Startup Legal Formation – a “101 Interview” with Joe Wallin
This is the first in a series of monthly interviews with Joe Wallin, who writes the “Startup Law Blog“. We talked about the Incorporation process and mechanics for startups.
Dave: Good morning Joe. Thanks for joining me on this conference call. I wanted to introduce the topic that we’ll be working on, on a monthly basis, called “Epic Fail and Startups” and we’re going to start with Legal Formation. I know you’ve had a ton of experience in legal formation but before we start on the topic, let’s start off with telling us a little bit about yourself, your blog and your firm.
Joe: Thanks Dave. You can find my blog at http://www.startupblogblog.com. I’m a startup lawyer. I’ve been practicing in the startup world since approximately 1998, or thereabouts, and so I’ve been through a couple of the cycles in the economy and I’ve had the chance to see some great Seattle companies grow up and have great success. It’s a fun practice.
My firm, Davis Wright Tremaine, LLP, has offices in New York, Washington, D.C., Seattle, San Francisco, Los Angeles, Portland, Anchorage and Shanghai. We are a full service law firm for businesses.
Dave: There are lots of mistakes you can make in formation and the goal of this blog is to help founders learn from other people’s mistakes rather than have to make them yourself.
Let’s start with the incorporation process, focused on new entrepreneurs, then we can move into where to use what types of shares, vesting, issuing and granting shares, etc. So let’s start with the formation topic. What do you know about formation and where have you seen that go wrong?
Joe: Well, first you’ve got to file articles with the Secretary of State to create the company and to create the legal framework in which to issue shares. The articles will authorize shares. You can authorize in the articles just common stock or you can authorize both common and preferred stock. Generally, we recommend you authorize both common and preferred. You’ll need to put a number next to each of those so you’ll need to authorize, say for example, if you want your total authorized number of shares to be 10 million shares you’d want to say something like 9 million of those are going to be authorized as common and one million of those are going to be authorized as preferred. And then, once you’ve got your articles filed with authorized share numbers, the corporation will exist and will have the ability to actually issue shares.
Dave: So, we’ve established a total number of shares authorized with the Secretary of State and now we’ve got these shares we can grant or issue. The question is how do we grant them or issue them and make them available to employees and founders? So we’ll avoid the how to do a founder split upfront. What are the mechanics of granting shares to founders?
Joe: It starts with the board. All equity issuances have to be approved by the Board of Directors. Frequently, or sometimes, your initial Board of Directors might be listed in your articles. Sometimes they are not listed, and the only thing that appears in the articles or the certificate is the name of the incorporator. And in that instance, the incorporator will sign a “Consent of Incorporator” designating the initial board of directors. Then that initial Board of Directors will have its initial board meeting or act by unanimous written consent and it will appoint officers, adopt bylaws and then will authorize the initial share issuances to the founders. Those are the steps from a board’s point of view and then the board will typically say that the shares are being authorized or authorized to be issued or will be issued to the founders in exchange for a specified consideration. So cash in IP and the board consent will also say in order to receive the shares the founders will have to sign a specified form of agreement like a founder stock purchase agreement, which might include vesting, for example.
Dave: So an Assignment Agreement is something that a founder should expect, which is, if you are a founder and you are bringing in the intellectual property, you are going to assign that intellectual property to the company for those shares. So you don’t get to keep the IP, right?
Joe: It’s almost always the case that founders will assign IP to the company in exchange for their initial shares. But I suppose, just like every rule, there are exceptions to the rule. However, if you don’t assign the IP at the founding and then you go on to do a financing, and anyone looks at your records for any type of due diligence and they notice that the IP was not assigned to the company, that could set that relationship off on the wrong foot and cause the investors to have a generalized discomfort with the investment, which is something you obviously want to avoid.
VESTING SCHEDULE: INITIAL STARTING SHARES AND REVERSE VESTING
Dave: One of the other trends that I’m seeing a lot more of, and it would be great to have you speak to this whole idea, is reverse vesting. Say I’m a new founder and I’ve granted myself shares. I own the shares and now an institutional investor comes along and says, “Hey, we want you to take the shares and subject them to vesting.” Can you outline how that mechanic works?
Joe: Sure. And that’s not uncommon. So, for example, let’s say, you and I formed a company and we split it 80% in favor of me and 20% in favor of you. In that instance say, for example, because I was the 80% owner, you and I decided well, it’s kind of silly to put my shares on the vesting schedule because well, gee, I’m the 80% owner. I could sign a document at any time changing my vesting schedule so my shares would be fully vested. But your shares would be subject to vesting. You’re the minority founder. And that’s not uncommon. However, if an investor comes along and finds out that my shares are fully vested, they might want to subject my shares to vesting so that I don’t walk off the job and keep 80% of the company. And so they might require, as a condition of the investment, that I sign a vesting agreement, essentially giving the company the right to buy back some number of my shares for the lesser of the price I paid for them or fair market value and have that repurchase right lapse over the vesting period. It’s not uncommon at all for investors to do that. Another example would be if you and I had both subjected our shares to vesting and we both plugged away for three years and we were both almost completely vested before we went and sought investment dollars. That’s another situation in which the investors might say hey, we want both of you to subject your shares to a new vesting schedule, and that’s just done by giving the company the right to buy back our shares at the lower of our cost or fair market value, which repurchase right lapses over a vesting period.
