Founder Equity Issues: Structuring Founder Relationships, Stockholder Agreements & Choice of Entity

Structuring Founder Equity And Relationships

The Capital Network - Expert Lunch Series

Paul G. Sweeney, Esq.

May 10, 2013

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Introductions

Paul Sweeney, Esq. – Partner in Foley Hoag’s Business Department – Named one of “Top 20 Startup Lawyers in Boston” and “Top 10

Most Innovative Lawyers in America” by the American Bar Association Journal

– Practice focuses on angel and venture capital financings, mergers and acquisitions, strategic alliances and related business transactions.

– Clients range from start-up and venture-backed portfolio companies to well-established public companies operating in a wide array of industries, including mobile, networking, computer security, information technology, and high tech.

– Helped clients raise hundreds of millions of dollars in angel and venture capital, and advised clients through several dozen acquisitions in the aggregate amount of over $2.8 billion.


Overview

 Cutting up the pie; dividing without being divisive  “Restricted Shares”  The Founders’ Agreement; getting it down on paper

© 2013 Foley Hoag LLP. All Rights Reserved. Incorporating your Startup | 5

Picking a Great Co-Founder

 Choosing the right co-founders is the most important decision you will make early on


Picking a Great Co-Founder

 Complimentary Skills  The Three “I”s - intelligence, intensity and integrity  Ideal team is comprised of people with a history of

working together, of similar age, life state and financial picture, where some are great at building things, some are great at managing things and some are great at selling things.

 4 things early-stage investors care most about = PIMM (People, Idea, Model, Market)


Choosing Your Co-Founders

 Use care in who you choose; founders are to a startup as location is to real estate.

 Ability is important, but character and commitment are even more so.

 Work hard to maintain the relationship; your co-founder is more than just a co-worker.

 You haven’t seen someone’s true colors unless you’ve worked with them on a startup.

 The success of a startup is almost always a function of its founders.


Critical Questions Facing Co-Founders

 Definition: Who should my co-founders be?  Equity Distribution: How will we divide the equity among

ourselves?  Control: How will decisions be made, and who will make

them?  Succession: What happens when one of us leaves?  Forced Departure: Can one of us be fired? By whom, and

for what reasons?  Cash Contributions: Will any of us be investing cash in the

company? How will this be treated?


Dividing The Pie

“Why not just split everything equally?” X= total number of founders, and each founder gets 1/X

of equity.

 It’s simple and quick  We’re all equals, so our equity stake should be too  There’s no “right” answer, so might as well divide it

equally  We want everyone to have skin in the game  Debating over equity will kill the company  If future events require, we can always adjust later


Dividing The Pie

Consider reasonable metrics for dividing equity:  Past contributions  Future contributions  Opportunity cost  Your relationship with co-founders

– (Note: Don’t confuse equity with income)


What do I pay for my Founders’ Stock?

 Address this EARLY!  Everyone should pay “fair market value” for the stock.  Cash is sometimes augmented by contribution of

intellectual property, but this is tricky: - Difficult to define scope of transfer - Difficult to properly perfect the transfer - Difficult to value the assets assigned - Potential tax ramifications (Section 351 of IRC)


What if I paid “more” than FMV?

 Need to balance control over company (relative percentage of company held) with company’s need for capital.

 In extreme cases, consider issuing junior preferred stock with a liquidation preference.


Equity - take aways

 Address the “splitting the pie” issue as early as possible  Pay attention to tax issues (get appropriate advisors)  Dividing equally is often sub-optimal  Choose metrics that are appropriate for your business  Co-Founder’s equity position should reflect his/her true

value  “Skin in the game” means different things to different

people  Don’t avoid the issue; this only gets harder (and more

expensive) over time


Should Founders’ Stock be Restricted?

 “Restricted Stock” –shares subject to forfeiture  The company has the right to repurchase the shares if

the founder leaves the company for any reason.  Vesting  Acceleration  Determining repurchase price  Critical Tax Considerations – 83(b) election  Timing- When to impose restrictions


What is “Vesting”

 At the beginning, Company has the right to repurchaes your shares (called “Restricted Shares”)

 Vesting = Company’s right to repurchase shares lapses over time or upon certain events

 “Vested Shares” – shares that are no longer subject to repurchase right.

 “Unvested Shares” - shares that are still subject to repurchase right.

 Note: Time based vesting vs. Performance based vesting


Vesting Schedule

 Standard Vesting Schedule: Four year total, with 25% vesting after one year (“cliff vesting”), remaining 75% vesting monthly over next three years.

