What are the different types of equity?

September 8, 2012 by Leave a Comment

Equity refers to an ownership interest such as shares of stock in a corporation, a membership interest in a limited liability company, or a partnership interest in a partnership.  Technically, an LLC member has only one membership interest.  So it is incorrect to refer in the plural to a member’s “membership interests”.  However, a member’s (single) membership interest can be represented by multiple “units”, just as a shareholder’s corporate ownership interest is represented by shares of stock.  If membership interests are to be represented by units, it will be provided for in the company’s LLC agreement.

Rights to buy or convert into stock, a membership interest, or a partnership interest are considered contingent equity interests.  The most common types of contingent equity are stock options, warrants, and convertible notes.  Preferred stock is a form of equity that converts into another class of stock (common) according to certain contingencies.  

A properly prepared capitalization table will show all contingent equity.  See this post explaining what a “fully-diluted capitalization table” is.  

Filed Under: Equity Compensation

What is pre-money value? How do you calculate it?

September 8, 2012 by Leave a Comment

Pre-money value is a metric used by investors that tells them the price of their investment without having to know the number of shares outstanding.  Pre-money value refers to the pre-investment value of the enterprise that is implied by the per-share price of the stock being offered and the number of shares outstanding.  Because it is adjusted for outstanding shares, the metric allows investors to compare prices across different investment opportunities.

If the issuing company has a simple capitalization table, pre-money value is simply the per-share price to be paid by the investor times the number of shares and contingent shares outstanding before the investment.  For example, if a company is offering preferred stock for $0.50 per share, and there are 10 million shares outstanding, the pre-money valuation is $5 million dollars.  A company that is offering shares for $1.00 and has 5 million shares outstanding also has a pre-money valuation of $5 million. 

As with capitalization tables, pre-money value can be calculated based on outstanding shares only, or on “fully-diluted” shares, meaning that contingent equity such as stock options, warrants, and convertible notes are included in the calculation.  Investors will expect pre-money valuation to be based on a fully-diluted cap table, and that is how you should always calculate the metric unless there are special reasons for not doing it that way.  A fully-diluted pre-money valuation will be higher (because the share price is multiplied by more shares).  Intuitively this makes sense because if an investor can be diluted by contingent equity, they will essentially have to pay more (buy more shares) to achieve the same percentage ownership of the company.

Above, I said that for simple cases the pre-money valuation can be calculated by multiplying the share price times outstanding shares.  The pre-money value metric has less explanatory value if the company is offering warrants in conjunction with the stock.  To see why, look at the more complete formula for pre-money valuation:

Post Money Valuation =  new investment  * total post investment shares/shares issued to new investor

Pre Money Valuation =  Post Money Valuation – new investment

Dividing new investment by the number of shares issued to the new investor equals the per-share offering price.  So doing a little algebra, you can see that, with a simple capitalization table, the above formulas reduce to: 

Post Money Valuation =  offering price  * total post investment shares

Pre Money Valuation =   offering price  * total post investment shares

But the formula is not so simply reduced if warrants are offered because the warrants have an exercise price.  Should the exercise price be considered part of the new investment?   It is not paid at the time the investment is made, but it will be if the warrants are ever exercised, and the exercise price will then benefit all other shareholders and be shared if the company is being sold or otherwise liquidated.  I have seen it done three different ways:

  • First method:  The warrants are completely excluded from the calculation – it is not usually done this way, because the warrants will be included in the fully-diluted capitalization table.
  • Second Method:  the exercise price is ignored but the number of warrant shares is included with post-investment shares – this is the way I see it done most often, but significantly understates the pre-money valuation in my view.
  • Third Method:  the exercise price is included in the new investment and the warrant shares are included in post-money shares – this makes more theoretical sense to me, but an argument can be made that for large exits, the exercise price becomes less significant so that the Second Method is more comparable to pre-money values where there are no warrants.

To get a sense of the difference obtained by using the three different calculation methods, look at this numerical example where 1,000,000 shares are being offered for $1.00 per share, and where each share comes with a warrant for one share with an exercise price of $0.50.

Pre-money value calculation done three ways when company has warrants

If you want to play with the numbers you can download the spreadsheet here.

Pre-money Value Calculated Three Ways with Warrants

As you can see there is a significant difference in the resulting value.  Including the warrant shares in the calculation but not including the warrant exercise price yields a significantly lower pre-money valuation.  Issuers will obviously like this metric, since a lower pre-money valuation implies investors are getting a better deal. Investors, if they haven’t looked too closely at how pre-money value was calculated,  may assume that the exercise price was concluded.

