written is when it becomes tangible and subject to copyright laws. In the internet and software context, source and object code can be protected under copyright laws if they are an expression of an idea, not if they are simply the idea themselves.

It also does not protect facts or data and the work must be original. Say you are using source or object code that is commonly used to create a widget or menu on your website. That common code is probably not protected under copyright law as it is not original, but the selection, arrangement, and presentation of each element put together to create your website or e-commerce site may be protected.

Most internet related issues will come under the purview of the Digital Millennium Copyright Act (DMCA) in the United States, but may also include areas from the Copyright Revision Act of 1976. The person who creates the work is generally considered the owner as soon as the work is created; however, the main exception in the tech context are works made for hire. If you hire a developer to design and create the back end code for your e-commerce site, the general rule on ownership of that back end comes down to whether the work was made for hire. If you hire a company or independent contractor to create it, they will likely own the rights to it; however, if you hire an employee to develop it, your company will likely own it. There are very specific tests to determine whether it is an employer-employee relationship and it is not as simple as putting into a contract that the person is an independent contractor. You will need specific legal guidance in this area and the value of these works could be too valuable to not hire an attorney. You can have a contractual agreement regarding the ownership rights of any works developed, but again, something that is best handled by an experienced attorney.

In order to protect works under copyright law, you do not have to publish or register the work with any agency as your rights would attach upon creation; however, it is best practice to include a copyright notice to make others aware of your rights. It is also a good practice, in some cases, to register the work with the U.S. Copyright Office as it gives you better chances in court to protect your works and other advantages. There are costs involved and if there are revisions made to the website or code, it may be too time consuming and costly to keep registering the newest version and the company may not want to disclose some specific information they want to keep confidential.

Patents

A patent is a form of protection for the actual idea behind an invention, which must be new or novel. There are too many specifics of patent law to get into the details, but there are many different types of ideas that can be patented, for example, many software companies do get issued patents on their software (code). The process generally involves filing a patent application with the U.S. Patent and Trademark Office (USPTO). It can be filed at various stages of the idea’s development, both prior to, and after use of the patented idea; however, failure to file the patent application and beginning to use the idea in commerce can result in all kinds of legal issues that can end up in court for many years, so it is usually best to file the application early on. Also, just filing the application is not an automatic guarantee of protection. The USPTO goes through a process of review before it actually issues the patent, so it may take time before you can be sure if you have that form of protection or not. You will often see products out there with something on the packaging that says “patent pending” meaning they (hopefully) filed a patent application, but it has not yet been issued to give them full patent protection.

You also have to prosecute your patent to protect from infringement, even if you have a validly issued patent. No one is going to do it for you and the company has to incur the costs of making sure no one is infringing on their patent. Again, similar to copyright notices/markings, it is not required, but usually a best practice to include some form of notice of a patent application being filed for the particular product if it is already launched and being sold or marketed. There can be significant costs involved to file the patent properly, so an attorney who also has the additional distinction of being a “patent attorney” qualified through the USPTO should be consulted to see what kind of costs will be involved and the time frame for filing. There are also “patent agents” qualified through the USPTO; however, they are typically not licensed attorneys and, if not licensed, cannot give you legal advice.

Trade Secrets

Trade secrets are most commonly protected under various state laws and in California, a trade secret is information with value kept secret within and used by a business and the fact that it is secret gives the owner an advantage or benefit. Trade secrets, copyright, and patent protection sometimes overlap and there are strategies involved in using patent, trade secrets, or copyright protection, so it is best to consult with a qualified attorney to make that determination. Often, tech companies don’t like the fact that a patent is a public filing and prefer to rely upon trade secret protections, since it does not involve a public filing or application. Once the idea becomes publicly available, you often lose any potential trade secret protection outside of copyright or patent protection. Some common forms of trade secrets are recipes, processes, customer lists, and business plans. In the tech community, a trade secret may not be the actual software code, but the idea or way that the software runs may be.

Trade secrets are protected so long as they remain confidential. The biggest problem is when someone with knowledge of those secrets quits or is fired from a company. In California, the law is on the side of allowing former employees the right to earn a living, which includes protections for the former employee possibly leaving and using trade secrets. This means the company may not be able to go to court to force the former employee not to use the secrets. This is similar to California’s significant limitations on contractual agreements not to complete. Companies doing business in California need to be very careful with any trade secrets and not take the policies surrounding hiring and termination of employment lightly. There are a number of measures that should be implemented to protect these secrets such as privacy policies, procedures for departing employees, confidentiality and similar agreements, and limiting the number of people who learn these secrets.

Trademarks

A trademark is an identifier related to a business, product, or other good or service to determine ownership of that mark or name. It can be a company name, a logo, or the way a name is used. This includes domain names. The anti-cybersquatting laws were put into place to give some protection against people registering domain names for profit with no intent to use the domain name. Trademarks can be registered on the state and federal level to provide protection through the USPTO or the state agency in charge of regulation. The trademark application is filed and then after a process, a trademark is issued and registered. Trademark applications list certain categories of goods and/or services that the company intends to use in association with the trademark. The common way of marking a trademark to let others know of the company’s IP ownership rights are using a super-script TM next to the trademark to signify that a trademark application has been filed, but not formally registered. Once registered and issued, the common form of notice is the R inside of a circle placed next to the registered trademark.

When it comes to starting a business, there are a number of things a company needs to consider. The name of their company, product name, and domain name are all things that may have trademark implications. If a search is not performed to determine if someone holds trademark rights to a new company’s name or a domain name, the company can face issues down the road of facing a trademark infringement lawsuit. Even if the company obtains a registered trademark, they still have to continue to keep it current to avoid it being determined to be abandoned and losing their rights.

