Author Archive

Who Are Stock Certificates Issued To and When?

Q: We are a Delaware C Corp registered as a Foreign Entity in Colorado our home state and we need to figure out the answers to the following questions with regards to stock certificates.
1. Who gets stock certificates issued and when?
             My assumptions are that cash investments DO get certificates, warrants DO NOT.
             Founders and Employees with vesting schedules DO NOT get certificates, until a portion of stock is vested.

2. Do the buy and print your own certificates follow the normal process?
3. Do private C Corps file capitalization stables with the SOS?

A (Jason):

It’s a pretty simple answer, really.  If you buy the stock, you get the certificates.  So cash investors do get certificates.  Warrants and options are securities that provide the holder to exercise them later by paying for the stock at a pre determined strike price.  At the time of exercise, money is paid by the holder to the company for the stock subject to that warrant or option and then a certificate is issued.  The options can not be exercised until vested, as you suggest.

i’m not sure what “buy and print” your own certificates mean, but there is no form that you have to follow.  It just needs to be signed by the President and Secretary of the company.  Furthermore, cap table are not filed anywhere.  You may keep this information private.

 

When Should A Company Be Formed Around an Idea?

Question:

I participated in a company’s “app challenge weekend” (which they described as somewhere between a hackathon and a startup weekend). I am excited to continue working on the product that my team built over the weekend with 2 of the team members (my brother and the guy who pitched the idea).

My preference is to formalize a relationship by forming a company.  My fear is that the guy who pitched the idea will decide in a month or two that he doesn’t need us and tell us we’re not working on it anymore.  He formed a company 2 years ago that he talks about (though from the research I’ve done has no IP or product of any kind) and thinks that this idea fits into that vision, but doesn’t want to include anyone.

Should we form the company now, using fairness and our best sense of who will be doing what work to split shares and come up with a conflict-resolution/decision-making process (I imagine this would be the board) to compensate for the fact that my brother and I just met the guy who pitched the idea a week ago? Or should we continue working on the product and see what happens?

If you have any concerns today, then the last thing you want to do is continue and “see what happens.”  We always tell startups to deal with their issues immediately.  One, they don’t get any easier over time, but more importantly, the issues are easiest to deal with when the company isn’t worth anything / much.  As soon as one of the parties starts seeing dollar signs in their eyes, issues become much harder to deal with.

We’d suggest that you form a company (LLC or S-Corp is fine at this point), divide up the equity and make sure it is subject to vesting.  That way, if someone does decide to leave, they will not leave with all of their equity.  Make sure that there is a strong agreement in place that contributes all the IP that you created during the weekend to the new company.

As for dispute resolution, there are two ways that this can work.  One, the equity owners of the company can vote the issues.  In this case, if you all owned equal amounts of equity, two of the three of you could vote the issue to approval or veto.  Or you can have the board vote, as well.  In general, if you are a three person team and you are already planning on “dispute resolution strategies” it might be time to sit down and make sure that you are all on the same page going forward before you start a business together.  It’s not normal that shareholder and / or board votes are happening very often with companies this small.

What Does A VC Mean When He Says Your Product Is “A Feature And Not A Company”?

Question: What does a VC mean when he says your product is “a feature and not a company”?

This (usually) means that the VC believes the opportunity you are pursuing isn’t a big enough opportunity for them to invest in.  In other words, what you are building should be a feature to something else already out there, instead of a stand-alone company that will generate the type of returns that the VC is looking for.  For instance, assume you are building something that fits inside an email client that does X.  (Perhaps “X” translates languages).  While super helpful to some folks, a VC may take the postion that this should be a feature or tool within the email client, but not an opportunity to build a large company with paying customers around it.  Of course, we can debate whether this is a correct statement, but in the eye of the VC this is how it is.

