Ten Common Startup Mistakes – Part 2

In this post, I wrote about the first five out of ten common startup mistakes. Now I will continue with the next five common startup mistakes.
Number 6 – Ignoring Securities Laws

When a startup raises money, it has to comply with the securities laws. The Securities Act of 1933 specifies that a company cannot issue stock without registering that stock with the SEC, unless there is an applicable exemption. There are exemptions for private sales of securities, but these exemptions have various requirements that must be satisfied. When seeking investment from an angel investor or a VC fund, it’s crucial that the startup work with an experienced, knowledgeable lawyer, who can guide the startup through the process. It’s also a good idea to work only with “accredited investors,” who are more likely to understand the kind of investment they are making, and better able to withstand losing their entire investment. Failing to comply with securities laws can give investors the right to get their money back, and can create serious civil and criminal liability on the part of the startup and its executives.
Number 7 – Failing to Protect Against Angel Investors and VCs
Angel investors and venture capital firms are in the business of investing in startups. It is something they do every day, while startups engage in financings only occasionally. Consequently, investors bring a much higher level of experience and sophistication to the process (no insult to startups intended). Startups that fail to understand this imbalance risk getting taken to the cleaners, but there are things startups can do to protect themselves. First, you need to investigate your potential investors, to make sure there is a good fit between the investors and the startup. Second, create a competitive environment, where the investors have to compete with other investors for the opportunity to become part of your startup. You will get more favorable terms that way, although you have to recognize that mishandling the competition could result in all the investors walking away. Third, you have to be willing to walk away, too. If the terms aren’t right, if the investor isn’t a good fit, walk away from the deal. The consequences of a bad deal can be worse than you imagine. Fourth, understand every aspect of the deal. The terms don’t just include the financial terms like pre-money valuation and conversion discount. There are numerous complex legal terms that may seem like boilerplate to you, but they can have a big impact on your company and your equity stake. Which leads to the fifth item, which is get your own lawyer to represent you and explain all these terms to you. Don’t rely on using the investor’s lawyer, or even a lawyer recommended by the investor. That lawyer will have a big conflict of interest, because he or she will not want to alienate the investor and future deal flow from the investor.  You can read more about this subject here and here.

 

Number 8 – Putting Off Developing Proper Management Structure

Many startups have flat organization structures, by design and preference. This may be acceptable at the early stages, but as the business grows and the headcount increases, so does the need for more structure and process. An employee handbook may seem unnecessary for a startup when there are only 3 or 4 employees, but when the hiring rate increases, a handbook is an important tool for communicating the desired culture and for setting expectations. It is also important to develop and communicate policies on harassment and discrimination, including processes for raising complaints. Clear policies in this area will help foster a productive work environment, and will help protect the company from liability. Another consideration in the HR area is creating a bring-your-own-device policy. If employees are doing company work on their own laptops, tablets, and smartphones, does the startup have procedures and policies in place to ensure data security and protection of its intellectual property? I work out of a co-work space where there are lots of startups, and I would guess that every one of them has employees and founders that use personally-owned devices. I would also guess that none of them have policies or technology in place to manage these devices (hint hint). You can read more about BYOD here.

Number 9 – Issuing Stock Options Without a Formal Stock Option Plan

Stock options can be an important compensation and recruitment tool for cash-poor startups. Stock options are securities, however, and failure to observe the formalities when issuing stock options can violate the securities laws. A company will need to reserve an option pool and create a formal stock option plan. Options will need a Section 409A valuation. Shareholder and board of director approval will be needed for all of this. There are legal and tax complexities, and a startup should consult an attorney before moving forward with stock options.