So which valuation method is correct?   None are necessarily correct or incorrect.  They are just metrics that are useful for  evaluation an investment.  What is important is that everyone understands how the metric was calculated.  To protect themselves from later claims of misrepresentation or securities fraud, issuers should be sure to clearly state which method they used in calculating pre-money valuation.

One take away from tall of this is don’t offer shares with attached warrants unless there is a good reason to.  Usually there is not, and simple is always better.

Filed Under: Raising Capital, Resources

Startup Company Valuation and Dilution Calculator

September 8, 2012 by 4 Comments

Each time a company raises capital, management must determine how much equity to give up to obtain the needed cash.  If too much equity is sacrificed too early, founders can find themselves so diluted that it will be hard to raise capital without destroying their incentives.  Too many times I see founders focusing too narrowly on their first capital raise, without giving due regard for the dilution that will surely come when the company reaches the next point where it will need to raise capital.

To help my clients get a better feel for how their ownership shares will be diluted over multiple capital raises, I prepared an Excel spreadsheet that calculates pre-money value and dilution over five capital raises. The purpose of this spreadsheet is to help founders set the price of their early capital raises while considering the complete growth cycle of the company.

[screencast url=”http://www.screencast.com/t/T1heTeoSc” width=”480″ height=”360″]

 

The video below explains how to use the Valuation and Dilution Calculator, which you can DOWNLOAD HERE.

 

Filed Under: Raising Capital, Resources

What legal documents are necessary to start a company?

September 5, 2012 by Leave a Comment

One can form a new corporation in minutes on the Secretary of State website, but much more documentation is required to establish rights and protocols with respect to ownership and management of the corporation.

To do it right, all of the documents listed below would be necessary in a corporation that is preparing to grow without legal hiccups.  Fortunately, over the years, this documentation has become fairly standardized, and is not expensive to prepare.

 
Formation of Corporation:
  
Master Business License Required by the State of Washington.
Local Business License May be required by your local city or county.
Articles of incorporation This is the foundational legal document of the corporation.  It is required by statute.  It establishes the classes and number of authorized shares, the rights and preferences of the stock, fiduciary and liability standards for board members, any special voting requirements, and other fundamental corporate matters.
Bylaws The Bylaws establish rules regarding the board of directors, shareholder meetings, and other matters.  Sometimes they contain indemnification rights for officers and directors.
Organizational resolutions These first resolutions of the board of directors authorizes the first issuance of stock, appoints officers, establishes authority to open bank accounts, and other matters
Subscription Agreement   This is the agreement between the company and a purchaser of stock.  Depending on choices they make, founders may have a simple subscription agreement, or they may have extensive documentation for restricted stock.
Stock Certificates The document that certifies to a shareholder’s ownership of shares.
Stock Ledger Ledger that shows the history of all issuances, transfers, and cancellations of stock.
Cap Table The Capitalization Table is derived from the Stock Ledger.  It shows the current ownership of the company, amounts paid and percentage interests.  It includes options, warrants, convertible notes, and other rights to purchase or be issued stock of the company.
Shareholder Agreement This sets forth agreements among the shareholders.  Common terms are rights of first refusal and co-sale rights with respect to proposed transfers of shares, rights to approve certain major corporate actions, protocols if someone dies or gets divorced, and composition of the board members.
Asset Assignments Usually the founders have created some IP before the company is incorporated.  IP could include software, a patent application, a business plan, a potential customer list.  All of these things should be assigned to the company when it is formed.  There may be other assets, such as contracts or office equipment, that need to be assigned to the company.
S Election For an S Corporation only, a document filed with the IRS that establishes the company’s election.
   
Limited Liability Agreement For a limited liability company, the Limited Liability Company Agreement (sometimes called an Operating Agreement) will replace the Articles of Incorporation, Bylaws and Shareholder Agreement.
   
Equity Compensation:
  
Founder Restricted Stock Agreement Founders often impose buy-back restrictions on their stock that incentivize founders to stay with the company.  See my post on the subject. 
83B Election If the founders take restricted stock, the 83B election is a necessary form to file with the IRS to obtain the desired tax treatment.
Stock Option Plan To issue stock options qualified for certain tax treatment, the options must be issued persuant to a written plan approved by the board of directors and the shareholders.
Employee Stock Option Agreement This document contains the Grant Notice, which sets forth the number, type, exercise price, and other terms of the the options.  The Stock Option Agreement, together with the Stock Option Plan and other incorporated documents, establishes and governs the employees rights with respect to the granted options.  
Authorizing Resolutions The board of directors and shareholders must approve the stock option plan, including the amount of shares set aside for the plan.
   