 Vesting commencement date – credit for past service?  “Re-vesting” at a financing event


Timing: Restrictions on Day 1?

 Primary reasons for imposing vesting even before VC financing: 1. If multiple co-founders, each is benefited if company is able to repurchase unvested shares of a departing co-founder. 2. If the terms are reasonable, they might survive the venture financing.


Acceleration Upon Change of Control

 Standard Approach - allow some amount of accelerated vesting (6-12 mos.) upon Change of Control

 “Double Trigger” - acceleration tied to the termination of the founder (usually without “cause”) within a certain period of time (12 mos.) after the Change of Control. - Difficult to implement if cash only consideration.

 Note: Founders and Investors have adverse interests


Acceleration Upon Termination

 Accelerate upon termination without “cause” or “constructive termination”? - Difficult to define “cause” and “constructive termination” - Difficult to implement - Usually results in regret (except for the departing founder).

 Consider treating acceleration like severance (3-6-12 mos.)


Repurchase Price

 Two Approaches: - 1) Company repurchases unvested shares at the nominal price paid by the founder. (Most common approach) - 2) Company repurchases unvested shares at a price equal to the fair market value (FMV) at the time of the repurchase.

• Board usually determines FMV • Problem #1- Investors often view the founders as having not yet “earned” the stock, and so they resist allowing founder to benefit from an increase in equity value.

• Problem #2- the Company might not have the $. • Possible Compromise: Differentiate the purchase price based upon the reason for the departure.


83(b) Election

 General Rule: If service-based vesting is imposed up on founder’s stock, founder recognizes income (the difference between fair market value and the price paid) as the stock vests.

 83(b) Election: If founder elects within 30 days of the issuance of the stock to be taxed on the value of the stock at the time of issuance (less anything paid for the stock, which can include the value of IP contributed to the business), then no income recognized upon vesting.

 30 Day Limit – Strictly Enforced. (Being close doesn’t count.)

 Election is voluntary - Can’t unwind if shares are forfeited.


83(b) Election

 Example: Founder purchases stock for $0.01 per share (fair market value is $0.01). Stock is subject to four year vesting with a one year cliff. – If founder does not make 83(b) election, then at each

vesting date founder recognizes income based on difference between $0.01 and FMV. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

– If the founder had made 83(b) election, the founder would not recognize any income as the stock vests.


The Founders’ Agreement

 Standard Provisions in Founders’ Agreement: – Structure of company and equity distribution – What are the vesting provisions? – Are Co-Founders allowed to pledge their shares? – Who is on the Board? – Any restrictions on new issuances by the company? (anti-

dilution, pre-emptive rights) – How are disputes to be resolved? – How are sales by Co-Founders handled? (e.g. right of first

refusal, tag along rights, drag along rights) – What are Co-Founders’ obligations and commitments?



 Main points to include (cont.): – Information rights of Co-Founders – What happens upon death or incapacity? (Life

insurance?) – How will stock be valued in future? – Compensation issues – Other agreements? (Employment contracts, NDA’s,

Non-Competes, Assignment of Inventions)



 Questions to Ask Yourself Before Signing the Founders’ Agreement: – Am I satisfied with my equity stake in this company? – Can I acquire more shares? (i.e. control and upside)? – Can I sell my shares (i.e. manage the downside) if I

need to? – Am I committing to something I cannot live up to? – Will I be able to exert sufficient control and influence

to protect my investment? – At the end of the day, what is my total financial

exposure and legal liability (present and future) with this company?



 Some Do’s and Don’ts: – Don’t confuse equity issues with management issues – Don’t assume everyone will always be agreeable – Don’t get bogged down in legalese – decide what

you want, then have your attorney put it into proper legal form

– Do make sure everyone’s objectives/visions/risk profiles are compatible

– Do talk to others who have had experience in these matters

– Do understand what is in the agreement


When do I involve the Lawyers?

 As early as possible!  Organization of company (charter, bylaws, stock

incentive plans)  Founders’ Agreement, or any other agreement

containing equity feature or right of first refusal  Financing transactions (both debt and equity)


Take Aways

 Choose your co-founders wisely.

 Choose your attorney wisely, and early!

 Always involve an attorney before issuing equity or entering into agreements among co-founders.


Sources and References

  www.onstartups.com

  www.founderresearch.blogspot.com

  “Founders at Work” by Jessica Livingston

  “Startups that Work” by Joel Kurtzman

  “Business Basics for Engineers” by Michael Volker

Founder Equity Issues: Structuring Founder Relationships, Stockholder Agreements & Choice of Entity

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