Building a company is not unlike building any structure – the strength of the foundation can significantly impact how large it ultimately can grow. Early decisions regarding stock vesting, employee recruitment, change of control provisions and intellectual property protection, among others, can have long-term implications for a company’s valuation and liquidity prospects. There are many examples of a company’s prospects diminishing as a result of not only poor decision making but inattention to what might be viewed as simple blocking and tackling.
Laying a proper foundation – setting up a common sense capital structure.
A typical venture-backed, start-up capital structure is two-tiered, meaning a company will issue both preferred and common stock.
Preferred stock is issued in connection with financing activities where the company’s principal purpose is raising money from investors. These shares have rights superior to the common stock including a liquidation preference, dividend rights, special voting provisions, redemption rights and other preferences.
Common shares, on the other hand, are typically reserved for issuance to founders, employees, directors and other service providers, and are not issued for the primary purpose of raising capital.
The senior status of the preferred stock means that more value is attributable to these shares, and as a result, the common stock can be issued at prices significantly below the preferred. The issuance of common stock to employees (in the form of stock options) and other service providers at prices that are a fraction of the preferred stock price can be the most important tool a company has to attract and retain its workforce. It is not uncommon, however, for venture investors to approach a potential portfolio company that has not adopted a two-tier structure, but instead, has raised money through the sale of common stock at successively higher prices to friends, family and angel investors. In these cases, the company will not have low priced common stock available to recruit employees, thereby putting it at a distinct disadvantage in a very tight labor market. This situation may be remedied through a recapitalization of the company; however, a recapitalization can be time consuming and expensive, and in some cases may not even be possible due to an inability to obtain certain required consents. A proper capital structure is necessary but not sufficient.
It is also important that a company avoid making undocumented promises or commitments with regard to the issuance of its equity. There are many well publicized cases of a company being approached by individuals claiming to have been promised significant slices of equity in exchange for services they provided. These claims are often brought at a time when the company is most vulnerable, such as immediately after the company has filed a registration statement for its initial public offering or when it is in discussions regarding a possible merger. As a result, these cases are often settled in a manner unfavorable to the company and its investors.
In addition to equity promises, companies have also been known to make undocumented promises to early investors of participation at guaranteed levels in future financing rounds. These “preemptive rights” are also unfortunately the subject of claims at or near liquidity events, often resulting in unfavorable settlements.
Other early common mistakes involving equity include the failure to impose reasonable vesting on founder or employee shares, providing overly aggressive acceleration of vesting on a sale of the company and failing to subject all issued shares to an appropriate lock-up in the event of a public offering.
There have been cases of founders imposing excessively long vesting schedules on early employees in an attempt to ensure strong commitments only to realize later that such schedules impede the hiring of truly talented employees, especially in tight labor markets. In such cases it can be difficult to adopt more reasonable vesting schedules for subsequent employees because of the resulting inequities.
On the other hand, there were cases of founders not imposing any vesting. A mistake realized later when one of the founders leaves – taking all of his stock with him. The remaining founders are demoralized by the thought that all of their ongoing efforts to build a successful company will inure to the benefit of the departed founder who may be spending all of his time at the beach.
In some cases potential purchasers have walked away from acquisitions or lowered their bids in the face of stock option plans that provide for full acceleration of all unvested options in the event of a sale of the company.
An important factor in the acquisition of most technology companies is post-closing employee retention. Purchasers have also walked away from transactions where there was a significant likelihood that a large number of employees would resign following the closing and they reduced the purchase price by the value of the options they estimate would be needed to grant to retain such employees.
Finally, underwriters will nearly universally require some form of lock-up in the event of a public offering to prevent large blocks of stock from coming on the market during the time underwriters are engaged in permitted stabilization activities. If these lock-ups are not obtained at the time the shares are initially issued (or included in the company’s stock option plan), it’s likely the company will lack the leverage necessary to obtain these lock-ups at the time of a public offering.
In particular, it is often very difficult to obtain lock-ups at the time of a public offering from founders or employees who have left the company or from investors who for a variety of reasons may be on less than favorable terms with the company.
Protecting technology. Protecting a company’s intellectual property and other proprietary information is of paramount importance. The first step in the protection process is to ensure that the intellectual property possessed by the founders and forming the basis of the new company is free from claims of others. Most often this will involve a careful review of the non-compete and proprietary information agreements that the founders signed with their prior employers, as well as detailed interviews with the founders to be sure that prior employers will not have valid theft of proprietary information or trade secret claims against the new company.
It is also critical that the founders have executed the contribution or assignment agreements with the new company effecting the contribution to the company of all of their rights to all intellectual property that is, or conceivably could be, used in the company’s business. This contribution is often completed at the company’s inception in exchange for founders’ common stock. As simple as this contribution may be, there are many cases of companies having to chase departed founders after the fact to obtain signatures on these documents at a time when the company has no leverage.
Other intellectual property matters that should be addressed at the time of inception include the transfer or assignment of patents in cases where patents are relied upon as an important means of intellectual property protection, ownership of appropriate URL’s and proper trademark investigations. It is important to note that the mere act of incorporating a business under a corporate name or qualifying in another state as a foreign corporation does not confer any rights to use the corporate name in association with any of the products or services of the business, even within the same state(s).
Since the vast majority of businesses will want to associate their corporate names with the products and/or services they offer, the corporate name for a new business should be evaluated as to its suitability for trademarking.
Ongoing due diligence is also critical in the protection of intellectual property. A company should have competent counsel prepare a standard proprietary information agreement to be signed by all founders, employees and other service providers documenting that all intellectual property developed by such persons in connection with their service to the company is owned by the company. In the absence of these agreements, the company may not have full rights even to the intellectual property for which the company and its investors have fully funded development. In addition, companies will often be required to disclose confidential information to third parties and it is essential that such disclosures are made pursuant to effective confidentiality/non-disclosure agreements to ensure adequate protection of such confidential information.
There have been cases where a substantial element of a company’s business is dependent upon a license from a third party. In such cases, it’s critical that the license provide for an adequate initial term or renewal terms such that the company has other options at the time of renegotiation and, therefore, cannot be held hostage.
Finally, it is essential that these licenses and other important agreements have appropriate assignment provisions such that the contracts can be assigned to a purchaser in the event that the company is sold. Without such provisions, it is likely that these important agreements will have to be renegotiated at the time of sale at substantially increased cost to the purchaser, which will result in a lower purchase price to the investors.
Good corporate housekeeping is mandatory. There is no substitute for good operating procedures and many problems can be avoided by simply implementing good systems. Pouring through boxes of unorganized, unsigned documents can shake the confidence of investors, investment bankers or potential strategic partners and reflects poorly on management.
A company’s equity is one of its most valuable assets and extreme care should be taken to avoid undocumented promises of equity participation.
Lock-up agreements should be standard in every equity issuance and all issuances of equity should be properly reflected in signed board minutes. In hiring new employees, a standard offer letter should be used containing appropriate “at will” employment language. The company’s form proprietary information agreement should be signed as a matter of course on the employee’s first day of employment and should be filed in an obvious location.
Important agreements should be reviewed for proper assignment provisions in the event of a sale of the company. These are just some examples of standard operating procedures that a company should adopt to avoid painful and potentially costly mistakes down the road.
Developing good habits early can yield surprising benefits down the road. Experience has shown that companies which have invested even a modest amount of time in creating a sensible corporate structure and taken steps to implement good corporate operating procedures stand the best chance of capitalizing on their success. t
Jay K. Hachigian is a founding partner and Kevin Sullivan is an associate with Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP, a law firm serving the emerging growth company marketplace.