If another company is distributing a product or service for the owner of the trademark rights, the trademark owner often needs a license agreement to give the other party permission to use the trademark in advertising or product packaging, but with limits on use and other specific contractual conditions. When using another company’s trademarked name or other IP on a website or within code, the company needs to be sure that they have the right to use the trademark or obtain consent from the owner of the trademark to avoid claims for trademark infringement.

There are many factors to be reviewed in technology and internet companies from their formation through product development, growth, and exit transactions that have intellectual property implications. The company definitely needs to consider many of these issues at all stages and if nothing else, needs policies and confidentiality agreements to use to try to protect its ideas and developments (or anything else that may have existing or future value to the company). For most tech and internet companies (in fact most startups early on), their intellectual property is often the only thing of value that they have, so it is critical to be sure the proper protections are in place. Even in the development stages, disagreements can arise as to who developed/designed and owns what, so agreements should be in place to deal with those types of issues before things go bad and end up in court (e.g. Facebook’s early years).

This article gives an overview of the forms of protection and some examples of issues faced by tech startups, but I will have future articles that talk more in depth about specific issues with licensing and technology transactions.

Cap Tables, Capitalization, & Initial Accounting for Startups

Sat, 03 Mar 2012 01:16:44 -0500

Many founders are asked during the funding process for a “cap table.” So what exactly is a cap table and where do you get one?

In this article, I will explain what cap tables are, how to prepare one, review capitalization, and the initial accounting associated with startups. This article is meant to be educational only and should not be used as legal advice. Laws and regulations can vary by state and particular circumstance, so if you have specific questions, you should consult a local licensed attorney.

I) Capitalization

People need to have a basic understanding of what capitalization of a company means before they can really understand what a cap table is. Capitalization is a term that deals with the capital structure of the company. It is made up of the amounts and types of financing used by a company. Types of financing include common stock (which can include founder’s stock), preferred stock, retained earnings, and debt. It provides a general overview of the company’s debt and equity (See Part I to understand equity). You add the long term debt, equity, and retained earnings together for the normal total number. Most people are familiar with a version of this called market capitalization or market cap. That is essentially taking the number of issued shares of common stock times the company’s current price per share for a total number of market cap. It is one number used to determine an estimated value of the company as a whole. It can also change due to accounting changes due to various transactions.

II) Cap Tables

A cap table is basically a summary of the company’s capitalization and ownership. There are various forms of cap tables used and there is no one template that is the agreed upon version of a cap table. Although they can give a summary overview, the detailed version needs to be put together from the start of a business which includes specific details about who owns what from day one. It could include things like a historical timeline of stock issuance with the date of issuance, name of shareholder, number of shares, consideration given in exchange for the shares, and some accounting entries related to that consideration (cash, services, etc.). It could also be less detailed with a general overview of the total number of shares of stock issued and amounts still available for issuance. You want to keep the detailed version with actual shareholder’s names internal and only use a summary grouping such as “founders”, “seed investors”, “Series A Preferred”, “Series B Preferred”, “employee options”, and so on.

Some other common terms used in connection with a cap table are pre-money valuation, post-money valuations, price per share, dilution, options, warrants, percentage of ownership, and preferred stock. It is usually easiest to create a cap table through Excel or an accounting program, such as Quickbooks. You can purchase and download templates online; however, they are not all that complicated to put together on your own if you understand the basics of capital structure and a little accounting and finance.

A very simple example of a cap table would be:

Type Value Price per Share Shares Total Ownership

Founders - $5,000 $1.00 5,000 50%

Investors- $5,000 $1.00 5,000 50%

Total- $10,000 10,000 100%

You will normally want to include variations in your cap table that show what happens if more shares are issued, such as upon someone exercising their option or warrant right to purchase stock or additional funding rounds. It should show clear calculations of valuation and percentages of ownership both pre-money, post-money, and fully diluted post-money (if you assume that any options are exercised, warrants are exercised, or a convertible note is converted and result in stock issuances). An investor wants to see exactly what they will own in all possible scenarios.

III) Initial Accounting Practices

I will discuss the initial accounting that goes along with capitalization to expand upon the cap table preparation. I will keep it pretty simple and use an example of a California corporation.

When you first form the corporation, you list in the articles of incorporation filed with the secretary of state the total number and type of shares that are “authorized” to be issued. Think of those like a total pool of available stock in the company’s bank to issue when needed. For purposes of this example, let’s say the company authorizes 1,000,000 shares of common stock and 1,000,000 shares of preferred stock. Although these days you often don’t have to list what they call a “par value” for the authorized stock, but it is easiest just to pick something like $0.001 as a par value for accounting purposes. The initial issuance to founders of 500,000 shares of the 1,000,000 pool of authorized stock is in exchange for them putting in $50,000 of their own money into the company would have an accounting entry like this:

Account Name Debit Credit

Cash 50,000

Additional Paid In Capital (APIC) 49,500

Founder’s stock (500,000 shares x $0.001 par value) 500

Each side (both debit and credit) total 50,000 so the accounting entry reconciles. Both APIC and founder’s stock go towards the overall equity and capital of the company, so the balance sheet would show assets of $50,000 in cash and owner’s equity of $50,000 total with no liabilities. There would still be 1,000,000 shares authorized and 500,000 shares issued as the capitalization structure. The founders would own 100% of the company as you only look to what they own out of the total amount issued of 500,000, not the amount authorized since those have not yet been issued. When the remainder are issued out of that pool, the founders would get diluted down from 100% ownership to as low as 50% if the rest of the authorized are issued to new investors. This would result in a price per share of $0.10 per share ($50,000 investment divided by 500,000 shares).

