Q&A Forum

  • Q&A Forum

    A:

    It may seem logical and fair that the founders contributing IP they invented to launch a new startup should retain a license to that IP should the company fail or should the founders identify other uses for the IP outside those contemplated by the company. After all, the founders developed the idea and invented the IP prior to forming the company.

    However, venture capitalists and other institutional investors will almost always object to the founders retaining rights to the IP. From a business perspective, the investors want to ensure the company has every chance to succeed and that any IP will be available in the future under circumstances that may be difficult to predict. From a signaling perspective, the investors want to see that the founders are entirely committed to the startup they are funding and aren’t hedging their bets or using the IP for other purposes.

    A:

    A foreign student is permitted to own equity in a company and to serve on the board of directors of a company. A foreign student may not perform work for a company without obtaining appropriate authorization from the foreign student office at his/her university. The rules are no different for founders.

    An individual (whether or not a founder) who is neither a US citizen nor a lawful permanent resident (“green card” holder) cannot work in the United States without a visa that authorizes employment—even if that person is the founder of the company. Depending on the circumstances (including, for example, what degree(s) a foreign national possesses, what country the person is from, the nature of the job, whether the person's fiancée or spouse is a US citizen, etc.), an individual may be eligible for a variety of non-immigrant and/or immigrant visas.  Any company whose founder is in need of a visa should begin by consulting immigration counsel to determine what options may exist.

    A:

    Many companies are built on intellectual property licensed from academic or research institutions, such as universities and hospitals. Companies may also license technology from those types of institutions to supplement their existing intellectual property. These licenses are typically patent licenses, but may also be licenses to software, materials or other intellectual property. Many institutions have their own licensing office dedicated to commercializing intellectual property of the institution. Some of the key points to consider when licensing intellectual property from these types of institutions include:

    A. Identify the relevant intellectual property. Often a licensee will know of research being conducted at the institution and have determined that the results of that research are of interest. You may also identify intellectual property owned by an institution from academic publications or presentations by the applicable researchers, records available at the US Patent and Trademark Office (or foreign equivalent) or in materials made available by the institution’s licensing office.  

    B. Establish contact with the institution. Prospective licensees of institutions’ intellectual property may have initial contact with the researchers involved in inventing the relevant technology, and those researchers can often be useful to help navigate the institution’s requirements to establish a license. However, the institution’s licensing office typically is the key gatekeeper for negotiation and execution of the license agreement.  

    C. Review the institution’s usual license terms. Before speaking with the institution, review available information regarding that institution’s intellectual property policies, which will tell you a lot about how the institution approaches requests to license its intellectual property. You may also be able to obtain a copy of the institution’s form license agreement online. Your legal counsel will often be experienced in negotiating licenses from the institution and should be able to provide relevant information on likely deal terms as well.

    D. Prepare your business plan. In order to negotiate a license agreement, you must be prepared with a business plan for your company and your proposed commercialization of the technology. The institution will want to maximize the use and value of their intellectual property, and, assuming the intellectual property is of interest to others as well, you must be prepared to make a compelling case that your company is the optimal licensee. You must also be prepared, in many cases, to discuss granting to the institution some equity in your company, which will require a realistic assessment of the value of your company and of the relevant technology.

    E. Academic and research institutions are not built to keep secrets. So, in all of your discussions with a university, hospital or similar institution, keep in mind that they are generally built on a principle and culture of knowledge sharing, and not on preservation of trade secrets. While the institution may be able to license materials or data, carefully consider whether those materials or data will in fact be accessible to the public generally. Consider to what extent inventors may be disclosing important details in their academic publications.

    F. Negotiate the license terms. Institutions are often faithful to their form license agreements, but there are numerous potential variations on those forms which your counsel should have experience negotiating with the institution. Read about terms you should have in your license agreement. Licenses with institutions include those same issues, but in many cases with many precedents indicating where there is flexibility in terms and where there is not.

    A:

    All employees (including founders) must be paid in cash in amounts at least to satisfy the minimum wage laws established by federal and state laws. Many founders opt to go without compensation in the initial stages, but technically doing so is in violation of the federal and state wages laws. Employees may receive equity in addition to cash payments, but due to tax and other complexities it is generally not feasible to grant them equity in lieu of minimum cash wages. Although the market may reflect standard salaries for different types of positions, there is no requirement that employees receive any more than minimum wage, and the wages employees receive often depend on how large and established their employer is.

    Companies will often grant employees equity (or options to purchase equity) as part of their compensation package (but not in lieu of minimum wages). Depending on the success of the company, the equity may ultimately be worth more than the cash compensation the employees may otherwise have received. So equity is often an important recruiting mechanism and retention tool—especially where the company is cash strapped and needs to pay below-market cash wages. Equity compensation may also better align management goals with shareholder interests.

    Employees have become more savvy about both their cash and equity compensation and base their compensation decisions on whether they believe their overall compensation package—cash plus equity—are competitive with what they should expect from a similarly situated employer in their industry. As a result, what is required to compensate the employee of your choice will vary based on market factors and the industry in which you operate.

    Learn more in our CompStudy

    A:

    The option “pool” represents the number of shares the company sets aside in reserve under its option plan to compensate its employees, consultants, advisors and directors. The size of the option pool depends on the company’s stage, circumstances and hiring needs. When the company issues shares under the plan, it dilutes the ownership percentage of the other shareholders proportionately. However, any shares reserved under the plan that are not used (i.e., that are not sold or issued by the company) do not dilute the actual ownership of the other shareholders. Therefore, the size of the option pool at the initial formation of the company doesn’t really matter all that much—if the pool is too small and you need more shares, it can always be increased; if the pool is larger than you actually need, any excess shares don’t have any negative impact on the actual ownership of the company. Most startups will initially reserve an option pool that is big enough to provide for the equity incentives needed to cover their anticipated hiring needs for the first six months to a year.

    Once you are ready to raise money by selling stock, the size of the option pool becomes much more important. This is because the new investors will typically assume that the full pool will be utilized, and they will calculate their price per share and resulting ownership percentage in the company so that the full dilutive impact of that option pool will be borne by the existing shareholders. Here’s an example to illustrate how this works:

    Assume the pre-money value of the company is $5M, and the new investors are going to invest $5M. At closing, the new investors would therefore own 50% of the company. Without an option pool, the existing shareholders would own the other 50%. However, the new investors will generally require the option pool to come out of the existing shareholders’ 50%. So if the target post-closing option pool is 20%, the existing shareholders would really only own 30% of the company post-closing.    

    This creates an obvious tension: the company wants a large enough pool to give it hiring flexibility; at the same time, the company wants the pool to be as small as possible in order to limit the dilution on existing shareholders. In the end, you should develop a thoughtful and complete hiring plan covering the anticipated hires and equity awards needed between the current financing and the anticipated next financing. The pool should cover those anticipated needs with maybe a small cushion, but not much more than that.

    A:
    Non-competition agreements may be enforceable, depending on the state in which the employee lived and worked when the agreement was signed, the consideration (value) given in exchange for the agreement and the reasonableness of the restrictions in the agreement. In some states, such as California, non-competes are not generally enforceable (other than in the context of a sale of the company). In most states, however, they are enforceable if they are reasonable in scope. Ultimately, whether a non-compete agreement is enforceable depends on the specific facts and circumstances and language in the particular agreement. If you violate a valid non-complete, your former employer may be able to obtain money damages, an injunction or both. Therefore, if you have questions about whether your agreement is enforceable or whether pursuing your new venture would cause you to violate your non-compete, you should speak with a knowledgeable attorney.
    A:

    If your company is incorporated in one state (e.g., Delaware), but you are “doing business” in one or more other states (e.g., California, Massachusetts, New York, etc.), then the laws of the states in which you do business require your company to be “qualified to do business” there. To qualify to do business in a state, you typically need to make a simple filing with the Secretary of State's office that describes your business. You will also typically need to file reports and pay a fee (typically referred to as a “franchise tax”) in that state annually.  

    “Doing business” is defined differently in each state by the laws of that state, and so whether the business your company is conducting requires you to qualify to do business in a particular state depends on the rules of that state. Most states provide guidance on the types of activities that do not constitute doing business rather than those that do. For example, in most states, merely having an employee or consultant, soliciting or accepting orders or even defending a lawsuit in that state is not enough activity to constitute “doing business.” The fact that your company does business online and therefore could reach every state does not, in and of itself, mean you have to qualify to do business in every state. In contrast, having an office or employees regularly and physically located in a state will often mean you will need to qualify to do business in that state.

    Most new corporations take steps to qualify to do business in the state where they are initially headquartered. For example, a Delaware corporation with its principal place of business in California would likely qualify to do business as a foreign corporation in California to start. Because each state defines “doing business” differently, you should seek guidance from your legal counsel when engaging in any new activity within a state.

    A:

    Starting a company is risky, and many startups fail. Even if things go well, someone might sue the business. One of the primary reasons for operating your business through a legal entity is to shield your personal assets from claims made by the creditors of the business. If you operate the business through a corporation or a limited liability company (often called an LLC) then the owners and operators of the business will not generally be responsible for the liabilities of the business. Other legal structures like partnerships don't offer the same protection for all owners of the business. So between an LLC and a corporation, what's the best structure for you?

    One of the key considerations in choosing the type of legal entity is the tax treatment of the entity. Every dollar earned by a Subchapter C corporation is subject to tax at the corporate level. If the corporation then distributes that same dollar (net of the corporate tax) to the shareholders, it is subject to tax a second time at the shareholder level. This so-called "double taxation" is a major cost to any entity that will be generating revenue and making distributions to its shareholders. In contrast, LLCs and Subchapter S corporations are referred to as "pass through entities" because corporate revenues—even if distributed to the shareholders—generally are taxed only one time: at the shareholder level. Similarly, the owners of an LLC or Subchapter S corporation may be able to offset personal income from other sources against losses of the business, thereby reducing their personal tax burden. 

    So it would seem to make sense that most every business should be structured as an LLC or Subchapter S corporation. Then why is it that most technology and life sciences startups are structured as Subchapter C-corporations?

    First, most technology and life sciences startups won't generate any revenue for some time, and when the business begins generating revenue, that amount is typically reinvested back into R&D and expanding the business rather than being distributed to the owners of the business. So for these startups, there is no "double taxation." Moreover, most founders of these types of startups devote their full-time to building the business, so they don't have other income that can be offset against the losses of the business. 

    Finally, there are a number of non-tax reasons most technology and life sciences startups are structured as Subchapter C corporations. Subchapter S corporations can't have more than one class of stock or entities as shareholders, for example. So a Subchapter S corporation is not possible if the business is to be venture-backed since venture investors typically get preferred stock and are legal entities themselves (typically formed as partnerships). Similarly, there are sometimes negative tax consequences to the limited partners of venture funds that invest in LLCs. Moreover, ISOs can't be granted in LLCs. And, significantly, the legal, accounting and other administrative costs of an LLC typically outweigh the benefits (if any) of operating most high-growth companies as an LLC. As a result, if you plan to start a business that will rely on outside capital, utilize equity to compensate employees and other service providers and seek rapid growth to sale or IPO, the best type of legal entity is most likely a Subchapter C corporation.

    A:
    Once you are ready to move forward with an idea, you should formally incorporate your startup as a legal entity. It is important to do this relatively early for a variety of reasons. First, you’ll want everyone that contributes to the development of the idea to assign all rights in the idea to the entity. The longer you wait to set up the entity the greater the risk that one or more team members will not be willing to do this, which could very well make the entity unfundable. Second, as you start vetting your idea with third parties, you’ll want them to sign a confidentiality agreement, joint development or other agreement—and you’ll want them to sign those agreements with your entity rather than with you personally. Finally, by creating a legal entity, you can protect yourself from personal liability, since, in general, only the assets of the entity (rather than your personal assets) would be at risk for the actions of the company.
    A:

    If you plan to raise external funding for your entity, then you should incorporate in Delaware. Delaware offers several advantages over other states. For many years, the legislature in Delaware has sought to attract companies to incorporate in Delaware by adopting a relatively company-friendly set of laws under which to operate. Delaware has a separate court whose sole job is to try cases under this set of laws, and so there are many published decisions interpreting these rules. Because so many other companies are incorporated in Delaware, lawyers, directors, investors and future acquirers of your business will all have a solid understanding of the laws governing your company, which makes it easier, more efficient and more comfortable for them to do business with your company (e.g., serve on your board or invest in/buy your company). Several other states have adopted laws that either mimic those in Delaware or that are intended to be even more company-friendly. However, Delaware has such a head start with a well-established set of court interpretations and with practitioners, directors, investors and others that understand the rules, the right choice for most companies will be Delaware.

       

    A:

    The shareholders of a corporation are its owners, and they vote their shares to elect the directors. The directors sit as a board, which, typically acting through a majority, oversees the corporation’s management and sets the overall corporate strategy and direction. Directors have fiduciary duties, so they generally must act in the best interests of the corporation and its shareholders. The corporation’s directors elect officers, including a CEO, who conduct the day-to-day business operations. The board must also approve certain significant corporate matters, such as stock issuances and important contracts.

    As a result of this framework, corporate officers generally control the corporation’s day-to-day decision making, but they must answer to the board, which in turn has responsibility to the corporation’s shareholders.

    When a corporation is formed, all of its shares are generally allocated among the founders. Together, the founders vote their shares to elect an initial board, which may consist entirely of founders or may include a key advisor or two. As the corporation completes equity financings, the investors will become shareholders, and they may require representation on the board, as well as other control rights. As a result, as corporations mature, the founders’ ownership and control rights tend to be diluted, often quite significantly.

     
    A:

    To successfully launch a new startup, the company needs to own, or have a license to use, the intellectual property that will be used in the business. This aggregation of IP does not happen automatically and requires careful planning with your legal counsel.

    Upon the formation of the company, each founder should assign all of his or her rights to the idea and other IP related to the proposed business to the company. However, the founders may not own all of the IP, even if the founders invented it. For example, inventions created while a founder was a student or employee may be owned by the founder’s school or former employer. If any founder is employed by another company or part of another institution while he or she is collaborating on or developing the idea for the business, you should carefully review the terms of any applicable agreements or policies to determine who has ownership rights over any resulting IP. In general, however, the more that a founder has (1) used resources from another institution in developing the idea or (2) developed an idea that relates to other work performed for another institution, the more likely that the institution owns the IP. In that case, it may be necessary to acquire the rights to the IP or obtain a clarifying waiver or consent from the other institution in order for the startup to commercialize the IP.  

    Some startups will commercialize technology that was originally developed at a university, hospital or other institution. In those cases, the company will typically need to obtain a license to the IP. In exchange for these licenses, the startup may need to grant the university or other institution equity, make up-front or milestone payments and/or pay royalties. Learn more about licensing IP from a university or hospital

    Copyright protects original works of authorship, including source code. Rights automatically vest upon creation, but the copyright belongs to the original author. So there needs to be an agreement transferring the copyright to the person who commissioned the code where the code writer is not an employee. For example, if your company hires a person to write some code the company can enter into a consulting agreement pursuant to which the code writer transfers copyrights (and any other intellectual property created as a result of the agreement) to the company.  

    You should also consider pursuing patent protection. A patent protects inventions or discoveries, including computer programs. In the United States, the inventor of the patent application is the person who conceived of the invention. To the extent the code writer is an inventor (which depends on how much detail was provided to the coder), the person or company that hired the code writer will want to obtain an assignment of the invention and the agreement of the code writer to cooperate with filing a patent application. This is best done when first commissioning the code writer. Learn more about filing a patent and registering a copyright.

    A:

    It may seem logical and fair that the founders contributing IP they invented to launch a new startup should retain a license to that IP should the company fail or should the founders identify other uses for the IP outside those contemplated by the company. After all, the founders developed the idea and invented the IP prior to forming the company.

    However, venture capitalists and other institutional investors will almost always object to the founders retaining rights to the IP. From a business perspective, the investors want to ensure the company has every chance to succeed and that any IP will be available in the future under circumstances that may be difficult to predict. From a signaling perspective, the investors want to see that the founders are entirely committed to the startup they are funding and aren’t hedging their bets or using the IP for other purposes.

    A:

    You may want the vesting of your shares to accelerate if you are fired or the company is sold. Is that a good idea? Will your investors agree to this?

    Acceleration of vesting if you are fired (terminated without cause) sounds like a good idea. Your investors won’t generally see it that way, however. First of all, proving you have “cause” is not easy to do. Second, investors don’t want to terminate you—you’re a primary reason they made the investment in the first place—and they want and need you to build the company. In the end though, they have their money (and their own investors) they need to think about, and they will make a change if they have to. That’s a difficult time for the company and they will need your unvested shares to recruit and incentivize your replacement. So, investors don’t generally allow for your shares to accelerate in these circumstances.  

    For similar reasons, acquirers of companies don’t want the talent they are acquiring to have a windfall on closing due to accelerated vesting. They may need those vesting incentives to continue or find other ways to incentivize the team, which results in higher acquisition and compensation costs to the acquirer (and likely a corresponding reduced purchase price for your company and its investors). Moreover, the people who are likely to benefit most from accelerated vesting on a sale are the employees who joined the company closest to the time of the acquisition. Compare those employees to the founders and earliest employees who are probably fully, or close to fully, vested by the time the company is sold. So pushing for accelerated vesting on founder shares may not really help you that much (and may make it more difficult for you to recruit employees if you aren’t willing to give them the same terms).

    Sometimes a small percentage of the vesting accelerates upon a sale (e.g., 25% of the shares). More frequently, we see full acceleration if the person’s employment is terminated without cause by the acquirer after a sale of the company (if the acquirer decides to terminate your employment then they can’t be so concerned about incentivizing you can they?). This is generally referred to as a “double trigger” because it requires both (1) the sale of the company and (2) a termination without cause.   

    Note that it is more common for acceleration upon a sale to apply for equity held by members of the board of directors and advisory boards because it is unusual for these people to play any role in the company or acquirer following the acquisition.

    A:
    Although this is ultimately a state law issue, founders are typically deemed to be “employees” who must therefore be paid at least minimum wages just like other employees in accordance with federal and state laws.
    A:

    A foreign student is permitted to own equity in a company and to serve on the board of directors of a company. A foreign student may not perform work for a company without obtaining appropriate authorization from the foreign student office at his/her university. The rules are no different for “founders."

    An individual (whether or not a founder) who is neither a US citizen nor a lawful permanent resident (“green card” holder) cannot work in the United States without a visa that authorizes employment—even if that person is the founder of the company. Depending on the circumstances (including, for example, what degree(s) a foreign national possesses, what country the person is from, the nature of the job, whether the person’s fiancée or spouse is a US citizen, etc.), an individual may be eligible for a variety of non-immigrant and/or immigrant visas. Any company whose founder is in need of a visa should begin by consulting immigration counsel to determine what options may exist.

    A:

    Equity allocation discussions among founders can be emotional and difficult, but it is critical to have an honest and robust discussion about founder equity early. Allocating too little equity to a founder whose role will be key to the venture creates an obvious challenge. However, allocating too much equity to a founder whose ultimate contributions will be less significant than others can have equally devastating consequences, as doing so has the tendency to create a lot of ill will among the other founders over time (“I have more responsibility than he does, so it isn’t fair that he has the same ownership stake as me”). So it’s important to think through these allocations very carefully.

    You may decide that splitting up the pie equally among the founders is the easiest way out to avoid the friction that often is part of these discussions. However, studies show that companies that divide the founder equity based on what is fair and thoughtful (rather than what is simple, frictionless or expedient) are more successful in the long run. When deciding what is “fair,” you should consider what each founder brings to the table. Did one of the founders, for example, develop the idea and devote a significant amount of time to it before forming the company and bringing on the other founders? If so, then that contribution should be recognized. However, be careful not to overvalue past contributions—investors care a lot more about the future contributions the team members will make and so should you. After all, it typically takes several years to build a great company and so a founder’s past contributions—even if made over several months before bringing the venture to reality—are typically not valued nearly as much as the contributions the team members will be making going forward.  

    And so you should also account for the roles each founder is anticipated to take on in the venture as things move forward. Initially, everyone will have lots of different responsibilities—that’s the nature of a startup. Over time, however, people will generally fall into specific roles and you should consider the importance of those roles as you determine your equity allocations. For example, the person who will take on responsibility for running the venture (whether called the CEO or otherwise) should typically be allocated more equity than the person who will take on responsibility for a single function in the venture (for example, marketing, sales, engineering, etc.). Of course, titles are often not dispositive, and in many technology companies founders who are coding, designing or masterminding the science might not necessarily be the face of the company, but may be equally, and sometimes more, important in making the startup successful.

    In the end, there’s a lot of variability when it comes to founder equity allocations. Every company, every situation and every group of founders will look at this issue differently. Calibrating all of the factors is a difficult exercise and may be ongoing. It is therefore equally important that the allocations are socialized early enough to obtain input from all co-founders. Once the founding team generally agrees on allocations, counsel can further be involved in helping fine-tune exact equity holdings by implementing vesting requirements such as vesting cliffs and vesting commencement dates.

