Startup Law Overview

(Originally compiled by Glen Van Ligten and adapted by Scott James and Adam Sterling for this
class)

Choice of Entity

This course is about working with startup companies and venture capital funds. The term “startup
company” is not a technical legal term and it does not have a precise meaning in the business world.

When we use the term startup company, we are referring to a “Silicon Valley” type startup that is a
plausible candidate for venture capital. Venture capital is a form of financing that is tailored to companies
with high growth ambitions and are characterized by a high degree of risk and a commensurate level of
potential return.

Silicon Valley startups are typically formed as c-corporations. This is something of a puzzle because s-
corporations[1] and limited liability companies (LLCs) are potentially more tax efficient.

Read through the following blog entries to discover why Silicon Valley startups are usually c-corporations:

● http://www.startupcompanylawyer.com/2009/03/12/what-type-of-entity-should-i-form/

● http://startuplawyer.com/venture-capital/why-the-corporation-is-king-for-getting-venture-
capital

● http://www.startuplawblog.com/2011/03/31/choice-of-entity-is-an-llc-ok/

How to Form an Entity

At a basic level, forming an entity requires very little paperwork. Articles of incorporation (called a
“certificate of incorporation” in Delaware) are filed with the secretary of state in the state in which you
chose to incorporate. For reasons described in these blog entries, Delaware is the most frequent choice:

● http://www.startupcompanylawyer.com/2009/03/03/what-state-should-i-incorporate-in/

● http://startuplawyer.com/incorporation/top-5-reasons-to-incorporate-in-delaware
After the secretary of state accepts the filing, you need to “organize” the corporation. Organizing a
corporation entails naming a board, adopting bylaws, naming officers, and issuing stock. We will look at
this basic paperwork in class, and the following blog entry explains the roles of directors, officers, and
shareholders:

http://www.techstartuplawyer.com/toolkits/incorporation/incorporating-a-technology-startup-the-
players-incorporator-board-officers-and-shareholders/

Taking the actions described above will get you a basic entity under state corporate law that is capable of
signing contracts and taking other formal actions.

Founders Stock

While the term “founder” has no technical legal significance, fundamentally, the term refers to the
entrepreneurs that generated the initial idea for a business and formally create the legal entity. Founders
are typically the company’s first shareholders, directors, and officers. Sometimes there is only one
founder and in other cases, you may have a team of founders. Founders are distinguished from investors
(those who contribute primarily cash rather than service) and employees (those who either perform
lower-level functions or join the company significantly after founding).

When the company is formed, the company usually issues the founders around 10,000,000 shares.[2] As
consideration for the shares, the founders typically pay some relatively modest amount of cash (often a
fraction of a penny per share) and/or contribute intellectual property (e.g. the founder’s rights in the
company’s business plan, initial code, etc.).

The stock issued to founders is a form of “restricted stock.” Restricted stock is stock that has to be
“earned” over time, and so it is subject to forfeiture if the founder quits working for the company or is
fired. In the event a founder departs or is fired, her stock is “repurchased” by the company at the price
the founder originally paid for the stock. Recall that the founder paid a relatively modest amount for the
stock. If the company’s value has increased greatly since its founding, having the stock repurchased at
that low initial price is tantamount to forfeiture. For example, if the founder initially paid a total of $500
(in cash or IP value) for her 5,000,000 shares, but the 5,000,000 shares are now worth $10,000,000, it is
going to be a bad day at the office for the founder when the company repurchases the stock at $500!

“Vesting” refers to the lapsing of this potentially punitive repurchase right over time. A very simple vesting
schedule would be: “vesting in equal parts monthly over four years.” Under that very simple vesting
schedule, 1/48th of the shares would vest (i.e. escape the punitive repurchase right) each month.[3] In
practice, you will frequently see the vesting schedule include an additional feature: the restriction that no
shares will vest for the first year; think of this as a probationary period. Once this one-year threshold is
met, then 25% of the shares vest all at once. Thereafter (for the next three years), the remaining shares
vest monthly (1/48th a month). The whole process takes four years. The one-year probationary period I
just described is called a “cliff,” so that this more complex vesting schedule might be referred to as “25%
vesting at a one-year cliff with monthly vesting over the next three years.”