Number 10 – Failing to Consider Privacy Issues

Privacy issues are increasingly important not just for startups, but for any company. If Target can get in trouble with data breaches, so can your business. If your company is collecting information about visitors to your website, you need to disclose that in your website privacy policy. You need to disclose the kinds of information you collect, how you use it, and how visitors can opt out of information collection. There are additional requirements if you collect information about children who are 13 years old or younger. Once you have collected information about customers and visitors, you need to secure that information. Almost every state (46 at last count) requires some kind of public notice when there has been a data breach. Failing to properly consider privacy issues can cost your company millions of dollars, and could result in a devastating loss of trust between you and your customers.

Thank you for reading, and I hope you found it informative. If you are running a startup (or thinking about it), I hope this post gives you food for thought.

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Five Things You Should Know About Stock Options

Startups often use stock options to attract, retain, and motivate talented employees. Stock options are complicated, however, so here are five key things any startup founder (and startup employee) should know about stock options, as well as two freebie tips.    

What Kind of Option Is It?

There are two kinds of options: incentive stock options (ISO’s) and non-qualified stock options (NSO’s). ISO’s can only be issued to employees of the company. NSO’s, on the other hand, can be issued to non-employees, such as directors, advisors, and consultants. The tax treatment of ISO’s and NSO’s is quite different.

If you have an NSO, you recognize ordinary income when you exercise the option, regardless of whether you sell the underlying stock at the time of exercising the option. Consequently, you may have a tax bill but no cash to pay it. If you have an ISO, you don’t recognize taxable income until you sell the underlying stock, and you get capital gains treatment if the shares acquired through exercising the options are held for more than one year after the exercise date, and are not sold prior to the two-year anniversary of the option grant date (among other conditions). This makes ISO’s much more favorable than NSO’s.

Better Price the Option at Fair Market Value

Under Section 409A of the tax code, the exercise price of the options must be equal to the fair market value (FMV) of the underlying stock as of the option grant date. Otherwise, the option grant will be treated as deferred compensation, with adverse tax consequences for the employee, and withholding obligations for the employer.

The Securities Laws Apply to Options

Stock options are securities, and therefore federal and state securities laws apply. Under the securities laws, a company cannot offer or sell securities unless (a) the securities are registered with the SEC, or (b) there is an exemption from registration. Fortunately, there is an exemption for offers or sales of securities pursuant to the terms of a compensatory benefit plan or written compensation agreement. Most states have a corresponding exemption. So, you need a stock option plan to take advantage of that exemption. This leads us to…

Do the Paperwork

The paperwork associated with a proper stock option plan is well-defined and complex, and it will cost money. This is when you really need to consult an experienced attorney, rather than trying to do things yourself at one of those legal document websites. You will need a stock option plan (and plan summary), a stock option agreement, stockholder resolutions approving the stock option plan, board of directors resolutions approving the stock option plan, and board of directors resolutions approving each option grant. Expect this to cost at least $1500.

Don’t Forget the Option Pool

The company will need to reserve a pool of stock for the option plan. While the pool should be big enough so that you can grant meaningful options to employees (and remember, your headcount will grow over time), you want to minimize dilution. A good size for your option pool is 10-15% of the total amount of authorized shares.

As promised, here are a couple extra tips:

Include Vesting

Make sure the options are subject to vesting. A typical vesting schedule is 4 years with a 1-year cliff. That means that the first 25% of the options will vest at the end of the first year, and the remainder will vest on a monthly basis over the next three years. You want to keep employees motivated, and if their options are fully vested from the outset, they won’t have an interest in sticking around.

Consider Using Restricted Stock Instead of Options

For earlier stage startups with few employees, it may be easier and less expensive to issue restricted stock, rather than stock options. There are several advantages. First, restricted stock is not subject to the fair market value rule of Section 409A. Second, because the recipients are getting actual stock, rather than options, the motivation may be somewhat stronger. Third, with restricted stock, the capital gains treatment and holding period begin at the date of the stock grant, provided the recipient files his 83(b) election on time. Fourth, you can use restricted stock with directors, advisors, and consultants, so you don’t have to worry about the ISO-NSO distinction. You’ll still need a restricted stock purchase agreement and some other paperwork, but the cost should be less than what is involved with a stock option plan. Just as with stock options, it is a good idea to have the restricted stock vest over time – 4 years for employees, and 2 years for directors and advisors.

