I’ve gotten a lot of requests for a program about the legal issues that entrepreneurs like you need to be prepared for, so I invited Bill Schreiber of Fenwick & West to Mixergy. Fenwick is one of the most trusted firms among tech startups. They incorporated Apple, when it was just a startup, and their current client list includes young companies like Twitter and Facebook, as well as bigger companies like Cisco and Symantec.
The topics we covered in this program include: How to keep from losing your intellectual property. How to structure your pre-VC funding. And how to pick the right legal entity for your business.
Bill Schreiber is a partner in Fenwick & West’s corporate group. His emphasis is on Start-up Counseling, Venture Capital Financing, Mergers and Acquisitions, and Joint Ventures. Fenwick & West is a national law firm that provides comprehensive legal services to technology and life sciences clients of national and international prominence. They have approximately 300 attorneys, with offices in Silicon Valley, San Francisco, Seattle and Boise.
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Starting the program:
Hey, everyone. My name is Andrew Warner. I’m the founder of Mixergy.com, Home of the Ambitious Upstart. And today I’ve got a program that’s a little bit different. We’re going to be talking with Bill Schreiber, Corporate Partner at Fenwick and West, about what you need to know if you’re going to set your company up for funding. And the outline that I’ve got for today’s conversation is, first, we’re going to talk about reasons why otherwise fundable companies are making themselves unfundable, so that we can learn from their mistakes. And in that first section, we’ll talk about how to have a clean IP, how to have clean employment and consulting agreements, how to have clean capitalization. In the second section, we’re going to be talking about the choice of entity. And in that section we’ll talk about LLCs, S-Corps, foreign jurisdiction issues, and so on. And finally, in the third section, we’re going to be talking about pre-venture capital funding. And in that section we’ll talk about convertible debt rounds versus equity debt, versus equity rounds, excuse me, typical terms for convertible debt rounds, typical terms for preferred stock equity rounds. And if you guys are seeing that I’m looking down at my notes, it’s because Bill sent me a set of notes before this program. And I’m going to be making sure that we just go through and cover as much of this information as possible. So Bill, I introduced you as the Corporate Partner at Fenwick and West. And can you tell people a little bit about the firm?
Bill Schreiber: Sure. For those of you who haven’t heard of Fenwick and West, we’re one of the top 2, 3, 4 of major law firms up in here Silicon Valley, that deal with VCs and VC-backed companies. We’ve been around for 30 years, a little more than 30 years, actually. One of the first companies we incorporated was Apple Computer. Now we represent companies as large as Cisco and Symantec, companies as sexy as Facebook and Twitter, and a whole host of companies that have just gotten funded, or haven’t yet gotten funded. So what we like to represent are high-growth companies, most of which end up getting VC funding, but frankly, some of which that don’t. So that’s a little bit about the firm.
Andrew: OK. And I should also add to that list of companies you guys represent, Mixergy. You guys have been incredibly helpful to me. I choose Fenwick because many of the people who’ve come here on Mixergy are clients of yours, and have just raved about you. And in addition to doing the legal work, from what I understand about Fenwick, in addition to doing the legal work for start ups, you also help start ups go through the process, find venture capitalists. You make the introductions that help open doors. Right?
Bill Schreiber: Yeah, exactly. I mean that’s one of the key values that we can add. We’ll be talking through a number of issues that have legal aspects to it on this meeting, but there is more to that. There’s sort of knowing how VCs think, what they look for, and helping you come up with strategies when negotiating with investors, frankly, whether they’re VC investors or otherwise. And also giving you the introductions, which we do, just as part of the service. We don’t charge for that. So because we work so regularly with all the VCs, it’s kind of an environment that just lends itself to VCs. Look at that personal value we can add, and obviously our start up clients look at that personal value we can add.
Andrew: OK. And I’ve had several venture capitalists speak at Mixergy events, and they say over and over, instead of getting your uncle, or your brother’s friend who happens to be a lawyer, to do your legal work, if you’re planning to ask for venture funding, get somebody who’s in this business, who understands what venture capitalists are looking for, so that you don’t end up with headaches. You don’t end up with tangled knots that you can’t untangle later on. Well, we’re going to be talking about, and by the way, you’re one of the law firms that they keep bringing up.
Bill Schreiber: Thank you.
Andrew: And what we’re talking about here is, how to make sure that you don’t tangle those knots.
So, let’s start with the first section. Reasons why otherwise fundable companies make themselves unfundable? This seems very painful. You have a company that’s in that spot that venture capitalists are looking for. You need the funding but because of mistakes that you’ve made in the past, you can’t get it. And you say that one of those mistakes, Bill, are ñ one of the things that people need to keep in mind is intellectual property. What do we need to know about intellectual property?
Bill Schreiber: So, intellectual property, most people when they ñ some people when they think of intellectual property think about patents. And we can talk a little bit about provisional patents later. But, when I talk about intellectual property, I mean broadly speaking, things like making sure the idea is owned by the company and not by some founder or not by, worse yet, some ex-founder who is off doing something else. And when you hire a consultant that the work that the consultant does is owned by the company.
So, the best way to do this is to get yourself a good set of forms because if you deal with good forms, whether that be have a consultant ñ always sign a consultant agreement that is very clear that the company owns the IP or have an employee sign a what’s usually called an invention assignment agreement that covers everything that he does is definitely owned by the company ñ or every board advisor signs a board advisor agreement that does the same thing. Everybody that you talk to about the company signs an NDA.
Everybody ought to sign some form that makes it clear that the company owns the IP. And what’s going to happen is when the venture capitalist goes through and does his diligence, he’s just going to look for these documents in order to sort of create a chain of everybody that you’ve been dealing with agrees that the company owns the IP. The reason it makes you want fundable if you don’t have this is because a lot of times you can’t find these people or the people decide that they want to hold you up, you know, for a, for a ridiculous price in order to sign something and clear it up. And it very, very frequently, if you end up with this problem, it’s just very, very difficult to solve. And if you don’t find out about it until it’s too late, the venture capitalists — they tend to have very short attention spans ñ they’re not going to wait around for weeks or months while you clean the stuff up. So, get yourself a good set of forms, obviously, [inaudible] provide those but get a good set of forms, and everybody that provides services to the company in any capacity should be signing one of these agreements.
Andrew: Yeah, you in your notes to me said that the golden rule is that everyone signs something.
Bill Schreiber: Right.