Many founders try to figure out how to account for the founders stock issuance if they didn’t put much cash into the company and got a large number of shares (e.g. 1,000,000 shares issued in exchange for $500 initial investment = $0.0005 per share price). There can be tax and accounting implications, but you shouldn’t be that concerned about that low of a share price since it is really more of an accounting entry and not a real determination of value of the company. If the company is that concerned about how that may look, they can make the initial issuance at a higher share price (and bring up the valuation) if there is a legitimate basis or valuation model to support it. One thing that would stick out is if you started the company with a $500 valuation based upon $500 cash being contributed and the next day the company is trying to raise $500,000 for 50% of the company based upon a valuation of $1,000,000. You would need to justify where the value is coming from (e.g. future revenues, contract deal, patent acquisition). Valuations in early stage companies can vary widely and are extremely difficult to accurately forecast anyway, so don’t get too caught up on a low per share price.

In many cases, you don’t need to worry about including things like par value on a cap table, but the total values involved with the stock issuances should be. Often you will see the more detailed accounting entries if you look at a public company’s financials in the statement of stockholders or owners equity. That is really a variation of a cap table and might be able to give you some further examples although it may not show dilution for options or valuations.

I may post some sample cap tables I have prepared online down the road, but for now, I hope this gives you a basic understanding of cap tables.

Founders & Startup 101: Part IV) Private Placements, PPMs, & Fund Raising

Fri, 02 Mar 2012 23:09:13 -0500

So what exactly is a private placement memorandum (PPM) and why do I need one?

This article goes over the basic information about what a PPM is, when and why you may need one. This information is being provided as a general overview and a basic education of the common terms and federal securities laws involved with a PPM. Each state has their own securities laws and the discussion in this article is not to be used as legal advice, as each circumstance is different and you should consult with a licensed attorney in your state to be sure that any PPM or offering you do complies with all current laws and regulations.

What is a PPM?

A private placement memorandum is an offering document, sometimes called a prospectus, offering circular, or PPM. The majority of early startups and emerging growth companies commonly raise money through what are know as private placements. It is simply a sale of stock (or debt) in the company to private investors that become shareholders in the company. The reason they are classified as private, is not because they are private investors, but because the offer and sale of stock (a security) does not involve any public advertising or general solicitation of investors. For example, when a stock goes public, they are offering stock publicly by filing a registration statement, press releases, etc. This process of registering the securities with the SEC allows the company to utilize the media and other methods to offer its stock for sale. Since most companies don’t have the money or resources to file a registration statement with the SEC, they rely upon selling the stock through exemptions from registration.

Although there are other exemptions that are used, the most common exemptions used under federal securities laws (Securities Act Section 3(b)) for startups raising money are:

Regulation D- Private offer and sale of securities requiring compliance with manner of offering requirements and limitations on resale of securities requirements. The common categories are listed under the following 3 classes:

Rule 504- raise up to $1 million within 12 month period; no specific information requirements for PPM

Rule 505- raise up to $5 million in a 12 month period; unlimited number of accredited investors and only up to 35 unaccredited investors; 502(b) information disclosures required

Rule 506- unlimited amount of money raised within a 12 month period to accredited investors; unlimited number of accredited investors and up to 35 unaccredited, but “sophisticated” investors; Rule 502(b) information disclosures required

If Rule 505 or 506 placements are only sold to accredited investors, there is no information specifically required to be provided. If there is even one non-accredited investor, the company must provide (unless they are already a reporting company with the SEC) certain financial and non-financial statement information.

Section 4(5)- up to $5 million; unlimited number of only accredited investors

The term accredited investor was amended recently under the Dodd-Frank Act. There are a number of categories to qualify based upon things such as recent income and net worth, but the main change was to limit the definition for net worth to not include the investor’s primary residence as an asset and not include the mortgage on their primary residence as a liability (except for debts taken out within 60 days, for example a cash out refinance).

Rule 502(b) does also required the company to provide reasonable access to information requested by potential purchasers for Rule 505 and 506 offerings prior to their purchase.

Even though a sale may be exempt from registration and have limited or no information requirements to provide to potential investors, the anti-fraud rules still apply and a company can get into a serious bind if they misrepresent, lie, omit, or misstate items about the company, its business, its management, future business, and other items.

Also, as of this article, we are still waiting for further rule-making changes from the SEC for loosening or eliminating the public advertising and general solicitation rules in some cases. This could end up being a help to small companies to give them better access to capital, but we will know more once those rules are finalized.

Those exemptions require that no public advertising or general solicitation is used in the offer and sale of those securities. So, the company is not able to start issuing press releases, posting website ads, or sending mass mailings to potential investors in most cases. This does make it more difficult to get your message out there, but it must be complied with for the offering and sale to qualify for the exemption and not violate securities laws. Often this results in needing to be introduced to prospective investors through connections.

When the company decides to raise money through a private placement (which can also be in the form of a loan, which is still classified as a security), they have certain rules they must follow for the placement to qualify for the exemption and comply with securities laws. Typically, the company was already in the process of, and I highly recommend, putting together things like a 30 second elevator pitch of their company/product/service, a 5 minute presentation, a written executive summary, and a full business plan with financial projections, pro forma data, exhibits, and other relevant materials. The full business plan is essentially the formal document given to potential investors to tell them about the business, its product or services, management, financial projections, and plans for the future.