Another vesting wrinkle is acceleration. Acceleration is a founder-friendly term that says the founder gets
some extra vesting (beyond what she would get under the schedule described above) in some situations.
The most common form of acceleration is called “double-trigger” acceleration. The two triggers are: (1)
a change of control, such as a merger, and (2) the entrepreneur getting fired after the change of control.
Usually, both events have to happen before any acceleration occurs. In addition to founders, you may
see key executives receive some form of acceleration for their equity grants.

Vesting is further described in the following blog entries:

● http://www.startupcompanylawyer.com/2007/07/19/what-should-the-vesting-terms-of-
founder-stock-be-before-a-venture-financing/

http://startuplawyer.com/incorporation/why-your-startups-founders-stock-should-vest-over-
time

When issuing founders stock, it is important to keep tax consequences in mind. When a person receives
property subject to forfeiture (whether it be a painting, a house, or stock), the default rule is that tax is
incurred as the restrictions lapse. For restricted stock, this would mean that the founder would have to
pay tax every time shares vest, calculated at the difference between the then current value and the price
that the founder initially paid. Through this lens, the founder is effectively penalized for the company’s
value having increased since the founding. This situation is especially problematic for the normal startup
company where its stock is still illiquid (i.e. not listed on a public stock exchange) and the founder cannot
readily sell shares to help offset the tax burden. Under the default rule, the IRS is not sympathetic to the
fact that a founder has not actually realized any gain from their equity. Luckily, there is an easy solve,
addressed by filing something called an “83(b) election.” The 83(b) election brings forward the tax
obligation and allows the founder to pay all of the tax when the stock is initially received. In this scenario,
there is effectively no tax due, as there is no hypothetical gain (i.e. the fair market value on that day is
identical to the cost at which the equity was issued. [4]

More on the 83(b) election here: http://www.startuplawblog.com/section-83b/

Stock Options

Stock options are the type of equity compensation that non-founder employees usually receive. A stock
option is simply a contract that allows the employee to buy stock in the future at a designated price per
share. Unlike restricted (founders) stock, the shares are not actually issued until the option is exercised.
In other words, the option holder does not vote, receive any dividends, or have any other rights of a
shareholder prior to exercise.
For reasons discussed below, the option price is usually set at the fair market value of the stock on the
day that the option is granted. If the company does well and the value of the stock goes up, then the
employee gets a (potential) economic benefit from exercising. For example, assume the value of Startup
A stock is $0.10 per share on January 1, 2016. Assume further that an employee is granted a stock option
for the purchase of 5,000 shares at $0.10 per share. If the employee exercises the option four years later
when the stock is worth $1.00 per share, the employee has a potential gain of $0.90 per share (referred
to as the “spread”).[5]

When a startup is formed, the company has in mind that a certain number of shares will be set aside as
what is commonly referred to as an “option pool.” At first, this option pool may just be a rough equity
budget or a column on a spreadsheet. At some point, however, the company will formalize this option
pool by adopting a formal stock plan. This stock option plan streamlines the process of granting options.
Instead of drafting option agreements from scratch with each grant, the company can simply provide a
brief option notice, with most terms incorporated by reference to the full stock option plan.

Options are typically subject to vesting. When we learned about restricted (founders) stock, vesting
referred to a punitive repurchase right that phased out over time. Options work differently – the right for
the employee to purchase the shares subject to the option phases in over time. But the practical effect is
the same: the equity is earned over time. In both cases, the prevailing custom is 25% vesting at a one-
year cliff plus an additional 1/48th a month thereafter. That means full vesting takes four years. See the
discussion of vesting for founders stock above.

There are two kinds of options: nonqualified stock options ("NSOs") and incentive stock options ("ISOs").
These are IRS tax classifications, so the substantive difference is tax treatment. ISOs are attractive as there
is no tax on exercise of an ISO and if those shares are later sold, any gains may be characterized as long
term capital gains (provided the requisite holding period is satisfied). See the table below for a some basic
comparisons of restricted stock, ISOs, and NSOs:

Type Grant/Issuance Vesting Exercise Sale

$0.10 FMV When FMV = @ $1.00 per

$0.20 per share share

Restricted stock No tax (b/c $0.10 No tax N/A Tax on $1.00

(& 83(b) election) actually paid) minus $0.10
purchase price
 NSO No tax No tax Tax on $0.20 Tax on $1.00
minus $0.10 minus $0.20
exercise price

ISO No tax No tax No tax Tax on $1.00

minus $0.10
exercise price.
May be eligible
for long term
capital gains.