Andrew: Now, where do we get these agreements beyond just working with a law firm like yours? Is there a set of a legal agreements that’s just available out there for us to use? I can’t imagine that the terms are very different from company to company when it comes to, um, board members or when it comes to founders’ ownership over the inventions?
Bill Schreiber: There are cases that come out every, I don’t know, six months maybe that actually do change these forms. So, you can go to no low press or, you know, do a Google search or go to various online places to find the documents. And I think chances are you’ll probably be fine. If you do happen to know somebody that works at a law firm that’s used to dealing with technology companies, just have them look at them. It’s only going to take them a second or it’s going to take more than a second. It’ll take them a couple of minutes to look at it and just make sure that the latest changes if there are any on a particular form are going to work. But the basic things that you ought to have are an invention assignment agreement for employees, a consulting agreement for consultant, a board advisor agreement which is nothing more than a consultant agreement and that’s sort of with a better name on it for your board advisors, and an NDA for people that you’re just giving proprietary information from the company out. Those are the four forms that you need.
Andrew: Okay. Let’s talk about NDA. My understanding is venture capitalists don’t sign NDA’s. I don’t even sign NDA’s. Most people in this space are laughing cause most of us in this space do not sign non-disclosed agreements. At what point does it make sense to have an NDA? Who’s willing to even sign them?
Bill Schreiber: NDA’s are important because the rule about keeping what’s called trade secrets, basically the company know how. The law in that area says that you have to take reasonable steps to make sure that the information stays confidential. Um, most people in Silicon Valley because you write BC’s almost always refuse to sign NDA’s. People have sort of taken that rule to mean that, of course, BC’s won’t sign NDA’s, so you would not expect that BC to sign an NDA but you would give them information in such a way that an entrepreneur would normally give a BC information. So, in other words you wouldn’t ñ at the beginning go through and give them every single detail about the company. So, it’s a little bit of a different test and it gets a little ñ um, you get into gray areas.
But where some people not signed an NDA, keep in the back of your mind, am I giving them the type of information that a reasonable person in these circumstance would give. Information, because that’s the ultimate test. Outside of BCs and perhaps yourself, I think most people are willing to sign very, you know, one or two page, very straight-forward NDA, that just covers disclosure and doesn’t go into a whole bunch of other directions.
Andrew: What kind of partners, what kind of conversations would require an NDA. I don’t want to send my audience out there with NDAs for their family members, for advisors, for potential investors, if it doesn’t make any sense. I want to just know where it makes sense and bring it up there and stay away from those opportunities where they’ll embarass themselves. So, if I’m hiring a company to build out my website, at that point, does it make sense?
Bill Schreiber: If you’re not going to be given, I mean the person that’s building your website, are you… You know, think through was it customary to get an NDA. That’s really the test; is, would other people have gotten an NDA in those same circumstances. So, you would not normally get an NDA from your mother and father. If you, if a web-designer is putting up information, but it’s not, it’s not in a way where you’re sitting, giving information sitting in a room, processing it, or you don’t think he’s technologically– technically capable of digesting it, most people would not have that person sign an NDA. If you are talking with a board advisor, who’s giving you significant ideas about your business, you really are opening up everything to him. It would be normal for him to sign an NDA, and in our form and in many people’s form, board advisor work, consulting work, would be an NDA built into that. So, you don’t have to have these people sign many agreements if you have a typical board advisor doing board advisor type things, all of that can sorta get wrapped into one agreement. But it would be normal for somebody like that in that situation to sign up to a Non Disclosure Obligation.
Andrew: Okay, can you give those four agreements that people need to keep in mind again?
Bill Schreiber: Sure. So the first one is for employees– there’s different names for it, but our form is called the Invention Assignment Agreement– basically, just makes it clear that all the IP the employee develops is owned by the company. Second, a consulting agreement for people who aren’t employees but are still providing services to the company. Third, a board observer agreement, because some people have consultants that are called board observers, but it’s really a consulting agreement with a different name. And fourth is the NDAs, which we just talked about.
Andrew: Okay, alright. Let’s see, let’s go over to the next point here, which is protecting yourself with agreements with employees and consultants. And in that section, we’re talking about offer letters with employees, with at-will, no severance employment. Why don’t you take it from there, instead of me reading through your notes.
Bill Schreiber: People…It’s a problem if you have a company that’s being funded and you have, people are providing service to you confused about whether they’re employees or whether they’re consultants. Because there’s certain things that you have to do for employees, like withhold taxes, and there’s certain things you have to do for consultants, like file a 1099. It’s, in addition to that, you may get audited later on down the road by California, who’s very agressive in this area about– and there’s some famous large cases. EA is one of them, Microsoft is another, where California has sort of created a billion dollar problem, or at least a hundred million dollar problem for these companies, about how you classify people. It’s a very easy problem to get taken care of, and again it’s form driven. Have your consultants– have people you think are consultants sign consultant agreements, have people that you think are employees sign offer letters and Invention Assignment Agreements. That will give you the benefit of the doubt if you ever are talking to BCs or you ever, god forbid, get audited by California Department of Labor. There are other things, like “well, do I have to pay minimum wage” and most of my start-ups do not do it even though you’re technically required to. There’s things, other things you’re technically required to do that don’t add up to big problems dollar-wise or that you can get away from once you raise around that are not going to scare off the BC. What will scare off a BC is if someone is running up saying “I thought I was an employee and you promised me employment forever, because I’ve got an email that says that” even though you meant that in kind of a different way than it appears on the email. If you have a written offer letter, a written Invention Assignment Agreement, the fact that that person is an employee will all be cleared up and the fact that you can terminate them at will will be cleared up. Same thing on the consultant side, you can
sort of imagine similar situations. But that’s just very clear, it’s very hard to clean up after the fact when everyone knows that they sort of have negotiating leverage over you, because if you don’t get it cleared up, you’re not going to get funded.
Andrew: And it’s easy for entreprenuers who just got somebody on board, to get excited about working with this person and send an email that says “you and I are going to build this thing..”
Andrew: …forever. Ten years from now, we’re going to be laughing at the world because we own this space. What you’re implying there, potentially to the person you’re working with, is that they’re a partner or that they own shares, that they’ll be around for ten years, when what you really mean is I hope we’re going this way, but as an entrepreneur, I don’t have enough vision to know where we’ll be in six months.