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Anatomy of a Term Sheet 2 – Pre-Money Valuation and the Option Pool

Welcome to Anatomy of a Term Sheet Part Two.

In the first part, we looked at the introductory language and some of the basic offering terms in the model term sheet of the National Venture Capital Association, which you can find here.

Today we are going to look at two remaining basic offering terms – price per share, and pre-money valuation. The pre-money valuation term raises a very important issue for founders, involving the employee option pool and the dilutive effect this term will have. So join me as we dig in… 

The first term to examine in this part is:

Price Per Share: $[________] per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).

This is the price that the VC investors will be paying for each share of preferred stock. If there are angel investors who put in money through a convertible note, they will probably be paying a lower price per share when converting the loan to equity, due to price discount and valuation cap terms in the convertible note financing.

The next term, which is a crucial one to understand, involves pre-money valuation and the employee option pool:

The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully‑diluted post-money valuation of $[______] (including an employee pool representing [__]% of the fully‑diluted post-money capitalization). 

The pre-money valuation is the valuation immediately prior to the VC investment, and the post-money valuation is the pre-money valuation plus the amount of the investment. So, if the pre-money valuation is $4 million, and the VC is investing $2 million, the post-money valuation is $6 million.

Note the use of the term “fully-diluted” in connection with the pre-money valuation, post-money valuation, and post-money capitalization. “Fully-diluted” means the highest potential amount of common stock that could be outstanding, regardless of vesting and assuming that all options and other securities (such as convertible notes) are converted into common stock.

The inclusion of the employee option pool in the post-money valuation and capitalization has the effect of diluting the founders’ share of the startup, without diluting the VC investors’ share. To see how this works, let’s return to the scenario just described, where the pre-money valuation is $4 million, the VC investment is $2 million, and the post-money valuation is therefore $6 million.

Assume there are two founders, each with 50% of the stock pre-money, and there is no option pool. Thus, prior to the VC investment, the founders owned 100% of the company, collectively. After the investment, if there is still no option pool, the VC fund will own 33% ($2 million divided by $6 million) and the founders’ stake will be reduced to 66%.

As a practical matter, however, the VC will require the startup to set up an employee stock option plan and set aside an option pool for the employees. Startup companies are typically short of cash, and the stock option plan is an important tool for attracting and retaining talented employees, and giving them an opportunity to share in the increasing valuation of the startup.

When the VC uses the above language to require an option pool, it is taking that option pool out of the founders’ share, further diluting the founders, but not diluting the VC. To determine the price per share, the post-money valuation is divided by the fully-diluted number of shares outstanding, plus all the shares or options that will be issued in the future as part of the option pool.

Let’s take a second look, assuming the option pool is 20% of the fully-diluted post-money capitalization (20% is a fairly common size for option pools). Now the cofounders only own 46% of the post-money company (66% minus 20%), while the VC investor still owns 33%. The founders’ share of the company has been diluted, but the VC’s share has not. The founders’ ownership has decreased by 30%, all due to that “post-money capitalization” language.

What can the founders do to avoid or mitigate the dilution that is caused by the option pool? As a practical matter, a startup will not be able to have the VC’s remove the option pool requirement, and that isn’t a good idea anyway. As I mentioned before, stock options are an important tool for attracting and retaining good employees, especially when the company is cash-poor. Stock options are desirable, it’s the dilution of the founders that is problematic. Unfortunately, founders also will not be able to get the VC’s to share in the dilution alongside the founders. The VC’s have the upper hand here, because they have the money. There are a few partial remedies that are possible.

The first remedy is to negotiate for a higher pre-money valuation, to compensate at least in part for the option pool dilution. Going back to the previous example, let’s suppose the pre-money is $5 million, with the VC’s investing $2 million. The post-money is now $7 million. The VC’s share of the post-money capitalization is 29%. The founders’ share is now 51% (taking into account the 20% option pool), which is better than the 46% share when the pre-money was $4 million.