Human Resource:
  
Employee Offer Letter For the general employee, this agreement will document employment-at-will status and clarify compensation and benefits.
Form Independent Contractor Agreement Most startup companies find it necessary or beneficial to hire consultants or other independent contractors.  A well drafted Independent Contractor agreement will provide for important terms such as the nature of the relationship (not an employee), scope of work, payment terms, and most importantly, ownership of intellectual property created under the contract.
Worker Intellectual Assignment Agreement The company should have a form confidentiality and intellectual property assignment agreement for employees and for independent contractors.
   
Other Agreements
 In addition to the above, a company may have supply agreements, customer agreements, distributor agreements, service contracts, agreements with advisors, and promissory notes from founders or other supporters to the company.

 

Filed Under: Incorporation

Should founders take restricted stock?

August 8, 2012 by 1 Comment

First off, we need to distinguish two definitions of restricted stock.  The term restricted stock also refers to stock that is restricted from public transfers under the securities laws because it has not been registered with the SEC and state securities agencies.  This post is about founder stock that is restricted in the sense that the company has the right to buy the stock back if the founder leaves the company.  Founder restricted stock typically has the following characteristics:

  • It is issued pursuant to a Restricted Stock Agreement between the founder and the company.
  • At least part of the stock is subject to repurchase by the company at the original purchase price if the founder leaves.
  • The restrictions on the stock, or in other words, the company right of repurchase, usually lapses according to a vesting schedule over two to four years, similar to stock options.
  • For tax efficiency, stock is ideally issued at the earliest stage of the company, when the value of the stock is low.
  • The founder makes an election under Internal Revenue Code Section 83(b) to include the value of the stock (in excess of the price paid for it) in the founder’s gross income for that year, which allows the founder to have capital gains treatment on the appreciated stock when it is later sold.
  • Although the stock is not vested (it is still subject to the buy-back right) it has all the rights and privileges of issued stock, including voting and distributions.

Although it may be deemed burdensome, restricted stock serves at least three purposes that are mutually beneficial for founders:

  1. It motivates founders and other key employees to stay with the company and do their fair share.
  2. It establishes a pre-agreed protocol for easing out founders who have lost interest or underperform.  (If a founder is perceived to be at higher risk than average to be tempted away to other projects, it is also possible to impose on the vested stock a buy back right at fair market value – as opposed to original purchase price for unvested stock.)
  3. Investors appreciate 1 and 2.  In some cases, investors have required founders to accept buy-back restrictions on their stock

Restricted stock can be particularly useful in early stage companies where one or more founders are not working full time on the project.  In such cases, rather than termination of employment, it is failure to contribute the minimum amount of service to the company that triggers the buy-back right.  A clause like the following in the founders’ mutual restricted stock agreements seems to work well to keep founders doing their share of the work:

“Service” means at least an average of 20 hours of weekly service to the Company if Founder is not otherwise compensated (e.g., as a full or part-time employee).  Founder will be assumed to be performing Service for the Company unless he receives a written notice from the other two Founding Shareholders that, in their view, Founder is not meeting the service requirement, in which case Founder will have 30 days to cure the failure.

If you decide to use restricted stock, it is wise to consult with an attorney or accountant, particularly with respect to the tax aspects and the 83(b) election.  The 83(b) election must be filed with the IRS within 30 days of when the stock is originally issued.

Filed Under: Articles, Equity Compensation

How do I protect IP created by contractors and volunteers before I incorporate?

August 7, 2012 by Leave a Comment

Before any start-up is formally incorporated, there is always a period when the founders have developed intellectual property in the form of market research, the business plan,  perhaps trademarks, and often software code.   Sometimes formation of the business entity is delayed too long, creating unintentional claims on the ownership of the business or its assets.  But even when transition to the state-organized entity is timely, care should be taken beforehand not to create unintentional ownership claims on your intellectual property or your business itself.

First Caution: Don’t form an unintentional partnership. Unlike a corporation or a limited liability company, a partnership does not need to be formally organized with the state to exist as an entity.   Under Washington law, a general partnership is formed anytime two or more people associate as co-owners to carry on a business for profit, whether or not they intend to form a partnership.  A formal written agreement is not necessary.  See RCW 25.05.055.  As a founder, you will probably seek input and advice from many people as you are starting to form your business concept.  Friends and family may help you work on your business plan, create a web site, or even assist with writing code.  You may think they were donating their effort.  But they might think they were your partners.  Moreover, they will own the copyright to any work product , unless they assign it to you or the business.  A frequent issue arises when two friends start work on a project, but one loses interest and stops contributing.  The other keeps going but the relationship between them was never settled.  Then when the business grows and becomes valuable, the non-contributing partner comes back and wants a share of the business.  These kinds of situations are not unusual.  Indeed, the majority of start-ups probably experience them to some degree.