Bill Schreiber: That’s exactly right. In California, in particular, is by far the most pro-employee state and the most anti-employer state in every dimension including how these types of emails that you described would be interpreted. They very much take the employee’s side’s offense. So it’s just very important that you get it straight and get it out front.
Andrew: Okay. And those two agreements that you’d need to have for somebody who you bring in as either an employee or a consultant, they are offer letter, number one…
Bill Schreiber: The offer letter is number one, and it can be a very short document. You can put in there whatever you want ñ how much you’re going to pay them, or whatever. The most important thing is to make sure that it says that they’re an employee and that their employment is at will, meaning that both parties can terminate the relationship at any time.
And then the second is the investment assignment agreement, which we talked about earlier, in connection with the IP assignment.
Andrew: By the way, in our audience, we have somebody who’s… Let’s see, Fenwick represents my company, Folio Inc. and these guys rock.
Bill Schreiber: Oh, great.
Andrew: Yeah, you guys are the top company, the top law firm, let’s just say one of the top firms in this base. You’re recognized as a firm that entrepreneurs ñ especially who go through this process ñ go to. There aren’t a million firms that do this. Fenwick, for those people who have gone down this road, they recognize them.
What I’m trying to say is I wouldn’t bring in just anybody to talk about this stuff, for anyone who is in the audience and is wondering.
Alright, let’s talk about capitalization. Capitalization means what?
Bill Schreiber: Capitalization is who owns what part of the company. How many shares does this person have versus this other person, versus this other person. Does somebody own shares, does somebody own stock options? Does somebody own preferred stock, does somebody own common stock? So it’s basically for companies at a pre-funding stage, usually a simple spreadsheet that lists everybody’s name, what everybody owns and what percentage of the company they own.
The reason that it’s important to have this very clear is because the VC’s want to know exactly what they own, which is easy enough to figure out. It’s usually somewhere between 30 to 60 percent of the company for some investment.
But also, it’s very important to them that they know exactly what everybody else owns. They’re going to want a certain percentage to be owned by the founders, so that the founders are adequately incentivized to work 24 by 7 until there’s an exit event. They’re also going to want a certain percentage to be allocated for future employees with a stock option pool, and they’re going to want to know if there’s anybody outside of that, which is basically people who are not going to be that important in the company going forward for the most part. They going to want to know exactly how much of that there is, and why.
So that’s why capitalization is so important. If you don’t have your capitalization nailed, the VC can’t figure out what the price per share is, they can’t figure out from a certain valuation, and they can’t figure out whether they’re happy with who owns what. That’s what it is and that’s why it’s so important.
Andrew: Okay. Let’s say Rob and I in the audience are going to start a company. We decide I own 60 percent because I’m the loudmouth who bullies him into giving me 60 percent. He owns 40 percent. 60 percent, 40 percent of what? Is it 60 percent, 40 percent of the company now? 60, 40 in the future? What is it?
Bill Schreiber: Well so, there’s a theme here in this entire first section which is get it documented. It’ll explain what 60, 40 percent of what it typically would be is 60/40 just between you two. And so you two would have a hundred percent of, let’s just call it the founder’s stock. When you adopted a stock option plan or if you brought somebody else on afterward that would dilute both of you guy’s equally, but in the first instance you would have 60 percent of the company and he would have 40 percent.
Getting that documented through a stock purchase agreement or a subscription agreement or something so it’s all clear that’s where it’s set in stone at the beginning is very important, because what often happens, particularly for early stage companies, is as things go along, founders have a different view ñ particularly if there’s multiplies or more than two founders. They have different views over time about who’s more important, who’s less important in the company.
And so while everybody may agree 60/40 on day one is the right way to split it, in a couple months they may think it’s more 55/45 or 60/40 the other way. To avoid that constant renegotiation ñ and again with two founders, it’s easier than if you have five or six or seven founders ñ is to stop that chasing the cat process that goes on to constantly renegotiate, because renegotiating one impacts the other.
Bill Schreiber: Again, if you’ve got a VC, you’ve got to have that stuff nailed down because VC’s attention span is so short you do not want to air your dirty laundry which is exactly how this is going to come off in many dimensions of the VC, that the founding team sort of is still arguing about that kind of stuff when they’re talking with the VC.
Andrew: What about this? Do we get 60 percent outright? Do we get our shares outright, or do we earn them over time, even if it’s just two of us? How does that work?
Bill Schreiber: So, most people sort of reflexively think, of course, I want to get my shares up front. Why wouldn’t I want them up front? There’s two reasons, and there’s nothing wrong with getting your shares up front other than if you do raise ground from a sophisticated institutional investor they will expect to vest your shares over, usually, four years or so, so that you are vesting through the amount of time it’s going to get to a liquidity event.
If you are fully vested, until you go into those negotiations, you’ll just be negotiating that like you will the valuation or who’s on the board or everything else. There’s nothing wrong with that, but that’s what will happen if you take fully vested shares up front.
The disadvantage of taking fully vested shares up front is if somebody leaves the company the day after or, God forbid, has to leave the company for health reasons or whatever, that person still owns all the shares and his estate would still own all the shares. What you want to make sure is that at all times as much as possible people that are continuing for the future success of the company own as much of the company as possible.
So, in your 60/40 example, if the 40 percent person or, even worse, the 60 percent person is now owned by the estate or it got split up in a divorce or something happened to it, that’s a bad situation to be in because it’s going to create a dysfunctional cap table where even after the investment there’s going to be a large percentage of the company that’s not going to be owned by people that are still producing by the company.
Andrew: I’m asking leading questions here. That’s what I was leading towards, vesting. How does vesting work? Over what period do you vest? What kind of paperwork do you need in place to do that?
Bill Schreiber: So, vesting is, basically, you buy the shares. So, you own the shares. For holding purposes, for tax purposes, you get to vote the shares. So, you actually own the shares, but if you end up stopping providing services to the company for whatever reason, at that point in time all your unvested shares go back to the company.
So, for example, if you vest over four years and two years into it you end up leaving for whatever reason, voluntarily or involuntarily, the company will rebuy back your shares you own. So, you would only own half as much shares. That’s what vesting is very simplistically.
There’s a whole bunch of nuances, like, for example, if the company gets acquired. Should I get some additional vesting because I’ve sort of done my job? I’ve gotten the company to an exit event. I’ve gotten money for the investors or if I left early but it’s not my fault. The company just changed directions, and my skill set isn’t as valuable as it originally was. Well, at least, I gotten the company to this point, and I’m not given the opportunity to vest any more shares. Should I get some pre-vested shares then? So, there’s a lot of nuances, but just very simplistically that’s what vesting is.