One thing always to consider with VC feedback to your company, however, is whether or not you are getting transparent and honest feedback.  In our experience, few VCs actually give feedback like this, so always have your skeptic brain alert.  One never knows what the real reason for investing might be.  Perhaps the VC is out of money and can’t even make an investment, but doesn’t want to admit that and thus the feedback.  This is just a general comment and not one particular to your question.

Convertible Debt – Wrap Up

And there you have it. We’ve completed our series on convertible debt and hope that you enjoyed it. If we ever get around to writing a second edition of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist we’ll be sure to include this as well.

If you go to the resources section of Ask the VC we’ve included standard forms used in a variety of venture deals. As of this posting, we’ll include some standard convertible debt documents subject to the disclaimer that we aren’t you lawyers and make no reps or warranties with respect to these documents, so use at your own risk.

Convertible Debt – Early Versus Late Stage Dynamics

Once again we continue our series on convertible debt deals. Today’s subject is early versus late stage dynamics.

Traditionally, convertible debt was issued by mid to late stage startups that needed a financing to get them to a place where they believed they could raise more money. Thus, these deals were called “bridge financings.”

The terms were basically the same unless the company was fairing poorly and there was doubt about the ability to raise new capital and / or the bridge was to get the company to an acquisition or even orderly shutdown. In these cases, one saw terms like liquidations preferences and in some cases changes to board and / or voting control come into play. Some of these bridge loans also contained terms like pay to play.

Given the traditional complexity and cost of legal fees associated with preferred stock financings, however, convertible debt became a common way to make seed stage investments as it tended to be simpler and less expensive from a legal perspective. Over time, equity rounds have become cheaper to consummate and the legal fees argument doesn’t hold much weight these days. In the end, the main force driving the use of convertible debt in early stage companies is the parties’ desire to avoid setting a valuation.

Convertible Debt – Warrants

Earlier in the convertible debt series we talked about the “discounted price to the next round” approach to providing a discount on convertible debt. The other approach to a discount is to “issue warrants”. This approach is more complex and usually only applies to situations where the company has already raised a round of equity, but it still pops up in early stage deals. If you are doing a seed round, we encourage you not to use this approach and save some legal fees. However, if you are doing a later stage convertible debt round, or your investors insist on you issuing warrants, here’s how it works.

Assume that once again the investor is investing $100,000 and receives warrant coverage in the amount of 20% of the amount of the convertible note. In this case the investor will get a warrant for $20,000.

This is where it can get a little tricky. What does $20,000 worth of warrants mean? A warrant is an option to purchase a certain number of shares at a pre-determined price. But how do you figure out the number of warrants and the price that the warrants will be at? There are numerous different ways to calculate this, such as:

  1. $20,000 worth of common stock at the last value ascribed to either the common or preferred stock;
  2. $20,000 worth of the last round of preferred stock at that’s rounds price of the stock; or
  3. $20,000 worth of the next round of preferred stock at whatever price that happens to be.

As you can see, the actual percentage of the company associated with the warrants can vary greatly depending on the price of the security that underlies it. As a bonus, the particular ownership of certain classes may affect voting control of a particular class of stock.

If there is a standard, it’s the second version where the warrants are attached to the prior preferred stock round. If there is no prior preferred, then one normally sees the stock convert to the next preferred round unless an acquisition of the company occurs before a preferred round is consummated and in that case, it reverts to the common stock.

For example, assume that the round gets done at $1.00 / share, just like in the previous example. The investor who holds a $100,000 convertible note will get $20,000 of warrants, or 20,000 warrants, at an exercise price of $1.00, to go along with the 100,000 shares received in the financing from the conversion of the note.

Warrants have a few extra terms that matter.

Term Length: The length of time the warrants are exercisable which is typically five to ten years. Shorter is better for the entrepreneur and company. Longer is better for the investor.

