Going Global : The Y Combinator Experience - Legal Issues For Start Ups

LEGAL ISSUES FOR START UPS

PRESENTS:

Agenda1. FORMATION

• Incorporation Process: Delaware “C” Corp. ; EIN Number; Opening a Bank Account• Formation of the Delaware C Corp with India based Founders/Investors• Employment Issues; IP issues• Working with 3rd parties: Consultants, employees, and advisors

2. EQUITY STRUCTURE• Founder Stock • Option Pool • Investors

3. FINANCING OPTIONS • Angel/Seed Financings • Venture Financings

4. STRATEGIC TRANSACTIONS• Licensing Agreements• Revenue Shares• Mergers and Acquisitions

Life Cycle of A Startup

EXIT: ACQUISITION

BRIDGE ROUND

STA

RT

INITIAL PUBLIC

OFFERING

SERIES C

SERIES B

SERIES A

BIG CUSTOMER

SMALLCUSTOMER

ANGEL ROUND

SERIES D

Incorporation

Founders Stock

Stock Incentive Plans

Selecting and Negotiating with VCs

Licensing IP/Filing Patents

Strategic Partnerships

The big question: when and how to exit????

FormationIncorporation:

• Delaware “C” Corp

Board and Officers: • Need a functioning Board; Need properly appointed Officers• Substantial Basis Test

Founder Stock Purchase: • Do it early• Do it properly

Working with Third Parties: • India Subsidiary; “Cost-Plus” Service Agreement • Consultants, Advisors, Employees • PIIAs• “Rogue” Founder Issue – Who founded Facebook?!

Equity StructureInitial Capital Structure

• Total Authorized: 10MM shares of Common Stock • Difference between Authorized and Issued & Outstanding

Capital • Founder Stock: 8-9 MM

• Issue stock early to avoid tax issues • Vesting (look back period for vesting) • Acceleration: Single Trigger versus Double Trigger• 83(b) elections: file on time (within 30 days of purchase)! • Founders’ Preferred – Consider in appropriate situations

• Option Pool: 1-2 MM • Vesting: Straight 4 year vesting, 1 year “cliff”, with monthly vesting

thereafter • Acceleration: Could hamper acquisition

• Outside Investors: Preferred Stock

Financing OptionsSeed Financings (Convertible Note Financing):

• Founders, Friends, Family, Angels, Early Stage VCs• Incubators: YC, MS Accelerator, 500Startups, Tandem, Fabric, etc. • Convertible Notes with a “kicker”, either a discount or warrant coverage

• Typically between $250k to $1MM • Debt that converts into preferred equity in the “next qualified financing” • Avoid any additional rights to seed investors, although institutional investors may

require right to lead the next round, management rights, board seat and protective provisions

• Look out for any issues that may affect future financings Venture Capital Financings:

• Valuations • Preferred Stock

Strategic Transactions: • Licensing Arrangements • Revenue Share; Affiliation Agreements; Reseller Agreements• Mergers and Acquisitions

Venture Financing – Term SheetThree Main Purposes of Term Sheet

• Pricing/Valuation• Percentage of the Company to be Sold (Pre and Post Money) • Liquidation Preferences• Dividends• Anti-Dilution Protections

• Management/Controls • Board Rights• Protective Provisions • Covenants

• Liquidity Rights• Co-Sale/Right of First Refusal • Registration Rights• Draft-Along Rights • Redemption Rights

Venture Financing (…contd.)Valuation

• Methodology for valuation: • Discounted Cash Flow • Multiple of Revenues/Sales, Multiple of Earnings • Customers, Revenues, Management Team, Patent Strategy, competition, size of

market, other precedents • Getting multiple term sheets always helps, but be careful how you play

your horses! • Watch out for milestone based investments • Not the only issue to think about

Time, Process and Expense• Time: 2-3 months from start to finish • Process: IP diligence, Legal diligence, Schedule of Exceptions; Financing

Documents • Expenses: Legal fees (both sides), Investor expenses

Venture Financing (…contd.)Privileges of Preferred Stock

• Voting (Board) rights• Protective Provisions • Dividends: Cumulative versus non-cumulative; should be non-cumulative and

discretionary, i.e., “when, as and if declared by the Board” • Conversion Rights: Right to convert into Common Stock; Upon requisite

preferred holders’ consent or upon a “qualified” IPO• Anti-dilution Protection: Full Ratchet is bad, Broad-based weighted average is

good and standard • Redemption: Watch out, not a good sign; right should be at least 5 years out and

spread over a period of time • Registration rights: standard registration rights OK, nothing to fight over • Information rights: standard information rights OK, nothing to fight over; limit to

“Major Investors” • Right of First Offer: maintain their pro rata ownership, right to “gobble up”; limit

to “Major Investors” • Right of First Refusal and Co-Sale Agreement: OK, but understand how it

works • Board Observer Rights: OK, but need to be careful as VCs don’t like the

distraction of too many observers

Strategic TransactionsLicensing Arrangements

• Licensing Terms: • Exclusive versus Non-Exclusive • Geographical Limitations

• Ownership of IP and “Work Product” • Other Material Provisions: Term, Termination, Assignment, and

Indemnification

Partnerships• Affiliate Agreements• Reseller Agreements

Mergers and Acquisitions • Set up right legal structure • Ownership of IP is critical • Contract terms play a big role in valuation