Andrew: Practically speaking, two developers are in college together. They decide to start a company. They’re not going to document anything day one. They start to build a site. Traffic comes to this site. At that point, they might think it’s time to document, but they don’t have any money yet. They don’t know whether this thing is going to work out or not. They’re just kind of goofing around and people are into it.
They know they want to vest it because one or the other of them might disappear tomorrow. How much work do they need in order to set this up? How expensive is it going to be for them? What do they need to do?
Bill Schreiber: So, talk to a lawyer who’s done this before. These things, as you can probably tell, just getting the thing set up is very form driven. It’s usually not a lot of time for a lawyer who’s regularly doing this to do this. So, for Fenwick & West to do it, our billable rates are, you know, higher than some other lawyers, certainly. It can be done for a couple of thousand dollars, including filing fees and everything.
One thing that we do, we have a committee to approve this. But one of the things we do for companies that we’re excited about is we’re completely willing to defer those fees until the actual financing happens. So, that’s anot
her possibility because we realize that cash is king for a company at that stage, and frankly the $2,000 isn’t king to us. What’s king to us is getting the funded company as a client, and that’s if you work with Fenwick & West.
If you’re working with a sole proprietor or somebody who’s used to doing this, they should be able to set this stuff up for you for even a fraction of the couple thousand dollars, maybe, half of that or something. So, if you’re serious about your company I would error on doing that early rather than later.
Bill Schreiber: rather than later. Um, I, I don’t know if anybody is listening to this, follow the base book, Uhh, of things where they pay off a huge settlement with somebody who claims that there was no documentation, they were just sitting in their dorm room exactly, you know, very similar to the situation and ended up paying off that person, rumor has it, for millions of dollars and there’s this other person that says, “no, no, this was my idea, too,” so I don’t know how big that dorm that they were living in is. There is a lot of potential problems because now none of the stuff was ever documented and it’s just all “he said, she said” and it’s a huge mess because she can’t prove anything. So, a . . to answer your question, umm . definitely there, it’s definitely worth a thousand dollars or $2,000 or $3,000 typically if you can get it deferred, of course into your financing, but it’s just you’re gonna avoid a . . a huge potential amount of problems. It will be the best money you’ll ever spend.
Andrew: Okay, so let’s, let’s talk about what somebody, we now talk about the price, let’s now talk specifically what they’re gonna go and ask their lawyer for. Two guys, in a dorm room, two guys, maybe working at a company, and on the side, while they’re in school or while they’re working for another company, they hatch this idea. They don’t want to spend too much time and money on the legal work until everything starts to pick up. What are their essentials they are going to need? They’re going to need to structure their company. And, we’ll talk about what . . what legal entity they’ll need. What about the agreement between the two of them?
Bill Schreiber: Yeah, so ah . . a first of all, the the person you’re talking to should be able to lead you through with exactly what you need to do and why you need to do it and what the choices are and, and if that person’s not doing that; that should be a huge red flag. But, um, basically what that person oughta be telling you at a minimum is walking you through the next topic we’re about to talk with, which is, “do I want to set this up as a corporation or a limited liability company or something else?” Um, asking you about: ah, founders stock and ah . . making sure it gets issued. Um, telling you about vesting and sort of walking you through the pros and cons of that. Um, giving you all the standard forms you need that we’ve talked about already in terms of consulting agreements and employment agreements and so forth. And then also a . . advising you on how to make sure that this thing is set up in a . . in a tax optimal way. So, for example, one thing that we didn’t touch on that I’ll just briefly mention is if you get shares that are subject to vesting, it is very, very important that you file what is called a form 83B. That’s a one page form. You file it with the IRS. You’re, You’re lawyer or your accountant will know all about this, but, if you don’t do that within 30 days of purchasing your shares, you have a bad tax problem. So, there’s just things that you, everybody, is ahh . .not expected to be an expert at. And, thank God, or I wouldn’t have a job. But, you know, for companies at this stage, where they very, um, acknowledgably and, um, easily, oughta be able to walk you through what the options are and what you need to do. But, that’s ah, sort of at the bare minimum, would be what I would have done; what I would expect.
Andrew: Okay, alright, let’s talk money again, then. All of this together at Fenwick, what roughly would it cost? And at a sole proprietorship.
Bill Schreiber: Oh, Oh,
Andrew: . . . what it would cost?
Bill Schreiber: Yeah, when I talk about doing all of this, that’s, it’s all within about a couple thousand dollars. Of course, all of this stuff, as I said before, is all very form-driven. And, we have it automated, we’ve done this many, many times before. So, it’s um, ahh . .a it should not cost a lot of money. Ahh . . a sole proprietor is not going to have the sort of a . .psychological advantages that um . .ah . . hopefully they’re knowledgable enough of doing it. That they’ve done it enough before that it’s a lot of cutting and pasting. I wouldn’t expect it. You know, it may be cheaper that us just cause they’re billable rates can be lower than ours. But, I would say, somewhere between half of that and maybe a couple of thousand dollars. But, it shouldn’t be more than that. Anyway, what you may want to do is adopt a stock option plan or an equity incentive plan, which is almost virtually the same thing, to easily give equity out to service providers in the future. And that, I also would include in sort of this total price of just a few thousand dollars.
Andrew: Can you describe how that works?
Bill Schreiber: Sure, so, ah . . there’s securities laws, ah . where the government basically tries to protect um, people from issuing stock to people who the government thinks ah . need protection. And, so there’s a concept of securities exemptions. One securities exemptions is that if you are particularly wealthy, or particularly sophisticated, you basically don’t need the government’s protection at bc’s so issuing stock to bc’s is very easy. Issuing stick to sort of “rank and file” engineers is, um or people like that, consultants, is harder because the government things they need more help. If you adopt a stock option plan, or an equity incentive plan, that, a, complies with all of the requirements that the government has and also can be optimized for tax purposes and a number of different ways. Um, you can give people equity what were usually stock options that, ah . . that give people equity and therefore you don’t have to pay them any cash or at least not as much cash. Um . .very easily, and to, there is no limitations to numbers as in what there qualifications are, in terms of what their sophistication is, in terms of their net worth, and so, um . . adopting a stock option plan, if you plan on giving to more than a handful of people is a really good idea. Because again, if you’re talking with the right service, if your talking with the right law firm, it’s a highly form-driven where, um . . it can make your life a lot easier and a lot chapter in the long run.