So what are your available strategies at the pre-formation stage?

  1. Don’t take any help.  (Not optimal and sometimes not even practical.
  2. Take help from only family members and close friends who you trust completely.  (Without taking further precautions, this strategy risks damaging relationships.  Any lawyer can give you examples of family members and friends whose relationships have been destroyed over business disputes.  If you do need to do business with family and friends, I advise more documentation rather than less.  Having an agreement in place beforehand can keep minor dissatisfactions from festering into real problems.)
  3. Use an independent contractor agreement with an IP assignment (see below), and pay the contributor a small amount for their work (even if payment is in something other than cash).
  4. In all cases, be very clear in your emails and other communications.  If you decide not to pay them for their work, state clearly in a written document that the contributor is donating the work to your project without expecting anything in return.
  5. Actually make them a partner.  If you do decide to make a contributor a partner, it may be a good time to consult an attorney or at least an experienced business person.  You should have a written agreement in place.   There are a host of issues that go into a forming a business with co-founders, not the least of which is how to divide up percentages in a fair way that leaves breathing room to issue stock in the future to financial investors, key employees, and other employees.  Other issues to work through are control, tax strategies, salaries and distributions, terms of departure, and so forth.  If you are ready to take on a partner, it’s probably worth the investment to consult a lawyer or accountant on entity choice.

Second Caution: Use Independent Contractor Agreements, even if you are not incorporated yet.   If you pay someone to develop software, you own the code, right?  Not necessarily so.  Non-employees (i.e., independent contractors), retain the copyright of works they create unless the work product falls into certain designated categories that qualify it as “work made for hire”.  17 U.S.C. § 101  Most software development projects don’t fall into one of the enumerated categories for work made for hire, which is why you should have the developer (or logo designer, etc.) sign an independent contractor agreement.   A well-drafted independent contractor agreement will have a work made for hire clause, and just to be safe, a backup clause that assigns the work product to the hiring entity.  If you are a founder who has not organized a business yet, you are the hiring entity.  The form of Independent Contractor Agreement that we have made available for downloading can be adapted to individuals who haven’t formed an entity yet.

Third Caution:  When you do form an entity, assign the assets and contracts to the entity.  One thing I see over and over again is that founders forget to assign their assets and contracts to the entity after it has been formed.  It is a fairly simple process to go to the Secretary of State website, set up a corporation or a limited liability company, get your business license, and start doing business.  But none of what you have created or produced before the company was formed is owned by the company unless it has been assigned to the company.  When it comes time to raise capital, sophisticated investors will look back to all of your material IP to see when it was created and by whom.   You will need to be able to show that it was created by employees of the company, or assigned by independent contractors to the company or to the founder, who in turn assigned it to the company.  Usually the founder assigns all of the IP of the business to the company at the time it is formed and initial stock is issued.   In addition to the business plan, market research, logos, trademarks, software and other IP,  other assets such as account balances, computer equipment, contracts and leases need to be assigned to the company at the time it is formed.

Filed Under: Articles, Intellectual Property Tagged With: , ,

What is Start-Up Act 2.0? (Immigration Bill for Entrepreneurs)

July 17, 2012 by Leave a Comment

Passport

Immigration law is undoubtedly a controversial subject. As a start-up business owner who is not a US citizen, you must first think of an appropriate visa that will allow you to legally work in the US.  Currently, there is no perfect visa for start-up owners (I will write about options available at the moment at a later date). Congress is aware of this problem and there are several bills of interest pending.

The bill of most interest for entrepreneurs is called the Start-Up Visa Act 2.0 which was introduced in May 2012. It is based upon the Start-Up Act introduced by Sen. Moran and Warner last year. U.S. Senators Marco Rubio (R-Fla.), Chris Coons (D-Del.), Jerry Moran (R-Kan.) and Mark Warner (D-Va.) along with Steve Case, Revolution LLC CEO and member of President Obama’s Council on Jobs and Competitiveness, and Robert Litan of the Ewing Marion Kauffman Foundation, unveiled this bipartisan legislation.
Among other things, the Start-Up Act 2.0 aims to do the following:
1. Create an Entrepreneur’s Visa for legal immigrants.
2. create a new STEM visa so that U.S.-educated foreign students who graduate with a master’s or a doctorate in science, technology, engineering or mathematics can receive a green card and stay in this country, launch businesses and create jobs.
3. It eliminates the per-country caps for employment-based immigrant visas.

Here is a link to what the senators said about the bill when it was introduced. We will update you as more information becomes available. Watch this space!

 

Filed Under: Immigration Tagged With: , , ,
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