Founders Equity – Law Office of Paul H. Spitz

Cap Table Math for Startup Founders

November 7, 2018 by wpadmin

“We want to give Barbara 4% of the company. How many shares is that?”

I get questions like that frequently, and once you understand the math, the solution is pretty simple. Hey, I’m a lawyer, and I can understand the math. If you are going to run a successful startup, you need to master your cap table and understand basic cap table math.

First, you have to decide what is the total universe of stock that you are talking about. Is it all the shares of stock that the company could have outstanding, or is it only the issued and outstanding shares? This can provide very different results, so it is really important to use the right language. My default is that our universe is the issued and outstanding shares, unless I’m specifically told to do otherwise.

So let’s imagine a typical early stage Delaware corporation startup, with 10 million authorized shares. There are two initial cofounders, and they collectively hold 7 million shares. Their 7 million shares are 100% of the total issued and outstanding shares. That’s our starting point. If you are going to issue Barbara enough shares so she has 4% of the total, then how many shares is that? Well, after you issue Barbara’s shares, whatever number that may be, the initial cofounders will hold 96% of the total issued and outstanding shares. So 7 million shares is now 96% of X, the new number of issued and outstanding shares. Divide 7 million by 0.96. That should give you 7,291,677. Subtract 7 million from 7,291,677, and voila! You have the number of shares to issue to Barbara.

That’s how I normally do it. However, let’s say that your universe is going to be all the shares that the company could have outstanding. Maybe someone promised Barbara 4% on a “fully-diluted basis,” meaning we assume that all stock vests, and all options, convertible notes, and warrants are exercised. This is going to be a higher number. If you have 7 million shares outstanding, and options and convertible notes for another 2 million, then our total universe is 9 million shares. So now you divide 9 million by 0.96, and you get 9,375,000. Subtract 9 million from that, and the different – 375,000 – is what you need to issue to Barbara. So, depending on how you define your universe, Barbara could get approximately 84,000 more shares.

One final tip: it’s better to say “I’m going to grant you X number of shares, which will be Y% at the time of issuance,” than to say “I’m going to grant you Y% of the company.” The reason is that when you say “I’m going to grant you Y% of the company,” the recipient hears “I’m always going to have Y%, and the company will have to issue new shares to me from time to time, so I can maintain my percentage.” They think they are getting anti-dilution protection, and you want to avoid that at all costs.

New Exemption for Sales of Restricted Stock

December 30, 2015 by Paul H. Spitz

President Obama signed legislation this month that creates a new, explicit exemption for private resales of restricted and control securities. The legislation, contained in Fixing America’s Surface Transportation Act (the FAST Act), will make it easier for the holders of restricted stock to cash out their holdings, provided they sell only to accredited investors.

Here is an overview of the new exemption’s requirements:

The seller can’t be the issuer of the stock or a direct or indirect subsidiary of the issuer
Each purchaser must be an “accredited investor”
There cannot be any general solicitation or advertising
The stock must be part of a class of stock that has been authorized and outstanding for at least 90 days prior to the sale date
The stock cannot be part of an unsold allotment to, or subscription or participation by, a broker or dealer as an underwriter or a redistribution
The seller is subject to the “bad actor” disqualification
If the issuer is a non-reporting issuer (not subject to the reporting requirements of Sections 13 or 15(d) of the Exchange Act), there are additional information requirements. The issuer must provide the seller and prospective purchaser, upon request, with reasonably current information about the issuer’s management team, financials, etc.

This new exemption, which is found in Section 4(a)(7) of the Securities Act, should provide a useful alternative to the Rule 144 safe harbor, which requires that the securities have been outstanding for at least 6 months if the issuer is a reporting company, or 1 year in all other cases. Rule 144 also places limits on the amount of stock that can be sold, a limitation that is not present in the Section 4(a)(7) exemption.

The new exemption also will provide a simplified alternative to the “Section 4(a)(1 ½) exemption,” which has been developed over a period of several years, but which has never been officially codified into law.