    A:
    Even if you finish conceiving of or developing your idea after quitting your job, your employer could still own the rights to your idea. You should have an employment attorney review your current employment contract to determine any rights your employer may have in your idea. Considerations that are often relevant in determining whether your employer could own rights to your idea include: whether you conceived of your idea at work or on your own time; whether you used any of your employer’s resources, such as your employer’s laptop, lab or other property; whether your idea is within your scope of employment or similar to what your company is doing; and whether you used any information owned by the company, obtained through company resources, or obtained as a result of your employment in order to conceive of your idea.
    A:
    Non-competition agreements may be enforceable, depending on the state in which the employee lived and worked when the agreement was signed, the consideration (value) given in exchange for the agreement and the reasonableness of the restrictions in the agreement. In some states, such as California, non-competes are not generally enforceable (other than in the context of a sale of the company). In most states, however, they are enforceable if they are reasonable in scope. Ultimately, whether a non-compete agreement is enforceable depends on the specific facts and circumstances and language in the particular agreement. If you violate a valid non-compete, your former employer may be able to obtain money damages, an injunction or both. Therefore, if you have questions about whether your agreement is enforceable or whether pursuing your new venture would cause you to violate your non-compete, you should speak with a knowledgeable attorney.
    A:

    Founders of technology-based and life sciences startups do not generally enter into “employment agreements” with their companies. Employment agreements typically provide the employee with rights to severance and other employment-related protections. Because of the large equity stake the founders have in the company and the importance of cash to a startup, investors will generally not agree to provide contractual severance rights to founders.  

    That said, founders should sign an employment offer letter with the company that sets forth the general terms and conditions of their employment and states that they are “at-will” employees. This means that they can leave the company at any time (although their rights to retain their shares or exercise their options will depend on the vesting terms), and also that the company can terminate their employment at any time—with or without cause. They should also sign an agreement with the company where they agree to keep the company’s information confidential, assign their rights to any developed intellectual property to the company and, in most states, agree not to compete with the company for a period of time following their employment. Take a look at our Document Generator for some of these forms.

    A:
    Yes! Founders should put vesting restrictions on their shares. “Vesting” means that you need to “earn” your shares before you are allowed to keep them if you leave the company. Investors will insist that the founders’ shares are subject to vesting, because it is important that the team they are investing in is motivated to stay with, and build value in, the company. As founders, you should want vesting restrictions imposed on each other’s shares as well. Otherwise, one founder could just leave the company and keep his or her shares while the other founders are the ones working hard to build value in the business.
    A:

    If your shares are subject to vesting, how and when you are taxed on those “restricted shares” is governed by Section 83 of the Internal Revenue Code. Specifically, the tax consequences depend upon whether you make an election—known as a “Section 83(b) election”—under Section 83 or not.

    No 83(b) election. If you don’t make a timely Section 83(b) election, then your purchase of the restricted shares is not a taxable event. So there is no tax resulting from your purchase of the shares. However, when the shares vest the difference between the fair market value of the shares that vest on the vesting date minus the amount you paid for the shares is treated as income to you (even though you aren’t receiving any cash from that increase in value)—and you need to pay tax (at ordinary income rates) on that income. So there’s another taxable event every time the shares vest (whether annually, quarterly, monthly or otherwise). Unfortunately this means that the better the company does and the more the stock increases in value, the bigger the tax burden. Note also that the capital gains holding period for the shares would not start until the day after the shares vest. When you ultimately sell the shares, the difference between the sale price and the fair market value on the vesting date would be capital gain or loss.  

    A timely 83(b) election. By making a Section 83(b) election within 30 days of the date the restricted shares are transferred to you, you elect to make the purchase of the restricted shares a taxable event, because you are required to pay tax (at ordinary income rates) on the difference between the fair market value of the shares on the date of purchase and the amount that you pay for the shares. Why would you do that? Why would you elect to pay tax on an earlier date than you would otherwise need to if you didn’t file the 83(b) election? Answer: Because in most cases for a startup company you will have paid fair market value for the shares (which, at incorporation, is usually nominal). So the taxable income (i.e., the difference between the fair market value and the purchase price) would be zero! And if you filed the 83(b) election, vesting becomes a non-event for tax purposes—there is no income (and therefore no tax) on vesting! Note that your capital gains holding period also starts earlier than if you didn’t file an 83(b) election.  

    Here’s an example of the difference: Let’s assume you pay $0.01 per share for 100,000 restricted shares, and the fair market value per share on the date of purchase is also $0.01. Assume the shares vest annually over four years, and on the first anniversary the fair market value of each share is $2.00.  

    If you timely file a Section 83(b) election, you elect to be taxed on the difference between the fair market value on the date of purchase ($0.01 per share) minus your purchase price (also $0.01 per share). So the tax on the date of purchase is zero. Vesting is not a taxable event and so you owe no tax on vesting. You only have to pay tax on the gain when you sell the shares.  

    In contrast, if you do not file a Section 83(b) election, you effectively defer being taxed until vesting. So while there is no tax due on the date of purchase, you do have taxable income when the shares vest. So on the first anniversary when 25,000 shares vest, you have $49,750 in taxable income (25,000 shares x [$2.00 per share ˗ $0.01 per share]). That’s a big tax bill when you aren’t likely to even be able to sell your shares to cover the tax.  

    Whether or not you decide to file a Section 83(b) election will ultimately depend on your particular facts and circumstances and you may want to consult with your own accountants or tax advisors before making the election.

    A:

    Equity is often the primary financial motivation for taking risk in a new venture. To be a proper incentive, the reward of equity should be tied to each person’s contribution to the success of the venture. In an ideal world this would mean milestone-based vesting over several years. However, the reality is that few startups can predict what milestones will be most important beyond a few months in advance with any accuracy, and therefore most equity award vesting is time-based. Shares held by founders typically vest over a four- to five-year period on a monthly or quarterly basis. Most non-founder employees vest over a four- to five-year period with a one-year cliff (25% vests after the first year) and monthly or quarterly vesting thereafter for the remaining three or four years. The cliff period gives the company time to determine whether the employee is working out before the person gets to keep any of his or her shares. Sometimes founders’ shares do not have a cliff.

    Vesting for board members and advisors is somewhat less standardized but, in general, you should match grant size and contribution to the time period the person is expected to provide services to the company and generally provide for monthly vesting. Consistency in grant size and vesting scheme for similarly situated contributors can save real headaches in the future, because it limits case-by-case negotiations and avoids negative feelings when compensation comparisons inevitably occur.

    A:

    To successfully launch a new startup, the company needs to own, or have a license to use, the intellectual property that will be used in the business. This aggregation of IP does not happen automatically and requires careful planning with your legal counsel.

    Upon the formation of the company, each founder should assign all of his or her rights to the idea and other IP related to the proposed business to the company. However, the founders may not own all of the IP, even if the founders invented it. For example, inventions created while a founder was a student or employee may be owned by the founder’s school or former employer. If any founder is employed by another company or part of another institution while he or she is collaborating on or developing the idea for the business, you should carefully review the terms of any applicable agreements or policies to determine who has ownership rights over any resulting IP. In general, however, the more that a founder has (1) used resources from another institution in developing the idea or (2) developed an idea that relates to other work performed for another institution, the more likely that the institution owns the IP. In that case, it may be necessary to acquire the rights to the IP or obtain a clarifying waiver or consent from the other institution in order for the startup to commercialize the IP.  

    Some startups will commercialize technology that was originally developed at a university, hospital or other institution. In those cases, the company will typically need to obtain a license to the IP. In exchange for these licenses, the startup may need to grant the university or other institution equity, make up-front or milestone payments and/or pay royalties. Learn more about licensing IP from a university or hospital.

    Copyright protects original works of authorship, including source code. Rights automatically vest upon creation, but the copyright belongs to the original author. So there needs to be an agreement transferring the copyright to the person who commissioned the code where the code writer is not an employee. For example, if your company hires a person to write some code the company can enter into a consulting agreement pursuant to which the code writer transfers copyrights (and any other intellectual property created as a result of the agreement) to the company.  

    You should also consider pursuing patent protection. A patent protects inventions or discoveries, including computer programs. In the United States, the inventor of the patent application is the person who conceived of the invention. To the extent the code writer is an inventor (which depends on how much detail was provided to the coder), the person or company that hired the code writer will want to obtain an assignment of the invention and the agreement of the code writer to cooperate with filing a patent application. This is best done when first commissioning the code writer. Learn more about filing a patent and registering a copyright.

    A:
    You can’t avoid the wage and hour laws for employees by simply characterizing your workers as “interns”.  The laws of each state vary, but in general, to properly classify a person as intern, the person must be a student or trainee, the focus of the internship must be on training the intern, and the company must not derive any immediate advantage from retaining the intern (must be similar to training given in an educational environment).  An individual’s ability to receive school credit for the internship is helpful, although not determinative in all cases.  If the person does not qualify as an unpaid intern and should instead be classified as an employee, then the person needs to be paid wages in accordance with federal and state laws, and be covered by unemployment and workers’ compensation insurance.
    A:
    You may want the vesting of your shares to accelerate if you are fired or the company is sold. Is that a good idea? Will your investors agree to this? 
    Acceleration of vesting if you are fired (terminated without cause) sounds like a good idea. Your investors won’t generally see it that way, however. First of all, proving you have “cause” is not easy to do. Second, investors don’t want to terminate you—you’re a primary reason they made the investment in the first place—and they want and need you to build the company. In the end though, they have their money (and their own investors) they need to think about, and they will make a change if they have to. That’s a difficult time for the company and they will need your unvested shares to recruit and incentivize your replacement. So, investors don’t generally allow for your shares to accelerate in these circumstances.  
    For similar reasons, acquirers of companies don’t want the talent they are acquiring to have a windfall on closing due to accelerated vesting. They may need those vesting incentives to continue or find other ways to incentivize the team, which results in a higher acquisition and compensation costs to the acquirer (and likely a corresponding reduced purchase price for your company and its investors). Moreover, the people who are likely to benefit most from accelerated vesting on a sale are the employees who joined the company closest to the time of the acquisition. Compare those employees to the founders and earliest employees who are probably fully, or close to fully, vested by the time the company is sold. So pushing for accelerated vesting on founder shares may not really help you that much (and may make it more difficult for you to recruit employees if you aren’t willing to give them the same terms).
    Sometimes a small percentage of the vesting accelerates upon a sale (e.g., 25% of the shares). More frequently, we see full acceleration if the person’s employment is terminated without cause by the acquirer after a sale of the company (if the acquirer decides to terminate your employment then they can’t be so concerned about incentivizing you can they?). This is generally referred to as a “double trigger” because it requires both (1) the sale of the company and (2) a termination without cause.   
    Note that it is more common for acceleration upon a sale to apply for equity held by members of the board of directors and advisory boards because  it is unusual for these people to play any role in the company or acquirer following the acquisition.
    A:

    It is almost unheard of that an entire team would be in place before securing a first round of funding. In fact, the primary use of a first round of outside capital is often to hire additional team members. The network and reputation that your future investors bring to the table can also be tremendously useful when recruiting new hires. Many entrepreneurs find that they are able to recruit more talented team members (and without giving up as much equity) after securing funding from strong investors.

    While you don’t need to have your whole team in place, your ability to secure funding will depend in large part on the capabilities of the current team and the confidence of potential investors in your ability to build out the remainder of the team. Venture capitalists are well-known for investing in teams over ideas—after all, it is much easier to pivot the business model than to replace the management team.

    A:

    A foreign student is permitted to own equity in a company and to serve on the board of directors of a company. A foreign student may not perform work for a company without obtaining appropriate authorization from the foreign student office at his/her university.  The rules are no different for “founders”.

    An individual (whether or not a founder) who is neither a US citizen nor a lawful permanent resident (“green card” holder) cannot work in the United States without a visa that authorizes employment – even if that person is the founder of the company.  Depending on the circumstances (including, for example, what degree(s) a foreign national possesses, what country the person is from, the nature of the job, whether the person’s fiancée or spouse is a US citizen, etc.), an individual may be eligible for a variety of non-immigrant and/or immigrant visas.  Any company whose founder is in need of a visa should begin by consulting immigration counsel to determine what options may exist.

    A:

    All employees (including founders) must be paid in cash in amounts at least to satisfy the minimum wage laws established by federal and state laws. Many founders opt to go without compensation in the initial stages, but technically doing so is in violation of the federal and state wages laws.  Employees may receive equity in addition to cash payments, but due to tax and other complexities it is generally not feasible to grant them equity in lieu of minimum cash wages. Although the market may reflect standard salaries for different types of positions, there is no requirement that employees receive any more than minimum wage, and the wages employees receive often depend on how large and established their employer is.

    Companies will often grant employees equity (or options to purchase equity) as part of their compensation package (but not in lieu of minimum wages). Depending on the success of the company, the equity may ultimately be worth more than the cash compensation the employee may otherwise have received. So equity is often an important recruiting mechanism and retention tool—especially where the company is cash strapped and needs to pay below-market cash wages. Equity compensation may also better align management goals with shareholder interests.   

    Employees have become more savvy about both their cash and equity compensation and base their compensation decisions on whether they believe their overall compensation package—cash plus equity—are competitive with what they should expect from a similarly situated employer in their industry. As a result, what is required to compensate the employee of your choice will vary based on market factors and the industry in which you operate. Read more about executive compensation in our CompStudy. 

    A:

    The option “pool” represents the number of shares the company sets aside in reserve under its option plan to compensate its employees, consultants, advisors and directors. The size of the option pool depends on the company’s stage, circumstances and hiring needs. When the company issues shares under the plan, it dilutes the ownership percentage of the other shareholders proportionately. However, any shares reserved under the plan that are not used (i.e., that are not sold or issued by the company) do not dilute the actual ownership of the other shareholders. Therefore, the size of the option pool at the initial formation of the company doesn’t really matter all that much—if the pool is too small and you need more shares, it can always be increased; if the pool is larger than you actually need, any excess shares don’t have any negative impact on the actual ownership of the company. Most startups will initially reserve an option pool that is big enough to provide for the equity incentives needed to cover their anticipated hiring needs for the first six months to a year.

    Once you are ready to raise money by selling stock, the size of the option pool becomes much more important. This is because the new investors will typically assume that the full pool will be utilized, and they will calculate their price per share and resulting ownership percentage in the company so that the full dilutive impact of that option pool will be borne by the existing shareholders. Here’s an example to illustrate how this works:

    Assume the pre-money value of the company is $5M, and the new investors are going to invest $5M. At closing, the new investors would therefore own 50% of the company. Without an option pool, the existing shareholders would own the other 50%. However, the new investors will generally require the option pool to come out of the existing shareholders’ 50%. So if the target post-closing option pool is 20%, the existing shareholders would really only own 30% of the company post-closing.    

    This creates an obvious tension: the company wants a large enough pool to give it hiring flexibility; at the same time, the company wants the pool to be as small as possible in order to limit the dilution on existing shareholders. In the end, you should develop a thoughtful and complete hiring plan covering the anticipated hires and equity awards needed between the current financing and the anticipated next financing. The pool should cover those anticipated needs with maybe a small cushion, but not much more than that. 

    A:

    Non-competition agreements may be enforceable, depending on the state in which the employee lived and worked when the agreement was signed, the consideration (value) given in exchange for the agreement and the reasonableness of the restrictions in the agreement. In some states, such as California, non-competes are not generally enforceable (other than in the context of a sale of the company). In most states, however, they are enforceable if they are reasonable in scope.

    Ultimately, whether a non-compete agreement is enforceable depends on the specific facts and circumstances and language in the particular agreement. If you violate a valid non-complete, your former employer may be able to obtain money damages, an injunction or both. Therefore, if you have questions about whether your agreement is enforceable or whether pursuing your new venture would cause you to violate your non-compete, you should speak with a knowledgeable attorney.

    A:

    Every employee of the company should have a standard offer letter that sets forth the general terms and conditions of their employment and states that they are “at-will” employees. This means that they can leave the company at any time (although their rights to retain their shares or exercise their options will depend on the vesting terms), and also that the company can terminate their employment at any time—with or without cause. They should also sign an agreement with the company where they agree to keep the company’s information confidential, assign their rights to any developed intellectual property to the company and, in most states, agree not to compete with the company for a period of time following their employment.

    To be enforceable, it is important that the employees sign these agreements upon their initial employment—their employment should be conditioned upon them signing these agreements. Otherwise, they may not be enforceable or the company will have to pay additional compensation in order to make them enforceable. View the forms you need in our Document Generator.

    A:

    If your shares are subject to vesting, how and when you are taxed on those “restricted shares” is governed by Section 83 of the Internal Revenue Code. Specifically, the tax consequences depend upon whether you make an election—known as a “Section 83(b) election”—under Section 83 or not.

    No 83(b) election. If you don’t make a timely Section 83(b) election, then your purchase of the restricted shares is not a taxable event. So there is no tax resulting from your purchase of the shares. However, when the shares vest the difference between the fair market value of the shares that vest on the vesting date minus the amount you paid for the shares is treated as income to you (even though you aren’t receiving any cash from that increase in value)—and you need to pay tax (at ordinary income rates) on that income. So there’s another taxable event every time the shares vest (whether annually, quarterly, monthly or otherwise). Unfortunately this means that the better the company does and the more the stock increases in value, the bigger the tax burden. Note also that the capital gains holding period for the shares would not start until the day after the shares vest. When you ultimately sell the shares, the difference between the sale price and the fair market value on the vesting date would be capital gain or loss.  

    A timely 83(b) election. By making a Section 83(b) election within 30 days of the date the restricted shares are transferred to you, you elect to make the purchase of the restricted shares a taxable event, because you are required to pay tax (at ordinary income rates) on the difference between the fair market value of the shares on the date of purchase and the amount that you pay for the shares. Why would you do that? Why would you elect to pay tax on an earlier date than you would otherwise need to if you didn’t file the 83(b) election? Answer: Because in most cases for a startup company you will have paid fair market value for the shares (which, at incorporation, is usually nominal). So the taxable income (i.e., the difference between the fair market value and the purchase price) would be zero!  And if you filed the 83(b) election, vesting becomes a non-event for tax purposes—there is no income (and therefore no tax) on vesting!  Note that your capital gain holding period also starts earlier than if you didn’t file an 83(b) election.  

    Here’s an example of the difference: Let’s assume you pay $0.01 per share for 100,000 restricted shares, and the fair market value per share on the date of purchase is also $0.01. Assume the shares vest annually over four years, and on the first anniversary the fair market value of each share is $2.00.  

    If you timely file a Section 83(b) election, you elect to be taxed on the difference between the fair market value on the date of purchase ($0.01 per share) minus your purchase price (also $0.01 per share). So the tax on the date of purchase is zero. Vesting is not a taxable event and so you owe no tax on vesting. You only have to pay tax on the gain when you sell the shares.  

    In contrast, if you do not file a Section 83(b) election, you effectively defer being taxed until vesting. So while there is no tax due on the date of purchase, you do have taxable income when the shares vest. So on the first anniversary when 25,000 shares vest, you have $49,750 in taxable income (25,000 shares x [$2.00 per share ˗ $0.01 per share]). That’s a big tax bill when you aren’t likely to even be able to sell your shares to cover the tax.  

    Whether or not you decide to file a Section 83(b) election will ultimately depend on your particular facts and circumstances and you may want to consult with your own accountants or tax advisors before making the election.

    A:

    Equity is often the primary financial motivation for taking risk in a new venture. To be a proper incentive, the reward of equity should be tied to each person’s contribution to the success of the venture. In an ideal world this would mean milestone-based vesting over several years. However, the reality is that few startups can predict what milestones will be most important beyond a few months in advance with any accuracy, and therefore most equity award vesting is time-based. Shares held by founders typically vest over a four- to five-year period on a monthly or quarterly basis. Most non-founder employees vest over a four- to five-year period with a one year cliff (25% vests after the first year) and monthly or quarterly vesting thereafter for the remaining three or four years. The cliff period gives the company time to determine whether the employee is working out before the person gets to keep any of his or her shares. Sometimes founders’ shares do not have a cliff.  

    Vesting for board members and advisors is somewhat less standardized but, in general, you should match grant size and contribution to the time period the person is expected to provide services to the company and generally provide for monthly vesting. Consistency in grant size and vesting scheme for similarly-situated contributors can save real headaches in the future, because it limits case-by-case negotiations and avoids negative feelings when compensation comparisons inevitably occur.

    A:

    A consultant (also called an independent contractor) is an expert in a particular field who is in the business of providing companies with his or her professional services. Consultants generally set their own hours, use their own equipment (e.g., as opposed to a company-issued laptop) and are not subject to the direction or control of the company to which they provide services. Every state has its own rules to determine whether a person is an employee or a consultant. In Massachusetts, for example, a consultant must perform services that are “outside the usual course of business” of a company. It is extremely difficult for an individual to satisfy the stringent tests to be properly classified as a consultant in Massachusetts (and some other states as well), and there is a presumption that any person who provides services to another is an employee. If these factors (and others showing a consultant’s independence) are not satisfied, an individual will be deemed an employee.

    Startup companies often try to classify workers as consultants, because there is generally no requirement that consultants be paid minimum wages under federal and state laws, be covered by unemployment and workers’ compensation insurance, etc. However, there are significant legal ramifications to misclassifying an employee as a consultant. For example, if the state determines that the person was really an employee and the company has not been paying the person the required minimum wages, the state can force those wages to be paid, and in many states, can impose significant penalties—often on the officers of the company personally.

    A:

    Acceleration of vesting if you are fired (terminated without cause) sounds like a good idea. Your investors won’t generally see it that way, however. First of all, proving you have “cause” is not easy to do. Second, investors don’t want to terminate you—you’re a primary reason they made the investment in the first place—and they want and need you to build the company. In the end though, they have their money (and their own investors) they need to think about, and they will make a change if they have to. That’s a difficult time for the company and they will need your unvested shares to recruit and incentivize your replacement. So, investors don’t generally allow for your shares to accelerate in these circumstances.