Andrew: All right. So, to sum up this section, if you want to avoid the common mistakes that otherwise fundable companies make and keep themselves from being fundable, first, you want to make sure that you own your intellectual property. We talked about the documents that you need and how clear you need to be with everyone you’re talking to that your company owns its own intellectual property.
The second section is you want to be clear with your employees and consultants about what their role is and what your relationship is with them.
And finally you want to be clear about who owns what in the company.
In all of this, if you’re going to go to a law firm it will cost a couple of thousand bucks, and in all of this if you’re aware of it are mistakes are pretty easy to avoid.
Bill Schreiber: Yes. I agree with all of that.
Andrew: OK. All right. Second section that we’re going to be talking about today is the choice of entity. I don’t want to spend too much time on this because a lot of this is basic information that, hopefully, people learned even back in college. But I do want to familiarize people with this. This is our first conversation here, and so we’re going to be talking about the basics. So, we’ll spend a little bit of time on this.
By the way, if you guys are listening to us in the recorded version and you’ve had some time to think about what you’d like to hear next from us. Let me know. What other questions do you have? What other areas do you want us to cover? How in depth should we go, and what areas would be helpful?
OK. So, let’s start off with sole proprietorship, very basic. What does it mean?
Bill Schreiber: Sole proprietorship, basically means you haven’t done anything. You’re operating as a person, an individual, as a human being. There’s two factors that we’ll keep on mentioning as we go through the list of possibilities of what you want to do.
The first one is whether you get corporation-like protection. Corporation-like protection is very, very good protection. It means that as long as you’re operating like you should that if the company ends up incurring obligations that the people who are to be paid off can only look to the company. If the company doesn’t have any money, they can’t look to you individually. For purposes of this conversation, it’s sort of as deep as we should go.
But a sole proprietorship on that factor has no protection at all. So, anything that you do as a business–they can come and they can take your house. They can go after your car. They can go after all your personal assets.
The second dimension is tax efficiency. One of these we’re going to talk about–actually, there’s double taxation that happens. The company that earns money pays tax and then when it pays it out to its investors, there’s another tax, a dividend tax.
Sole proprietorship only has one level of tax, obviously. You pay as an individual, as you make the money, but there are other entities, other structures, that we’re going to talk about that also have added advantage and that advantage is important to you.
I definitely would take corporate level protection over tax efficiency. A lot of these, you can do both but definitely I would not sign an agreement if I were running a company on anything unless I adopted a couple of these, at least, one of these entities. It’s very inexpensive to do. We’ll get to that, but filing fees for these things are $800. The work to do it is just faxing in a one page document.
Andrew: Sole proprietorship. Isn’t it essentially a company? Is it?
Bill Schreiber: It’s you individually. So just like you can sign up for a cell phone and sign a contract with AT&T if you’re acting as a sole proprietor. So, if you individually that gets looked at first and you that gets looked at individually only if there’s any problems at all.
Andrew: OK. The second thing, the second entity we need to talk about is partnerships, and by the way I see Moses in the audience is asking about a LLC. We’re going to get to that in a moment.
Partnership is, basically, two people own the company. It’s like a sole proprietorship but two people own it, true?
Bill Schreiber: Partnership is, basically, a contract. It’s very flexible because you can put in that contract whatever you want. It puts in who owns what percentage of the company in terms of the economics. If the company generates money, it’s how the voting works which doesn’t [?] It’s the percentage of the company that’s owned. You could put all kinds of things in there.
Somebody’s ownership may go up or down over time with the tax benefits. The company may be allocated in different ways. So, it’s completely flexible. That’s the good news. It does offer– if you choose the right type of partnership, it does offer corporation-like protection, and there’s only one level of tax.
In other words, the company to the extent it earns money or it loses money, it gets allocated to the equity holders. There’s no double tax once the money goes to the equity holders. So, those are the advantages. The huge disadvantage to a partnership is it’s a contract. It’s a blank piece of paper.
If you don’t write it down in the contract, it doesn’t exist.
And so, to do things the way most investors expect them, or even the way most employees that work for technology companies expect to see them, can be very, very difficult. And adopting the stock option plan, for example, is very, very difficult to do. So, a partnership, if you think you’re going to be small, and there’s only going to be a very few equity owners, may be the right decision. But, it becomes very inefficient if you’re trying to recreate the wheel, starting with a blank piece of paper, to get to certain outcomes that different people want.
Andrew: I see. OK. Let me just bring back, looks like the live audience lost the feed algorithm right back here. They can hear us still, but they can’t see us, it looks like. And I’ll fix that in a moment. [pause] All right there, now they can see us, and we were talking about… [2 beeps] Great, great. OK, guys, let me know if you still can’t see it, but you should be. Oh, good, they can see us. OK, partnership is where I, a roommate of mine and I come up with an idea, we decide that we’re going to own the idea together. It’s not necessarily a conversation that we’re clear about, but it’s implied that we own it together, and we’re going to continue to build up this business. That seems pretty common, and that, at that point, what should people do to protect themselves?
Bill Schreiber: Well, a partnership, a legal partnership, is a partnership when you actually file a Certificate of Partnership with California or Delaware or whatever state you want to…
Andrew: Oh, I see. You actually have to file a Certificate of Partnership to be a partner?
Bill Schreiber: This is actually a legal entity, is the partnership I’m talking to. I think what you’re talking about is more the way Facebook started out when there was no legal entity at all, when they were in the dorms. That was really a sole proprietorship that happened to have two people involved in some way. But, it wasn’t formalized as a partnership or anything else.
Andrew: OK. Should, if it’s, I guess at that point, if we’re going to file something, then we might as well move onto a different entity instead of staying as a partnership, right?