A recommended list of categories for your business plan (which will also cover many of the PPM information requirements):

Executive Summary- A brief, usually one page or so, overview of what your company does, how it is different or solves an existing problem, who your team is, and what your plans are to grow the business (i.e. how are you going to make money for the investor)

Management Team- Name, title, and a bio on each top member of the management team (officers and directors) to show what experience or assets they are bringing to the table

Product or Service Description- What do you do and how is it novel or better than something else out there and how do you make money from it?

Intellectual Property Protection- How have you or will you protect your company’s ideas, brand name, developments?

Manufacturing and Operations- How will you produce the product or provide the service, as well as manage and operate the administrative side of things?

Human Resources- How many people do you have now and how many do you plan to bring on? Any other challenges, such as using independent contractors versus employees? Do you still need to identify and hire certain positions in the company?

The Market- What market are you targeting and where do you fit into it? What is the landscape and current trends in the market or industry?

Competition- You are probably not the first person to think of this, so how are you better or different than your current or future competitors?

Sales and Marketing- How do you plan to get your message out about your produce or service?

Company Background and Structure- things like current capitalization, how the company was formed, is it a C corporation formed in a certain state…

Financial Information- current, historical, and future pro forma financial statements such as balance sheet, statement of cash flows, and profit and loss statement.

It becomes essential for the company and management during this process to cover all bases and be sure it is protected from lawsuits and SEC or other regulatory action. When a company fails to execute what they said they would do and the investor loses their investment, the plaintiff’s lawyers start circling looking for someone to go after, like the board of directors and upper management or just about anyone involved with the investment process. This is where a private placement memorandum can be a valuable tool to help protect the company and its officers, directors, and others.

How does a PPM help?

No one can guarantee that the SEC, state regulators, or private investors won’t pursue claims against the company or management, but there are steps you can take to limit any potential exposure. This is where the PPM comes in. The PPM is an offering document that is an expanded form of the business plan that is given to investors. The basis for PPMs go back to the information often required in a full registration statement filed with the SEC. Depending upon the exemption used for the number and level of investors, time for funding, and amount of money raised, there can be differing requirements for what must be provided in the PPM. Even if the exemption doesn’t require some element to be disclosed to investors, it is often a best practice to simply cover all your bases in that document. That is not to say that there may not be a legitimate business reason for not disclosing something when you are not required to do so. For example, in some cases you need to provide a recent audited balance sheet. Many startups don’t have the money to pay auditors to come in and audit their books to obtain the balance sheet, so if there is no requirement to provide that audited balance sheet, it may be best for the company to avoid that additional expense.

The basic principle behind the PPM is to fully inform the investor about all aspects of the business, company, industry, management, prior financial performance, and future prospects, as well as providing certain risk factors involved with investing in a new company, often with no revenue to sustain it. The SEC and state regulators want to be sure that you disclose what is required and don’t over-hype your company. The biggest threat is the anti-fraud statutes. If you put something in the PPM that is materially misstating the facts, misleading, fail to include relevant facts, or an outright lie, you can end up facing serious civil and criminal penalties. As an officer or director, you have certain duties and you have to be sure that you have control over what is happening in the fund raising process. Just as was discussed in Part III, you don’t want a random finder running around selling your stock by saying whatever they need to make the sale and try to get a commission.

How do I get a PPM?

There are services online and companies that offer templates for PPMs, but be cautious in going down that path just because it looks a lot cheaper. If you fail to disclose something you should have and lose your exemption from registration, you could end up in a situation where the invested money is gone, but a regulator is telling you to offer to buy back the stock you sold the investor. Guess who can end up holding the bag if the company is out of business at that point? You.

It is always best to hire a local licensed attorney to assist you in this process. Look for someone with experience in securities laws and private placements. You can save time and money by putting together a good business plan internally, but then having the lawyer add, edit, or clarify the business plan to make it into a full and compliant PPM.

What needs to be in the PPM?

This depends upon the exemption being used for the current offering, but it is best to try to include some general discussion in categories such as: summary information and risk factors, offering terms (e.g. offering for sale of 1,000 shares of common stock at $1 per share), use of proceeds, dilution, plan of distribution, description of securities to be offered, and certain information about the company and its business. This is really a matter for your lawyer to review to be sure you have adequate disclosures. Also, they should review the PPM to be sure that anything that you say in there may not be construed by an investor as misleading or fail to include something material to the business. You want to be sure the document is clear and easily understandable.

Many startups worry about weighing the document down with all that “legal mumbo-jumbo,” but if you are dealing with any investor who has been through the process with a legitimate company, they are familiar with those disclosures. You can see examples of how much risk disclosures are involved by finding a copy of a prospectus for any large publicly traded company. They go on for pages and pages and cover all kinds of random disclosures of possible risks down the road, but they are being cautious to warn investors. The SEC wants to know that investors are being informed and not misled. Most PPMs will include a statement about risks of “forward-looking statements” for things like projected revenues, which is normally a safe harbor from enforcement for public companies, but it is a best practice to include it anyway.

What else needs to be done in the process?

There are other things that are a best practice to in connection with a private placement. You should setup a control log where you document to whom the PPM was given and when. You normally should set definite dates to close the round of funding, be sure to file any required federal or state disclosures, such as a Form D with the SEC or a Form 25102 in California, keep track of when and how much was raised for calculations of exemptions for future rounds, and complete closing checklists. You need to be sure that all your investors got the same version of your PPM, even if they got a shorter business plan. These are all things that companies don’t realize can affect their ability to do business down the road, so it is always best to have a licensed, local attorney assist them with the entire process.