Merger Considerations: What happens to the warrants in the event the company is acquired? We can’t opine more strongly that all warrants should expire at a merger unless they are exercised just prior to the transaction. In other words, the warrant holder must decide to either exercise or give up the warrants if the company is acquired. Acquiring companies hate buying companies that have warrants survive a merger and allow the warrant holder to buy equity in the acquirer. Many a merger have been held up as warrants with this feature have upset the potential acquirer and thus as part of the closing requirements mandated that the company go out and repurchase and / or edit the terms of the warrants. This is not a good negotiating spot for the company to find itself in. It will have to pay off warrant holders while disclosing the potential merger (so the company will have little leverage) and at the same time will have a sword over its head by the acquirer until the issue is resolved.

Original Issue Discount: This is an accounting issue that is boring, yet important. If a convertible debt deal includes warrants, the warrants must be paid for separately in order to avoid the OID issue. In other words, if the debt is for $100,000 and there is 20% warrant coverage, the IRS says that the warrants themselves have some value. If there is no provision for the actual purchase of the warrants, the lender will have received an “original issue discount” (OID) which says that the $100,000 debt was issued at a “discount” since the lender also received warrants. The issue is that part of the $100,000 principal repaid will be included as interest to the lender, or even worse, it will be accrued as income over the life of the note even before any payments are made. The easy fix is paying something for the warrants, which usually is an amount in the low thousands of dollars.

The difference between warrants and discounts is probably insignificant for the investor. We suppose if the investor is able to get warrants for common stock, then perhaps the ultimate value of warrants may outweigh the discount, but it’s not clear. As evidenced by the number of words above, warrants add a fair amount of complexity and legal costs to the mix. On the other hand, some discounts will include valuation caps (more on this in our next post) and that can create some negative company valuation ramifications. Warrants completely stay away from the valuation discussion.

Finally, in no case should an entrepreneur let an investor double dip and receive both a discount and warrants. That’s not a reasonable position for an investor to take – he should either get a discount or get warrants.

Teaching With Our Book – Venture Deals

We’ve been flattered through the years to hear that several highly acclaimed universities have used our term sheet series to teach business, law and engineering students the ins and outs of the venture financing term sheet.  With the release of our book, Venture Deals:  Be Smarter Than Your Lawyer and Venture Capitalist, we’ve begun to hear that folks are using our book in the classroom, as well.  The book is much more broad than the term sheet series in that it discusses fundraising, negotiation tactics and potentially most importantly, how VC firms are organized and incentivized, thus providing a never-seen-before look into the inner workings of venture firms.

Jason co-teaches a class at the University of Colorado Law School called VC 360 with professor Brad Bernthal.  They’ve been teaching the class for four years now and both enjoyed teaching from the book, rather than cobbling together a disjointed coursepack on the subject matter.  (Okay, we are biased, but take our word for it).

We’ve also learned that Woody Benson and Philip Lowe are teaching a course at Bentley University using the book.

With that in mind, we’ve created a new page at AskTheVC.com: Teaching.  To start, the University of Colorado and Bentley University have open sourced their syllabi and we welcome other educators to join us by posting theirs as well.  If you want to get involved, just leave a comment and we’ll get back to you.

We’ve also created a forum in case we get enough participation that we can share stories and issues about teaching from the book. Finally, Brad Bernthal and us will be writing a teacher manual for the book to help future use in the education ecosystem.

Thanks Philip and Woody on being our first partners!

 

How Many Shares Should I Use To Incorporate My Company?

Question: How many shares should I use to incorporate my company?

Keep it simple.  The more shares you authorize, the more you’ll have to pay in taxes (although these are not large numbers).  They key is having enough shares to have the ability to grant all sorts of equity to different people who help your company.  For instance, if you only authorized 10 shares, the minimum amount of the company that you could grant would be 10%.  So you want a large enough number to be able to grant small portions to folks.  Whatever number you choose, don’t worry.  These are all easily changeable with stock splits later down the road.

Convertible Debt – Other Terms

In today’s episode of our convertible debt series, we discussion a few other terms that come into play with a transaction.

