Start-up Formation and VC and Angel Investor Financing

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1. Time of Start-up Company Formation

There are several good reasons to form the company as early as possible.

Holding Periods

The earlier the company is formed, the sooner the shares can be issued and the capital gains holding period begins to run. Upon a liquidity event, shares that have been held for one year or more will be taxed at the long-term capital gains rate. Gains on shares held for less than one year are taxable at an individual's ordinary income tax rate which can be significantly higher than the long-term capital gains tax rate.

Cheap Shares Issues

Founders of companies often make the mistake of waiting until they have received a strong indication of interest from an investor before they decide that it is time to incorporate. Forming a company so close in time to raising capital can create a significant tax issue.

Ability To Contract

The founders may want to establish certain relationships with third parties that require contracts. As an example, there may be an independent contractor that is going to be developing some software code. For the company to own this code, it needs to enter into a work for hire agreement with the contractor. This obviously cannot be done until the company is formed. Non-disclosure agreements, or NDAs, raise a similar issue. Founders are often in contact with potential strategic partners, advisors, employees, and others at the very earliest stages.

Limited Liability

Perhaps the most fundamental benefit of incorporating is the protection of the corporate shield. Individual shareholders are generally not liable for the liabilities of the company in which they hold shares. Until a company is formed, the individuals are acting in their personal capacity, and may be personally liable. To enjoy the benefit of the corporate shield, certain corporate formalities must be adhered to, including the maintenance of separate corporate records and accounts, the holding of annual meetings of the shareholders and directors, and the execution of documents in the name of the company.

2. Choice of Entity

One of the initial decisions founders must make is the form of entity to use for their new company. On the whole, corporations tend to be the entity of choice for most start-ups that plan to raise money from the venture capital (“VC”) community.

3. Jurisdiction of Incorporation

We always recommend incorporating a start-up federally. We never recommend incorporating a start-up provincially. If for some reason it is beneficial to incorporate outside Canada, we recommend incorporating in Delaware for two primary reasons - maturity of Delaware corporate law, and relative ease of taking shareholder actions.

The subject of founder's equity is one of the more involved aspects of organizing a start-up. Issues to consider include capitalization at the time of formation, division of shares among founders, share transfer restriction agreements, the dilutive effect of the employee pool required by the VCs, and equity budgeting.

4. Division of Shares Among Founders

The issuance of shares among founders is for the founders to determine, and is typically based on relative contributions to the formation of the company, including:
• The conception of the business idea;
• Leadership in promoting the idea;
• Assumption of risk to launch the company;
• Sweat equity;
• Writing the business plan; and
• The development of any underlying technology.

In addition to pre-formation contributions, the potential for future success in commercializing the business idea may also be a factor, including the background and experience that each person brings to the task.

Basic Elements Regarding Vesting

There are five essential elements to address in a share transfer restriction agreement regarding vesting:
• Duration of vesting schedule;
• Up-front vesting;
• Cliff vesting;
• Acceleration upon termination; and
• Acceleration upon change of control.

Vesting Period

Founders shares generally vest over three to five years. You rarely see five-year vesting requirements any more. Founders with significant bargaining leverage may be able to get a three-year vesting schedule. Four-year vesting seems to be the most common.

Up-Front Vesting

It is fairly common in VC transactions for founders to have some percentage of their shares vested up front. VCs will often agree to this if there has been a significant amount of effort put into the company before funding. The range of up-front vesting typically falls between 10 percent and 25 percent.

Cliff Vesting

Vesting is said to be on a “cliff” basis when a certain minimum period of time must elapse before any additional shares of stock vest. Six and 12-month cliff vesting is fairly common, with the current trend toward the shorter end of that range.

Termination

Any number of circumstances could lead to the termination of a founder's employment. VCs often take the position that the equity must be earned, and that if the founder leaves for any or no reason, no additional stock vests. There are four basic circumstances in which a founder might leave the company:
• Resignation (for no reason and for good reason);
• Termination (for cause and without cause);
• Death; and
• Disability.