    For similar reasons, acquirers of companies don’t want the talent they are acquiring to have a windfall on closing due to accelerated vesting. They may need those vesting incentives to continue or find other ways to incentivize the team, which results in a higher acquisition and compensation costs to the acquirer (and likely a corresponding reduced purchase price for your company and its investors). Moreover, the people who are likely to benefit most from accelerated vesting on a sale are the employees who joined the company closest to the time of the acquisition. Compare those employees to the founders and earliest employees who are probably fully, or close to fully, vested by the time the company is sold. So pushing for accelerated vesting on founder shares may not really help you that much (and may make it more difficult for you to recruit employees if you aren’t willing to give them the same terms).

    Sometimes a small percentage of the vesting accelerates upon a sale (e.g., 25% of the shares). More frequently, we see full acceleration if the person’s employment is terminated without cause by the acquirer after a sale of the company (if the acquirer decides to terminate your employment then they can’t be so concerned about incentivizing you can they?). This is generally referred to as a “double trigger” because it requires both (1) the sale of the company and (2) a termination without cause.

    Note that it is more common for acceleration upon a sale to apply for equity held by members of the board of directors and advisory boards because  it is unusual for these people to play any role in the company or acquirer following the acquisition. See more.

    A:

    Advisory boards can be useful things—especially in the earliest phases of your startup. They are often luminaries, academics and industry experts, and having people like that who are willing to make themselves available to answer questions, provide you with insights, perspective and feedback or to merely lend some credibility to your venture can be very valuable. Calling it a “board” is a bit of a misnomer, because advisory boards rarely actually meet as a group. The amount of time they contribute is often quite limited, and they aren’t generally tasked with a specific project or deliverable like a consultant would be.

    Most companies don’t compensate the members of the advisory board with any cash compensation. Rather, they will typically give each advisor a small equity grant (usually in the form of a stock option) that vests over time. While size of the grant will vary slightly from company to company, it is usually around 0.1% to 0.2% of the then outstanding equity per advisor.  

    Advisors should enter into an agreement with the company in which they agree to keep the company’s information confidential and agree that the ideas they help you develop will be owned by the company. Visit our Document Generator for access to an Advisory Board Form

    A:

    Equity is often the primary financial motivation for taking risk in a new venture. To be a proper incentive, the reward of equity should be tied to each person’s contribution to the success of the venture. In an ideal world this would mean milestone-based vesting over several years. However, the reality is that few startups can predict what milestones will be most important beyond a few months in advance with any accuracy, and therefore most equity award vesting is time-based. Shares held by founders typically vest over a four- to five-year period on a monthly or quarterly basis. Most non-founder employees vest over a four- to five-year period with a one year cliff (25% vests after the first year) and monthly or quarterly vesting thereafter for the remaining three or four years. The cliff period gives the company time to determine whether the employee is working out before the person gets to keep any of his or her shares. Sometimes founders’ shares do not have a cliff.  

    Vesting for board members and advisors is somewhat less standardized but, in general, you should match grant size and contribution to the time period the person is expected to provide services to the company and generally provide for monthly vesting. Consistency in grant size and vesting scheme for similarly-situated contributors can save real headaches in the future, because it limits case-by-case negotiations and avoids negative feelings when compensation comparisons inevitably occur.

     
    A:

    The shareholders of a corporation are its owners, and they vote their shares to elect the directors. The directors sit as a board, which, typically acting through a majority, oversees the corporation’s management and sets the overall corporate strategy and direction. Directors have fiduciary duties, so they generally must act in the best interests of the corporation and its shareholders. The corporation’s directors elect officers, including a CEO, who conduct the day-to-day business operations. The board must also approve certain significant corporate matters, such as stock issuances and important contracts.

    As a result of this framework, corporate officers generally control the corporation’s day-to-day decision making, but they must answer to the board, which in turn has responsibility to the corporation’s shareholders.

    When a corporation is formed, all of its shares are generally allocated among the founders. Together, the founders vote their shares to elect an initial board, which may consist entirely of founders or may include a key advisor or two. As the corporation completes equity financings, the investors will become shareholders, and they may require representation on the board, as well as other control rights. As a result, as corporations mature, the founders’ ownership and control rights tend to be diluted, often quite significantly.

    A:

    A board of directors has the ultimate authority to direct the management of the business and affairs of the company. Legally, the board will authorize the issuance of stock, hire (and fire) senior executives, approve compensation arrangements, including the issuance of stock options, and authorize the company to enter into significant agreements. The board will also be asked to provide advice and approve strategic and operating plans, adopt company budgets and oversee the company’s audit and financial statement functions. Most importantly though, the board’s most critical function is to help management navigate the myriad critical business decisions that will determine the ultimate success or failure of the company.  

    In the initial startup stage, a board of directors might consist solely of one or more founders. However, finding an additional board member with insight and experience that no founder has, but who knows the company’s market or technology particularly well, can be particularly helpful in building the business. In addition, the right director can provide some independent validation that a company’s business has promise. Once a company raises capital, particularly from venture capital funds, board seats will be a negotiated part of the transaction, with a board of directors typically consisting of a combination of founders, investors and independent directors.   

    Directors can provide valuable input and an independent voice during discussions over important business matters. As such, directors who offer complementary strengths and work well together are necessary to a well-functioning board. It is important to have strong board members who are willing to voice their opinions and speak up when they disagree. Prospective board members should not only be able to show up for meetings, but be able to devote enough time and attention to come well-prepared for each meeting.

     
    A:

    You may want the vesting of your shares to accelerate if you are fired or the company is sold. Is that a good idea? Will your investors agree to this?

    Acceleration of vesting if you are fired (terminated without cause) sounds like a good idea. Your investors won't generally see it that way, however. First of all, proving you have "cause" is not easy to do. Second, investors don't want to terminate you—you're a primary reason they made the investment in the first place—and they want and need you to build the company. In the end though, they have their money (and their own investors) they need to think about, and they will make a change if they have to. That's a difficult time for the company and they will need your unvested shares to recruit and incentivize your replacement. So, investors don't generally allow for your shares to accelerate in these circumstances.

    For similar reasons, acquirers of companies don't want the talent they are acquiring to have a windfall on closing due to accelerated vesting. They may need those vesting incentives to continue or find other ways to incentivize the team, which results in a higher acquisition and compensation costs to the acquirer (and likely a corresponding reduced purchase price for your company and its investors). Moreover, the people who are likely to benefit most from accelerated vesting on a sale are the employees who joined the company closest to the time of the acquisition. Compare those employees to the founders and earliest employees who are probably fully, or close to fully, vested by the time the company is sold. So pushing for accelerated vesting on founder shares may not really help you that much (and may make it more difficult for you to recruit employees if you aren't willing to give them the same terms).

    Sometimes a small percentage of the vesting accelerates upon a sale (e.g., 25% of the shares). More frequently, we see full acceleration if the person's employment is terminated without cause by the acquirer after a sale of the company (if the acquirer decides to terminate your employment then they can't be so concerned about incentivizing you can they?). This is generally referred to as a "double trigger" because it requires both (1) the sale of the company and (2) a termination without cause. 

    Note that it is more common for acceleration upon a sale to apply for equity held by members of the board of directors and advisory boards because  it is unusual for these people to play any role in the company or acquirer following the acquisition.

    A:

    The option "pool" represents the number of shares the company sets aside in reserve under its option plan to compensate its employees, consultants, advisors and directors. The size of the option pool depends on the company's stage, circumstances and hiring needs. When the company issues shares under the plan, it dilutes the ownership percentage of the other shareholders proportionately. However, any shares reserved under the plan that are not used (i.e., that are not sold or issued by the company) do not dilute the actual ownership of the other shareholders. Therefore, the size of the option pool at the initial formation of the company doesn't really matter all that much—if the pool is too small and you need more shares, it can always be increased; if the pool is larger than you actually need, any excess shares don't have any negative impact on the actual ownership of the company. Most startups will initially reserve an option pool that is big enough to provide for the equity incentives needed to cover their anticipated hiring needs for the first six months to a year.

    Once you are ready to raise money by selling stock, the size of the option pool becomes much more important. This is because the new investors will typically assume that the full pool will be utilized, and they will calculate their price per share and resulting ownership percentage in the company so that the full dilutive impact of that option pool will be borne by the existing shareholders. Here's an example to illustrate how this works:

    Assume the pre-money value of the company is $5M, and the new investors are going to invest $5M. At closing, the new investors would therefore own 50% of the company. Without an option pool, the existing shareholders would own the other 50%. However, the new investors will generally require the option pool to come out of the existing shareholders' 50%. So if the target post-closing option pool is 20%, the existing shareholders would really only own 30% of the company post-closing.    

    This creates an obvious tension: the company wants a large enough pool to give it hiring flexibility; at the same time, the company wants the pool to be as small as possible in order to limit the dilution on existing shareholders. In the end, you should develop a thoughtful and complete hiring plan covering the anticipated hires and equity awards needed between the current financing and the anticipated next financing. The pool should cover those anticipated needs with maybe a small cushion, but not much more than that.  

    A:
    Restricted stock is almost always issued to founders when the company is formed. Most early stage companies prefer to limit the number of shareholders who have the right to vote and therefore tend to instead grant options to non-founders. Also, because recipients of restricted stock must pay the fair market value of the stock up-front (as opposed to options where they wait to pay for the shares until they exercise the option) it becomes more and more expensive to purchase restricted stock as the company increases in value. As a result, most private companies will instead grant options to non-founder employees, consultants, advisors and directors. 
    A:
    YES! Founders should put vesting restrictions on their shares. "Vesting" means that you need to "earn" your shares before you are allowed to keep them if you leave the company. Investors will insist that the founders' shares are subject to vesting, because it is important that the team they are investing in is motivated to stay with, and build value in, the company. As founders, you should want vesting restrictions imposed on each others shares as well. Otherwise, one founder could just leave the company and keep his or her shares while the other founders are the ones working hard to build value in the business. 
    A:

    Advisory boards can be useful things—especially in the earliest phases of your startup. They are often luminaries, academics and industry experts, and having people like that who are willing to make themselves available to answer questions, provide you with insights, perspective and feedback or to merely lend some credibility to your venture can be very valuable. Calling it a "board" is a bit of a misnomer, because advisory boards rarely actually meet as a group. The amount of time they contribute is often quite limited, and they aren't generally tasked with a specific project or deliverable like a consultant would be.

    Most companies don't compensate the members of the advisory board with any cash compensation. Rather, they will typically give each advisor a small equity grant (usually in the form of a stock option) that vests over time. While size of the grant will vary slightly from company to company, it is usually around 0.1% to 0.2% of the then outstanding equity per advisor.  

    Advisors should enter into an agreement with the company in which they agree to keep the company's information confidential and agree that the ideas they help you develop will be owned by the company.

    A:

    In the US, there are two types of compensatory stock options: incentive stock options (often called ISOs) and non-qualified stock options (often called NSOs). Companies can grant ISOs or NSOs to their employees. However, they cannot grant ISOs to non-employees. Therefore, options granted to contractors/consultants, advisors and non-employee directors can only be NSOs. Other requirements of ISOs include: 

    • ISOs must be granted under an equity plan that has been approved by the company's stockholders and that has a limit on the number of shares that may be issued under the plan; 
    • ISOs must have an exercise price per share that is no less than the fair market value per share of the underlying stock as of the date of grant (110% if the person is a 10% shareholder); 
    • ISOs must have a term of no more than 10 years (5 years if the person is a 10% shareholder); 
    • The value of the shares that may vest in any calendar  year (calculated using the grant date fair market value) may not exceed $100,000; and
    • ISOs must be nontransferable.

    NSOs don't have the same restrictions. However, to avoid significant adverse  tax consequences to the optionholder it is generally the case that even NSOs must have an exercise price per share that is at least equal to the fair market value per share of the underlying stock as of the date of grant. Read our article on best practices for option grants by venture-backed companies.

    The tax treatment to the option holder differs between ISOs and NSOs. These differences are summarized in the table below.

    Option TypeTax Upon Grant of Option*Tax Upon VestingTax Upon Exercise of OptionTax Upon Sale of Shares
    ISONoneNoneNone**

    If shares are held at least (i) one year after exercise and (ii) two years from grant date, then the entire spread is taxed as capital gain.

    Otherwise, the option is taxed as if it were a NSO (but no income or employment tax withholding is required).

    NSONoneNone

    The difference between (i) the fair market value of stock at time of exercise minus (ii) the exercise price is taxed as ordinary income and is subject to income and employment tax withholding.

    The difference between (i) the fair market value of stock at time of exercise minus (ii) the exercise price is taxed as ordinary income and is subject to income and employment tax withholding.
     
    The difference between (i) the sale price minus (ii) the fair market value of the stock at the time of exercise is taxed as capital gain.

    *Assumes that the exercise price per share is equal to or greater than the fair market value per share on the date of grant.

    **The difference between (i) the fair market value of stock at time of exercise minus (ii) the exercise price is included in the person's Alternative Minimum Tax (AMT) calculation.

    While there are potential tax advantages to ISOs, it is frequently the case that people sell their option shares very shortly after exercising the option. For example, option holders in public companies often sell the shares right after exercise in order to lock in the gain or to help cover the exercise price and AMT arising on the ISO exercise. Further, option holders in both private and public companies may be required to exercise their options when the company is acquired, and the shares are then sold or exchanged in connection with the acquisition. As a result, most holders of ISOs won't ultimately benefit from the tax advantages of having ISOs, because these sales are treated as "disqualifying dispositions" thereby causing the option to be treated as a NSO. Despite this, most private companies nevertheless grant employees ISOs instead of NSOs because of the potential tax benefits.

    A:

    If your shares are subject to vesting, how and when you are taxed on those "restricted shares" is governed by Section 83 of the Internal Revenue Code. Specifically, the tax consequences depend upon whether you make an election—known as a "Section 83(b) election"—under Section 83 or not.  

    No 83(b) election. If you don't make a timely Section 83(b) election, then your purchase of the restricted shares is not a taxable event. So there is no tax resulting from your purchase of the shares. However, when the shares vest the difference between the fair market value of the shares that vest on the vesting date minus the amount you paid for the shares is treated as income to you (even though you aren't receiving any cash from that increase in value)—and you need to pay tax (at ordinary income rates) on that income. So there's another taxable event every time the shares vest (whether annually, quarterly, monthly or otherwise). Unfortunately this means that the better the company does and the more the stock increases in value, the bigger the tax burden. Note also that the capital gains holding period for the shares would not start until the day after the shares vest. When you ultimately sell the shares, the difference between the sale price and the fair market value on the vesting date would be capital gain or loss. 

    A timely 83(b) election. By making a Section 83(b) election within 30 days of the date the restricted shares are transferred to you, you elect to make the purchase of the restricted shares a taxable event, because you are required to pay tax (at ordinary income rates) on the difference between the fair market value of the shares on the date of purchase and the amount that you pay for the shares. Why would you do that? Why would you elect to pay tax on an earlier date than you would otherwise need to if you didn't file the 83(b) election? Answer: Because in most cases for a startup company you will have paid fair market value for the shares (which, at incorporation, is usually nominal). So the taxable income (i.e., the difference between the fair market value and the purchase price) would be zero!  And if you filed the 83(b) election, vesting becomes a non-event for tax purposes—there is no income (and therefore no tax) on vesting!  Note that your capital gains holding period also starts earlier than if you didn't file an 83(b) election.

    Here's an example of the difference: Let's assume you pay $0.01 per share for 100,000 restricted shares, and the fair market value per share on the date of purchase is also $0.01. Assume the shares vest annually over four years, and on the first anniversary the fair market value of each share is $2.00.  

    If you timely file a Section 83(b) election, you elect to be taxed on the difference between the fair market value on the date of purchase ($0.01 per share) minus your purchase price (also $0.01 per share). So the tax on the date of purchase is zero. Vesting is not a taxable event and so you owe no tax on vesting. You only have to pay tax on the gain when you sell the shares.  

    In contrast, if you do not file a Section 83(b) election, you effectively defer being taxed until vesting. So while there is no tax due on the date of purchase, you do have taxable income when the shares vest. So on the first anniversary when 25,000 shares vest, you have $49,750 in taxable income (25,000 shares x [$2.00 per share ˗ $0.01 per share]). That's a big tax bill when you aren't likely to even be able to sell your shares to cover the tax.  

    Whether or not you decide to file a Section 83(b) election will ultimately depend on your particular facts and circumstances and you may want to consult with your own accountants or tax advisors before making the election. 

    A:
    Equity is often the primary financial motivation for taking risk in a new venture. To be a proper incentive, the reward of equity should be tied to each person's contribution to the success of the venture. In an ideal world this would mean milestone-based vesting over several years. However, the reality is that few startups can predict what milestones will be most important beyond a few months in advance with any accuracy, and therefore most equity award vesting is time-based. Shares held by founders typically vest over a four- to five-year period on a monthly or quarterly basis. Most non-founder employees vest over a four- to five-year period with a one year cliff (25% vests after the first year) and monthly or quarterly vesting thereafter for the remaining three or four years. The cliff period gives the company time to determine whether the employee is working out before the person gets to keep any of his or her shares. Sometimes founders' shares do not have a cliff.   
     
    Vesting for board members and advisors is somewhat less standardized but, in general, you should match grant size and contribution to the time period the person is expected to provide services to the company and generally provide for monthly vesting. Consistency in grant size and vesting scheme for similarly-situated contributors can save real headaches in the future, because it limits case-by-case negotiations and avoids negative feelings when compensation comparisons inevitably occur.
    A:

    "Restricted Stock" is a term often used to refer to shares of stock of a company that are subject to vesting requirements. The shares are purchased and owned by the shareholder. The shareholder can vote the shares. If a dividend is paid on the shares, the shareholder is entitled to be paid the dividend. However, the shares are subject to vesting. However, if the shareholder ceases providing services to the company—as an employee, consultant, advisor or otherwise—the company has the right to get back any of the shares that were not then vested (typically be paying the shareholder back the original purchase price paid for the shares). With time-based vesting, this means that the percentage of the shares that the company has the right to purchase decreases over time. This is sometimes referred to as "reverse vesting" in order to describe the contrast with vesting of options where the number of shares the option holder is entitled to purchase increases over time/as they vest.  

    A stock option is a contract between the company and an employee, consultant, advisor or other service provider. It gives the individual the right to buy a certain number of shares of stock at a fixed price, called the exercise price. The right to exercise the option will vest—typically over time. So initially, the holder cannot exercise any of the shares, but the number of shares that become exercisable will increase over time as long as the individual continues to provide services to the company.

    The exercise price of an option is typically set at the fair market value as of the time of grant (when the board of directors authorizes the grant of the option). This price is fixed—so even though the value of the stock may increase, the option holder gets to buy the shares at the earlier and lower fixed price. This is the key advantage of an option—the individual gets to wait and see how the company does before paying anything out-of-pocket. If the company does well and the stock increases in value, the holder can exercise the option by paying the exercise price knowing that the shares are then more valuable than the purchase price. If the company doesn't do well and the stock decreases in value, the individual can just choose not to exercise the option and therefore pay nothing. Compare this to restricted stock, where the individual must pay for the shares (or pay tax) up-front. Unlike a holder of restricted stock, however, the holder of an option is not a shareholder until the option is exercised. Until that time, therefore, the holder cannot vote the shares, and is not entitled to any dividends paid on the shares.

    A:

    In the context of financing, crowdsourcing is the process of getting funding, usually online, for a project from a large number (or crowd) of people who typically each contribute small dollar amounts. With crowdsourcing platforms (such as Kickstarter), the entrepreneur will set a target for the dollar amount to be raised, the deadline by which it must be raised and any reward to the persons contributing to the project. Typically, the dollar amount to be raised must reach the targeted amount on or prior to the deadline or all funds raised must be returned to the people who contributed to the project. Crowdsourcing does not involve the issuance of shares of stock, convertible notes or other securities to those persons who contribute. Instead, they typically receive a copy of the product that their contribution helped fund or some other token of appreciation rather than a stake in the company.

    Crowdfunding, such as proposed under the JOBS Act, is different than crowdsourcing. In crowdfunding, many investors are connected—usually through the Internet—and pool their money to purchase securities of a company. Some online networks, such as AngelList, only connect entrepreneurs and companies with accredited investors. In 2012, Congress passed the JOBS Act, which includes provisions that are intended to allow individuals that are not accredited investors to invest in securities through crowdfunding. Crowdfunding under the JOBS Act is not yet the law in the United States, because the Securities and Exchange Commission has not finalized the crowdfunding rules. When those rules are completed, it is expected that a company would be able to raise up to $1 million in any 12-month period from investors even if they are not accredited investors. While crowdfunding under the JOBS Act may open up new opportunities for certain types of companies to raise capital, there will be a number of additional restrictions on the amount of investment from each individual investor, as well as a number of additional requirements—such as the need to provide financial statements and, in some cases, tax returns—that are likely to limit the feasibility of crowdfunding for high growth companies.

    A:

    You definitely need a “plan” for your business, but you probably don’t need a formal 30-page “business plan” like the one you might prepare in business school. Preparing a formal business plan can be a good exercise—it will probably make you think critically about your business in ways you might not otherwise. But don’t expect most investors to read it or even expect to see it.

    You will need to have a well-written and concise 1–2 page executive summary. The executive summary needs to tell your story. It needs to be compelling. It is often your first and only opportunity to make an impression on a potential investor. If you don’t impress, you won’t get a second chance. 

    If your executive summary piques the interest of a potential investor, you’ll then be expected to “pitch” your story in person. This is where you get a chance to articulate your vision. Practice. Get feedback from people you trust. Develop a slide deck to help guide you and the story. Be prepared—if you are targeting the right investors, they will be knowledgeable about your market. They will test and question your assumptions. You need to be prepared to articulate and defend them. 