See also http://www.startupcompanylawyer.com/2008/03/05/whats-the-difference-between-an-

iso-and-an-nso/

Finally, it is worth mentioning 409A. 409A is a punitive tax provision that is largely targeted at curtailing
corporate excesses like deferred cash payouts to big company executives, but it has also been interpreted
to cover stock options if the exercise price is set below fair market value on the date of grant. Practically,
this means it's really important to always set the exercise price of an option at fair market value on the
date of grant to avoid punitive tax consequences (e.g. steep tax bills at vesting). To be clear, it was already
important before 409A that the exercise price be equal to fair market value on the date of grant.[6] 409A
just raised the stakes and provided some additional guidance on the process that a company should follow
in setting the exercise price. Simple advice: you can significantly mitigate 409A risk by establishing fair
market value via independent, 3rd party valuation reports. There are a number of competent,
competitive valuation firms and a report can be obtained at reasonable expense (e.g. $3-5k for a Series A
company). There are frequently a lot of nuanced issues involved with granting stock options, so corporate
counsel should be actively involved.

http://www.startupcompanylawyer.com/2008/01/19/what-is-section-409a/

Intellectual Property
(For Corporate Lawyers)

Intellectual property (“IP”) is a specialized field of practice. One could spend the majority of law school –
and a career, frankly – learning the intricacies of IP law. But even a corporate lawyer needs to understand
some basic IP concepts because IP law permeates the work of a startup lawyer.

First, you should have at least a (very) basic understanding of major categories of intellectual property.
Four major categories are relevant: trade secret, copyright, trademark, and patent.
 · Trade secret – Fundamentally, trade secrets include valuable information that is not
generally known and that a company has taken reasonable efforts to keep secret. A classic
example is a secret formula for a food product (KFC’s secret blend of 11 herbs and spices).
Nonpublic elements of software are generally eligible for trade secret protection too. As long as
reasonable efforts are taken to maintain the secrecy of the information, the startup may have a
right to exclude others from certain uses of the information. There is no registration process for
establishing trade secret protection.

· Copyright – Copyright covers original works of authorship in a fixed medium.

Think of a sound recording or software code. There is a registration process for copyright.
Registration is not necessarily required to claim copyright protection, but registering does
provide some enforcement advantages.

· Trademark – Trademark protection applies to a name, symbol, device, or design

identifying goods or services. An example would be a brand name like “Coke” or the name of an
app. Like copyright, there is an optional registration process that provides enforcement
advantages.

· Patent – Patent covers novel, useful, and nonobvious inventions. A medical device is a
good example. Some software is eligible for patent protection too, but the patentability of
software is a complex issue beyond the scope of this class. To establish patent protection,
registration is required. That registration process is generally quite costly and requires a
company to disclose the invention to the public.

A corporate lawyer is unlikely to be heavily involved in the registration process for copyrights, trademarks,
or patents. Specialized IP lawyers generally handle those matters.

Still, IP affects the work of the startup lawyers in several ways. Below are three documents drafted by
corporate (non-IP) lawyers that have major IP implications:

· IP assignment at founding – As discussed under “Founders Stock” above, a founder usually pays
for his or her stock through an assignment of IP. As a result, corporate lawyers must describe the IP being
assigned. This is usually done by category (“all IP rights relating to the business, including trade secrets,
copyrights, trademarks, and patents, including without limitation, those items listed on Exhibit A . . .”).
Often, a firm will have a form that is a useful starting point and can be customized to the particular
circumstance.

· Confidentiality/nondisclosure agreements (“NDAs”) – A startup will occasionally allow outside

parties (potential investors, acquirers, suppliers, customers, strategic partners, etc.) access to valuable
nonpublic information. To maintain trade secret protection, it is important that the company make
reasonable efforts to protect the secrecy of the information. Requiring outside parties to sign
nondisclosure agreements evidences such reasonable efforts.