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Ten Common Startup Mistakes – Part 1

June 13, 2014 by Paul H. Spitz

Today seems like a good day to tie together a number of subjects I’ve written about in the past, as a list of the Ten Biggest Legal Mistakes Startups Make. Here are the first five:

Number 1 – Choosing the Wrong Form of Entity

All too often, I encounter startup founders and would-be founders that reflexively think they need to set their company up as an LLC (a limited liability company). So I ask them, “are you thinking about getting venture capital funding?” If the answer is yes, then right away I tell them they need a C corporation, because venture capital investors will not invest their money in LLC’s. This isn’t some well-kept secret, either. A simple internet search on the subject will quickly show that VC’s require that the startups they invest in be set up as corporations, and preferably, Delaware corporations. So it is always frustrating to me when someone has wasted time and money setting up an LLC, when he or she really needs a corporation. Even more frustrating is when that founder had a lawyer set them up with an LLC; that’s sloppy lawyering, at best. Aside from the VC issue, I find that the corporate structure is generally simpler and easier to work with than LLCs, which are really jumped-up partnerships with complex tax issues. Many startups want to compensate employees with stock options, but options are a corporate concept. You can’t do stock options with an LLC. Finally, the dreaded “double taxation” you get with corporations is not really an issue for startups, because they generally don’t have profits and aren’t making dividends.

Number 2 – Failure to Split Founders’ Equity Properly

Following fast on the heels of picking the wrong entity is failing to properly split up the equity among founders. I’ve written a full post about this subject, so I’ll just write a brief summary here. Founders often just reflexively split the equity into equal shares. The truth is, different founders contribute differently to the startup. Some of those contributions are more valuable than others. It is an uncomfortable and difficult discussion, however, and while opting for equal shares seems like an attractive, less controversial alternative, the discussion is going to happen sooner or later. Better to have it happen sooner, before issuing founders shares.

Number 3 – No Vesting or Buyout Provisions

It is very common for startups to fail to include vesting and buyout provisions that apply to founders’ equity. This is particularly the case when the founders go cheap and use DIY services like LegalZoom to set up their corporation (or worse, their LLC). Everything might seem warm and fuzzy among the founders when starting out, but over time, frictions arise or someone gets burned out, and a founder leaves. What you don’t want is for that founder to leave with all her shares. By vesting those shares over time, and having the option to buy back vested shares at a nominal price, a startup protects itself against having an ex-founder out there with 40 or 50 percent of the ownership. You can read more about this subject here.

Number 4 – Forgetting the 83(b) Election

When you have founders’ stock or stock options that vest over time, you want to make sure that you do a timely 83(b) election. This is one of those wonky tax issues, and you can read more about it here, but I’ll give a brief rundown. When you receive stock that vests over time, you recognize taxable income as the stock vests, because in theory, that stock has increased in value since it was originally granted. The 83(b) election allows you to recognize income on the increase in value at the time you receive the stock, rather than when it vests. There should be minimal increase in value (if any) at that earlier point in time, so there should be almost no tax liability. You have to make the 83(b) election within 30 days of receiving the restricted stock or stock options, however. Not 31 days later. Not 50 days later but I can pay a penalty. Thirty days. Failing to do this can be a huge and costly mistake. Don’t make it.

Number 5 – Failing to Lock Up Intellectual Property

It is crucial for startups to lock up their intellectual property at every opportunity. When setting up the startup, one or more founders may have developed IP that is important to the enterprise. The startup should have the founder execute an IP assignment agreement in exchange for receiving her founders’ shares. By doing so, the startup now owns the IP, and if the founder leaves, she can’t take the IP with her. In addition, other employees may be developing IP for the company, and they should all execute contracts that specify that the IP belongs to the company, not the employee. Finally, if some of the founders are still working “day jobs” at other companies, it is important to review their employment agreements with those other companies. IP that they think they are developing for the startup may actually belong to the day job.

Those are the first five common startup mistakes. The next five will be in Part 2, which is here. Thank you for reading!

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Anatomy of a Term Sheet 8 — Anti-Dilution Protection

April 15, 2014 by Paul H. Spitz

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. We have had 7 installments so far, covering topics like the option pool, voting rights, the liquidation preference, dividends, conversion, and protective provisions.

The next item in our Anatomy of a Term Sheet series is the anti-dilution term. This post will have some math in it, including a formula, but there won’t be a test or pop quiz. And no quadratic equations or string theory. Promise.