    As a result, preparing a business plan—whether a formal and lengthy plan, your executive summary and/or your slide deck—can help you accomplish some key goals. First, it forces you to articulate your vision and, if you are working with a team, can help align the team towards a common set of objectives. Second, it forces you to test your assumptions regarding the feasibility of the business. Third, your business plan is your primary pitch document—a way to attract and sell yourself and your company to potential investors. Although it may be possible to raise capital without a business plan, not having one will make your efforts more difficult and likely extend the amount of time it takes to raise capital. 

    A:

    It is almost unheard of that an entire team would be in place before securing a first round of funding. In fact, the primary use of a first round of outside capital is often to hire additional team members. The network and reputation that your future investors bring to the table can also be tremendously useful when recruiting new hires. Many entrepreneurs find that they are able to recruit more talented team members (and without giving up as much equity) after securing funding from strong investors.

    While you don’t need to have your whole team in place, your ability to secure funding will depend in large part on the capabilities of the current team and the confidence of potential investors in your ability to build out the remainder of the team. Venture capitalists are well-known for investing in teams over ideas—after all, it is much easier to pivot the business model than to replace the management team.

    A:

    This is a complex question. The answer really depends on the facts and circumstances. For example, the information below assumes that the company is privately held and does not otherwise wish to engage in a public offering like an IPO. So you need to get good legal advice to determine the best answer for you.

    Technically it is not always required that all of your investors be “accredited investors.” However, whether legally required or not, it is almost always the case that it makes good business sense for private companies to only raise money from “accredited investors.” 

    The term “accredited investor” is defined by rules of the SEC. An individual can be an “accredited investor” if it meets certain income or net worth thresholds. Companies, partnerships and other entities can also qualify as “accredited investors” if they satisfy the SEC’s rules. 

    While the SEC’s rules relating to fundraising are somewhat complicated, raising money only from “accredited investors” has a number of significant advantages that will save you time, money and a lot of potential headaches now and in the future. For example, raising money from unaccredited investors would generally require you to prepare a lengthy, technical and detailed disclosure document. Complying with those disclosure rules can be very expensive and time-consuming at a time when your business wants to raise money quickly and inexpensively. Further, allowing unaccredited investors to purchase securities from your company can create complex issues down the road when raising additional money or when your company is acquired. For these and many other reasons, you should typically avoid raising money from unaccredited investors.

    A:

    Raising capital can be a long and arduous process. What can you do to make that process go as smoothly as possible? First, make sure you have your pitch in great shape. Your pitch needs to be in more than one form, too. You should have an “elevator pitch”—a 30-second story about what your company does and why your business is compelling. Sometimes that’s as long as you will get to tell your story to someone, so you need to get potential investors interested enough to want to hear more. 

    You also need to have a strong executive summary and full-blown pitch (typically including a slide deck presentation). Although more detailed and thorough, these longer pitches need to be as compelling as your elevator pitch. Every pitch is different, but some of the more important components of most pitches will show some or all of the following:

    • There is a large and compelling market for your business. You might have a great idea, but if the market it too small investors won’t be interested.
    • Even if there are current solutions in the market, they are failing to meet the market’s needs. Describe your potential customers. Why does the market need a better solution?
    • Your company’s solution is different and better. It will solve the needs of the market and the problems your customers need solved in a compelling way—it’s cheaper, faster, better and/or materially different. Customers (and lots of them) will want your solution!
    • Where true, the intellectual property in your solution will protect your eventual position in the market. This is very important is some businesses like most life sciences companies, hardware businesses, etc. In other cases, like many consumer Internet businesses, intellectual property protection may be less important or available. In those cases, you may need to show that you have a compelling marketing plan to help you gain rapid and viral growth or that you have already demonstrated some significant customer traction.
    • A summary set of realistic financial projections over the next few years that shows that you expect your company will scale to become a sizable company.
    • A summary of your team and the expertise it has relevant to making your company a success.

    Second, you need to have developed a financial plan so that you know how much capital you need to raise. If you only need $100,000 to start, you may be able to tap friends, family and other angel investors, but if you need $5 million you are going to need to target venture capitalists and other institutional investors. Without a base financial plan, you are likely to waste time talking to the wrong types of investors. 

    Raising capital is often very time-consuming. Be patient and be persistent. Tap into the networks of your advisors, and work with them to help develop a strategy for reaching out to potential investors. Be a good listener and update your pitch and your approach based on the feedback you receive. If you believe in your story, don’t give up. 

    A:

    Entrepreneurs need to determine which VCs to contact. Read about how to pick your investors. Once you’ve done your research, made a list of potential investors to approach and prioritized that list, you’re ready to plan how you get meetings with them.

    To get a meeting, you should try to get an introduction to the VC, and your job is to find someone who will be willing to make that introduction. This approach is necessitated by the fact that VCs are extremely busy. They are either attending board and other meetings with their portfolio companies, attending industry conferences, meeting with entrepreneurs and negotiating potential investments or traveling to those meetings and conferences. In short, they have very little time, so the VCs are more likely to consider a company that was referred to them by someone they know and trust. 

    Entrepreneurs have resources they can use to assist in getting introductions. Tools such as LinkedIn are extremely useful to help find connections. If you work with an attorney that specializes in working with startups and venture-backed companies, the attorney will likely have strong connections with most VCs and be willing to reach out to them on your behalf. While the attorney can never promise that a VC will meet with the entrepreneur, if their relationship is strong enough they can be confident that the VC will at least look at your executive summary. From your review of the VC’s portfolio companies, you should search on LinkedIn to see if you have contacts at a portfolio company of that VC. Be resourceful and use all of your contacts. The takeaway is that you will need to search your network of contacts to find an introduction. 

    While it is possible get a meeting with a VC without any “warm” introduction, such as by introducing yourself to the VC at a conference, this approach has a low probability of success. The same as true of making a “cold call” or just emailing your business plan to the venture firm without an introduction. An associate at the venture firm may review it, but the probability of getting a response is extremely low. 

    A:

    Entrepreneurs need to determine which VCs or angel investors to seek to raise money from. Don’t waste your time with investors that aren’t likely to be interested in your business—either because of the company’s industry, stage or otherwise. Some of the more important considerations when choosing investors include:

    • Industry Focus. Each investor has a different area of focus—some focus on life sciences companies, while others focus on software companies, for example. Even within broad categories, some investors have a more narrow industry focus, such as digital media, mobile, semiconductors or clean tech. Choose investors that understand your business and industry. They will be in a better position to help you build a successful company by leveraging their experiences and industry contacts on your behalf.
    • Company Stage. The company’s stage of development is an important factor when assessing which investors are most appropriate. Some investors will only invest in the seed or initial rounds of funding. Others will invest later, but only if they also invested in the first round, and others won’t invest until the company is more mature. Understand the stage preference of the investors you target so you don’t waste your (or their) time. 
    • Geography. The location of the investor in relation to the company may also be relevant. Many angels, for example, prefer to invest in companies within a reasonably close proximity so that they can more easily monitor their investments and provide hands-on assistance to the company. Geographic proximity is generally less important to venture capitalists, but even they tend to make more investments closer to home or in certain geographies—especially when it comes to investing in early rounds of funding. 
    • Competitive Investments. A further consideration is whether the investor has already invested in a company doing something very similar to what your company is looking to do. It is definitely a plus to have investors that have direct experience with companies similar to yours. Their insights into your industry, customer base and business model will be very valuable. However, if the investor already has a portfolio company that is a competitor or otherwise too similar to yours, then conflicts (or worse) can arise. In that case, most investors will want to avoid those conflicts themselves and won’t invest in your company. Even if they would, why chance it? 
    • Reputation of Investor. Investors will ask a lot of questions about your company, your technology, your team and your strategy. They should—they are making a big bet on your company. But aren’t you betting your company’s success on them as well? Ask around. Talk with other entrepreneurs that have raised money from your potential investors. If you are expecting them to continue to invest in the company as it grows, do they have the means to do so? How do they behave when things don’t go well? Every company has its ups and downs, and yours will too. Investors can’t and shouldn’t blindly continue to support companies that are failing, but you should try to pick investors that have a reputation for being supportive even during challenging times. 

    The point is before you start contacting investors, you need to do your diligence in determining which ones will be the best for you and which ones are most likely to make an investment in your business. A good place to start is with the investor’s website (if it has one), where you’ll be able to review the investor’s investment approach, a list of portfolio companies and the backgrounds and investments made by each investor and their team. If there isn’t a website, then you can search the Internet under the investor’s name for press releases regarding investments made by that investor. Ask people in your network. If you work with an attorney that specializes in working with startups and venture-backed companies, the attorney will likely have strong connections with most investors and can help you build a list of the most promising potential investors. Your accountants, bankers and other advisors may also have good insights for you as well. Once you’ve done your research and made a list of investors to approach, you’re ready to plan how you get meetings with them. Learn how to get meetings with VCs.  

    A:

    You’ve got a great idea and you’ve put together a great team. All you need now is the seed capital to launch your venture. Do you ask your friends and family to become your first investors? It’s a question with no easy answer and any decision you make will come with a host of both personal and legal ramifications.

    Assuming you value your relationships with your friends and family, before you take a dime from them, you should be sure that everyone understands the risk they will be taking. If it all goes well you could make your early investors wealthy, and everyone will be happy. But the truth is, most startup ventures are far more likely to fail than they are to succeed. Are your friends and family investing money they can afford to lose? If not, you shouldn’t even ask. How would you feel about losing a sizable chunk of your grandmother’s retirement savings? Probably not very good. You should have a frank discussion with your friends and family about the risks of investing in your business and be sure they understand that they may lose all of their investment. 

    Even if things go reasonably well after raising money from friends and family, you will probably eventually need to raise additional capital. At that time, your early investors will be faced with a tough choice: invest more capital, which they may not have the means or desire to do, or face dilution at the hands of your new investors. This dilemma can be particularly acute if your new investors are professional investors, like venture capitalists. Professional investors are in business to make money, and their assessments regarding how much risk to take, whether and when to sell the company to find liquidity and other matters are very likely to be different than those of your early investors. If you expect that your business will require more than one round of funding make sure you and your seed investors understand that this is the case and how it may impact them. 

    If everyone is comfortable with these risks, the next challenge is to make sure that the terms of the investment are clearly memorialized. All too often entrepreneurs accept checks from seed investors without having the terms of the investment properly documented. “Hey, we’re all friends here, we can figure it out later.” This approach is almost always a recipe for disaster as future confusion about the exact terms of the investment can sour a relationship between a founder and his investors and can threaten the company’s future financing plans. If the investment is a loan, what are the repayment terms, what is the interest rate, is it a convertible loan? If the investment is in equity, is the company issuing common stock or preferred stock? What, if any, rights come with the stock being offered? What does the company’s pre- and post-money capitalization look like? These are all important questions that should be addressed before an early investor’s check is ever cashed. 

    Accepting an investment from friends and family members has the potential to not only sour your personal relationships, but it can cause legal headaches as well. Taking an investment from someone who is not an “accredited investor” can create legal and business headaches for the company both at the time of the unaccredited investor’s investment and in the future. Any decision to allow unaccredited investors to invest in the company should be carefully considered with legal counsel in advance. Read more about accredited investors

    If your friends and family really want to get involved in your venture, but you are concerned with taking an investment from them, consider whether there are other ways you might get them involved in your business that don’t require them to write a check. Can they serve as an advisor to the company or as an early member of your board of directors? Perhaps they can help with a particular skill or introductions to others in the company’s field that might be useful to your venture. While it may be easier to ask your friends and family members to invest in your startup than it is to go out and convince strangers that you have created a compelling investment opportunity, taking money from those closest to you can often involve a number of potential complications that should be carefully considered before moving forward.

    A:

    Venture debt is a form of debt financing typically provided by certain lenders to venture-backed companies that lack the assets or cash flow for traditional bank debt financing. Venture debt is generally structured as a term loan that is paid down over time—usually three years. Venture debt is typically senior to other company debt and is collateralized by all of a company’s assets. Unlike traditional bank debt, venture debt typically does not include financial covenants (such as a requirement to maintain a minimum amount of cash in the company’s bank account), though the interest rates on venture debt are typically higher than traditional bank loans (generally, ranging from 10% to 15%). In addition, a venture lender typically receives a warrant to purchase stock of the company. A warrant is like a stock option—it provides the holder with the right to purchase shares of stock (common or preferred) of a company at a fixed price for a period of time. A warrant issued to a venture lender is typically exercisable for preferred stock with an exercise period of five or 10 years.

    A key consideration for a venture lender as it analyzes a potential loan to an early stage company is whether the company has closed at least one round of equity financing with venture capital firms and/or other institutional investors. In fact, a venture lender’s decision to extend a loan to an early stage company is more based on the reputation and stature of the venture capital firms and/or other institutional investors in the company than the creditworthiness of the company. The venture lender is relying on these institutional investors to continue to fund the company past the maturity date of the loan. Thus, a venture lender will spend a fair amount of time meeting with the institutional shareholders of the company as part of the venture lender’s approval process for the loan, and they will typically prefer to loan money to companies backed by venture capital firms with whom the lender already has had prior business relationships.

    The principal benefit of venture debt is that it is largely non-dilutive to the existing shareholders of a company (other than the dilution resulting from the exercise of the warrant). That is, the venture debt provides capital to the company while not significantly reducing the percentage of ownership of existing shareholders. The downside is that venture debt must be repaid, so the company will need to have the cash or cash flow to pay off the loan. The risk is that if the company does not execute on its plan, the venture lender may seek to have the loan repaid before the end of the term of the loan—precisely when the company does not have the cash to repay the loan. 

    A:

    Banks generally don’t loan money to an unfunded startup without a credit history and without assets to offer as collateral. Similarly, bank loans for more mature private companies often contain financial covenants that restrict access to capital when the financial condition of the company deteriorates, which is exactly when the funds could be most helpful.

    So when are bank loans useful? Bank loans can be very useful for managing cash flows for companies that have assets (e.g., accounts receivable or intellectual property) to offer as collateral. In certain circumstances (usually where a lender has a relationship with a company’s existing investors and has confidence that future funding will be forthcoming), bank loans may be available to extend a company’s cash runway prior to raising additional equity financing. 

    Moreover, we recommend establishing a relationship with a bank that understands and values technology and life sciences companies before you need a bank loan. Your company needs a checking account, and these specialized banks will value your relationship much more than the bank down the street. Over time, your bank can learn more about your business and help you understand when and why a bank loan may be most useful.

    A:

    Corporations, limited liability companies and partnerships can have foreign investors as stockholders, members or partners. Before raising money from foreign investors, however, be aware of the following issues:

    • Potential tax issue. If the company is a Subchapter "S" corporation (read about what type of entity to create), it cannot have shareholders that are non-resident aliens. Therefore, raising money from a foreign investor that lives (or later moves) outside the US will result in the company losing isstatus as a Subchapter "S" corporation (the result will be that the company will be taxed as a Subchapter "C" corporation from that point forward).
    • US and Foreign Securities Laws. Any time a company sells securities in a financing, it must comply with applicable securities laws. In the US, most private companies try to limit their investors to those that qualify as “accredited investors” (read more about accredited investors). When raising money from foreign investors, the company can take advantage of a US federal securities law exemption called Regulation S that does require the foreign investors to be “accredited investors.” There are other requirements of Regulation S, some of which are somewhat complicated. However, it may present a viable option for your company when raising money from foreign investors even if they are not accredited. On the other hand, the sale must also comply with the securities laws of the foreign country in which the securities are being sold. Depending on the countries involved, this may involve disclosure and/or filing requirements, which can be expensive or time-consuming.
    • Prohibited Investors. If your company is seeking to raise capital outside the US, it needs to do extra diligence on any prospective foreign investors because US laws prohibit transactions with these countries or people sanctioned by the US government. Seek introductions to foreign investors through trusted advisors or regulated organizations with an extensive network of contacts, such as investment banks. The company still needs to conduct its own diligence, but using referral sources that can be trusted can help reduce the risk of running afoul of these laws.
    A:

    In the context of financing, crowdsourcing is the process of getting funding, usually online, for a project from a large number (or crowd) of people who typically each contribute small dollar amounts. With crowdsourcing platforms (such as Kickstarter), the entrepreneur will set a target for the dollar amount to be raised, the deadline by which it must be raised and any reward to the persons contributing to the project. Typically, the dollar amount to be raised must reach the targeted amount on or prior to the deadline or all funds raised must be returned to the people who contributed to the project. Crowdsourcing does not involve the issuance of shares of stock, convertible notes or other securities to those persons who contribute. Instead, they typically receive a copy of the product that their contribution helped fund or some other token of appreciation rather than a stake in the company.

    Crowdfunding, such as proposed under the JOBS Act, is different than crowdsourcing. In crowdfunding, many investors are connected—usually through the Internet—and pool their money to purchase securities of a company. Some online networks, such as AngelList, only connect entrepreneurs and companies with accredited investors. In 2012, Congress passed the JOBS Act, which includes provisions that are intended to allow individuals that are not accredited investorsto invest in securities through crowdfunding. Crowdfunding under the JOBS Act is not yet the law in the United States, because the Securities and Exchange Commission has not finalized the crowdfunding rules. When those rules are completed, it is expected that a company would be able to raise up to $1 million in any 12-month period from investors even if they are not accredited investors. While crowdfunding under the JOBS Act may open up new opportunities for certain types of companies to raise capital, there will be a number of additional restrictions on the amount of investment from each individual investor, as well as a number of additional requirements—such as the need to provide financial statements and, in some cases, tax returns—that are likely to limit the feasibility of crowdfunding for high growth companies.

    A:
    This is a complex question. The answer really depends on the facts and circumstances. For example, the information below assumes that the company is privately held and does not otherwise wish to engage in a public offering like an IPO. So you need to get good legal advice to determine the best answer for you.

    Technically it is not always required that all of your investors be “accredited investors.” However, whether legally required or not, it is almost always the case that it makes good business sense for private companies to only raise money from “accredited investors.”

    The term “accredited investor” is defined by rules of the SEC. [Can we link them to a definition?] An individual can be an “accredited investor” if it meets certain income or net worth thresholds. Companies, partnerships and other entities can also qualify as “accredited investors” if they satisfy the SEC’s rules.

    While the SEC’s rules relating to fundraising are somewhat complicated, raising money only from “accredited investors” has a number of significant advantages that will save you time, money and a lot of potential headaches now and in the future. For example, raising money from unaccredited investors would generally require you to prepare a lengthy, technical and detailed disclosure document. Complying with those disclosure rules can be very expensive and time-consuming at a time when your business wants to raise money quickly and inexpensively. Further, allowing unaccredited investors to purchase securities from your company can create complex issues down the road when raising additional money or when your company is acquired. For these and many other reasons, you should typically avoid raising money from unaccredited investors.
    A:

    An angel investor or angel istypically an affluent individual who provides capital for a business startup, usually in exchange for convertible debt or preferred stock. Some angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital, as well as to provide advice to their portfolio companies.

    Angel investors are often retired or serial entrepreneurs or executives who may be interested in angel investing for reasons that go beyond pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less than full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts. Private companies meet angel investors in any number of ways, including referrals from trusted sources and other business contacts; at investor conferences and symposia; and at meetings organized by groups of angels where companies pitch directly to investors in face-to-face meetings.

    Angels typically invest their own funds, unlike venture capitalists who manage the pooled money of others in a professionally managed fund. Angel capital often fills the gap in startup financing between “friends and family” who provide seed funding—and formal venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to make or evaluate small investments under $1-2 million. Thus, angel investment is a common source of early financing for startups and early stage companies.

    A:

    Your startup has gotten some traction and you’ve attracted the attention of some of the big players in your space. So much so that they’ve approached you about potentially investing in the company. While you’re flattered, you will need to carefully consider the pros and cons of taking money from a strategic investor as their investment may come with more strings attached than you and your company may like.

    Taking money from a strategic investor may help open the door to a larger commercial relationship with the investor, which may be a great benefit for the company. An investment from a strategic investor may help legitimize the company in a way that makes it easier for the company to attract additional venture capital investment or achieve greater commercial success for its products. Teaming up with a strategic investor may mean access to labs, equipment or know-how that your company doesn’t currently possess. The relationship forged as part of the investment process may even help pave the way for a future acquisition by the strategic investor. The strategic investor may lend domain expertise to the company that the company may not otherwise have access to, and if the strategic investor insists on the right to appoint a director to the company’s board, that director may add a perspective to board meetings that the company’s board may be lacking.

    Strategic investors also may be willing to invest at a higher valuation than a venture capital investor because they are likely investing in the company to achieve their own benefits that go beyond just the monetary return that venture capitalists and other financial investors are focused on. In short, an investment from a strategic investor may carry with it a wide range of potential benefits to the company. There are, however, several potential downsides that should also be considered carefully.

    Are your short- and long-term interests aligned? The company’s motivations and the those of the strategic investor may not be same. Venture capital investors exist to put money to work, build a successful company and exit the investment with a return if they are successful. Their intentions are clear, but the motivations of a strategic investor typically go beyond simply earning a return on their investment. For example, while your company may be focused on hyper-growth and achieving profitability, a strategic investor may be narrowly focused on ensuring that it has access to your company’s technology and know-how without being concerned about the company’s long-term prospects. A strategic investor’s first and foremost concern will always be the core business of the strategic investor. If the interests of the strategic investor and the company diverge, as they inevitably will at some point during the life of the investment, your company will be better prepared to constructively address this inherent conflict of interest if it understands where the strategic investor’s loyalties lie from the outset.