· Confidentiality and invention assignment agreement (“CIAA”) – A startup will eventually have
personnel – employees, consultants, independent contractors, interns, etc. You might think that a startup
would automatically own the IP that it hires its personnel to create. But it’s not always that simple. There
is a “work-for-hire” doctrine under copyright law that gives a company ownership of things created by
employees: http://www.copyright.gov/circs/circ09.pdf . But what about other IP rights, such as patent,
and what about other types of personnel, such as consultants? It gets surprisingly complicated:
http://www.nolo.com/legal-encyclopedia/who-owns-patent-rights-employer-inventor.html. As a result,
companies routinely use a CIAA with all personnel.

Finally, a startup lawyer always needs to be thinking ahead to possible exit. For example, a company will
be required to represent to a potential acquirer that it has solid rights in its IP. A standard merger
agreement would require, among other things, that the company to promise that it owns or has a valid
right to use its core IP, that there are no claims of infringement, and that all personnel signed a CIAA.
Transactions go more smoothly when the company has taken the precautions described above from the
very start.

Convertible Notes & SAFEs

Imagine a company that has the corporate basics in place – an entity, founders stock, and a stock plan –
and now needs cash to finance product development. Because traditional banks usually won’t lend to
risky startups (think: prospects of repayment are too uncertain and the company lacks customary forms
of collateral), a startup company often turns to specialized investors with experience investing in high risk
startups. Venture capital funds are the most well known type of investor in startups, but historically they
are often hesitant to invest until the company already has some form of traction. The earliest investors
in a startup may be friends and family of the founders, angel investors (typically wealthy individuals or
groups), or accelerators/incubators (organizations that provide a mix of financial support and business
expertise to help young businesses get started and grow).

Often, these very early investors put money into a company through a convertible note rather than buying
stock outright. On its face, the note is a debt instrument (i.e. a loan that has to be repaid at some future
date). With a convertible note, a key feature is the holder’s right to convert the loan amount into stock
at some specified rate. The investor’s motivation is fundamentally to be a stockholder (i.e. holder of
equity), not a lender.

Companies and early investors may prefer convertible notes as a way to avoid immediately having to place
a “value” on the company’s stock. In their infancy, startup companies are particularly hard to value, with
traditional notions of financial value largely useless. Convertible notes effectively punt the valuation
question and “piggy back” on a price that will be set in a later financing. Fundamentally, the note holder
has a prepaid right to buy stock (by converting the note in lieu of repayment) in the next round of financing
with other investors, where the company’s valuation is relatively easier to establish with more data and
time to observe progress. For example, assume an angel investor in Startup B holds a $500,000
convertible note. When Startup B later sells stock to a venture capital fund at $1 per share, the angel
investor would convert convert the note in exchange for 500,000 shares of stock.

To reward the higher risk taken by the earlier note holder, the conversion will often take place at an
effective discount to the price paid by the new investors at the later round. For example, if the Note
featured a 10% discount, in our hypothetical the note would convert into 555,555 shares (as if the note
holder was buying $500,000 worth of shares at a price $0.90 rather than $1.00). A discount is a nice
benefit, but may insufficiently reward the risk taken by the early investor where that future financing
takes place at an extremely high valuation. With a discount, there is truly no ceiling on the price you may
end up “paying” when your note converts to equity.

In anticipation of this potential outcome (a sky-high Series A valuation), noteholders, in addition to a

discount, will require that the convertible note include a “valuation cap.” With a valuation cap, the
conversion price is not simply a flat discount from the Series A price. Instead, it is structured as the lower
of: (1) the discount from the Series A price or (2) a specified maximum pre-money valuation at which the
note will convert. For example, say we have a convertible note with a 10% discount and $10 million
valuation cap. If the Series A values the company at $50 million, you have two potential outcomes for the
conversion of the note: (i) a 10% discount, where the effective “price” paid by the Note holder is $45
million (i.e. 90% of the $50 million valuation) or (ii) the valuation cap of $10 million. As the early investor,
you would much prefer a $10 million valuation v. $45 million, and with this disparity in outcomes, you can
see how the valuation cap protects the investor from a runaway Series A valuation (and consequently
significantly more ownership when the note converts). We will look at models and detailed examples in
class.