Bill Schreiber: Yeah, I think if you like the aspects of a partnership. In other words, if you like the corporate level of protection, you like the single tax, and you don’t mind dealing with some hassles like adopting a stock option plan, the best answer is not going to be a partnership. It’s going to be an LLC, it’s going to be a Limited Liability Company. And, the advantage of a Limited Liability Company is, it takes sort of the tax aspects of a partnership, and if you want, it’s sort of the contractual aspects of the partnership. That you can be very creative if you want to be with an LLC, but it adds to it sort of the default rules which are, like corporate rules. In terms of, if you just check the box and it’s a certain type of LLC, it will say, OK, here’s who makes certain decisions. And the same way with the corporate-wide, you don’t have to reinvent the wheel on a blank piece of paper. So, those are the advantages of an LLC. You know, the main disadvantage of an LLC again is, it’s not built, it’s just been along, it’s been around for maybe 20 years, 15 years, it hasn’t been around as long as corporations. So, things like stock option plans and things that most people think are pretty fundamental to high-tech companies. It, in a lot of ways, haven’t caught up to, the LLC rules haven’t caught up to the corporation rules. But it’s happening over time. And certainly, it’s a better choice than a partnership if you like single-up tax and if you like a lot of flexibility.
Andrew: OK. I actually noticed that in the Web 2.0 world, several smaller companies were LLCs right up until the point that they got bought out, which was surprising. I was expected companies that were that, companies at that level would be corporations. What are the advantages of being an LLC, why would they want to be an LLC, and continue to be an LLC right up until the purchase?
Bill Schreiber: The analog in the corporation world to an LLC is what’s called an S-Corporation. So, let me sort of explain that for a minute. And then I can compare that to an LLC, because I think if you want corporate level protection and single-level tax, which is what companies like that find most attractive about an LLC, they also can find it in an S-Corporation. An S-Corporation basically operates just like a partnership or an LLC for tax purposes in that there’s only a single level of taxation. There are, however, some restrictions in running an S-corporation for early stage tech companies. The ones that they normally run afoul of are; you’re not allowed to have any foreign shareholders, is number one. Number two, you are not allowed to have, you’re only allowed to have one class of stock. So, you can’t issue preferred stock, for example. So, if you can fall within those parameters of just issuing one class of stock, and not having any foreign shareholders, I think an S-Corporation makes a lot more sense than an LLC, because you can’t easily issue…
Bill Schreiber: Ö because you can easily issue stock options and you can flip very easily into a C corp by just issuing the preferred stock if you did want to do a bunch of capital financing. So, I actually think, if you can live within those two restrictions, then an S corporation makes a lot more sense than an LLC. LLC’s sort of have become, you know, sexy because they are so flexible that a lot of people decide that they want to use them instead. I think that the advantages of being a corporation, an S corporation, again, I keep on going back to stock option plans cause they’re just so fundamental — it’s what service providers expect to get for their services ñ that I think those advantages outweigh an LLC. But to your point that enough people stay in LLC all the way through an exit event, I think that’s fine as long as they don’t need to issue a whole lot of equity to a lot of different people, and as long as, you know, that they’re able to deal with sort of a cost benefit of whatever complexity there is of having to work that into the actual operating agreement as opposed to defaulting back to corporate rules.
Andrew: Okay. Let’s see. Moe who is in the audience is saying ñ I’ll just read his question verbatim: Single member LLC, keep it as a sole proprietor or check the S or C corp option, which is better? Um
Bill Schreiber: I think that’s a lot of what I just answered
Bill Schreiber: So, Moses, let us know if it’s not. But, again, if you could live within restrictions, my advice would be to do an S corporation. If you really ñ if you can’t live within those restrictions or if you um want a lot of flexibility, use an LLC. I would never use a sole proprietorship under any circumstances unless it was just a hobby. And we can talk about a C corporation after this. But, that’s the other option.
Andrew: Okay. Let’s do that. Let’s talk about a C corp.
Bill Schreiber: So, a C corporation is sort of ñ you get, honestly get corporate level production but this has the double tax. So, this has if the corporation makes money, it pays taxes. And then if dividends the money out to the or otherwise distributes the money to the shareholders, they pay tax as well. So, it’s very inefficient for a company that plans on generating a lot of cash through its operations getting it to its shareholders very quickly. The advantage of a C corporation, of course, is that you can very easily issue two classes of stock. So, for venture capitalists who always want preferred stock, it’s a natural vehicle and that’s basically the only vehicle. I try to replicate preferred stock into LLC’s. Let me just tell you, it’s not something you want to do and it’s not something you want to pay your lawyer to do. It’s very complicated. But, so a C corp is what 99.99% of all companies that are funded by, you know, recognized venture capitalists end up using. It’s bad for tax but it’s good for ñ but it’s sort of the only choice left if you’re going to have multiple [inaudible].
Andrew: Okay. I hate to go … to go with basic questions that I know anyone who’s taken even business courses in college, is going to say that these questions are too basic, but what’s a preferred stock?
Bill Schreiber: A preferred stock is actually I should have explained this. I apologize cause many people I’ve talked to as founders don’t know what a preferred stock is. SoÖ
Andrew: Oh, good. You know what, I’m glad. I don’t know what level is going to be so basic that people are going to just turn it off and say, ‘I know this stuff already. Andrew, get to the deeper questions.’ And what’s going to be so helpful that the questions that they might themselves think are too dumb to ask. So, we’ll do our best to find that line.
Bill Schreiber: So, so, let’s start with what is preferred stock. So, preferred stock is as the name implies, better than common stock. In what ways it’s better than common stock, it’s negotiated but in terms of venture capital round, where it’s sophisticated and best around, it’s usually better, at least in the following ways: it’s better in that they usually have some sort of right to abort or multiple aborts. If the company exits through an acquisition, they get some preferential treatment in terms of getting paid first. Um, they might get a right to get some free shares if they invested a certain, let’s say a dollar a share, and if you the next round at less than a dollar a share. There’s a number of different ways where it’s just better economically and in terms of voting than common stock is. The reason preferred stock is so popular for [sounds like easyback] companies is one advantage to the common holders is if you have a preferred stock and say you’re issuing it at a dollar a share, the IRS and the SEC and everybody else recognizes that preferred stock is better than common stock. Usually the common stock
therefore the fair market value of it can be maybe 10% to 30% of what the preferred stock is. So, yes, the BC has all these rights they paid a dollar a share for, but the employee that gets hired can get a stock option. They only have to pay, say $0.10 a share or $0.30 a share for their stock. So, common stock is worse but it’s also cheaper because it has those less rights. And so that paradigm where you have people that put in real money sort of pay top dollar for it
…but people that are providing what I call sweat equity — S-W-E-A-T, sweat equity — end up getting their equity for much cheaper is one of the secrets of why high tech has done [so well].