A second remedy is to try to reduce the size of the option pool as much as possible. If your startup already has an executive team in place, you might be able to get away with a 10% option pool; you don’t need the extra options to entice a CEO or other top executives.

A third remedy is to already have the option plan and pool in place before going to the VC investors. Whether this is possible will depend on where the startup is in its development process, as well as the finances of the startup. Setting up a stock option plan will cost about $1500 to $2000 (maybe more, maybe less), and if the startup has money available from an angel investment, it may be a good use of funds. The stock option plan will make it easier for the startup to attract employees at this stage, allowing it to stretch its funds a bit further. And if the plan is already in place, the VC’s may not push as hard on the size of the option pool.

Hopefully this helps to explain a fairly complex yet common issue that arises when negotiating with VC investors. Next time, I will write about the alternative provisions for dividends.

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83(b) Basics for Startup Founders and Employees

Typically, any blog post or article about a section of the tax code promises to be a snoozer, but knowing about Section 83(b) is crucial to any startup founders and employees. It’s pretty easy to do it right, but if you are sloppy or uninformed, and you mess it up, and you are in a world of pain. This could be the most important blog post any startup founder or employee reads.

Why is Section 83(b) so important? Typically under Section 83 of the tax code, a founder or employee does not recognize income on stock until the stock vests. When I refer to income, I mean the difference between the fair market value of the stock and the price paid for the stock. Section 83(b), however, allows the founder or employee to make a voluntary election to recognize income upon purchase of the stock, rather than waiting until the stock vests. If the founder/employee does not make the 83(b) election, she may have a great deal of income by the time the stock vests, particularly if the stock value increases substantially over time. OK, I know your eyes are glazing over, but indulge me a bit longer.

Let’s look at two different scenarios — failing to make the 83(b) election, and making the 83(b) election. Suppose we have two co-founders, Reggie and Daniella. Each gets 1 million shares of stock when they form their corporation, at a price of $0.001/share. The stock is subject to four year vesting with a one year cliff (see my other blog post on the importance of vesting). Reggie does not make an 83(b) election. By the end of the first year, 25% of Reggie’s stock is vested, and because of the efforts of the founders and the interest shown in the company by investors and the public, the stock is now worth $1/share. Reggie recognizes income on the vested stock equal to the difference between $1/share and $0.001/share, or $0.999/share. Multiply that by the number of his vested shares, and you’ll see that Reggie has recognized income of $249,750 on his vested shares. As time goes on and more of Reggie’s stock vests, he will continue to recognize income equal to the difference between the FMV of that vesting stock and the original price of $0.001/share. In addition, the company has to pay the employer share of FICA tax on the income, and withhold federal, state and local income taxes. Both Reggie and the company are taking a big tax hit because he failed to make that 83(b) election.

Now let’s look at Daniella. She got the same amount of stock, at the same price, and is subject to the same vesting schedule, but she made the 83(b) election. Instead of recognizing income of $249,750 at the end of Year 1 when 25% of her stock vests, she chose to recognize income at the beginning of Year 1, when she first received the stock and when its fair market value was pretty much equal to the price of $0.001. So basically, Daniella recognizes no income, because at the outset the stock had no real value.

Hopefully these two examples will make clear why the 83(b) election is a crucial issue for founders and employees. To make a timely 83(b) election, the purchaser must file the election with the IRS prior to the date of purchase, or within 30 days after purchasing the stock. No exceptions. In counting those 30 days, the IRS includes Saturdays, Sundays, and holidays. Best practice is to sign the 83(b) election form immediately upon purchasing the stock, and mail it by certified mail, return receipt requested, to the IRS that same day. Give a copy of the signed 83(b) election to the company for its records, and attach a copy to the purchaser’s federal tax return for the year in which the stock was purchased.