Convertible notes must also address what happens if the company is sold before there is ever a Series A
and the note converts. Since the convertible note is a debt instrument, it will generally have a priority
right to equity to be repaid from the acquisition proceeds. The base case is to receive back principal plus
accrued interest. Early stage investors are typically investing to generate outsized returns, not to receive
gain measured solely in accrued interest. Recall, that even when using a convertible note, the investor
has the intention of converting to equity and subsequently receiving equity-like returns. As a result, an
investor may negotiation that, in the event of an acquisition, they have the right to receive a multiple of
invested capital, instead of just their money back. Depending on the circumstances, a “normal” range of
multiples would be the right to be repaid 1.5x (money back plus an additional 50%) up to 3x (money back
plus an additional 2x capital). Where a company has low leverage or other extenuating circumstances are
at play (e.g. company is out of money), multiples can climb to 4-5x.

When a convertible note features a valuation cap, the treatment on acquisition will often include the right
for the holder to convert the note to common stock (at the valuation cap) and then receive a share of the
sale price like other common shareholders. Depending on how the acquisition price pencils out, this may
enable the note holder to experience equity like returns (i.e. unlimited potential) after they convert to
common. If that conversion is not economically rational for the note holder, they can just take their
repayment right as a debt holder.

The “SAFE”

SAFE is an acronym for “simple agreement for future equity.” It was developed by YC, a prominent
accelerator and investor. The SAFE follows the logic of a convertible note, but it is not a debt instrument
and thus does mature and come with a repayment obligation. The holder of a SAFE, like that of a
convertible note, has a contractual right to convert the investment amount into a future preferred stock
financing. The SAFE was designed to address a number of perceived issues with convertible notes,
including the recognition that no Silicon Valley investor really expects a startup to have money to repay a
convertible note at maturity, so why go through the charade of using debt? The SAFE is used prolifically
for early stage financings, so read more about them here: https://www.ycombinator.com/documents/

Series Seed

Convertible notes and SAFEs (hereinafter referred to as “Convertibles”) are the primary instruments for
early financing of startups. In other words, startups usually hope that they will eventually convince a
venture capital fund (“VC Fund”) to invest in preferred stock (“VC Preferred”). But the early angel
investors who precede venture capital usually buy Convertibles rather than VC Preferred. The
conventional wisdom behind this custom is that: (1) Convertibles require less extensive documentation
and (2) Convertibles let the startup put off the difficult task of putting a valuation on the company.

There is a simplified form of VC Preferred referred to as “Series Seed” that was initially developed by a
Silicon Valley lawyer on an “open source” model for early stage equity financing. Series Seed is
fundamentally very simple preferred stock. It has some of the essential features of VC Preferred (such as
a liquidation preference and a right to convert into common), but is highly standardized and much more
lightweight than VC Preferred. For more information, see:

http://www.seriesseed.com/posts/2010/02/about-the-series-seed-documents.html
https://www.cooleygo.com/documents/series-seed-equity-financing-package/

VC Preferred Stock

If all goes well, a startup will progress from financing via Convertibles to a full-blown preferred stock
investment by a VC Fund. Terms can vary widely, but we will look at some of the “normal” features of VC
Preferred that you would see in a Silicon Valley Series A financing.

VC Preferred has the following key features:

· A liquidation preference. A VC Fund will insist on a liquidation preference that fundamentally acts as
downside protection for the investor. The liquidation preference gives priority to the return of capital to
the investors in an exit, ahead of any proceeds that go to founders or employees. It’s worth noting that
equity sits junior to debt, so the holder of a convertible note would still sit in priority to the holder of VC
Preferred.

The standard liquidation preference is the right to just receive your invested capital back (i.e. 1x), with all
holders of VC Preferred treated equally (i.e. everyone shares equally on a proportionate basis). The
investor has a choice: (i) take their liquidation preference or (ii) convert to Common Stock and receive
your proportionate share of proceeds as a holder of Common Stock (e.g. if you owned 5% of the Company,
you get 5% of the proceeds going to Common Stock. The investor will take the outcome that produces
the larger result, but they would not be able to receive both their liquidation preference and
proportionate share of proceeds.