Andrew: Okay. Let’s talk about moving from one entity to the other. You start off as an S-corp or an LLC or a partnership and you want to move on to a C-corp. Easy? Hard?
Bill Schreiber: Yeah, so a lot of people want to have their cake and eat it too. We’re going to be losing money in the early days, we want to recognize those losses, we want the single tax aspect but we realize some day we don’t want to foreclose getting funded by a sort of traditional VC and we know someday we’ll probably have [inaudible]. So how do we sort of have the best of both worlds? There’s nothing wrong with that. Many, many of my clients do it this way. You’d set yourself up as an S-corp and an LLC in the first instance but recognizing you have to fund it obviously yourself but you get to recognize those losses. When you flip from an LLC into C-corp or from an S-corp into a C-corp it’s a tax free transaction unless ñ and this is important ñ unless at the time you do the flip you have negative net assets. In other words, you have more liabilities than you have assets, for tax purposes. And if you do, and the only way this would happen by the way, is if something happened where you had more liabilities than were created by the cash that you were putting into the company so that there was some lawsuit or somehow you had some liability that was more than just…you had a payable or something for something you bought with the cash you put into the company. But if you had this unusual situation where you had more liabilities than you had assets, when you flip into the C-corp the IRS is going to take that negative net assets and that’ll be taxable income to the shareholders when you flip into the C-corp. So that, you know…I’ve only seen that happen once or twice or three times in a 15 year career so I don’t want to scare people but that’s the only disadvantage, that’s the only risk of starting out as an S-corp or an LLC and then flipping into a C-corp. The opposite isn’t true. If you start off as a C-corp and you think you’re going to raise money, it turns out you have pretty good business and you figure out you’re not going to need outside
funding, and you just want to sort of eliminate the double tax, flipping from a C-corp into an S-corp is very painful. It’s more nuanced than this but just very simplistically, what the IRS does is it says, ‘Okay. Whatever the fair market value of the C-corp is when you flip into the S-corp or the LLC is taxable income to you today.’ And if you’ve got a business that you’re excited about that you want to flip into an S-corp or an LLC chances are it’s doing pretty well and the fair market value is going to be…it’s going to hurt to flip the other way.
Andrew: Okay. So a C-corp for companies starting out doesn’t make sense. Think about an S-corp or an LLC.
Bill Schreiber: I would say a C-corp makes sense if you know that you’re going to get funded and if you don’t get fund you’re not going to get have [a company]. And you might as well have a C-corp. You’re not going to be generating anything for the shareholders to get anyway. At least nothing meaningful. If you think there’s a real chance that your business is going to never need funding, just going to be able to live off the cash flow, make sure that you never fall into a negative net asset position but then, yes, starting off with an LLC or an S-corp makes a lot of sense.
Andrew: Okay. I talked about earlier offshore issues. Maybe we spend a little bit of time on that?
Bill Schreiber: Yeah, just a comment or two. If you have offshore development, huge tax advantage that you can give yourself by creating the entity offshore. And the popular places to do that are the Caribbean places like the British Virgin Islands, Bermuda, Cayman Islands or Mauritius. By doing that…and you can either set up the parent there or you can set up the subsidiary there and have the parent here. But by doing that the advantage is that for all of the sales that are generated by the company that are outside the US the US doesn’t get to tax it because it was generated in this corporation that was located outside the US and was sold directly to a foreign customer. That’s a big advantage because the US has the second highest corporate tax rate in the country. Sorry, in the world. So just consider that. It’s complicated and you have to do some agreements but if you have off shore development ñ and I’m not talking you outsource your QA to India. I’m talking about you know, valuable IP development, take advantage of that and think about that in addition to just whether you pick an LLC or an S-corp or a C-corp. Obviously every jurisdiction has their own peculiarities so it’s beyond the scope of this call. But just keep that in the back of your mind, that if you do have the advantage, the potential tax advantage of having offshore material, offshore it [inaudible].
Andrew: What about just one last question on this section? What state should you incorporate in? Or what state should you form your company in?
Bill Schreiber: The logical choice for companies based in California is obviously California or Delaware. Some people say, ‘Well, I want to incorporate in Nevada because they don’t have any taxes.’ There’s two types of taxes. There’s income taxes and there’s what’s called franchise taxes. Income taxes are where you work; it doesn’t matter where you incorporated. So incorporate…
Andrew: Oh, sorry. I lost your audio. Let’s see if we can get it back on. I think I can hear you again.
Bill Schreiber: I’m not sure where I left off but basically the logical choices are California or Nevada. I’m sorry. California or Delaware. Don’t think about Nevada or some place that doesn’t have incomes taxes it’s not going to save you any money because it’s where you work that governs where you pay income taxes not where you’re incorporated. Between California and Delaware, Delaware is much, much easier to work with. They are… in a lot of different dimensions. They have a lot more law just because a lot more people are incorporated in Delaware than they are in California so my heavy bias is to incorporate in Delaware. The advantage in California is, to some degree, California treats minority shareholders better than Delaware does. But if you’re going to get VC funding, VC’s understand that as well and they basically virtually always end up giving away those types of advantage that you otherwise would think you’re getting in California, you give it away by contract as opposed to getting to keep it just because you incorporate in California. So there’s some minor disadvantages. You have to qualify in…You have to qualify to do business in California if you’re not incorporated here. But generally, my clients, certainly over 95% of them are incorporated in Delaware. So ten years ago people used to debate it back and forth. I think most of the practitioners are advising their companies just to go in Delaware.
Andrew: Delaware. Let’s move onto the last section. Pre-venture capital funding. First question here is convertible debt rounds compared to equity rounds. Maybe we can define them first? What’s a convertible debt round and what’s an equity round?