Interest Rate: We believe interest rates on convertible debt should be as low as possible. This isn’t bank debt and the funders are being fairly compensated through the use of whatever type of discount has been negotiated. If you are an entrepreneur, check out what the Applicable Federal Rates (AFRs) are to see the lowest legally allowable interest rates are and bump them up just a little bit (for volatility) and suggest whatever that number is. Typically we see an interest rate between 7% and 10%.

Pro-Rata Rights: This term allows debt holders to participate pro-ratably in a future financing. Since many times the dollars amounts are low / lower in a convertible debt deal, investors may ask for “super pro-rata” rights. For instance, if an investor gave a company $500,000 in a convertible debt deal and the company later raises $7,000,000, the investor’s pro-rata investment rights wouldn’t allow them to purchase a large portion of the next round. Sometimes investors will ask for pro-rata rights that are a multiple of their investment. In this case the investor may ask for two to four times their amount. While pro-rata rights are pretty typical, if you have people asking for super pro-rata rights, or a specific portion of the next financing, you should be careful as this will likely limit your long term financing options.

Liquidation Preferences: Every now and then you’ll see a liquidation preference in a convertible debt deal. It works the same as it does in a preferred stock deal – the investors get their money back first, or a multiple of their money back first, before any proceeds are distributed to anyone else. This usually happens in the case when a company is struggling to raise capital and current investors offer a convertible debt (also called a bridge loan) deal to the company. Back in the good old days usury laws prevented such terms, but in most states this is not an issue and allow the investors to not only have the security of holding debt, but the upside of preferred stock should a liquidation event occur.

Other Terms: If you see other terms in a proposed deal outside of these, we’d guess that they are unique to your situation, as the ones we’ve discussed should cover the vast majority of debt transactions.

Convertible Debt – Conversion In A Sale Of The Company

In today’s installment of our convertible debt series, we cover a specific case where the company is acquired before the debt converts into equity. There are a few different scenarios.

The lender gets its money back plus interest. If there is no specific language addressing this situation, this is what usually ends up happening. In this case, the convertible debt document doesn’t allow the debt to convert into anything, but at the same time mandates that upon a sale the debt must be paid off. So the lenders don’t see any of the upside on the acquisition. The potential bad news is that if the merger is an all stock deal, the company will need to find a way to find cash to pay back the loan or negotiate a way for the acquiring company to deal with the debt.

The lender gets its money back, plus interest plus a multiple of the original principle amount. In this case, the documents dictate that the company will pay back outstanding principle plus interest and then a multiple on the original investment. Usually we see 2-3x, but in later stage companies, this multiple can be even higher. Typical language follows.

Sale of the Company: If a Qualified Financing has not occurred and the Company elects to consummate a sale of the Company prior to the Maturity Date, then notwithstanding any provision of the Notes to the contrary (i) the Company will give the Investors at least five days prior written notice of the anticipated closing date of such sale of the Company and (ii) the Company will pay the holder of each Note an aggregate amount equal to _____ times the aggregate amount of principal and interest then outstanding under such Note in full satisfaction of the Company’s obligations under such Note.

Some sort of conversion does occur. In the case of an early-stage startup that hasn’t issued preferred stock yet, the debt converts into stock of the acquiring company (if it’s a stock deal) at a valuation subject to a cap. If it’s not a stock deal, then one normally sees one of the above scenarios.

With later stage companies, the investors usually structure the convertible notes to have the most flexibility. They either get a multiple payout on the debt, or get the equity upside based on the previous preferred round price. Note that if the acquisition price is low, the holders of the debt may usually opt out of conversion and demand cash payment on the notes.

While in many cases issuing convertible debt is often easier to deal with than issuing equity, the one situation where this often becomes complex is an acquisition while the debt is outstanding. Our strong advice is to address how the debt will be handled in an acquisition in the documents.