    Will your ability to do business with others be negatively impacted? A strategic investor may actively dissuade the company from pursuing certain business opportunities that may be great for the company but may not be in the long-term interest of the strategic investor. The involvement of the strategic investor may in and of itself inhibit certain competitors of the strategic investor from doing business with your company or considering a potential acquisition of your company thereby limiting the company’s future strategic opportunities.

    What if there are internal or strategic changes within the strategic investor’s organization? The strategic investor is probably a much bigger company than yours. They probably have a lot of different strategic initiatives—yours is just one of those. You may wake up one day to find that the strategic investor is no longer motivated to make your partnership with them work, either because the person within that organization that championed your investment no longer works for the strategic investor or the corporate focus of the strategic investor has shifted to address a changing marketplace.

    Will the strategic investment create IP or other operational issues? If the strategic investment is combined with a broader commercial agreement between the two parties, be sure that you would be comfortable with that commercial arrangement independent of the investment. If the strategic investor will obtain rights to your intellectual property or your products, be sure the terms of that arrangement make sense for your business in both the short- and long-term independent of whether there is a related investment.

    How will the strategic investment impact your ability to get the best deal when the company is acquired? One of the strings often attached to a strategic investment is a right of first offer or right of first look with respect to any future sale of the company. Granting a strategic investor such a right will make it more difficult for you to develop competition in the process you run when selling the company, which could limit the price you are able to negotiate. Merely having a strategic investor involved in your company may dissuade some would-be buyers, such as competitors of the strategic investor, from doing business with you or seeking to acquire your company if they view doing so as somehow benefitting the strategic investor.

    Be careful not to limit your own optionality too soon. By taking money from a strategic investor means you have made a choice to build your company in a certain way—in a manner that is consistent with commercial goals of the deal you struck with the strategic investor. The direction of your business will change over time as your technology evolves, you gain customer insights and you adapt to the market. Be careful not to limit your flexibility to adapt to these changes too soon by agreeing to take your business in a certain direction with a strategic partner.

    Be careful not to limit your ability to raise additional rounds of funding. If a strategic investor is investing in your company’s early rounds of financing, you should take special care to be sure that the company has retained enough flexibility to complete future financing rounds without the strategic investor being able to block future investment rounds. If a strategic investor’s motivation is to acquire a relatively inexpensive insider’s view of your company’s technology and progress they may be able to achieve that objective without the company ever needing an additional round of financing, but the company may not be able to achieve its growth objectives without access to additional financing. Additionally, depending on the success of the strategic investor’s core business, the strategic investor may not have access to enough investment capital to participate in follow-on rounds. It is almost always better to have a strategic investor as part of an investment syndicate rather than your sole investor so as to ensure your investor’s motivations are better aligned with the company’s going forward. If you incorrectly structure an early investment round you can expect this mistake to have lasting adverse implications for the company.

    Accepting an investment from a strategic investor will undoubtedly have several long-term ramifications for the future of your company—some positive and, quite possibly, some negative. Carefully consider the pros and cons prior to proceeding with a strategic investor.

    A:

    You’ve got a great idea and you’ve put together a great team. All you need now is the seed capital to launch your venture. Do you ask your friends and family to become your first investors? It’s a question with no easy answer and any decision you make will come with a host of both personal and legal ramifications.

    Assuming you value your relationships with your friends and family, before you take a dime from them, you should be sure that everyone understands the risk they will be taking. If it all goes well you could make your early investors wealthy, and everyone will be happy. But the truth is, most startup ventures are far more likely to fail than they are to succeed. Are your friends and family investing money they can afford to lose? If not, you shouldn’t even ask . How would you feel about losing a sizable chunk of your grandmother’s retirement savings? Probably not very good. You should have a frank discussion with your friends and family about the risks of investing in your business and be sure they understand that they may lose all of their investment.

    Even if things go reasonably well after raising money from friends and family, you will probably eventually need to raise additional capital. At that time, your early investors will be faced with a tough choice: invest more capital, which they may not have the means or desire to do, or face dilution at the hands of your new investors. This dilemma can be particularly acute if your new investors are professional investors, like venture capitalists. Professional investors are in business to make money, and their assessments regarding how much risk to take, whether and when to sell the company to find liquidity and other matters are very likely to be different than those of your early investors. If you expect that your business will require more than one round of funding make sure you and your seed investors understand that this is the case and how it may impact them.

    If everyone is comfortable with these risks, the next challenge is to make sure that the terms of the investment are clearly memorialized. All too often entrepreneurs accept checks from seed investors without having the terms of the investment properly documented. “Hey, we’re all friends here, we can figure it out later.” This approach is almost always a recipe for disaster as future confusion about the exact terms of the investment can sour a relationship between a founder and his investors and can threaten the company’s future financing plans. If the investment is a loan, what are the repayment terms, what is the interest rate, is it a convertible loan? If the investment is in equity, is the company issuing common stock or preferred stock? What, if any, rights come with the stock being offered? What does the company’s pre- and post-money capitalization look like? These are all important questions that should be addressed before an early investor’s check is ever cashed.

    Accepting an investment from friends and family members has the potential to not only sour your personal relationships, but it can cause legal headaches as well. Taking an investment from someone who is not an “accredited investor” can create legal and business headaches for the company both at the time of the unaccredited investor’s investment and in the future. Any decision to allow unaccredited investors to invest in the company should be carefully considered with legal counsel in advance.Learn more about accredited investors.

    If your friends and family really want to get involved in your venture, but you are concerned with taking an investment from them, consider whether there are other ways you might get them involved in your business that don’t require them to write a check. Can they serve as an advisor to the company or as an early member of your board of directors? Perhaps they can help with a particular skill or introductions to others in the company’s field that might be useful to your venture.

    While it may be easier to ask your friends and family members to invest in your startup than it is to go out and convince strangers that you have created a compelling investment opportunity, taking money from those closest to you can often involve a number of potential complications that should be carefully considered before moving forward.

    A:

    Fundamentally, when investing in early-stage companies, investors are looking for a solid management team, a good return on their investment and the opportunity to realize that return within a reasonable period of time. A solid management team is essential. In early-stage investments, VCs invest in people as much (if not more) than they invest in ideas or markets. It is critical that you be able to demonstrate that you have assembled a management team comprised of people with relevant experience and expertise who, above all, have the drive and determination needed to weather the many ups and downs of building a successful venture.

    Next, be prepared to demonstrate the potential for a big return on investment in a relatively short period of time. Having a unique product in a substantial or rapidly growing market is key. It should come as no surprise that being the 5th or 6th or 7th product in an already saturated market is unlikely to lead to the “home run” investment the VCs are seeking. Ticked off those boxes? That's great, but big markets and rapid growth aren't enough.

    VCs are not in the business of doling out money for indefinite periods of time, because they need to return their investment dollars and profits to their own investors. And so, they want to know going into an investment that they will have a good opportunity to get their money back and more (hopefully much, much more) in a fairly short period of time (think 3–5 years). Is your company a good acquisition target or does it make more sense to take it public? As hard as it is to think about the “end game” at the beginning, you have to have an exit strategy that you can clearly communicate to your investors.

    A:

    Venture debt is a form of debt financing typically provided by certain lenders to venture-backed companies that lack the assets or cash flow for traditional bank debt financing. Venture debt is generally structured as a term loan that is paid down over time—usually 3 years. Venture debt is typically senior to other company debt and is collateralized by all of a company’s assets. Unlike traditional bank debt, venture debt typically does not include financial covenants (such as a requirement to maintain a minimum amount of cash in the company’s bank account), though the interest rates on venture debt are typically higher than traditional bank loans (generally, ranging from 10% to 15%). In addition, a venture lender typically receives a warrant to purchase stock of the company. A warrant is like a stock option—it provides the holder with the right to purchase shares of stock (common or preferred) of a company at a fixed price for a period of time. A warrant issued to venture lender is typically exercisable for preferred stock with an exercise period of 5 or 10 years.

    A key consideration for a venture lender as it analyzes a potential loan to an early stage company is whether the company has closed at least one round of equity financing with venture capital firms and/or other institutional investors. In fact, a venture lender’s decision to extend a loan to an early stage company is more based on the reputation and stature of the venture capital firms and/or other institutional investors in the company than the creditworthiness of the company. The venture lender is relying on these institutional investors to continue to fund the company past the maturity date of the loan. Thus, a venture lender will spend a fair amount of time meeting with the institutional shareholders of the company as part of the venture lender’s approval process for the loan, and they will typically prefer to loan money to companies backed by venture capital firms with whom the lender already has had prior business relationships.

    The principal benefit of venture debt is that it is largely non-dilutive to the existing shareholders of a company (other than the dilution resulting from the exercise of the warrant). That is, the venture debt provides capital to the company while not significantly reducing the percentage of ownership of existing shareholders. The downside is that venture debt must be repaid, so the company will need to have the cash or cash flow to pay off the loan. The risk is that if the company does not execute on its plan, the venture lender may seek to have the loan repaid before the end of the term of the loan—precisely when the company does not have the cash to repay the loan.

    A:

    Banks generally don’t loan money to an unfunded startup without a credit history and without assets to offer as collateral. Similarly, bank loans for more mature private companies often contain financial covenants that restrict access to capital when the financial condition of the company deteriorates, which is exactly when the funds could be most helpful.

    So when are bank loans useful? Bank loans can be very useful for managing cash flows for companies that have assets (e.g., accounts receivable or intellectual property) to offer as collateral. In certain circumstances (usually where a lender has a relationship with a company’s existing investors and has confidence that future funding will be forthcoming), bank loans may be available to extend a company’s cash runway prior to raising additional equity financing.

    Moreover, we recommend establishing a relationship with a bank that understands and values technology and life sciences companies before you need a bank loan. Your company needs a checking account, and these specialized banks will value your relationship much more than the bank down the street. Over time, your bank can learn more about your business and help you understand when and why a bank loan may be most useful.

    A:

    Seed-stage investments are often structured as convertible loans. Investors loan money to the company. In exchange, the investors receive convertible promissory notes. When the company later sells preferred stock in its next financing, the loan will automatically convert into shares of that same series of preferred stock. The notes would typically convert at a discount (generally between 10% to 20%), so the seed investors would receive their shares of preferred stock at a better price in recognition of the fact that they took an earlier and bigger risk on the company as compared to the new investors in the preferred stock financing.

    Using convertible debt for seed-stage investments has the following advantages over selling preferred stock:

    A. No Current Valuation. Selling preferred stock requires the company and investors to agree upon the current value of the company, which can be difficult for early-stage companies, especially if investors are not experienced or if founders feel that the company is not mature enough to be fairly valued by investors. With convertible debt, the company and investors generally do not need to agree upon the company’s current valuation. Instead, they defer the valuation decision until the time of the next preferred stock financing.Read about valuation caps on convertible notes.

    B. Efficiency/Cost. With fewer and less complicated documents, a convertible debt financing can be completed more quickly, and at a lower cost, than a preferred stock financing. This can be particularly important in a seed round where the amount raised may not be that significant.

    C. Status of Investors. Holders of promissory notes are creditors and as such, receive preferential treatment, as compared to equity holders, in the event of a bankruptcy or liquidation. Since early stage investing is very risky, this is an important consideration to some investors.

    D. Familiarity. Convertible debt is not likely to present obstacles to completing a future financing because institutional investors, which may participate in the future financing round, are familiar with its structure.

    E. No Impact On Common Stock. Selling common stock for fundraising purposes has the effect of fixing the current fair market value of the company’s common stock. As a result, the company will effectively no longer be able to issue equity incentives to potential employees (in the form of options to purchase shares of common stock) at a price below the common stock sold for fundraising purposes without creating negative tax and accounting issues. Issuing convertible debt does not create those same issues for the value of the common stock.

    If you are looking for a relatively quick and cost-effective method of raising capital and plan to raise more equity capital in the future, convertible debt may be a good option.

    A:

    The “liquidation preference” is the amount of proceeds from a sale or liquidation of the company that the preferred shareholders will receive before the common shareholders are entitled to receive anything.

    Standard 1x Non-Participating Liquidation Preference. Typically, preferred shareholders have a liquidation preference equal to the amount of their investment—a “1x” liquidation preference. After the preferred shareholders receive their liquidation preference, the remaining value of the company is paid to the common shareholders. The liquidation preference operates as downside protection to the preferred shareholders. If the value of the company increases sufficiently such that the preferred shareholders would receive more by converting their shares into common stock, then the liquidation preference will be ignored and the preferred shareholders and common shareholders will share in the proceeds together based on their relative ownership percentages of the company. In other words, the preferred shareholders get either their liquidation preference before the common shareholders get paid OR they split the full value of the company with the common shareholders, but not both.

    For example, assume the preferred shareholders invested $4 million and own 50% of the company.


    Scenario 1
    Sell the company for $5 million

    Scenario 2
    Sell the company for $10 million

    Preferred Stockholders Receive$4 million liquidation preference (i.e., their original purchase price)$5 million based on owning 50% of the company
    Common Stockholders ReceiveThe remaining proceeds of $1 million$5 million based on owning 50% of the company

    Multiple Liquidation Preference. While not typical, the preferred shareholders may instead have a “multiple” liquidation preference allowing them to receive a multiple (for example, 2x, 3x and so on) of their investment in advance of payments to the common shareholders. This provides more protection to the investors because they are capturing more of the initial value of the company upon a sale or liquidation, but obviously is detrimental to the common shareholders. Continuing with the assumptions above, the distribution where the preferred shareholders have a 2x liquidation preference would work as follows:

     

    Scenario 1
    Sell the company for $5 million

    Scenario 2
    Sell the company for $10 million

    Scenario 3
    Sell the company for $10 million

    Preferred Stockholders Receive$5 million$8 million (i.e., 2x their original investment)$10 million based on owning 50% of the company
    Common Stockholders Receive $0The remaining proceeds of $2 million$10 million based on owning 50% of the company

    Because of the multiple liquidation preference, common shareholders receive nothing in Scenario 1; and the preferred shareholders would only ignore the liquidation preference and be paid along with the common shareholders based on their relative ownership percentages once the company is sold for at least $16 million (i.e., where 2x the original investment exceeds 50% of the total amount of proceeds from the transaction).

    Participating Preferred. Another variation of the liquidation preference is referred to as “participation” or “participating preferred stock.” With participating preferred stock, the preferred shareholders receive their liquidation preference (whether 1x, 2x or otherwise) AND they then also share in any remaining proceeds with common shareholders. Again, using the same assumptions as above, participating preferred stock with a 1x liquidation preference would work as follows:


     

    Scenario 1
    Sell the company for $5 million

    Scenario 2
    Sell the company for $10 million

    Preferred Stockholders Receive$4 million liquidation preference (i.e., their original purchase price), PLUS 50% of the value after the liquidation preference is paid for a total payout of $4.5 million$4 million liquidation preference (i.e., their original purchase price), PLUS 50% of the value after the liquidation preference is paid for a total payout of $7 million
    Common Stockholders Receive50% of the value after the liquidation preference is paid for a total payout of $500,000
    50% of the value after the liquidation preference is paid for a total payout of $3 million

    Companies forced to accept participating preferred should try to negotiate a “cap” on participation, which limits investors to an agreed-upon multiple of their liquidation preference (including the amounts received on “participation”), after which common shareholders receive any remaining proceeds from the sale.

    A:

    Whether a company should agree to a valuation cap in a convertible note will depend on its particular circumstances. From the company’s perspective, it is better to exclude a valuation cap, because it offers the investor down-side protection but has no benefit to the company. However, it may not be possible to exclude the cap if the investors condition their investment on including a cap and the company needs the money to fund its operations. Before making a decision, a company should consider the pros and cons of agreeing to a valuation cap.

    There are downsides to a “cap” from the company’s perspective. First, it can result in an investor effectively paying a fraction of the full price for shares issued in the equity financing. In the example above, the convertible note holder received a share worth $1.00 but only paid $0.50, so the dilution resulting from the convertible debt was twice that resulting from the new money invested in the financing round. Second, not only does this result in more dilution, it also results in more liquidation preference. In the example above, the convertible note holder invested $100,000 and received 200,000 shares with a liquidation preference of $1.00 per share, because the liquidation preference per share is the non-discounted price per share paid by the new investors. So the $100,000 investment has a 2x liquidation preference of $200,000 (i.e., 200,000 shares x $1.00). Finally, one of the primary advantages of convertible debt financings as compared to preferred stock financings for an early stage company is that the company and investors can defer negotiating the company’s valuation. After all, the valuation of an early stage private company is very subjective. While the valuation cap discussion may not represent a true determination of the current value of the company, it means the parties are making some assessments of value—whether current or future.

    A:
    Term sheets for venture capital financings include detailed provisions describing the terms of the being issued to investors. Some terms are more important than others. The following brief description of certain material terms divides them into two categories: economic terms and control rights.

    A. Economic Terms:
    (1) Valuation/Purchase Price. Pre-money valuation is used to determine the purchase price and resulting percentage ownership of the investors in the company immediately following the closing of the financing. What shares are included in the purchase price calculation is also important. Investors typically include shares reserved for future issuance (but not yet issued) under an option pool in the calculations and so the option pool has the effect of diluting founders and other existing shareholders and not the new investors. This means the larger the option pool, the lower the purchase price (meaning more dilution to existing shareholders).

    B. Control Rights:

    (1) Board Composition. Investors typically request at least one seat on the board of the company. Each time the company raises a new round of capital, the lead investor of that round will seek representation on the board. Most venture-backed companies have a board comprised of founders or other management (e.g., the CEO), representatives of the investors and independent members. While board actions generally require the affirmative approval of a majority of the members of the board, the investors typically require that certain actions of the board include the approval of the directors representing the investors.
    (2) Protective Provisions. Investors typically seek additional control by requiring the company to obtain the separate approval of the preferred shareholder for material actions to be taken by the company. These special approval rights typically include decisions relating to: company sale, future financings, changes in the capital structure, transactions with affiliates, bank loans, etc.
    (3) Drag Along. Investors may require common shareholders to vote in favor of a company sale if it is approved by preferred shareholders (and often the board). This could have the impact of forcing a sale when it would not otherwise be approved by management/founders.
    A:

    Common stock is so named because it is just that—common. Common stock isn’t generally accompanied by any special rights, preferences or privileges; it lacks the bells and whistles that are usually attached to preferred stock that give it the “preferred” status. Shares of common stock typically give the holder the right to vote on matters presented to the shareholders of the company and the right to receive proceeds upon the dissolution or sale of the company after the holders of preferred stock are paid any “preferential” or senior amounts. Common stock is typically issued to the founders of the company and to other employees, consultants, advisors and directors who receive grants of common stock or options to purchase shares of common stock.

    Preferred stock is stock that has special economic and control rights that are generally senior to the rights of the common stock. Determining exactly what those rights will be is determined by negotiation between the company and the investors. The most common of these rights include liquidation preferences, dividend rights, anti-dilution rights and special voting rights. The preferred shareholders will often negotiate additional contractual rights, such as registration rights, information rights and rights to participation in future financings. Learn more aboutliquidation preferencesandpreferred stock terms.

    A:

    You generally have four different options for how to structure your seed financing: common stock, debt, convertible debt and preferred stock. For business, tax and other legal considerations, however, using convertible debt or preferred stock are typically the two best options for an early-stage company.

    Selling common stock to investors is typically problematic because it either results in too much dilution or creates tax problems when you want to incentivize employees and other contributors with the company's equity. Look at it this way: you generally want to raise money at the highest valuation possible so that you give up the smallest amount of the company possible. At the same time, you want to attract and retain the best talent by offering them equity (usually in the form of stock options) at the lowest price possible so that they choose to work with your company over a competing job offer, have a strong incentive to build value in the business, etc. For tax reasons, you can't sell common stock to investors at one (high) price and at the same time sell (or grant options for) common stock at a different (low) price. This would result in very negative tax consequences to your employees. So common stock is generally not used for fundraising purposes.

    Borrowing money in the form of straight debt (a loan that needs to be repaid at some point in the future) is also generally disfavored as a fundraising vehicle. First of all, investors in early-stage companies are taking a big risk. In exchange, they are hoping for a chance for a big return. They don't simply want you to pay their money back with a little interest. Second, future investors won't want to invest their money into the company if you are using that money to pay off earlier investors. Instead, they want you to use their money to build future value in the company.

    As a result, companies will generally raise money by selling to the investors convertible debt or preferred stock. Unlike straight debt, convertible debt is a loan that won't be paid off when the next round of funding comes in; instead, the earlier debt will be exchanged or converted into equity at the time of the closing of the next round.Learn about convertible debt.

    Because it is a loan that is not expected to be paid off, it doesn't have the same disadvantages in fundraising as straight debt does. Likewise, preferred stock is used, in part,because it can be valued/priced at a higher (less dilutive) price than common stock while still allowing the company to use common stock at a lower valuation to incentivize employees and other contributors.Learn more about preferred stock.

    So should you use convertible debt or preferred stock in your seed round? The answer will depend on many factors unique to you and your situation, including how much money you are raising, the type of investor investing in the company and your future fundraising plans. There are advantages and disadvantages to both structures depending on your perspective and your circumstances. There is no one size that fits all. However, in general, if you are raising a small amount of money (e.g., under $2 million) from individual investors, it is frequently the case that convertible debt will be the best structure. Conversely, selling preferred stock will often be the approach taken where you are raising more money from institutional (e.g., venture capital) investors.

    IP

    A:

    A. Why do I need Terms of Use for the company’s website?

    Terms of Use of a website is a written contract between the company and the users of the company’s website. It governs the relationship between the website and the user. When drafted and implemented properly, it helps protect the company from legal claims that might arise from the operation of the website. More complex and customized Terms of Use will apply when the company provides products or services through its website.