Founders & Startup 101: Part III) Finder's Fees

Fri, 02 Mar 2012 01:37:00 -0500

Part III) Finder’s Fees-

So you have a great idea, founded a company, and you are telling your friends and family about it. It is difficult to succeed without some working capital, i.e. cash in the bank. If you are new to startups or haven’t had to worry about raising money before, you suddenly are introduced to a new world of people who claim they have very rich friends or “know people.” They would love to help you raise some money, but they want a piece of the action. They may ask you for a percentage of the cash their “people” bring in, a percentage of equity in your company, a job with your company, or maybe some combination of these. So what can you do to compensate someone who claims to be able to bring you in anywhere from a few thousand to many millions of dollars in funding?

This is a very common problem that founders and early startup companies face. Here are some common questions:

What the “norm” is for these types of deals? None, if done, they vary widely on circumstance.

What percentage of equity should I give them? Probably not a big deal what you give as long as you still retain control of the company and are allowed to dilute them down in the future

Should I use options instead? Possibly.

Should I just give them cash? Probably not.

Am I wasting my time with this person or can they really can bring in the dough? Probably.

Should they sign some kind of non-disclosure agreement (NDA) or other legal document? Probably, yes.

Are there any risks to me or the company if I go with this person? Yes, even if they are licensed or registered to be a broker/dealer.

Can I pay my employees or bring the finder on as a VP to pay them a finder’s fee? No, that doesn’t really change the analysis of whether it is legal if it is a percentage of the raise.

I will discuss the legal issues associated with finder’s fees and the bottom line, starving company CEO point of view, as well.

A) Legal Issues with Finder’s Fees

Broker-dealer Issues

The core issue comes down to the fact that you may not think about it, but you are trying to sell a security. You or the finder will be offering and selling stock or some form of ownership in your company. A “security” is defined by the Securities Act as any note, stock, treasury stock, bond, debenture, evidence of indebtedness, and numerous other transactions. So, even if you do a debt finance deal, that is still the sale of a security, i.e. the promissory note or other evidence of indebtedness. Anyone who receives a commission or compensation from that transaction is normally considered a broker-dealer in those securities since they are making their money from trying to sell the security. There are state and federal regulations on broker-dealers, the most relevant of which is that they must be licensed/registered with the appropriate regulatory agency. The SEC and states have their own registration or licensing regulations and procedure.

When you think of your big bank brokerage account and think about the investment advisors and similar roles within them, that is normally a licensed broker-dealer. Just because it is you or a finder out trying to raise money for your small startup company and not selling shares of Microsoft, that doesn’t mean that broker-dealer regulations aren’t still in play. As the issuer (company selling the securities) and its personnel (CEO, CFO, etc.), you are probably not in the business of buying and selling securities and do not need to be registered or licensed to raise money just for your business; however, the finder often is under those obligations.

There are some limited exemptions provided so that an un-registered person may still engage in the buying or selling of securities. They are too technical to go into detail, but there are exemptions for certain intrastate transactions, for personnel of the company in offering their own securities for sale (although they cannot be compensated with a commission based upon those transactions to fall within this exemption), and some others. The law is very specific about the requirements for insiders to use these exemptions. For example, you cannot simply hire a finder as an employee or officer of your company, have them raise money, and then let them move on. They can’t be paid a commission on the transaction amount, even if they work for you, must perform substantial duties for the company outside of raising money, and can only use this exemption generally once every 12 months.

There are also disclosure requirements and other things that a licensed broker/dealer must comply with to comply with the law. A finder would technically be subject to those if they are required to be registered. As the issuer, you can face liability for fraud through misrepresentations, omissions, or blatant lies made by the finder or anyone else you send out there to raise money.

Legal Risks in Signing with a Finder

Assuming the finder is not licensed or registered with the appropriate agencies and does not fall under an exemption from registration, the finder can be held liable to the person who purchased the security (the investor) for the amount paid, as well as possibly subject to civil penalties to the regulatory agency and possibly face criminal liability. These actions can be taken by the state or federal agency in charge of regulation, or possibly both. Although I am not an expert on the civil or criminal ramifications for issuers (company) and its management, I can see potential aiding and abetting the crime of selling securities without a license. Also, the issuer and management can be held liable for recklessly made hype about the company, its prospects, financial condition, and a variety of other items. This could come in the form of shareholder lawsuits, SEC or related agency civil or criminal prosecution. For example, in California, under Corporations Code Section 25501.5, the investor has the right to rescind (cancel) the investment and seek damages against the unlicensed person (finder). Generally, that would mean the finder has to give them their money back that they invested and could face additional damages. However, this section does not directly impose liability on the company, but that doesn’t mean a plaintiff’s lawyer won’t try to sue the company and its management.

The majority of the risk falls on the actual finder and many self proclaimed “finders” are not even aware of the fact that they are doing something that may require registration or licensing as a broker-dealer. However, a loose cannon out promoting your company and making all kinds of promises about how good of an investment it is or anything along those lines can take the company and its management down into potentially major risks for the company and the persons involved.