Dilutive Impact of Employee Pool Required by VCs

Every VC term sheet includes a requirement that the company put in place an equity incentive plan equal to between 15 percent and 25 percent (sometimes higher) of the common stock of the company on an as converted, fully diluted basis, including for this purpose the entire employee pool even though no awards may have been made at the time of the closing of the venture investment. The more key hires the VCs perceive will be necessary to fill out the executive management team, the higher will be the proposed employee pool. Very few first- time founders understand the important implication that this percentage has for their equity stake in the company.

5. Equity Incentive Plans

There are two basic types of equity incentives used by start-up companies - shares options and restricted shares. Shares options come in two forms - incentive shares options and non-qualified shares options. These basic forms of incentives differ primarily in the tax consequences to the recipient.

Restricted Shares

Restricted shares are the shares that are held outright, but subject to the company's option to buy back unvested shares at the time the employee leaves the company.

Equity Incentive Ranges

Companies often ask us to comment on what percentage ownership interest would be appropriate for an executive hire. There are certain ranges that are recognized as “market”:
• CEO - six to ten percent;
• VP Technology - two to six percent;
• VP Marketing - one to three percent;
• VP Business Development - one to three percent; and
• VP Finance and Operations one-half of one percent to two percent.

These numbers are determined as of the closing of the first VC round, and are not subject to dilution by the grant of options out of the employee pool. For example, if there is a 20 percent employee pool, a CTO receiving five percent would be granted options or receive restricted stock for 25 percent of the shares in the employee pool.

6. Angel Financing

As a company gets into initial fund-raising efforts, it may find that it either needs to or prefers to raise money from “angel” investors rather than through traditional venture capital firms.

Type of Security Sold

Angels will typically be expecting one of two types of securities in exchange for their money - preferred shares or debt convertible into preferred shares. Preferred shares give the holder certain preferences and privileges relative to the holders of common shares.

Conversion and Anti-Dilution Protection

Preferred shares typically are convertible into common shares. Usually the conversion ratio at the time the preferred shares are issued is one-to-one - that is the preferred shareholder may convert each share of preferred stock into one share of common stock at any time. The preferred shareholder typically has protection that results in an increase in the conversion ratio in the event that the company sells any of its shares at below the price paid for it by the preferred shareholder - so-called anti-dilution protection.

Conversion Price

The “conversion price” is a key concept for understanding the mechanics of anti-dilution protection. Upon issuance, preferred shares typically convert into a number of shares equal to the original purchase price per share of the preferred stock divided by the conversion price. Before any adjustment, the conversion price usually equals the purchase price, and therefore the original conversion rate is one share for one share. The conversion price, and as a result the number of shares into which each preferred shares may be converted, changes when the shares are sold at a price below the price per share paid by the preferred shareholder and an anti-dilution adjustment results. The calculation of the “new conversion price” depends on the nature of the anti-dilution protection.

Full Ratchet

The most favourable kind of anti-dilution protection for a preferred shareholder is called “full ratchet” protection. In full ratchet protection, the “conversion price” equals the most recent price per share of common shares sold by the company. To take a simple example, assume there were 300 shares of common shares held by the founders on January 1, 2014. Assume also that the company sold 100 preferred shares to investors at $1 per share on that date, convertible one-to-one into 100 common shares, or 25 percent of all common shares. Then assume that 100 common shares were subsequently sold at 50 cents per share. The new conversion ratio would be $1 divided by fifty cents, or two, and the preferred shares would then be convertible into 200 common shares, which on an as converted basis would equal 33 percent of all common shares.

Typically full ratchet anti-dilution protection is applied without regard to how many shares are subsequently sold at the lower price. In the above example, if just one common share was sold at 50 cents, the result would have been much more favourable to the preferred stockholder, who would still have the benefit of the two-to-one conversion ratio. With that ratio, the preferred shareholder would then own shares convertible into 200 out of a total of 501 shares of common shares, or nearly 40 percent of the common shares!