    B. What information should be contained in the company’s Terms of Use?

    A company’s online Terms of Use is often a key aspect of the company’s interaction with its users or customers and should be drafted accordingly. The contents of the Terms of Use can vary widely depending on the manner in which you and the public use the company’s website.

    If the company is merely providing information to the public through its website, but not providing products or services, then the Terms of Use can be relatively simple. In that case, the Terms of Use should simply describe the permitted users and uses of the website, the rights of the company and the user in various types of information exchanged through the website, certain prohibited activities, and other general terms. The Terms of Use should also address whether linking to the website is permitted and warn users that links to other sites may be provided but those other sites are not under the company’s control and are governed by separate Terms of Use of the separate site owner. Additionally, the Terms of Use may address whether framing or incorporation of the company’s website onto third-party sites is permitted.

    Additionally, where users are submitting content to the site, or the site contains content contributed by third parties (including site developers, site owner employees and/or independent contractors), the Terms of Use should include terms necessary to comply with available “safe harbors” under US federal law, particularly the Digital Millennium Copyright Act, which establishes specific processes (referred to as a “safe harbor”) which, if followed, enable website operators to reduce exposure to liability for copyright infringement arising from content provided by users of the website.

    If the website is a portal through which the company provides products and services, such as Software as a Service, then the Terms of Use should be a far more customized services agreement that addresses the issues raised by the applicable products and services, and the company’s business model, in detail. In that case, the Terms of Use may be the primary contract between the company and its customers.

    The manner in which you present the company’s Terms of Use to users is important for enforceability purposes. A simple link at the bottom of a webpage is common, but is less likely to be enforceable in some contexts and jurisdictions. Where the Terms of Use establish critical protections for the company, particularly where the company provides products or services or receives user contributions through the site, you should consider implementing the Terms of Use as a click-through agreement with a process that ensures clear user awareness of the Terms of Use and a clear acceptance of those Terms of Use by the user.

    C. Can I borrow the Terms of Use of other companies whose business is similar to mine?

    It is a mistake to assume that all Terms of Use are the same. Do not take a “one size fits all" approach to drafting your Terms of Use. Terms of Use have many provisions that are similar across the Internet. However, your Terms of Use should be drafted to encompass the particular business needs of your company. It is a mistake to simply “cut and paste” terms from another site, even if that site seems to be similar to your website. Ideally, you should draft the company’s Terms of Use in conjunction with an attorney with expertise in contract and Internet law.

    D. What is a Privacy Policy and why do I need a Privacy Policy?

    A Privacy Policy is a written document, typically made available through the company’s website, that tells the user how the company will collect and use their personal information. The Privacy Policy establishes the guidelines the company must follow when collecting and using information from users. When drafted properly, a Privacy Policy helps protect the company from claims that it has misused information or misled the user about the company’s collection or use of information.

    E. What information should my Privacy Policy include?

    Privacy Policies are fairly consistent across many websites, but they need to reflect the specifics of how your company will collect, use and disclose personal information. As a result, you need to carefully consider your current and future plans when drafting the company’s Privacy Policy. The Privacy Policy should address not only the company’s current practices in collection and use of personal information, but also permit the activities that the company intends to engage in over time, as it is far simpler to start off with a proper Privacy Policy than to amend it later. The core functions of a Privacy Policy are to:

    1. explain the types of personal information the company collects through the website or the company’s services, and how the company collects that information;
    2. make clear that information submitted by users, which is viewable by third parties in the normal operation of the website, will not be protected;
    3. explain how the company will use the information submitted by users;
    4. explain to whom the company may disclose that information and for what purpose; and
    5. provide contact information to any users with questions about the Privacy Policy.

    It is important to know, however, that privacy laws differ significantly from country to country. The European Union, for example, has adopted a very restrictive data protection directive that limits how sites may collect and use personal data and that requires user consent before a website can use cookies. So if your business or website operates in different countries, you will need to ensure that your Privacy Policy accounts for these different laws.

    As the company changes over time, its Privacy Policy may need to be adapted to reflect the company’s growth. The Privacy Policy should mention when and where changes to the Privacy Policy will be posted, and you should check with counsel on whether the changes to your Privacy Policy require more significant notification and/or consent steps.

    F. Can I borrow the Privacy Policy of other companies whose business is similar to mine?

    Don’t assume that all Privacy Policies are the same. While there are many Privacy Policies on the Internet that have somewhat similar terms, your Privacy Policy should be drafted to reflect your specific business needs. You may find samples that offer a good starting point, but you likely cannot simply “cut and paste” a full Privacy Policy from another site, even if that site seems to be similar to your website.Find Privacy Policy forms on our Document Generator.

    A:

    Even if you finish conceiving of or developing your idea after quitting your job, your employer could still own the rights to your idea. You should have an employment attorney review your current employment contract to determine any rights your employer may have in your idea. Considerations that are often relevant in determining whether your employer could own rights to your idea include: whether you conceived of your idea at work or on your own time; whether you used any of your employer’s resources, such as your employer’s laptop, lab or other property; whether your idea is within your scope of employment or similar to what your company is doing; and whether you used any information owned by the company, obtained through company resources, or obtained as a result of your employment in order to conceive of your idea.Read about who owns the IP.

    Read more on this topic:
    Launching a Startup? Make a Clean Legal Break from Your Employer First

    A:

    Be careful. Open source software is commonly used by software companies, often with great success, but also often with unforeseen adverse consequences. While many open source licenses enable you to utilize the open source software with few restrictions, other open source licenses can require that (A) you make available all of your proprietary code in source code form under that same open source license if you link or integrate that open source code improperly or (B) you agree not to sue certain parties under some or all of your patent rights, among other provisions. Key points to consider include:

    • What license terms apply? Do the license terms simply disclaim the responsibility of the licensor(s), or do the license terms impose restrictions on code which is used, integrated or distributed with the open source software? Read the FAQs accompanying the license, if available; often the FAQs are much clearer than the open source license agreement itself.
    • Consult with an expert. Make sure that you discuss the consequences of the open source software with your legal counsel or other appropriate expert. Some open source licenses are extremely ambiguous. Many companies have gotten into trouble by reviewing the legal terms themselves, without expert consultation.
    • Do the benefits outweigh the costs? Open source software can have significant benefits, often with low costs, ready access to source code and a broad developer community. However, depending on the open source license and how you use the code, the downsides of using open source software can be severe. Weigh these costs and benefits carefully each time you decide to use open source software.
    • Are there less problematic alternatives? Consider whether other sources of the relevant software functionality, or home-grown development, would be preferable in light of the restrictions of the open source license.
    • Potential customers and buyers and investors will want assurances that your use of open source software does not cause problems. Potential investors and future acquirers of your company, and some customers, will ask for detail on all open source software in your products and for assurances that open source is not problematic. Before using any open source software, make sure that you can answer those anticipated questions unambiguously and satisfactorily. Keep records of all open source software you use so that you are prepared to quickly answer those questions when they arise.
    • Establish a clear review process. Each company should have a process in place to ensure that the costs and benefits of using open source software are evaluated by the proper personnel before open source software is utilized.
    A:

    Absent any agreements to the contrary, consultants typically have the rights to any intellectual property that they develop. At the very least, a company should ensure that all of their employees sign assignment of inventions agreements at the beginning of employment and that all consultants sign consulting agreements when they are first retained. These agreements should make clear what work performed within the scope of employment and/or derived from the company’s proprietary information belongs to the company. Similar provisions can also be included in non-disclosure agreements or confidentiality agreements that are provided in addition to an employment or consulting agreement. These provisions should address all inventions, invention disclosure forms, copyrightable materials, etc., not just materials that are covered in patent applications. [Cross-reference to forms]

    In addition, the company should obtain assignment forms from all inventors (employees and consultants) when filing any sort of patent application (provisional, utility or foreign). Specifically, the company should ensure that all named inventors on the patent application sign assignment forms that assign their rights in the patent application to the company. These assignment forms should then be recorded with the United States Patent and Trademark Office at the time the patent application is filed.

    A:

    While your domain name and your trademark may be the same word or phrase, they are different things. A domain name is a human readable Internet address, e.g., www.wilmerhale.com. It is the name that users/customers type into their Internet browser to access your website. The right to use a domain name is regulated by domain name registrars. You can obtain a domain name by purchasing it from the registrar for your particular domain name.

    A domain name can be registrable as a trademark if it functions to identify the source of particular goods or services. Examples include the use of the domain name on the actual pages of a website offering services, offline use of the domain name as something more than just a URL address, such as use of the domain name on marketing or promotional materials for services, and use of the domain name on packaging for a product.

    It is also important to secure the domain names corresponding to your trademarks. Similar domain names can pose practical problems for people looking for you or your facilities on the Internet and they also can dilute or weaken the distinctiveness and enforceability of your trademark. For these reasons, you may want to acquire the .com, .net, .org, etc. domain names corresponding to your important trademarks, including any variations in spelling, spacing, hyphenation, and abbreviation, as well as gripe names, common typographical errors, etc.

    A:

    A non-disclosure agreement (NDA) is an agreement between two or more parties to not disclose to third parties the confidential information exchanged between the parties. These types of agreements protect non-public business information. The agreement can be one-way, where only one party is disclosing confidential information to the other or two-way/mutual, where both parties are disclosing confidential information to each other. NDAs also can be referred to as confidentiality agreements, confidential disclosure agreements, proprietary information agreements or secrecy agreements.

    You should use NDAs when you plan to disclose confidential, non-public information to third parties outside of your business, for example, customers, clients, investors (to the extent they are willing to execute an NDA), consultants, contractors and anyone else you plan on sharing confidential information. The NDA should be a formal, written agreement that clearly describes the confidential information, defines the permitted uses of the confidential information and also specifies the length of time the parties agree not to disclose the other’s confidential information.

    NDAs generally contain a list of standard exceptions; be on the lookout for exceptions to the NDA that are out of the ordinary or that create ambiguities or broad exceptions to the confidentiality obligations. Also be sure that the term of the NDA is long enough to protect the anticipated duration during which it will be important that your confidential information is not in the public domain. Finally, the NDA should be limited to what it is—an agreement about confidentiality; if the NDA includes provisions purporting to cross-license confidential information of one or more parties, ownership of jointly developed intellectual property or similar matters, it has no place in an NDA. If those provisions make business sense, they should be carefully reviewed and negotiated as part of a separate agreement specific to that purpose.Access NDA forms in our Document Generator.

    A:

    To successfully launch a new startup, the company needs to own, or have a license to use, the intellectual property that will be used in the business. This aggregation of IP does not happen automatically and requires careful planning with your legal counsel.

    Upon the formation of the company, each founder should assign all of his or her rights to the idea and other IP related to the proposed business to the company. However, the founders may not own all of the IP, even if the founders invented it. For example, inventions created while a founder was a student or employee may be owned by the founder’s school or former employer. If any founder is employed by another company or part of another institution while he or she is collaborating on or developing the idea for the business, you should carefully review the terms of any applicable agreements or policies to determine who has ownership rights over any resulting IP. In general, however, the more that a founder has (1) used resources from another institution in developing the idea or (2) developed an idea that relates to other work performed for another institution, the more likely that the institution owns the IP. In that case, it may be necessary to acquire the rights to the IP or obtain a clarifying waiver or consent from the other institution in order for the startup to commercialize the IP.

    Some startups will commercialize technology that was originally developed at a university, hospital or other institution. In those cases, the company will typically need to obtain a license to the IP. In exchange for these licenses, the startup may need to grant the university or other institution equity, make up-front or milestone payments and/or pay royalties. Read about licensing IP from a university or hospital.

    Copyright protects original works of authorship, including source code. Rights automatically vest upon creation, but the copyright belongs to the original author. So there needs to be an agreement transferring the copyright to the person who commissioned the code where the code writer is not an employee. For example, if your company hires a person to write some code the company can enter into a consulting agreement pursuant to which the code writer transfers copyrights (and any other intellectual property created as a result of the agreement) to the company.

    You should also consider pursuing patent protection. A patent protects inventions or discoveries, including computer programs. In the United States, the inventor of the patent application is the person who conceived of the invention. To the extent the code writer is an inventor (which depends on how much detail was provided to the coder), the person or company that hired the code writer will want to obtain an assignment of the invention and the agreement of the code writer to cooperate with filing a patent application. This is best done when first commissioning the code writer. Learn aboutfiling patentsandregistering copyrights.

    A:
    Generally, you should file for a patent application before you publicly disclose your invention to others. However, if you have made a public disclosure, you have one year from the date of the public disclosure to file your patent application in the United States. While you have a year in the United States, each foreign country has varying rules on whether and when you can seek patent protection on something that was publicly disclosed before the filing date of the application. Determining which countries allow such filings can be an expensive endeavor, involving attorneys in each foreign country in which you are seeking protection. Accordingly, it is best to file the patent application before the public disclosure.
    A:

    The US patent system will issue patents for an invention that is a process, a machine, a manufacture or a composition of matter so long as the invention is new, useful and non-obvious. Also, while abstract ideas cannot be patented, a particular application of an abstract idea is patent eligible.

    The test for whether your invention is new and non-obvious involves comparing it to all of the knowledge that was available before you filed your application (called “prior art”). The core question for what is new is relatively simpleis your invention different from what has come before? In other words, if the combination of elements in your claim does not appear as a combination in the prior art, your invention is new. Meanwhile, the core question for what is non-obvious is this: if your invention is different from what came before, is it different enough? In order to be non-obvious, a person having ordinary skill in the field of your invention must look at your invention as a whole, including all of the differences, and conclude that he or she would not have come up with your invention based on the prior art available. For example, a trivial combination of items found in the prior art is not patentable.

    You can come a long way in answering whether your invention is new and “different enough” by looking at prior art via searching the USPTO patents and publications database (http://patft.uspto.gov) and via Internet search engines. You may indeed find parts of your invention in the prior art, but looking through the eyes of the other authors and inventors may help you arrive at convincing reasons for why a person of ordinary skill would not have brought all of the parts together.

    A:

    As a technology startup, your core technology may be the company’s largest asset and the cornerstone of the business. Owning patents or applying for patents demonstrates the company has cutting-edge technologies and is investing in developing and protecting its IP. A strong patent portfolio can boost a company’s value and help attract investors. Patents can also establish your own technology territory and prevent or deter others from entering the same business to compete with you.

    You can file a patent for a new or improved technology, which is novel (new), and not obvious. Except for a few excluded areas, you can apply for a patent for almost any technology area. A patent gives you the exclusive right to make, sell or use a product covered by your patent, or to use a method covered by your patent. A patent generally lasts for 20 years from when you first file the non-provisional application.

    In exchange for these exclusive rights, you are required to disclose to the public what your invention is and how the invention works. So, if you intend to keep your invention from public eyes, you should consider keeping it as a trade secret (which would not be publicly available) instead of filing a patent. Keep in mind though that if someone else obtains the same technology either through independent research or by reverse engineering, your trade secret is lost and you will have no recourse. Also, trade secret protection requires affirmative steps to keep your technology secret. For example, employees, visitors and joint venturers should be required to sign confidentiality and/or nondisclosure agreements; documents containing trade secrets should be marked as proprietary and confidential; and access to trade secret information should be limited to only those employees who need to know the information. In contrast, a patent gives you protection even if someone else independently comes up with the same invention later or was not aware of your patent.

    A:

    In order to be granted a patent, you must file a “utility” patent application. That filing must contain enough detail to show the people in your field what your invention is and how it works. If you don’t have all of those details ready for filing or you are on a budget, you can file a “provisional patent” application instead, which doesn’t need to have all of the details required in a utility application. Filing a provisional patent application allows you to establish a filing date for less money, and often more quickly, than a utility application. However, a provisional application will not be examined by the Patent Office, and, thus, cannot mature into a granted patent. If you filed a provisional patent application and want to obtain a granted patent application, you must file a related “utility” patent application within one year of the filing date of the provisional application. Further, if you wish to obtain patent protection in foreign countries, you must also file those applications within one year of your provisional filing date.

    Provisional applications help you make the most of a limited budget early in the life of your company. The money saved can be invested in exploring the invention’s commercial potential, continuing R&D, and/or finding investors. Meanwhile, you can use the phrase “Patent Pending” in connection with the invention to put the world on notice and deter copycats. Also, if your invention is one that is likely to be more profitable near the end of the patent’s life as opposed to early in its life (as is sometimes the case for medical devices and pharmaceuticals), a provisional application gives you the advantage of the early filing date without counting against the 20-year life of the patent.

    Although a provisional application avoids many of the filing formalities required of a utility application, don’t cut corners on the material you put into the provisional application. The provisional application must enable others to make and use the invention, and you must disclose enough detail to show others what you invented. You will only get an early filing date for claims that are supported by the disclosure in the provisional application, so it is important to be as complete as possible and to consider what will ultimately be claimed in the utility application when drafting the provisional application. Your patent attorney should work closely with you to help put high quality material into a provisional application so you get the most value out of your early filing date.

    A:

    A freedom to operate analysisor landscape analysisis a study of the patent environment in a particular technology area. If doing a landscape analysis, it’s important to first create a strategy based upon the needs and circumstances of the business and then conduct a search to find relevant patents and pending applications. In other words, tailor your search; it isn’t practicalespecially for an early stage company on a budgetto just search the patents covering an entire field or industry. From those search results, you can analyze what patents have issued, what is protected, what applications are published, what protection is sought, who owns the patents and/or applications, and when the applications were filed and patents granted.

    Companies use landscape analyses for a variety of purposes. For example, you can identify the major players in your field. A landscape analysis can also identify patents owned by others that might be an issue for your business. The analysis can also uncover important patent trends. For example, simply knowing the number of issued patents and/or pending applications addressing a particular problem may help you decide how to dedicate resources to that problem. If the field is too crowded, you may elect to invest those resources on other areas.

    Finally, the patents and applications discovered during the search may qualify as prior art against your own patent applications. Knowing whether there is a lot of prior art can save you time and money that may otherwise be wasted by pursuing a patent that ultimately won’t be granted.

    A:
    Provisional patent applications do not publish; only non-provisional patent applications publish 18 months from your earliest filing date (provisional or non-provisional). However, when the non-provisional application publishes, the provisional application becomes publicly available on the United States Patent Office website.
    A:

    The United States recently switched from the so-called “first to invent” system to the so-called “first to file” system. Under the old law, an inventor had an opportunity to argue he or she actually invented first even if he or she applied for a patent later than his or her competitor. If successful, the first inventor was entitled to pursue the patent and the second inventor was not, even though the second inventor filed for protection first. The new law eliminates this scenario. For patents filed after March 15, 2013, whoever filed for the invention first has priority over later filers, regardless of who actually came up with the invention first. Therefore, it’s important to file early.

    You need more than just an abstract idea to file a patent. Your patent application needs to contain enough details to show the people in your field what the invention is and how it works. Often, if you have a substantially developed idea and can articulate a concrete implementation, you are patent ready. If you already have a working prototype, you are more than patent ready.

    A:

    While your domain name and your trademark may be the same word or phrase, they are different things. A domain name is human readable Internet address (e.g., www.wilmerhale.com). It is the name that users/customers type into their Internet browser to access your website. The right to use a domain name is regulated by domain name registrars. You can obtain a domain name by purchasing it from the registrar for your particular domain name.

    A domain name can be registrable as a trademark if it functions to identify the source of particular goods or services. Examples include the use of the domain name on the actual pages of a website offering services, off-line use of the domain name as something more than just a URL address, such as use of the domain name on marketing or promotional materials for services, and use of the domain name on packaging for a product. 

    It is also important to secure the domain names corresponding to your trademarks. Similar domain names can pose practical problems for people looking for you or your facilities on the Internet and they also can dilute or weaken the distinctiveness and enforceability of your trademark. For these reasons, you may want to acquire the .com, .net, .org, etc. domain names corresponding to your important trademarks, including any variations in spelling, spacing, hyphenation, and abbreviation, as well as gripe names, common typographical errors, etc.

    A:

    Trademarks can protect words, phrases, pictures, symbols or sounds that distinguish your goods and services from competitors. Trademarks can be very valuable and are relatively easy to obtain, so long as the mark is not confusingly similar in use to someone else’s mark. Trademarks are useful to protect your business name, product names and any slogans associated with your business. 

    You can establish common law trademark rights simply by using the trademark in commerce. These common law rights include the right to prevent others from using the same or a confusingly similar mark in the same market area. Federal and state laws provide a registration process that allows trademark owners to document their exclusive ownership of, and right to use, a trademark. Federal registration is particularly valuable because it provides for nationwide protection, a federal forum for enforcement and penalties against infringement not available with common law protection or a state registration.

    A:

    As a technology startup, your core technology may be the company’s largest asset and the cornerstone of the business. Owning patents or applying for patents demonstrates the company has cutting-edge technologies and is investing in developing and protecting its IP. A strong patent portfolio can boost a company’s value and help attract investors. Patents can also establish your own technology territory and prevent or deter others from entering the same business to compete with you. 

    You can file a patent for a new or improved technology, which is novel (new), and not obvious. Except for a few excluded areas, you can apply for a patent for almost any technology area. A patent gives you the exclusive right to make, sell or use a product covered by your patent, or to use a method covered by your patent. A patent generally lasts for 20 years from when you first file the non-provisional application.