Bill Schreiber: So what a convertible…let’s start with an equity round. What an equity round is we’re going to issue…we’re going to give you stock for your money. And by the way, a disadvantage to giving somebody common stock in a financing round is that’s going to increase the price that you can give out common stock to other people like stock options to your employees. So it’s best to do, if you’re going to do a financing round and you’re going to do it in equity, if you want to maintain a low stock option price it’s better to do a preferred stock financing. But basically you’re giving somebody stock for their money. The advantages of that are that’s what people sort of intuitively expect. And so they’re holding this stock. Compare that to a convertible note round which basically says, ‘I’m not going to give you stock today what I’m going to give you is a note and that note is a promissory note, a promise to repay you at some point in time. But the note is going to convert when I actually do do my next round. So you’re not going to get stock today but you’re going to get stock tomorrow we just…neither one of us know what that’s going to be. But we won’t worry about how much that is today. We don’t have to argue about valuation. We don’t have to argue about what the terms are. We don’t have to argue about almost everything because you’re going to let the next investor do that for you. And maybe because investing today is more risky than investing when the next round comes maybe we give you a discount into the next round where you only have…your stuff converts in at 60% of the price or 90% of the price. Or maybe we give you what’s called warrants which are basically stock options on top of the conversion. Give you a bigger ownership than you otherwise would have if you just converted in on a dollar for dollar basis. So that’s a summary of what the two are. Equity and debt. Uh, convertible and debt.
Andrew: Why is it that sophisticated investors are on their blogs and publicly at events saying they don’t want equity rounds?
Bill Schreiber: That they don’t want convertible debt rounds?
Andrew: Yeah, sorry. Right. Why do they prefer equity rounds, thank you? I’m actually reading from your notes and ad libbing and adjusting your notes unfortunately. So yes. Why do they prefer equity rounds? Why don’t they want convertible debt rounds? That convertible debt seems to make sense. Lots of start ups seem to want it.
Bill Schreiber: I think if you’re a founder of a start up you want a convertible debt round. The reason you want one is because it’s very simple to do. You don’t have to argue about valuation because for an early stage company everybody’s going to have a different opinion on that. You don’t have to argue about what all the terms are. You don’t have to have 80 pages of financing documents, meaning you don’t have to pay a lawyer $20,000 to do it. All it is is a two or three page note so it can be done in an hour. It can be done for a couple of hundred dollars of legal time and like I said, you don’t have to go through the excruciating experience of negotiating what you think your company’s worth versus what the investor does.
Bill Schreiber: So for those reasons, being cost, I think the convertible notes are the way to go, if you’re a founder. The investors, frankly, I would imagine, would think the same way, because to the extent that the company’s not spending money, and not wasting time arguing, but instead, focused on the business. It’s better for everybody, including the investors. But there’s a lot of investors that scar tissue, when they have a convertible note, when the next round comes, the next round guy says, “Well, if you remember how I said earlier how that the founders get a piece of the company when the VCs get some money, then there’s future employees. Then there’s these group of people that get the rest of it.” Some VCs, due the later round, look at the investors in the seed round and say, “Well, it was nice that those people gave money. But they’re not going to be as important as these other groups of people going forward. And so, I don’t think giving them a 40% discount is fair. Let’s get rid of that discount. And if you don’t get rid of that discount, I would do the round. So the angel investor’s sort of put in a very awkward position, where if they don’t agree to relinquish the economics that they’ve negotiated, the round won’t happen. Or at least the threat is the round won’t happen. There’s no reason in the world why these future investors couldn’t do the same thing when trying to renegotiate the terms of the existing preferred stock, if the seed run was done as a preferred round, instead of a convertible round. It just, for whatever reason, tends to happen less. And so, seed round investors just feel more comfortable if they’re holding stock rather than a convertible note, because they think it’s harder for the next round guy to leave. It shouldn’t be that way. Numerically, it probably is that way, to some degree. But, in my opinion, if you’re a founder, you still should push as hard as you can for a convertible debt round.
Andrew: You still should push for it?
Bill Schreiber: Yes.
Bill Schreiber: Because the advantages of speed and cost are worth more than whether this guy is, whether this person with the convertible note is nervous that he’s being put in an awkward position. I mean I would even offer the convertible debt in approval, right on the next round, if I had to, in order to get a convertible debt structure, if he felt he needed that protection. Because at the end of the day, he is going to capitulate in order to get a round done. Because if, in fact, you don’t do the next round, there is no viable company. So you’re not really losing anything. And just spending, you know, 15, 20, maybe more, thousand dollars to put together 80 pages of financing documents for a half million dollar round or a million dollar round, it just doesn’t make any sense.
Andrew: OK. And so this is for investors. This is for sophisticated investors that we’re trying to get a convertible debt round with, but it’s also for friends and family. What we’re essentially, am I understanding that part right, too?
Bill Schreiber: Yeah, so wherever that seed money comes from, your more sophisticated angel investors who will call this round, more sophisticated people will tend to ask for, or demand, equity. If you’re dealing with true friends and family, I think that there’s a trust factor that can very quickly get through the, “Oh, I’m worried you’re not going to look out for my interest”, when we actually do the actual round. So I think it’s easier to convince those people that we’ve just got to do a convertible debt. In my experience, you know, virtually 100%, in those circumstances, it is done as a convertible debt. For the reasons that I talked to you about, the advantages.
Andrew: OK. What we’re saying in that stage is, “Hey, I used to work for you, boss, a year ago. You liked me back then. You said if I ever started a company, I should come back and talk to you. Well, it’s a year later. I’ve started this company. I could use some money. Instead of giving you a share of the business now, instead of negotiating what share of the business you get, I’m going to owe you some money. So I’ll give you some debt. And then when I get a real round of funding afterwards, or when I bring in the next round afterwards, that’s when we’ll decide what share you’ll get. Or that’s when you’ll get your shares. And we’ll decide now how to value those shares. What percent? Sorry, go ahead.
Bill Schreiber: Two things. And we’ll give you a little bit extra because we’re coming in now and not later,so that helps figure out what that is, somewhere between 10 and 20…
Andrew: Sorry, I’m losing your audio.
Bill Schreiber: Oh, sorry.
Andrew: Let’s see. For anyone who, this is their first Mixergy program, we do this via Skype. Bill is in northern California, I’m actually in Buenos Aires today. And all of my interviews, even when they happen to be in the same city, are done by Skype. I did an interview with Mike Jones, who now is with MySpace, and he was just a few blocks away from me, and he just assumed I was coming into his office. And he couldn’t believe we were going to do it by Skype. But it makes more sense to do it this way. Plus it allows us to include a live audience. Sorry, so I was saying, what interest rate should we charge? What should we be paying?
Bill Schreiber: This is for convertible debt. Obviously, there’s a number of terms to negotiate. One of them is the interest rate. Interest rate really is not important. The convertible note is not like negotiating a note with the bank. What it is, is just sort of a placeholder, it really is like equity. And we just won’t determine the number of shares until the future. So, the interest rate, the IRS has minimums…