Dave: I know it’s one of those things that first time founders will see that and feel like it is personal, and I always warn them that it’s not a question of personal, it’s a question of ‘you must be present to win.’
Joe: That’s right. I think one of the things that generally people should try to do is not take things personally. If you can divorce personal feelings from business, then you’ll have a greater chance of success.
Dave: Let me pull back to the starting point. If someone came in to you and said hey, I’ve got to start a new company. Joe and I need to incorporate. If you had the formula, you would say, “If you are going to be a company htat will try to raise angel or venture capital, here’s the number of shares I would recommend.” Because a lot of people will ask, I know that this is one of those, “How many shares do you want to issue?” And most of the first time founders say, “I don’t know. How many shares should I issue?” So if you had a template in mind for a general one, what would you invest? Do I issue a million shares or do I issue 10 million shares or do I issue 20 million shares?
Joe: There’s a lot of people with questions about how many shares to authorize and how many shares to issue. And these are really, for someone who’s done it before, been around it before, really basic questions. But if you haven’t done it, people get really confused.
I had a new client reach out to me the other day and she had carefully thought out that she was going to authorize 10 million total shares and she was going to issue 4.5 million to each her and her co-founder, and then reserve 1 million for the option pool. And so she wanted to know if that made sense or if there were any adverse tax consequences to reserving 10 million shares or authorizing 10 million shares in a charter. I told her, of course, under Washington law there are no adverse state tax consequences to authorizing 10 million shares in a charter (Washington doesn’t have a tax that starts out by looking at authorized capital like Delaware), but if she followed her carefully laid out plan, which wasn’t necessarily a bad plan, except that if she only authorized 10 million and she already allotted all those 10 million, then the minute she wanted to do a financing, which she wanted to do, she was going to have to go back to the Secretary of State to authorize more shares.
Part of the goal of establishing a company is to set up all the legal paperwork to reduce future legal work, to the extent you can. So put a structure in place that provides maximum flexibility and minimizes the legal work to do in future transactions. So you wouldn’t want to, in that case, only authorize 10 million shares because, again, when you get to your first financing you wouldn’t have any shares available. So you would probably want to, in that instance, authorize say 20 million and, of course, you’d also want to make sure you have some preferred stock authorized but unissued and blank check preferred authority in the articles as well.
That’s another question that comes up all the time. The question of how many shares do I issue. The best way I can think of it is this. You and I, Dave, if we formed a company, we could issue 500,000 shares to each of us or we could issue 5 million shares to each of us. Why would we choose 500,000 over 5 million? The best explanation or justification I can give you for choosing one or the other is, I tell founders, ask yourselves, when you go out and raise your first round of financing, at what pre-money value do you think you are going to raise that money? I know, we all know, that pre-money valuations fluctuate and go up and down, and it’s going to depend on who the founders are and if they’ve done it before. You know, if you just sold your second company to Google, your pre-money on your third company is going to be higher than if you are a first time founder. But let’s just say you and I decide hey, you know what, we think our first fundraising is going to be about $500,000 and we think our pre-money on that is going to be $1.5 million. So let’s just presume those facts for purposes of this example. Well, if your pre-money is going to be $1.5 million and you are going to raise $500,000, you’re not going to want your price per share in that offering to be half a penny per share. Similarly, you’re not going to want your price per share in that offering to be $10.00 a share. What you are going to want your price per share to be in that offering is something that is consistent with what investors in this community typically see for a seed round or a first round price per share. And generally, people see something around $1.00 or a little less than $1.00. So, therefore, if we’re going to raise money at $1.5 million pre-money we want to generally price our shares around $1.00. Then we should issue about 1.5 million shares in the aggregate to both of us at the start.
Dave: So it really comes down to not so much the question of what I think the company is worth, but really about if I’m going to go raise money, what the investors’ expectations are, which are kind of common practice. So to your point, I don’t want $1,000 per share and I don’t want a penny a share. I don’t want to have a billion shares outstanding and I don’t want to have three shares outstanding.
Joe: That’s right. You want to issue a number of shares to the founders and reserve an option pool such that the total shares outstanding on a fully diluted basis ranges to a price per share of around a dollar, typically.