    In exchange for these exclusive rights, you are required to disclose to the public what your invention is and how the invention works. So, if you intend to keep your invention from public eyes, you should consider keeping it as a trade secret (which would not be publicly available) instead of filing a patent. Keep in mind though that if someone else obtains the same technology either through independent research or by reverse engineering, your trade secret is lost and you will have no recourse. Also, trade secret protection requires affirmative steps to keep your technology secret. For example, employees, visitors and joint venturers should be required to sign confidentiality and/or nondisclosure agreements; documents containing trade secrets should be marked as proprietary and confidential; and access to trade secret information should be limited to only those employees who need to know the information. In contrast, a patent gives you protection even if someone else independently comes up with the same invention later or was not aware of your patent.

    A:

    A non-disclosure agreement (NDA) is an agreement between two or more parties to not disclose to third parties the confidential information exchanged between the parties. These types of agreements protect non-public business information. The agreement can be one-way, where only one party is disclosing confidential information to the other or two-way/mutual, where both parties are disclosing confidential information to each other. NDAs also can be referred to as confidentiality agreements, confidential disclosure agreements, proprietary information agreements or secrecy agreements. 

    You should use NDAs when you plan to disclose confidential, non-public information to third parties outside of your business, for example, customers, clients, investors (to the extent they are willing to execute an NDA), consultants, contractors and anyone else you plan on sharing confidential information. The NDA should be a formal, written agreement that clearly describes the confidential information, defines the permitted uses of the confidential information and also specifies the length of time the parties agree not to disclose the other’s confidential information. 

    NDAs generally contain a list of standard exceptions; be on the lookout for exceptions to the NDA that are out of the ordinary or that create ambiguities or broad exceptions to the confidentiality obligations. Also be sure that the term of the NDA is long enough to protect the anticipated duration during which it will be important that your confidential information is not in the public domain. Finally, the NDA should be limited to what it is—an agreement about confidentiality; if the NDA includes provisions purporting to cross-license confidential information of one or more parties, ownership of jointly developed intellectual property or similar matters, it has no place in an NDA. If those provisions make business sense, they should be carefully reviewed and negotiated as part of a separate agreement specific to that purpose. Access NDA forms in our Document Generator. 

    A:

    It may seem logical and fair that the founders contributing IP they invented to launch a new startup should retain a license to that IP should the company fail or should the founders identify other uses for the IP outside those contemplated by the company. After all, the founders developed the idea and invented the IP prior to forming the company.

    However, venture capitalists and other institutional investors will almost always object to the founders retaining rights to the IP. From a business perspective, the investors want to ensure the company has every chance to succeed and that any IP will be available in the future under circumstances that may be difficult to predict. From a signaling perspective, the investors want to see that the founders are entirely committed to the startup they are funding and aren’t hedging their bets or using the IP for other purposes.

    A:

    In many cases, you do not need to formally register your copyrights, because rights automatically vest upon creation of the work. Regardless of whether you register your copyrights, however, you should provide a copyright notice. A copyright notice informs the public of the company’s claim to copyright ownership in the work, and can be used as a deterrent against infringement. Therefore, the company should make it a practice to include copyright notices on manuals, brochures and other documents (including source code) that are generally published or provided to third parties. A copyright notice includes the word “Copyright” or the C-in-a-circle symbol ©, the year of first publication of the work, and the name of the copyright owner.

    Formal registration with the Copyright Office, while not required, does provide some advantages. If a third party infringes a registered copyright, registration provides access to statutory damages of $750-$30,000 per occurrence without proving actual damages, which can increase to $150,000 per occurrence for willful infringement. Further, if registration occurs within five years of publication, it is considered prima facie evidence of proof of ownership and validity of the copyright.

    The filing fee to register a copyright is only $35 if done online, or $65 if filed by paper. Since the cost is relatively modest, it is often beneficial to register a copyright. But most companies do not file registrations for all works. Often, companies only file for formal registration if it is a publicly facing document or for computer code that is released to the public, and only for the original version and for major revisions of the document.

    A:

    A copyright protects original works of authorship, including literary, dramatic, musical and artistic works. These works often include presentations, company operating/instructional manuals, whitepapers, computer software, screen displays and graphical user interfaces. Copyright does not protect facts, ideas, systems or methods of operation, although it may protect the way these things are expressed. For example, while the actual facts in a company manual are not protected, the way the facts are expressed in the manual is protected.

    Copyrights give the creator exclusive rights to the work. At a basic level, a copyright holder has the right to control reproduction of the work and the right to display the work publicly. Additionally, the copyright holder has the right to determine who may adapt the work to other forms, as well as to determine who may perform the work.

    A:

    To successfully launch a new startup, the company needs to own, or have a license to use, the intellectual property that will be used in the business. This aggregation of IP does not happen automatically and requires careful planning with your legal counsel.

    Upon the formation of the company, each founder should assign all of his or her rights to the idea and other IP related to the proposed business to the company. However, the founders may not own all of the IP, even if the founders invented it. For example, inventions created while a founder was a student or employee may be owned by the founder’s school or former employer. If any founder is employed by another company or part of another institution while he or she is collaborating on or developing the idea for the business, you should carefully review the terms of any applicable agreements or policies to determine who has ownership rights over any resulting IP. In general, however, the more that a founder has (1) used resources from another institution in developing the idea or (2) developed an idea that relates to other work performed for another institution, the more likely that the institution owns the IP. In that case, it may be necessary to acquire the rights to the IP or obtain a clarifying waiver or consent from the other institution in order for the startup to commercialize the IP.

    Some startups will commercialize technology that was originally developed at a university, hospital or other institution. In those cases, the company will typically need to obtain a license to the IP. In exchange for these licenses, the startup may need to grant the university or other institution equity, make up-front or milestone payments and/or pay royalties.Learn more about licensing IP from a university or hospital.

    Copyright protects original works of authorship, including source code. Rights automatically vest upon creation, but the copyright belongs to the original author. So there needs to be an agreement transferring the copyright to the person who commissioned the code where the code writer is not an employee. For example, if your company hires a person to write some code the company can enter into a consulting agreement pursuant to which the code writer transfers copyrights (and any other intellectual property created as a result of the agreement) to the company.

    You should also consider pursuing patent protection. A patent protects inventions or discoveries, including computer programs. In the United States, the inventor of the patent application is the person who conceived of the invention. To the extent the code writer is an inventor (which depends on how much detail was provided to the coder), the person or company that hired the code writer will want to obtain an assignment of the invention and the agreement of the code writer to cooperate with filing a patent application. This is best done when first commissioning the code writer. Read more aboutfiling patentsandregistering copyrights.

    A:

    Many companies are built on intellectual property licensed from academic or research institutions, such as universities and hospitals. Companies may also license technology from those types of institutions to supplement their existing intellectual property. These licenses are typically patent licenses, but may also be licenses to software, materials or other intellectual property. Many institutions have their own licensing office dedicated to commercializing intellectual property of the institution. Some of the key points to consider when licensing intellectual property from these types of institutions include:

    A. Identify the relevant intellectual property—Often a licensee will know of research being conducted at the institution and have determined that the results of that research are of interest. You may also identify intellectual property owned by an institution from academic publications or presentations by the applicable researchers, records available at the US Patent and Trademark Office (or foreign equivalent) or in materials made available by the institution’s licensing office.

    B. Establish contact with the institution—Prospective licensees of institutions’ intellectual property may have initial contact with the researchers involved in inventing the relevant technology, and those researchers can often be useful to help navigate the institution’s requirements to establish a license. However, the institution’s licensing office typically is the key gatekeeper for negotiation and execution of the license agreement.

    C. Review the institution’s usual license terms—Before speaking with the institution, review available information regarding that institution’s intellectual property policies, which will tell you a lot about how the institution approaches requests to license its intellectual property. You may also be able to obtain a copy of the institution’s form license agreement online. Your legal counsel will often be experienced in negotiating licenses from the institution and should be able to provide relevant information on likely deal terms as well.

    D. Prepare your business plan—In order to negotiate a license agreement, you must be prepared with a business plan for your company and your proposed commercialization of the technology. The institution will want to maximize the use and value of their intellectual property, and, assuming the intellectual property is of interest to others as well, you must be prepared to make a compelling case that your company is the optimal licensee. You must also be prepared, in many cases, to discuss granting to the institution some equity in your company, which will require a realistic assessment of the value of your company and of the relevant technology.

    E. Academic and research institutions are not built to keep secrets—So, in all of your discussions with a university, hospital or similar institution, keep in mind that they are generally built on a principle and culture of knowledge sharing, and not on preservation of trade secrets. While the institution may be able to license materials or data, carefully consider whether those materials or data will in fact be accessible to the public generally. Consider to what extent inventors may be disclosing important details in their academic publications.

    F. Negotiate the license terms—Institutions are often faithful to their form license agreements, but there are numerous potential variations on those forms which your counsel should have experience negotiating with the institution. Read more about the terms you should have in a license agreement. Licenses with institutions include those same issues, but in many cases with many precedents indicating where there is flexibility in terms and where there is not.

    A:

    Granting important customers, distributors, resellers or other third parties exclusive rights to pricing, products, channels, etc. is not uncommon, but these arrangements must be entered into cautiously. By giving a third-party exclusive rights to something, you are agreeing not to give that same thing to anyone else. As a result, you are foregoing other potential opportunities and you should be convinced that the benefits of the exclusive arrangement outweigh those lost opportunity costs. 

    Assuming you are, the terms of the exclusive arrangement would be implemented via a clause in the applicable agreement. These provision often can have unanticipated consequences if not drafted clearly and with consideration of the impact on the businesses of both parties. If they are too broad or too narrow, they can have very negative effects or can make a positive business relationship disastrous. Some arrangements may not be permissible under applicable law or regulation, depending on the context. The following are some of the key considerations in establishing exclusivity arrangements in a reseller, OEM, distributor or license arrangement:

    • Subject products or technology. What products and/or technology are subject to the clause? Is the clause applicable to the party’s entire business or only a specific product or technology? Does it cover similar products and technology, or future developments?
    • Scope of Exclusivity. What fields of use, applications, geographic territories or activities are subject to the exclusivity obligation?
    • Term. How long will the exclusivity last? Can the exclusivity be easily terminated by one or both parties? 
    • Diligence Requirements. What must the benefitting party do in order to maintain their exclusivity rights? There are often periodic minimum royalties, sales, milestones or other targets that must be met in order for the rights to continue or to remain exclusive. Those targets must also be very carefully defined to avoid disputes, as the maintenance of exclusivity can often be of very significant economic value.
    • Antitrust. Exclusive arrangements should also be analyzed an antitrust expert before they are put in place. In certain jurisdictions, these provisions are subject to significant regulation because they can amount to a restraint on trade.
    A:

    License agreements come in many different shapes and sizes, depending on the nature of the licensed technology and the terms of the business arrangement underlying the license. The following are some of the key terms included in most licenses, though there are many more details negotiated in each license agreement and each such agreement is unique:

    • Licensed technology. What is the licensed technology? Is the licensed technology comprised of patents, copyrights, trade secrets, software, designs, materials, compounds or other? Define the scope of the licensed technology clearly. Consider whether to include rights in future-developed technology that arises for some time period after the date of the license agreement.
    • Exclusivity and field of use. Will the license be exclusive or non-exclusive? If so, in what geographic territory, and in what field of use? If you are licensing technology core to your business from a university, hospital or other institution your investors may require that the licenses be exclusive in all fields of use throughout the world, but the result depends on the context. Learn about licensing IP from a university or hospital. What level of royalties must be paid, or sales of covered products made, in order to retain exclusivity? If an arrangement is exclusive, it is critical to define that exclusivity as clearly as possible, particularly from the perspective of the licensor. Read more about exclusivity agreements.
    • Sublicensing. The license grant should make clear whether a license is sublicensable or non-sublicensable. The affiliates of a licensee may be permitted sublicenses, even if other third-parties are not. Even if sublicensing is permitted, there may be restrictions on the type of sublicense or customer. Depending on the anticipated business model, sublicensing is often required in order to effectively utilize a license. 
    • Fees, royalties and milestones. How much will be paid up front, in ongoing royalties and/or upon achievement of development or commercial milestones? Some licensees do not have readily available cash, so prefer royalties, while other licensees are prepared to pay more substantial amounts up front in order to reduce or avoid future payments such as royalties and milestone payments. The royalty rate is usually a significant topic of negotiation, with rates varying depending on many factors, particularly the value of the intellectual property and the additional work or third-party intellectual property required to develop a commercial product or service. The royalty rate is often higher where derived from sublicensing of the licensed technology. It is important to carefully define the net sales, gross revenues or other triggers of any ongoing royalties or milestone payments. An audit provision may be included, which allows the licensor to conduct audits of the licensee’s records to verify proper payment of royalties and milestone payments.
    • Equity. Some licensors will require equity in the licensee, depending on the context. Such equity grants are fairly common, for example, in license grants by universities and hospitals. 
    • Control of patent prosecution and enforcement. Who will prosecute and maintain licensed patents? Who will have the right to sue third-parties for infringement? Where there is an exclusive license, these rights often are held by the licensee, while non-exclusive licenses often retain these rights to the licensor.
    • Improvements to the licensed technology. If the licensee improves the licensed technology, will the licensor have any rights under those improvements?
    • Confidentiality. Many license arrangements require the licensee to keep the licensed technology, and/or the deal terms, confidential.
    • Warranties. What warranties does each party make to the other in connection with the agreement? While a warranty of proper authorization to sign the agreement is common, numerous other warranties of either party may be relevant as well.
    • Indemnification. Indemnification is commonly used to define the scope of each party’s responsibility for third-party claims that arise from the license agreement. The proper scope of that indemnification is highly context specific.
    • Limitations of Liability. Disclaimers and limits of liability are commonly included.
    • Support. Will the licensor provide ongoing support in connection with the licensee’s or its customers’ use of the licensed technology? Support services are common in software licensing, but can also be relevant in know-how and other licensing arrangements.
    • Escrow. In some license arrangements, most commonly software, a third-party escrow arrangement may be established. The suitability and nature of these arrangements is highly context specific, though there are fairly standardized third-party technology escrow services available.
    • Export Restrictions. Some technologies are subject to restrictions on export, which must be evaluated in advance of any license agreement. Further, the license agreement often will restrict further export of the relevant technology.
    • Assignment. Will the license be assignable without consent to any third-party, to buyers of the licensee, or not at all? The assignment clause is an extremely important provision because it defines whether a buyer of the licensee can continue to utilize the license. If the license is important to the licensee, restrictions on assignment of the license can have significant adverse effects on the licensee (for example, it may make the licensee less attractive by potential acquirers and investors).
    • Ancillary Agreements. License agreements are often accompanied by development agreements, reseller agreements or other commercial terms establishing greater detail regarding the interactions of the licensor and licensee. These ancillary arrangements may be embedded in the license agreement itself or may be in separate agreements.
    A:

    There are many ways to expand internationally. Successfully building a startup often means that global aspirations need to be built into the initial launch and marketing effort of a new business or product. Most startups are keenly aware that going global is not only good for business but often the only viable way to build a successful company. However, international expansion can have its own pitfalls—resources and cash are often strained and taking your eyes off the ball within the home market may lead to trying too much with too little, thereby diluting all efforts, and potentially leading to ultimate failure of the business.

    Companies initially often try to sell directly or license directly to end-users abroad. This is often a good launching pad and testing ground to see whether localization is necessary or required. Initial customer feedback is often invaluable for devising a good product roadmap and roll-out strategy. Another way to expand internationally is through third-party end-user sales. These third-party distribution arrangements are in most instances accomplished through sales representatives, agents, commissionaires and distributors. Startups should be aware that distribution arrangements in foreign jurisdictions may be subject to different laws than ordinarily would be applicable in the United States, and need to be reviewed carefully. For example, the grant of an exclusive territory may be deemed to violate antitrust laws, and distributors may be entitled to compensation if a company determines to terminate a distributor other than for cause. Similarly, for companies with a franchising strategy, international franchise laws are often quite burdensome and a minefield for the unwary.

    Many companies also look to expand into foreign jurisdictions to take advantage of cheaper labor or technological expertise that may not be available locally. In those instances, startups are confronted with (i) working with independent contractors or third-party development teams or (ii) working directly with team hires. Hiring employees abroad always requires a careful analysis as to whether doing so would make the company a so-called “permanent establishment” in any particular foreign jurisdiction, as a “permanent establishment” may subject the company to taxation in the applicable jurisdiction. 

    In many instances, startups hire their first employees as sales representatives with little or no authority. However, if successful, the activities of the employees may quickly expand and registration of a branch or the establishment of a separate local subsidiary may become necessary. Larger structuring exercises include the establishment of off-shore holding companies as part of a broader tax planning exercise. In all these cases, startups need to carefully review mandatory contractual duration, removal and termination requirements under local laws that can be more expansive than in the US. Further, upon establishment of a subsidiary, startups need to consider entering into intercompany and cross-licensing arrangements. In each case, startups expanding abroad to increase sales need to tailor their approach by making sure these are best suited for penetrating the respective target markets.

    In all these scenarios, protection of a startup’s intellectual property will play an integral part for purposes of analyzing and establishing the legal structure of any expansion. If expansion is the result of expanding the development team abroad these IP considerations are critically important. Making sure that foreign employees or contractors assign – in a legal and enforceable manner - all intellectual property created while working for, contracting with or advising the company is probably one of the most important considerations when working with either employees or contractors abroad.

    Finally, a company planning to expand overseas, particularly a customer-facing company, needs to think carefully about protecting their trademark and brand before entering the market by filing local registrations and obtaining localized domain names for its local operations.

    A:

    Granting important customers, distributors, resellers or other third parties exclusive rights to pricing, products, channels, etc. is not uncommon, but these arrangements must be entered into cautiously. By giving a third party exclusive rights to something, you are agreeing not to give that same thing to anyone else. As a result, you are foregoing other potential opportunities and you should be convinced that the benefits of the exclusive arrangement outweigh those lost opportunity costs.

    Assuming you are, the terms of the exclusive arrangement would be implemented via a clause in the applicable agreement. These provisions often can have unanticipated consequences if not drafted clearly and with consideration of the impact on the businesses of both parties. If they are too broad or too narrow, they can have very negative effects or can make a positive business relationship disastrous. Some arrangements may not be permissible under applicable law or regulation, depending on the context. The following are some of the key considerations in establishing exclusivity arrangements in a reseller, OEM, distributor or license arrangement:

    • Subject products or technology. What products and/or technology are subject to the clause? Is the clause applicable to the party’s entire business or only a specific product or technology? Does it cover similar products and technology, or future developments?
    • Scope of Exclusivity. What fields of use, applications, geographic territories or activities are subject to the exclusivity obligation?
    • Term. How long will the exclusivity last? Can the exclusivity be easily terminated by one or both parties?
    • Diligence Requirements. What must the benefitting party do in order to maintain their exclusivity rights? There are often periodic minimum royalties, sales, milestones or other targets that must be met in order for the rights to continue or to remain exclusive. Those targets must also be very carefully defined to avoid disputes, as the maintenance of exclusivity can often be of very significant economic value.
    • Antitrust. Exclusive arrangements should also be analyzed by an antitrust expert before they are put in place. In certain jurisdictions, these provisions are subject to significant regulation because they can amount to a restraint on trade.
    A:

    Your startup has gotten some traction and you’ve attracted the attention of some of the big players in your space. So much so that they’ve approached you about potentially investing in the company. While you’re flattered, you will need to carefully consider the pros and cons of taking money from a strategic investor as their investment may come with more strings attached than you and your company may like.

    Taking money from a strategic investor may help open the door to a larger commercial relationship with the investor, which may be a great benefit for the company. An investment from a strategic investor may help legitimize the company in a way that makes it easier for the company to attract additional venture capital investment or achieve greater commercial success for its products. Teaming up with a strategic investor may mean access to labs, equipment or know-how that your company doesn’t currently possess. The relationship forged as part of the investment process may even help pave the way for a future acquisition by the strategic investor. The strategic investor may lend domain expertise to the company that the company may not otherwise have access to, and if the strategic investor insists on the right to appoint a director to the company’s board, that director may add a perspective to board meetings that the company’s board may be lacking. 

    Strategic investors also may be willing to invest at a higher valuation than a venture capital investor because they are likely investing in the company to achieve their own benefits that go beyond just the monetary return that venture capitalists and other financial investors are focused on. In short, an investment from a strategic investor may carry with it a wide range of potential benefits to the company. There are, however, several potential downsides that should also be considered carefully.

    Are your short- and long-term interests aligned? The company’s motivations and the those of the strategic investor may not be same. Venture capital investors exist to put money to work, build a successful company and exit the investment with a return if they are successful. Their intentions are clear, but the motivations of a strategic investor typically go beyond simply earning a return on their investment. For example, while your company may be focused on hyper-growth and achieving profitability, a strategic investor may be narrowly focused on ensuring that it has access to your company’s technology and know-how without being concerned about the company’s long-term prospects. A strategic investor’s first and foremost concern will always be the core business of the strategic investor. If the interests of the strategic investor and the company diverge, as they inevitably will at some point during the life of the investment, your company will be better prepared to constructively address this inherent conflict of interest if it understands where the strategic investor’s loyalties lie from the outset. 

    Will your ability to do business with others be negatively impacted? A strategic investor may actively dissuade the company from pursuing certain business opportunities that may be great for the company but may not be in the long-term interest of the strategic investor. The involvement of the strategic investor may in and of itself inhibit certain competitors of the strategic investor from doing business with your company or considering a potential acquisition of your company thereby limiting the company’s future strategic opportunities. 

    What if there are internal or strategic changes within the strategic investor’s organization? The strategic investor is probably a much bigger company than yours. They probably have a lot of different strategic initiatives—yours is just one of those. You may wake up one day to find that the strategic investor is no longer motivated to make your partnership with them work, either because the person within that organization that championed your investment no longer works for the strategic investor or the corporate focus of the strategic investor has shifted to address a changing marketplace. 