The anti-dilution term is designed to protect the Series A investor from dilution in case the startup issues new shares in a later round at a price lower than the price paid by the Series A investors. Along with the liquidation preference, anti-dilution protection is a signature feature of preferred stock. Typically, the Series A preferred shares will convert into common stock on a 1-to-1 basis. Anti-dilution provisions are designed to increase the number of shares of common stock into which each preferred share is convertible. Since the Series A preferred stock votes on an as-converted basis, anti-dilution provisions also affect voting rights.

Here are how the three alternative anti-dilution provisions look in the model term sheet:

In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:

Alternative 1: “Typical” weighted average:

CP2 = CP1 * (A+B) / (A+C)

CP2 = Series A Conversion Price in effect immediately after new issue

CP1 = Series A Conversion Price in effect immediately prior to new issue

A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)

B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP1

C = Number of shares of stock issued in the subject transaction

Weighted average anti-dilution protection is the most common form, and luckily, that’s the only formula you’ll see today. Like I promised, no quadratic equations, and no string theory. Let’s plug some numbers into the formula to see how it works:

Our startup company, Greasy Lake, Inc., has 4 million common shares outstanding, plus 1 million common shares in the option pool, and 2 million Series A preferred shares, which are convertible into common stock. Thus, the total number of shares outstanding (“A” in our formula) is 7 million shares. The Series A conversion price prior to the new financing is $1 (this is “CP1” in our formula). The Series A investor is Jimmy the Saint Fund.

Greasy Lake is going through a Series B financing, in which Hazy Davey Fund is going to invest $2 million, at a price per share of $0.50. Consequently, it will be purchasing 4 million Series B preferred shares. Because the price per share in the Series B round is less than the price per share in the Series A round, anti-dilution protection is triggered.

“B” in our formula, therefore, is $2 million divided by $1, or $2 million. “C” in our formula is 4 million, the number of shares being issued in the Series B round. Now we can plug those numbers into the formula.

CP2 = CP1 x (A + B)/(A + C)
= 1 x (7,000,000 + 2,000,000) / (7,000,000 + 4,000,000)
= 1 x (9,000,000)/(11,000,000)
= 1 x 0.818
= 0.818

So our new Series A conversion price is now $0.818. Without the anti-dilution protection, Jimmy the Saint Fund would convert its 2 million Series A preferred shares into 2 million shares of common, at a 1:1 ratio. Applying the anti-dilution protection, however, enables Jimmy the Saint Fund to obtain a larger number of common shares upon conversion – 2 million divided by 0.818, or 2,444,988. The new conversion rate is 1.2:1, instead of 1:1.

OK, that’s pretty much it for the math. Keep in mind, the actual formula in a specific term sheet may vary somewhat from what we have here. The important takeaway, however, is that anti-dilution protection is designed to adjust the conversion price, so that earlier venture capital investors can convert their preferred shares into a greater number of common shares.

Alternative 2: Full-ratchet – the conversion price will be reduced to the price at which the new shares are issued.

As a reward for suffering through all that math, we have our second alternative for anti-dilution protection, which is called “full-ratchet.” This is much simpler than the weighted average approach. You simply reduce the conversion price of the existing preferred stock to the same price per share being paid in the new, dilutive round of financing.

So, if Jimmy the Saint Fund’s Series A preferred stock was sold at a price per share of $1.00, and Hazy Davey Fund is paying $0.50 per share for the Series B preferred, then Jimmy the Saint’s conversion price is reduced to $0.50/share. The effect is that Jimmy the Saint Fund had been able to convert each share of Series A preferred stock into one share of common stock, and now it can convert each share of Series A preferred stock into two shares of common stock.

The problem with full-ratchet is that it is something of a blunt instrument: the conversion price reduction is the same whether Greasy Lake raises $5,000 at $0.50/share, or $5 million at $0.50/share. With the weighted average approach, on the other hand, the amount of money raised influences the new conversion price. The full-ratchet approach benefits the investor, because it offers full protection against price erosion in later rounds. At the same time, however, the full ratchet protection will be unattractive to the potential investors in these later rounds, making an already difficult financing even more difficult for the company. It also exacerbates the dilution of the existing common stock. Full-ratchet price protection terms are fairly uncommon, and founders should push to have full-ratchet replaced by a weighted average formula.