B) Bottom Line Starving CEO View

I have worked in the trenches and can tell you that when your company needs cash to survive and grow, you tend to forget about the legal ramifications and just want to get to that right person who is going to get you the cash. I am not telling you to forgo the law and do whatever you want, but knowing the risks, each startup exec needs to make the decisions to move forward or not. I have worked within companies where it paid out equity and cash and signed many finder’s fee agreements usually anywhere from 1% to 10% typically, sometimes more. It was paid in cash, equity, options, or a combination. In some cases, the finder’s fee was even disclosed in public filings with the SEC and audited financials/footnotes. The SEC, SIPC, or any other regulatory agency did not come and knock our door down and take everyone away in handcuffs. That isn’t to say that you couldn’t be arrested and charged by the SEC with some form of fraud or other crime if your finder was out there over-hyping your company. There are risks associated with these deals, but usually that would come in the form of lawsuits by unhappy shareholders who invested through these finders.

Some quick pointers if you do decide to take on a finder’s fee arrangement:

If the person or organization is one that normally raises money for companies (e.g. investment banker), they are probably or should be licensed broker-dealers and can receive a commission, success fee, or other arrangement, so go with those first if they are currently licensed and put it in writing. This is not to say you should just blindly sign on with them. There are still risks if the person doesn’t comply with any disclosure requirements or makes fraudulent or misleading claims about the company or its future, so be sure you have checked them out and they are reputable.

Don’t accept everything they say as accurate. Many finder types are natural salespeople and can be a good asset to talk up your company, but they are notorious for what many call “puffery” or exaggerating the facts to make something sound better than it is. Whether licensed or not, a broker-dealer or finder can be liable, as well as the company and potentially management, for material misstatements, omissions, misrepresentations, and outright lies by this finder. Think of the examples from the media about “boiler room” operations and avoid those like the plague.

Do try to protect your company by putting something in writing. At the very least, get a good non-disclosure agreement in place with non-compete, non-circumvention language to the extent that it is enforceable in whatever state or place where you are raising money. You can at least try to let them know you are not going to let them try to steal your ideas, plans, or other intellectual property

There are ways to draft finder’s fee agreements to, at least in writing, limit the extent of what the person can and can’t do or say when out there trying to bring in investment dollars. This way if things go bad, you can at least have something you can point to in court to show that you made it clear that they could only do and say certain things. These won’t stop the SEC from pursuing fraud, criminal or civil claims against you or your company, but it is a way of trying to limit exposure. I always advise clients of the potential major risks for the company, management, and the finder before pursuing any form of finder’s fee agreement.

Be clear to limit what the person can and can’t do and make it a non-exclusive relationship. Don’t promise them some future board seat or CEO role, limit it to the transaction at hand. Be clear that they are there to provide introductions only to people that may be a potential investor. The least risk is to only get the name and contact info for the potential investor and then have management deal with follow up. Be sure the finder is not out doing road shows or hyping your company on their own. Have them provide their investor contacts in writing and when they were referred to the company. Also, don’t agree to an “exclusive” finder or similar arrangements if you can. An exclusive finder is one who can be a real pain if you bring in money from elsewhere and there is a fight over where the money came from. When you stick with non-exclusive, it puts the burden on them to be sure they document that it was their contact and could avoid litigation.

Assume the person will not come through. Unless you have some connection, relationship, or prior experience with this person that has proven their worth, don’t rest your company’s future on one person who is probably working on 100 other companies through finder’s fee agreements. They are out for their bottom line, just as you should be with your company. Keep working on other ways to raise the money yourself.

Don’t worry so much about some exact percentage of cash or equity to be agreed upon. Do agree on something from the start so that everyone knows going in. The capitalization of the company is going to change so many times in the company’s evolution that 10% of equity now will probably be 0.001% later.

In the end, it is up to each company and their executives or board to make these kinds of decisions based upon risk versus reward. You also need to think about it this way, if this person is so well connected and believes in your company so much, ask them to put their own money into the company. I know a lot of people in the finance and legal world will tell you just not to do this in any event, but I am aware of the challenges of being management in a company that needs those funds to grow, so I will tell you that the best option is to avoid these relationships, but if you do enter into them, try to limit your potential downside risk and seek out some legal guidance in moving forward.

Coming up next in the series:

Part IV) Private Placement Memorandums (PPM)

The information provided in this article is not legal advice and should not be relied upon to apply to your particular situation as facts and laws can vary. This information is provided as educational only. Viewing of this post does not create an attorney-client relationship.

Founders & Startup 101: Part II) Forms & Sources of Funding

Tue, 28 Feb 2012 18:47:00 -0500

So you developed the next big app or social media website idea, formed an entity, and developed a business plan, now how do you get funding?

This is the second part of a series of blog articles that will explain in layman’s terms some of the things that every founder should know about the types of equity and how common forms of funding relate to your company’s equity. All answers and discussion are meant to be educational only and should not be relied upon as legal advice for your specific situation. I will discuss things generally and as applied in California, so this is not meant to be all inclusive, but a general basic education.

Here is part II:

There are many forms of funding and sources. This gives a basic description of the most common forms of funding a startup company and where the funding comes from. This is only a basic brief discussion to give beginners an understanding so they understand some basic terms.

A) Debt Finance

The somewhat more common form in the last few years has been different types of debt financing, which is to say, a loan to the company. This can be created in many ways, as simple as an individual investor agreeing to give the company some cash and the company signing a one page promissory note. The more complex types involve significant legal documents like security agreements, credit facility agreement, security purchase agreement, and others. There a variety of terms that could be incorporated into a debt deal on when the money comes in, what it is to be used for, when payment is due, rate of interest, and other common loan terms that you may be familiar with from a mortgage or other loan you have had in the past.