Weighted Average

A type of anti-dilution protection more favourable to the company is called “weighted average” protection. Weighted average protection gives effect to the dilutive effect that the subsequent issuance has, and typically results in a much less dramatic change in the conversion ratio.

Issues Associated with Preferred Shares

Although preferred shares are a widely accepted security for early stage financing, relative to convertible notes, they have certain shortcomings.

Fixing Fair Market Value

Issuing preferred stock to angel investors requires the company and the prospective investors to establish a pre-money valuation of the company without the benefit of someone in the business of determining such valuations (such as a VC). The company and the angel investors might not be entirely comfortable placing a valuation on the company at this stage. They might fear that the valuation will turn out to be substantially different (even after taking into account the development of the company between the two rounds of financing) than that established in the next, VC round of financing.

Blocking Rights

Once a series of preferred shares have been issued, the company would typically need the consent of the holders of the preferred to approve future issuance of preferred shares, including the issuance of shares to VCs. This can occasionally result in problems with the angels, who might, for example, disagree with the valuation being offered to the VCs.

Convertible Debt

Instead of issuing preferred stock to angels, early stage companies may issue notes that convert into whatever the company issues in the future, presumably to VCs, but at a discount. The single most attractive benefit of this is that the valuation of the company can be deferred until the VCs, who are generally professional investors, make their investment. The tax consequences of an issuance of convertible debt may be more complicated than those associated with preferred stock financing, and should be considered carefully by the company and the investors. The basic terms of a convertible note offering are discussed below.

Promissory Note

The security sold in a convertible debt offering is a promissory note that automatically converts into preferred shares at some future time. The intent of the company and investors is that the preferred shares into which the note will convert will be whatever is negotiated between the company and the VCs in the first venture financing - typically Series A Preferred Shares. The debt typically converts at some discount - usually in the 15 percent to 30 percent range from the price paid by the VC investors. Companies occasionally try to come up with complicated discount matrixes in which the discount may vary as a function of:
• The VC valuation. (The higher the valuation, the steeper the discount in order to align the interests of the note holder and the company); and
• The duration that elapses between the time of the sale of the convertible note and the closing of the VC round. (The longer the duration, the steeper the discount, on the theory that the venture must have been riskier at such an early stage).
These complicated structures are something to avoid. They are very difficult to explain and they confuse investors. Convertible debt financing seem to work best when they are kept clean and simple.

Default Preferred

In the event that there is no subsequent VC financing within a certain period of time, the notes convert (usually automatically, but sometimes at the option of either the company or the investors) into a pre-defined class of preferred stock, at a pre-determined pre-money valuation. This type of default conversion allows the company to remove the debt from its books.

7. Hiring Considerations

Once the issues of formation and capitalization have been addressed, the founders can begin to think about filling personnel positions.

Offer Letters

Offers of employment are typically extended to new hires using simple offer letters. These simply serve to outline the key terms of the offer, including the position of employment, the base pay, the options package and benefits. They also attach a form of employee agreement that each new hire must sign as a condition precedent to becoming an employee.

Employee Agreement

An employee agreement is for the benefit of the company, not the employee. It has four basic provisions:
• A confidentiality agreement whereby the employee agrees not to disclose or misappropriate the confidential information of the company during or after the period of employment;
• An assignment of rights provision, whereby the employee agrees to assign any and all rights in any work product resulting from or related to the employee's services, to the company;
• A non-solicitation provision whereby the employee agrees not to solicit the employees or customers of the company for a period of time (usually one year) after the termination of employment; and
• A non-compete provision whereby the employee agrees not to compete with the company for a period of time (again, usually one year) after the termination of the employee's employment.

The company should require prospective hires to sign this agreement before they begin employment with the company; otherwise it may be difficult to enforce. In addition, in certain companies, it may be best to remove the non-compete provision for lower level employees who will not be privy to proprietary information.

This agreement is not to be confused with an employment agreement, which provides protection for the employee, including severance, acceleration of vesting upon termination, and other similar provisions. Employment agreements are typically reserved for very senior management people who have significant negotiation leverage coming into the company.