Alternative 3: No price-based anti-dilution protection.

This third alternative is the simplest of all – no price-based anti-dilution protection. Unfortunately, these are about as common as unicorns capering across my front yard.

Finally, there are some carve-outs that do not trigger anti-dilution adjustments.

The following issuances shall not trigger anti-dilution adjustment:

(i) securities issuable upon conversion of any of the Series A Preferred, or as a dividend or distribution on the Series A Preferred;

(ii) securities issued upon the conversion of any debenture, warrant, option, or other convertible security;

(iii) Common Stock issuable upon a stock split, stock dividend, or any subdivision of shares of Common Stock; and

(iv) shares of Common Stock (or options to purchase such shares of Common Stock) issued or issuable to employees or directors of, or consultants to, the Company pursuant to any plan approved by the Company’s Board of Directors [including at least [_______] Series A Director(s)].

These carve-outs are obviously different situations from where the startup has to do a down-round, and issues new preferred stock at a lower price than the existing preferred stock. Thank you for reading along with this math-heavy posting, and stay tuned for our next installments, which will cover pay-to-play and redemption rights.

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Startup Checklist

April 1, 2014 by Paul H. Spitz

In previous posts, I have provided a lot of information on various aspects of getting a startup company established. I thought it would be useful to put a lot of that information in one post, as a startup checklist. So here we go…

1. Review your employment agreement – before doing any substantial development work, founders who are maintaining their day jobs should review their employment agreements (and this could include employee handbooks, etc.) to ensure that there are no conflicts with the startup. In particular, a startup founder wants to make sure that any IP she develops will belong to her startup, and not to her day job. It’s a good idea to have a lawyer take a careful look at employment agreements and policy statements.

2. Decide how you will split the equity among the founders – while equal shares might seem easy and uncontroversial, it may not be the best, fairest way of splitting the equity.

3. Form a corporation – if you have any aspirations of seeking angel investments or venture capital funding, form a corporation, not an LLC. And form it in Delaware. You might think forming an LLC is cheaper or easier, and you will be wrong. You will end up needing a corporation anyway, and will waste time and money fixing things that should have been done right the first time.

4. Adopt bylaws – once you have filed your certificate of incorporation, you will need to adopt bylaws to govern the management of your new company.

5. Appoint a Board of Directors – You will need one or more directors to oversee management of your company. The directors can now approve various resolutions to get the company operating.

6. Enter into a shareholders agreement with vesting and buyout provisions, and issue stock – you will want to have vesting provisions in place from the start, in case any founders leave the startup. Otherwise, you will have an ex-founder wandering around outside the company with fully-vested shares. Also, make sure each founder receiving shares files an 83(b) election with the IRS at the time you issue shares. Let me repeat that in boldface, because it is really important: make sure each founder receiving shares files an 83(b) election at the time you issue shares.

7. Assign IP to the company – at the time of issuing shares, make sure that all founders assign to the startup any IP they are creating. This will be part or all of the payment for their shares, depending on the situation.

8. Qualify to do business – You will need to qualify to do business in whatever state your principal location is located in, unless you are located in Delaware (see number 3). This is fairly easy to do; you just file some paperwork and pay the state a fee.

9. Stock options – do not issue stock options until you have a proper stock option plan in place, approved by the board of directors, with a Section 409(A) valuation of the stock options. This doesn’t necessarily have to be done at the outset, but there are advantages to doing it before entering into negotiations with VC’s over a Series A round.

10. Employment/consulting agreements — if you are going to hire employees or use outside developers, make sure they sign agreements specifying that any work they do for the startup is the property of the startup.

11. Comply with securities laws – just because you are not a public company does not mean that you are exempt from the securities laws. This is a complex area, with many risks and pitfalls. Definitely consult a knowledgeable lawyer in advance, and preferably each step of the way. Only seek funding from accredited investors; it will make your life much easier. There are no friends-and-family exemptions from the securities laws.

All of the above items are essential to making sure that your startup has a smooth path to growth. If you omit any of the above items, you jeopardize the well-being of the startup, and create many headaches and costs downstream.

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