There are a number of ways that liquidation preference can be structured to provide additional downside
and upside options to an investor. We’ll discuss in greater detail in class, but consider:
(i) Multiple - instead of the baseline 1x right, the liquidation preference could instead by 2x or 2.5x off the
top. This can also be achieved by attaching a dividend right to the VC Preferred that effectively increases
the liquidation preference over time (e.g. an 8% cumulative dividend would bump up with liquidation
preference to 1.08x after year 1, 1.16 after year 2 and so on.
(ii) Seniority - does a particular series of VC Preferred sit senior to others? E.g. a later Series B sits ahead
of the Series A.
(iii) Participation - the VC Preferred can be structured where the investor has the right to receive its
liquidation preference and proportionate proceeds as an effective holder of Common Stock. You could
have “fully participating” VC Preferred where there is no limit on the return (and thus the investor would
never want to convert to Common Stock and lose the right) or participation with a cap. An example of a
capped scenario would be the VC Preferred having the right to receive its liquidation preference AND then
participate in the remaining proceeds up until it has received 3x the invested amount.

· A conversion right. Fundamentally, think of VC Preferred as Common Stock with additional negotiated
rights (generally by contract with some statutory backing). VC Preferred typically has the ability to convert
into common stock and in doing so, losing all rights attached to the VC Preferred. The normal triggers for
conversion of VC Preferred to common stock are: (1) at the election of the holder, (2) if the company has
an IPO and (3) at the election of a designated group of holders of VC Preferred (e.g. if a majority of the VC
Preferred decides to convert, the rest are automatically converted to common stock).

VC Preferred starts with a conversion ratio of 1-to-1 (one share of preferred converts into one share of
common). But VC Preferred might become convertible into even more shares if certain things happen,
such as the company having a “down round.” A down round means that the company sells stock at a price
that is lower than the last price it charged for its stock. For example, assume startup A sold its Series A
preferred stock at $1 per share. If it then sells its Series B preferred stock at $0.75 shares, that’s a down
round. It suggests the Series A price was too high, and so the Series A might get a beneficial adjustment
to its conversion ratio (i.e., it will be convertible into more common shares). There are two types of
adjustments: (1) full-ratchet and (2) weighted-average. We will discuss in greater detail in class, but
generally the former is better for the investor and the latter is better for the company.

· Voting rights. VC Preferred typically votes alongside the common stock on general matters. It also
may get to vote separately on certain designated matters, often giving the VC Preferred a veto right over
certain key decisions of the company. VC Preferred often also gets special voting rights with respect to
the election of directors to a company’s Board of Directors. Certain Board seats will be reserved for
designees of the holders of VC Preferred, separate from any seats that the holders of common stock may
have the right to designate.. Voting rights are specified in the company’s certificate of incorporation and
typically also in a separate voting agreement.

· Other Key Terms. We will cover a number of additional VC Preferred rights in class, but these include
rights to certain information, rights of first refusal on transfers of stock by the founders or sale of stock by
the startup, and registration rights (basically, the right to have their shares included in the securities filings
of the company if there is an IPO).

[1] There is no difference between s-corporations and c-corporations under state corporate law. They are both formed the
same way, and they are both governed by the same state-level corporate codes. The difference is one of federal tax status. A
corporation can elect to be taxed as an s-corporation under federal law. If no election is made, a corporation will be taxed as a
c-corporation under federal law.
[2] There is nothing magic about this number. You could have just ten shares, and each share would just be worth a lot more.
But the perception is that it would look funny to have just 10 shares. Likewise, you could have a billion shares, with each one
being worth a small amount. But that would also just look funny.
[3] It is 1/48th because there are 48 months in four years.
[4] In fact, the result is usually no tax. The tax would be calculated as follows: value of the stock minus amount paid for the
stock. The founder usually “pays” for the stock through an assignment of IP deemed equal to the value of the stock.
[5] We refer to this as potential gain, as private company stock is typically illiquid and while the “value” of the stock may have
risen, there is not a market where the employee can realize this gain. An employee will typically have to wait until a broader
liquidity event, like an acquisition or IPO.
[6] There are at least two problems if the exercise price is set too low. First, under general tax principles, any “spread” (stock
value above exercise price) would be taxable income when the option was granted. Second, the tax rules governing ISOs say
that an option can’t be an ISO if the exercise price is less than fair market value at the date of grant.