The loan agreement is essentially a security in most cases, so there are securities laws and other considerations to execute this type of agreement properly. One of the most important to the bank/investor is to secure any rights to collateral if the company is delinquent in payments. In many cases with startups, the bank will try to secure any rights to not only the company’s assets, but may ask for personal guarantees. When the bank seeks this type of security, it is considered a “secured loan” versus an “unsecured loan” when there is no collateral.

Many founders get so blinded by their feelings that their startup is the best idea since sliced bread that they don’t realize the ramifications of signing a personal guarantee. If the company fails, the bank will take actions to enforce its rights against the founder who signed the personal guarantee. I have had many people, especially due to recent economic conditions, come to me in the last few years needing to file personal bankruptcy just to get out of these personal guarantees when their company failed. The bank may require a personal guarantee, so the founder is stuck either accepting those ramifications or having no working capital.

Common types of debt finance: credit line, bridge loan, straight promissory note, convertible note, credit card debt

B) Equity Finance

Equity financing is when the company sells equity (ownership interests) to an investor. See this prior Part I discussion of the types of equity to understand the forms of equity that could be sold. The most common is selling a certain number of shares of common stock in the company representing a certain percentage of the company ownership. This is most often determined by using a valuation of what the company is worth before the funding (pre-money valuation) and after (post-money valuation). If it is a more sophisticated investor, group, or, especially with venture capital firms, the use of various rounds of preferred stock, e.g. Series A preferred, Series B preferred, etc.

These transactions involve documents such as subscription agreements, stock purchase agreements, investor representation letters, and other “closing” documents. Again, this also involves a security, often common stock being offered and sold, so the transaction and process must comply with state and federal securities laws.

C) Hybrid Finance

I use the term hybrid finance to categorize the different types that aren’t traditional debt or equity finance. This can include things like convertible notes, where the company is loaned money, but the lender has certain rights to convert their debt into equity in the company. Usually the lender holds the right to determine when to convert, but sometimes it converts automatically upon the occurrence of a certain event. For example, say the company is loaned $50,000 and the terms may state that upon the company going public, the $50,000 loan turns into x number of shares of stock in the company.

Some other hybrids include convertible equity finance, such as convertible preferred stock (can be converted into common stock), combinations of debt and equity (loan and stock given to investor), and attaching warrants or options to a debt or equity financing (investor gets the contractual right to purchase stock at a set or pre-determined price). Someone could also invest money into the company in exchange for discounted options to purchase stock, although I haven’t seen that by itself in the past as it doesn’t give the investor much protection or rights.

There are also gifts, cash contributed by founders, personal credit cards or cash advances by founders, and grants that can sometimes be used for working capital in the beginning which may not be the traditional forms of finance.

All kinds of factors come into play when determining funding options for both the company and the investor such as tax consequences, security/collateral, liquidation preferences, stage of development of the business, and potential exit plan. Here is a graph showing various forms of funding and, in some but not all cases, their attractiveness/risks for the company and investor.

D) Sources of Financing

So where do you go to get financing? There are too many potential sources to cover them all in detail, but here are the more common:

Most common sources for debt financing are small/regional or specialized banks, small investor groups, small institutions, friends and family, and, one of the more common, the Small Business Administration (SBA). SBA loans are actually done through a bank that participates in the SBA program and the government provided a guarantee so that if the company fails, the bank gets back a certain percentage of their loan from the government.

Other sources of debt and equity can be categorized as: 1) angel investors- typically high net worth individuals who look for alternatives or diversification to traditional large company public stock, mutual funds, CDs, and other investments, 2) venture capital- firms that specialize in funding and growing startup and emerging growth companies, 3) friends and family- this is pretty obvious, get your friends or family to give you the money, and 4) institutions- which I classify and include certain divisions of bank, private equity firms, and hedge funds.

In order to pursue these sources, you need to have your idea well developed and thought through, usually best in a business plan. It is also good to put together a 30 second elevator pitch of your business, 5 minute presentation, written executive summary, and the dreaded full business plan with financial projections and other related exhibits. Founders often don’t realize that this process involves offering a security in the process (whether in the form of a loan or sale of stock/options) and securities laws are involved. I will go over private placement memorandums and some of the more common legal and securities pitfalls to avoid during this process in another upcoming section.

Next Section Coming Soon: Finder’s Fees & Private Placement Memorandums (PPM)

In my next section coming soon, I will deal with the common problem that startups face of when someone says they can bring money into the company through someone they may know, but they want to get paid for bringing the new investor in. The problem of “finder’s fees” has been a common issue for many years and I will discuss it further to come and another section on PPMs…

Founders & Startup 101: I) Forms of Equity

Mon, 27 Feb 2012 19:59:00 -0500

So you developed the next big app or social media website idea, formed an entity, and developed a business plan, now how do you get funding?

This is the first in a series of blog articles that will explain in layman’s terms some of the things that every founder should know about the types of equity and how common forms of funding relate to your company’s equity. All answers and discussion are meant to be educational only and should not be relied upon as legal advice for your specific situation. I will discuss things generally and as applied in California, so this is not meant to be all inclusive, but a general basic education. I am also using a C corporation for the discussion relative to equity structures, so this doesn’t necessarily apply if you formed an LLC (limited liability company) or other type of entity.

Here is part I:

I) Forms of equity (ownership interest in the company)

Founder’s Stock- This is a generic term often used when dealing with start up companies. This is the stock issued by the company to the founder’s of the company. The most common way this occurs is that the corporation is formed and then there is a corporate resolution to issue a portion of the corporation’s authorized stock to the people who started the company. They are usually issued in exchange for the founder’s initial services to start the company, for technology assigned to or developed for the company, or for some other thing of value, such as cash provided to the company. It is pretty typical that a company issues common stock as founder’s stock versus preferred stock. It is usually no different than any other type of common stock issued by the company, other than it was issued to those who founded the company.