    Will the strategic investment create IP or other operational issues? If the strategic investment is combined with a broader commercial agreement between the two parties, be sure that you would be comfortable with that commercial arrangement independent of the investment. If the strategic investor will obtain rights to your intellectual property or your products, be sure the terms of that arrangement make sense for your business in both the short- and long-term independent of whether there is a related investment. 

    How will the strategic investment impact your ability to get the best deal when the company is acquired? One of the strings often attached to a strategic investment is a right of first offer or right of first look with respect to any future sale of the company. Granting a strategic investor such a right will make it more difficult for you to develop competition in the process you run when selling the company, which could limit the price you are able to negotiate. Merely having a strategic investor involved in your company may dissuade some would-be buyers, such as competitors of the strategic investor, from doing business with you or seeking to acquire your company if they view doing so as somehow benefitting the strategic investor. 

    Be careful not to limit your own optionality too soon. By taking money from a strategic investor means you have made a choice to build your company in a certain way—in a manner that is consistent with commercial goals of the deal you struck with the strategic investor. The direction of your business will change over time as your technology evolves, you gain customer insights and you adapt to the market. Be careful not to limit your flexibility to adapt to these changes too soon by agreeing to take your business in a certain direction with a strategic partner. 

    Be careful not to limit your ability to raise additional rounds of funding. If a strategic investor is investing in your company’s early rounds of financing, you should take special care to be sure that the company has retained enough flexibility to complete future financing rounds without the strategic investor being able to block future investment rounds. If a strategic investor’s motivation is to acquire a relatively inexpensive insider’s view of your company’s technology and progress they may be able to achieve that objective without the company ever needing an additional round of financing, but the company may not be able to achieve its growth objectives without access to additional financing. Additionally, depending on the success of the strategic investor’s core business, the strategic investor may not have access to enough investment capital to participate in follow-on rounds. It is almost always better to have a strategic investor as part of an investment syndicate rather than your sole investor so as to ensure your investor’s motivations are better aligned with the company’s going forward. If you incorrectly structure an early investment round you can expect this mistake to have lasting adverse implications for the company.

    Accepting an investment from a strategic investor will undoubtedly have several long-term ramifications for the future of your company—some positive and, quite possibly, some negative. Carefully consider the pros and cons prior to proceeding with a strategic investor. 

    A:

    License agreements come in many different shapes and sizes, depending on the nature of the licensed technology and the terms of the business arrangement underlying the license. The following are some of the key terms included in most licenses, though there are many more details negotiated in each license agreement and each such agreement is unique:

    • Licensed technology. What is the licensed technology? Is the licensed technology comprised of patents, copyrights, trade secrets, software, designs, materials, compounds or other? Define the scope of the licensed technology clearly. Consider whether to include rights in future-developed technology that arises for some time period after the date of the license agreement.
    • Exclusivity and field of use. Will the license be exclusive or non-exclusive? If so, in what geographic territory, and in what field of use? If you are licensing technology core to your business from a university, hospital or other institution your investors may require that the licenses be exclusive in all fields of use throughout the world, but the result depends on the context. [cross-reference university licensing FAQ] What level of royalties must be paid, or sales of covered products made, in order to retain exclusivity? If an arrangement is exclusive, it is critical to define that exclusivity as clearly as possible, particularly from the perspective of the licensor. [Cross-reference Exclusivity FAQ]
    • Sublicensing. The license grant should make clear whether a license is sublicensable or non-sublicensable. The affiliates of a licensee may be permitted sublicenses, even if other third-parties are not. Even if sublicensing is permitted, there may be restrictions on the type of sublicense or customer. Depending on the anticipated business model, sublicensing is often required in order to effectively utilize a license. 
    • Fees, royalties and milestones. How much will be paid up front, in ongoing royalties and/or upon achievement of development or commercial milestones? Some licensees do not have readily available cash, so prefer royalties, while other licensees are prepared to pay more substantial amounts up front in order to reduce or avoid future payments such as royalties and milestone payments. The royalty rate is usually a significant topic of negotiation, with rates varying depending on many factors, particularly the value of the intellectual property and the additional work or third-party intellectual property required to develop a commercial product or service. The royalty rate is often higher where derived from sublicensing of the licensed technology. It is important to carefully define the net sales, gross revenues or other triggers of any ongoing royalties or milestone payments. An audit provision may be included, which allows the licensor to conduct audits of the licensee’s records to verify proper payment of royalties and milestone payments.
    • Equity. Some licensors will require equity in the licensee, depending on the context. Such equity grants are fairly common, for example, in license grants by universities and hospitals. [cross-reference university licensing FAQ]
    • Control of patent prosecution and enforcement. Who will prosecute and maintain licensed patents? Who will have the right to sue third-parties for infringement? Where there is an exclusive license, these rights often are held by the licensee, while non-exclusive licenses often retain these rights to the licensor.
    • Improvements to the licensed technology. If the licensee improves the licensed technology, will the licensor have any rights under those improvements?
    • Confidentiality. Many license arrangements require the licensee to keep the licensed technology, and/or the deal terms, confidential.
    • Warranties. What warranties does each party make to the other in connection with the agreement? While a warranty of proper authorization to sign the agreement is common, numerous other warranties of either party may be relevant as well.
    • Indemnification. Indemnification is commonly used to define the scope of each party’s responsibility for third-party claims that arise from the license agreement. The proper scope of that indemnification is highly context specific.
    • Limitations of Liability. Disclaimers and limits of liability are commonly included.
    • Support. Will the licensor provide ongoing support in connection with the licensee’s or its customers’ use of the licensed technology? Support services are common in software licensing, but can also be relevant in know-how and other licensing arrangements.
    • Escrow. In some license arrangements, most commonly software, a third-party escrow arrangement may be established. The suitability and nature of these arrangements is highly context specific, though there are fairly standardized third-party technology escrow services available.
    • Export Restrictions. Some technologies are subject to restrictions on export, which must be evaluated in advance of any license agreement. Further, the license agreement often will restrict further export of the relevant technology.
    • Assignment. Will the license be assignable without consent to any third-party, to buyers of the licensee, or not at all? The assignment clause is an extremely important provision because it defines whether a buyer of the licensee can continue to utilize the license. If the license is important to the licensee, restrictions on assignment of the license can have significant adverse effects on the licensee (for example, it may make the licensee less attractive by potential acquirers and investors).
    • Ancillary Agreements. License agreements are often accompanied by development agreements, reseller agreements or other commercial terms establishing greater detail regarding the interactions of the licensor and licensee. These ancillary arrangements may be embedded in the license agreement itself or may be in separate agreements.

     

    A:

    A board of directors has the ultimate authority to direct the management of the business and affairs of the company. Legally, the board will authorize the issuance of stock, hire (and fire) senior executives, approve compensation arrangements, including the issuance of stock options, and authorize the company to enter into significant agreements. The board will also be asked to provide advice and approve strategic and operating plans, adopt company budgets and oversee the company's audit and financial statement functions. Most importantly though, the board's most critical function is to help management navigate the myriad critical business decisions that will determine the ultimate success or failure of the company.

    In the initial startup stage, a board of directors might consist solely of one or more founders. However, finding an additional board member with insight and experience that no founder has, but who knows the company's market or technology particularly well, can be particularly helpful in building the business. In addition, the right director can provide some independent validation that a company's business has promise. Once a company raises capital, particularly from venture capital funds, board seats will be a negotiated part of the transaction, with a board of directors typically consisting of a combination of founders, investors and independent directors. 

    Directors can provide valuable input and an independent voice during discussions over important business matters. As such, directors who offer complementary strengths and work well together are necessary to a well-functioning board. It is important to have strong board members who are willing to voice their opinions and speak up when they disagree. Prospective board members should not only be able to show up for meetings, but be able to devote enough time and attention to come well-prepared for each meeting.

    A:

    Whether a company is seeking private financing, participating in an acquisition or undertaking a public offering process, the other parties to the transaction will conduct a due diligence investigation of the company in varying degrees. Due diligence is the process of independently identifying and verifying information that either must be disclosed in offering or acquisition documents or is otherwise relevant to an understanding of the company's business. Due diligence may also include an evaluation of the company's operations, management, finances, accounting, legal matters and prospects, and, in an IPO process, an assessment of the company's readiness and ability to function as a public company. A due diligence investigation will vary in scope and comprehensiveness depending on the transaction in question—a follow-on investment by existing investors may require little, if any, due diligence, while the due diligence process in an acquisition or public offering is aimed at leaving no stone unturned.

    Organization and advance work to remediate known problems before formal due diligence commences are the key elements to ensuring a smooth due diligence process. A first step is to allocate internal responsibility for overseeing the due diligence process. Companies typically designate one employee to coordinate its responses to information requests. This person should be very familiar with the company, have the internal authority and access to corporate resources to assure prompt action and be sophisticated enough to understand and prioritize diligence requestsd.

    Next, documents need to be gathered, organized and made available to the other parties, often through an online “virtual” data room. Company counsel can provide a good indication of what types of documents companies should have ready for the particular type of due diligence process. By keeping at hand in advance key documents that are likely to be relevant in any process, such as organizational documents, material contracts, intellectual property materials and regulatory compliance documents, the amount of work and distraction inherent in the due diligence process can be minimized. An organized due diligence process also builds the confidence of the other transaction participants that the company is operating successfully and that it is on top of its businessd.

    Advanced corporate housekeeping can facilitate the due diligence process. Problems that are unearthed early on can be remediated (or a plan for remediation put into place) in advance of the commencement of the process. Ideally, a company should never be surprised by its own responses to due diligence inquiries.d.

    The due diligence process is intrusive, time-consuming and tiresome, but can also be instructive and useful. As the other transaction participants inquire into the company's business, finances, contracts, accounting, human resources matters and regulatory position, the company can identify its strengths and weaknesses and develop strategies to take advantage of the former and mitigate the latter, while at the same time increasing its protection against and minimizing the potential liabilities that are inherent in these significant corporate events.

    A:

    This really depends on your particular circumstances; it’s basically an investment decision. Investment banking fees can really add up, and most investment banks charge a substantial minimum fee so it makes good sense to really consider what you get in exchange for the fee you pay. As with most decisions involving M&A, you need to carefully assess your specific circumstances; however, here are some general considerations you will likely want to consider:

    • How big is the transaction?Depending on the bank’s minimum fee (which is often subject to discussion), a transaction will need to be large enough to support that fee—typically at least $5-$10 million.
    • How much M&A experience do you and those on your management team have?Selling a business and maximizing sale proceeds is a different task than building that business. If neither you nor your team has a lot of experience in successfully managing an exit or understanding industry-specific valuation metrics, give a banker some thought.
    • How difficult/time-consuming/distracting will the sale process be?Many CEOs underestimate how difficult this process can be and how long it will take. A target company can lose focus on executing its business plan while pursuing a sale. This can dissipate the target’s leverage in the sale transaction and ultimately harm the company’s value as current performance is the main value driver for most M&A transactions.
    • What is the likelihood of shareholder litigation in your deal?This is generally more of a public company issue; however, if your company has experienced a cram down financing or if the sale proceeds will not likely be sufficient to pay all liquidation preferences and otherwise offer all shareholders meaningful value, the potential for shareholder litigation shouldn’t be overlooked. Accordingly, having an independent third-party assist in the sale process and potentially opine as to the fairness of the transaction consideration can help mitigate that risk. These issues should be discussed with legal counsel.
    A:

    Preparation is fundamental to success. Here are some things you can do before the M&A process has begun in order to improve the outcome:
    Assess your company’s readiness and management team’s M&A capabilities and create an internal team or task force. Make an honest assessment of your company together with the management team, its current challenges and bandwidth. How much exit experience is around the table? Create an internal task force with appropriate representatives from key functional areas (e.g., finance, human resources, legal). Identify who should be in charge of the readiness process, assign clear deliverables and deadlines after consulting with any desired outside experts.

    Supplement internal task force with qualified external experts.Companies often work with outside counsel and accounting professionals to prepare for an exit. In addition, some companies retain an investment banker to assist in the sale process. Read about some of the considerations you should have when deciding to hire an investment banker.

    Understand how buyers generally value companies in your industry and be prepared to explain your own valuation model. Essentially, you need to understand how buyers typically arrive at a purchase price for companies in your space. Stay current on precedent exit transactions in your company’s space to better understand how buyers value important business attributes (e.g., multiples of sales, EBITDA, number of users or discrete views per month). The details of many of these transactions may not be public so it may be difficult to discern the valuation metrics used by the buyers. Investment bankers can supplement this piece of the process and assist you in building a credible M&A valuation for your company.

    Perform “reverse due diligence” on your company. Essentially, you need to understand the risks and liabilities a buyer would worry about in acquiring the company. Outside counsel is well-suited to assist with your efforts here. You can ask counsel to send you a standard due diligence review checklist and perhaps the representations and warranties section from an acquisition agreement. From this, you can build and update an electronic dataroom that can be reviewed by a buyer and its advisors. Answering the embedded diligence questions will often flag areas of weakness that should be addressed before the acquisition process begins (and before a third party realizes that it has leverage in the process). Learn more about preparing for due diligence.

    Focus on key risk/liability areas

    • Who owns the company’s equity? Working with counsel, ensure that equity ownership and those that have rights to acquire equity ownership are clear.
    • Who has a claim on deal proceeds? After reviewing the company’s charter and other documents, prepare a “waterfall” spreadsheet showing by class and series how deal proceeds will be allocated. Identify any shortfalls for potential unhappy constituencies, and consider how and where interests/incentives diverge (e.g., preferred vs. common/option holders).
    • Who can block or hold up the deal? Check the charter and other documents for blocking positions and material contracts for third-party consents. Are there any practical blockers like key employees who need to be part of the deal?
    • Does the Company have its assets, particularly intellectual property, in order? Check that you have all your assignment of inventions agreements signed. For many companies, periodic IP audits such as an open source audit should be part of a sensible risk minimization plan.
    • Are there any key liabilities or other areas of concern? Is there any actual or threatened litigation/allegations of infringement? It’s always better to be prepared to answer those anticipated questions from buyers rather than react in response to a buyer’s inquiry off the cuff.
    • Are there any other third-parties/governmental entities to consider? Review key customer and vendor agreements. Be wary of broad and potentially upstream non-compete clauses (provisions that would bind the buyer and/or its other subsidiaries) that might concern a buyer. Are there any existing founder guarantees?
    • What will a close review of tax returns and financial statements show? Can you produce all tax elections, returns and filings? Are there any issues noted in audit letters or in the returns?
    • Ensure that your company’s insurance profile, especially its D&O coverage, has been reviewed and premiums paid.
    • Assess whether the company has sufficient controls in place to comply with the operating covenants applicable once you are “under agreement”. Acquisition agreements often place burdensome restrictions on the operations of target companies between signing and closing, and the consequences of breaching those covenants are serious. This can be a real concern depending on your company’s internal controls and compliance culture.
    A:

    Whether a company is seeking private financing, participating in an acquisition or undertaking a public offering process, the other parties to the transaction will conduct a due diligence investigation of the company in varying degrees. Due diligence is the process of independently identifying and verifying information that either must be disclosed in offering or acquisition documents or is otherwise relevant to an understanding of the company’s business. Due diligence may also include an evaluation of the company’s operations, management, finances, accounting, legal matters and prospects, and, in an IPO process, an assessment of the company’s readiness and ability to function as a public company. A due diligence investigation will vary in scope and comprehensiveness depending on the transaction in question — a follow-on investment by existing investors may require little, if any, due diligence, while the due diligence process in an acquisition or public offering is aimed at leaving no stone unturned.
    Organization and advance work to remediate known problems before formal due diligence commences are the key elements in ensuring a smooth due diligence process. A first step is to allocate internal responsibility for overseeing the due diligence process. Companies typically designate one employee to coordinate its responses to information requests. This person should be very familiar with the company, have the internal authority and access to corporate resources to assure prompt action and be sophisticated enough to understand and prioritize diligence requests.

    Next, documents need to be gathered, organized and made available to the other parties, often through an online “virtual” data room. Company counsel can provide a good indication of what types of documents companies should have ready for the particular type of due diligence process. By keeping at hand in advance key documents that are likely to be relevant in any process, such as organizational documents, material contracts, intellectual property materials and regulatory compliance documents, the amount of work and distraction inherent in the due diligence process can be minimized. An organized due diligence process also builds the confidence of the other transaction participants that the company is operating successfully and that it is on top of its business.

    Advanced corporate housekeeping can facilitate the due diligence process. Problems that are unearthed early on can be remediated (or a plan for remediation put into place) in advance of the commencement of the process. Ideally, a company should never be surprised by its own responses to due diligence inquiries.

    The due diligence process is intrusive, time-consuming and tiresome, but can also be instructive and useful. As the other transaction participants inquire into the company’s business, finances, contracts, accounting, human resources matters and regulatory position, the company can identify its strengths and weaknesses and develop strategies to take advantage of the former and mitigate the latter, while at the same time increasing its protection against and minimizing the potential liabilities that are inherent in these significant corporate events.

    A:

    The decision to go public is a critical one. Going public involves a substantial commitment of financial and management resources and cannot be easily reversed. Picking the optimal time to start an IPO process is something of an art because it depends on two elements being present at the same time: (1) the company must be ready for the IPO market and (2) the public markets must be willing to invest in IPO companies like the company. Since the company cannot control the latter factor, companies wishing to go public need to put into place a number of necessary items that potential underwriters and public investors will expect so that when a market window does open, it is ready to take advantage of the opportunity.

    IPO companies typically are built on people, intellectual property and market opportunity. Companies increase their chance for a successful public offering if they have a management team in place that is committed to the IPO effort and has the skills and experience to carry it out, seasoned professional advisors who can guide it through the complex financial, legal and accounting requirements necessary to complete an IPO, an intellectual property position that will protect the company’s competitive advantage in the market and a strong competitive position in a large and growing market. Biotech companies present a somewhat unique case—sales and profitability at the time of the IPO are significantly less important than the patent position of and the likelihood of FDA regulatory approval for the pharmaceutical products being developed.

    Building the right team is vital to a successful IPO. The company should examine its board of directors and determine if a change in the composition of the board is warranted to ensure that the board has the capabilities that it will need to operate as a public company. In particular, exchange listing requirements and tax regulations may necessitate adding independent board members who can serve on the Audit Committee and Compensation Committee of the public company. In addition to a talented CEO, the executive team should include a CFO who has experience in handling public markets and a capable accounting team that can provide the support that is needed to handle the extensive accounting disclosure required in the IPO offering documents, as well as the myriad ongoing public company responsibilities, including compliance with the Sarbanes-Oxley Act.

    Experienced professional advisors are critical to a successful IPO process. First and foremost, IPO candidates need to examine the capabilities of their existing outside auditors. Familiarity with the existing audit team and the auditing firm’s knowledge of the company must be weighed against the need for extensive IPO and public company capabilities. IPO candidates who are not using one of the Big 4 firms, another national firm or a highly regarded regional firm with IPO experience, need to consider switching to an audit firm with more IPO and public company capabilities. It is not uncommon for a company to outgrow the local audit firm that provided excellent, cost-effective service while the company was private but lacks the experience and resources to execute an IPO. However, as switching accountants can be quite disruptive, a company that finds it necessary to do so should provide ample time for the new accounting firm to complete any audits work that may be necessary and otherwise get up speed in advance of the commencement of the IPO process.

    Outside counsel will lead the preparation of the offering materials and will take the lead in the SEC filing process. Similar to the analysis involving auditors, a company must take a critical look at its outside counsel’s capabilities. There is no substitute for counsel with substantial and relevant experience, including serving as counsel in many IPOs, preferably including offerings by companies in the same industry, advising public companies on their ongoing reporting obligations, and having relevant knowledge of not only the relevant securities laws and the IPO process, but also key legal issues affecting the company’s industry. Experienced company counsel also understand the due diligence process and other underwriter’s requirements. In advance of the commencement of the IPO process, counsel should help the company undertake the necessary organization of corporate records and other various aspects of corporate housekeeping. This advanced preparation will not only facilitate the completion of the IPO, but also build the confidence of the underwriters and the other offering participants that the company is ready to operate successfully as a public company.

    The company will need to select underwriters to manage the offering. The company’s directors, outside counsel and independent auditors often will have contacts with investment banking firms and can help guide the company to underwriters with strong track records and expertise within the company’s industry. In some cases, investment banks will have already initiated contact with a company they believe is an attractive IPO candidate. A company seeking to undertake an IPO should begin to build relationships with investment bankers and key research analysts. These professionals can offer useful insights and planning guidance early on at no cost to the company.

    Nearly every IPO candidate has intellectual property assets. For technology or life sciences companies intellectual property is often their most critical asset, but almost all companies rely on some combination of patents, trade secrets, trademarks, copyrights, domain names and other intellectual property in their businesses. Before undertaking an IPO a company should take stock of its intellectual property assets. Together with its intellectual property counsel the company should evaluate the strengths and weaknesses of its intellectual property position and determine whether it needs to take any necessary actions to shore up its intellectual property position, such as making additional patent filings, addressing compliance with existing licenses (particularly with respect to any open source software uses) and ensuring that any technology developed by third-party contractors has been appropriately assigned to the company.

    A company that has developed a strong and growing business in an attractive market, put in place an experienced team and secured its intellectual property position is well-positioned to execute an IPO. Advanced preparation facilitates the offering process, builds confidence in the company’s capabilities and will allow the company to act quickly when the securities markets are most receptive to IPOs.