There are often restrictions placed on founder’s stock, such as vesting over a period of time to be sure the founder stays with the company.

The initial amounts of stock used for founder’s stock and otherwise are determined by the company’s “capitalization.” This just means the total equity structure of the company, e.g. Company A has 1,000,000 shares of common stock authorized, 500,000 shares issued to founders with no one else owning any other form of shares or options to purchase shares. The founders would own 100% of the company even though the company can still issue more shares.

Common Stock- This is the general basic form of equity (ownership interest) in a corporation. It is represented by a physical stock certificate (or, in some cases, in electronic form with a broker). It shows the name of the person or entity owning the stock, number of shares, name of the corporation, and sometimes other info like date of issuance, signatures by corporate officers, number of authorized shares of the corporation. It is issued for many different reasons: to founders (see above), for funding, as compensation for services, etc.

Many people want to know, how much of the company do I own, i.e. what percent. In the capital structure of most corporations with only common stock, there are a certain number of shares authorized to be issued by the corporation, which is typically found in places like the articles of incorporation, board resolutions, or in documents filed with the secretary of state in the state of incorporation. Authorized shares are the pool of available stock the company can issue to people now or in the future. The number of shares actually issued to people is the amount of stock outstanding. So, if there are 100 shares authorized, but only 10 shares issued, only 10% of the potential ownership of the corporation has been issued. If you own 10 shares of the corporation, right now you own 100% of the company. If the company issues another 90 shares to someone else, you now only own 10% of the company’s now issued 100 shares of stock. When seeking equity funding, you are selling a portion of the company’s shares of stock. This almost always results in you owning less of the company. The only way to keep your percentage the same would be to sell them the stock you own (not the company issuing new stock) or for the company to issue you more shares of stock to keep your total percentage of the company the same (called anti-dilution, so you are not “diluted” down). Now most investors are not going to want to line your personal pockets by buying your personal stock, they want to help the company grow and get a percentage ownership and they are usually going to require that you be diluted down.

Don’t always assume you are losing control of “your” company or that you are getting screwed. First, a corporation is a separate legal entity owned by its shareholders, so although you may own 100% of the shares right now, it is best to get out of the habit of thinking it is “your” company. Also for control, take the example of Mark Zuckerberg who was diluted down in Facebook (although surprisingly not much) and he did just fine. He still maintains control of the company through board seats and voting agreements/proxies, but that is another topic entirely. You will be diluted down and probably lose 100% control over the company, but if you want to get funded, it is part of the deal, especially in the VC world.

Restricted Stock- This is a designation that can apply to any type of stock and usually the specific restriction is required to be printed on the physical stock certificate so that the shareholder knows about it. It usually means that the stock has some form of restrictions on transfer, meaning you can’t just easily sell it without complying with those restrictions. Common stock, founder’s stock, or preferred stock could all potentially be restricted stock (any usually is). If you go onto your online stock brokerage account and buy 100 shares of Microsoft, you are buying freely trading, unrestricted common stock. In other words, there are no restrictions on transfer. In most cases with startups, the initial stock is going to be restricted. You can only sell the stock after it is registered with the SEC (“goes public”) or there is an exemption that allows you to sell. SEC Rule 144 is a rule that has to do with the holding period that you must hold the restricted stock before it can become free trading stock.

Preferred Stock- The next form of equity in a company is preferred stock. Preferred stock can come in many forms, but it usually has greater rights and preferences than common stock, but is issued in the same fashion as common. In a liquidation of the company (say for a bankruptcy), preferred stockholders get paid back before common stockholders if there is anything left to distribute to stockholders. There are also many other preferences, rights, and privileges that can apply to preferred stock and in some cases, the preferred stock can be converted into common stock. These rights and preferences are usually added into amended articles of incorporation of the corporation that state these specific rights. You often hear of Series A, Series B funding, those are typically going to be rounds of funding with preferred stock, i.e. Series A preferred stock first, then Series B, then Series C and so on. The rights and preferences are too lengthy to discuss here as that is when the lawyers get involved, but things like conversion, anti-dilution, voting rights, board seats, and liquidation preferences are common.

Options & Warrants (not equity)- I put warrants and options in this section as they are commonly associated with or attached to funding, but they are not technically equity. An option or warrant is a contractual right to purchase stock in the future. It is ruled by the grant, which is typically in the form of a written agreement with the company to issue stock upon the occurrence of some future event. Examples of this are when the company goes public, gets more funding, or the holder of the option to purchase exercises that right and purchases the actual stock with cash.

I also bring this up in equity as options and warrants are technically “securities” which are covered by various securities laws, so some people don’t realize the implications of option grants or exercises. They also affect the ownership percentages in the company. The company’s accounting department is supposed to reserve stock for these future rights so that the company has enough stock to cover the options if they are exercised. This is when you hear about the “fully diluted” amount of stock in a company, it typically includes things like stock that would be issued in the future if the person exercises the option.

Below is a graph that shows forms of funding/liquidation preferences with warrants/options being low on the scale of rights held by an investor, but more flexibility for the company. The closer you get on the scale to straight debt (a loan), the more protected the investor usually is, but the company has less flexibility.

The next section, Part II, will look at the common types of funding drawing upon this basic knowledge of equity, so stay tuned for the next section coming soon…