Example

Here is an example of what happens in a typical convertible note transaction: A startup is looking for seed money to get the company off the ground. The company finds an investor willing to invest $50,000 in exchange for a convertible note. The note specifies that the company will convert the $50,000 of debt into shares of the company at a 20% discount upon the acquisition of an additional $1,000,000 in financing. If the company is unable to raise $1,000,000 then it must repay the $50,000 debt to the investor with interest. Later, the company raises the additional $1,000,000 by selling shares at $1.00. Now that the conversion event has occurred, the $50,000 debt plus interest owed to the investor is converted into shares of the company ($50,000/$.80 per share = 62,500 shares + additional shares for interest accumulated up to the date of conversion). The company no longer owes the $50,000 debt and the investor owns a portion of the company.

Advantages to Convertible Notes

There are several benefits for the startup company in using a convertible note. The main advantage is delaying the initial valuation of the company. The valuation discussions between the company and the investor can be a stressful, time-consuming endeavor, due to the difficulty on placing a value on an early stage venture still in the planning phase. The convertible note offers startup companies a quick resolution to this problem of raising initial capital. It is often simpler, quicker, and costs less in legal fees than conducting a full sale of Series A Preferred Stock. By using a convertible note, the startup company can have access to capital almost immediately and delay valuation discussions until further down the road when they need to raise additional money. Since the company will also spend less time raising and closing the initial funding round, they will be able to spend more time developing the company into a successful operation.

A convertible note offers several advantages for the investor as well. The main advantage is that in exchange for taking the early risk, the investor will receive stock in the company at a discounted rate. Another advantage is that the investor receives some additional protection in its investment with a convertible note as opposed to a straight equity investment. If the company folds before it is able to acquire additional financing and is unable to accomplish the agreed upon goal, then the investor is a creditor. In the event of a company liquidation, creditors get paid back first, before shareholders. Also, the investor may structure the note to be secured by company assets, which would allow the investor to foreclose on the assets of the company to recover its debt. If the investor were a shareholder at this point, the investment would most likely be a complete loss.

Disadvantages to Convertible Notes

While a convertible note can be a great option for a startup company, it is not always the best option. There are some disadvantages with convertible notes, just as there are with all methods of raising capital. One disadvantage of using a convertible note is that once the investor’s debt is converted into stock, the founder’s percentage of ownership in the company is diluted, as happens in any equity financing. Another disadvantage is that when it comes time for the valuation of the company in the next financing, the original investor may seek a lower valuation, which they may or may not have any power to influence. The company wants to maximize the pre-money valuation for the next round to minimize shareholder dilution as much as possible. A lower valuation gives the investor a greater ownership percentage of the company, a higher valuation gives them less. This misalignment of interests could have a negative effect on the company.

The investor faces some disadvantages as well. During a conversion, the pre-money valuation of the company and the percentage of the company received by the initial investor are inversely proportional. This means that the more successful a company becomes between issuance of the convertible note and the conversion event, the higher the pre-money valuation of the company during the next qualified financing. In turn, a higher pre-money valuation means the initial investor will receive a smaller percentage of ownership in the company upon conversion. The investor is sometimes caught between wanting the company they invested in to succeed and not wanting it to become too successful and therefore diminish their percentage of ownership in the company upon conversion. Investors often cite this misalignment in interests as a reason for refusing to do convertible notes. However, the counterargument to this point is the old adage, “Would you rather own 10% of a $1B company or 100% of a $1M company?” Another disadvantage for the investor is that if the company is unsuccessful and unable to acquire additional financing, the company might not have any significant assets to be liquidated or foreclosed on, making it nearly impossible for the investor to recoup the money owed on the note. Although being a creditor and having the ability to foreclose upon the assets of the company can be an advantage, the ability to foreclose is meaningless if the company has nothing to foreclose upon. Because of these disadvantages, many investors are often unwilling to use convertible notes.

Conclusion

If you are an entrepreneur looking to start and fund a new business or an investor seeking to get the most of your investment, a convertible note may be an option worthy of your consideration. Each company and each investor has different requirements, and each investment opportunity is unique, so the advantages and disadvantages of a convertible note will vary in each situation. To discuss whether or not a convertible note is the best option for you, please contact the Copeland Law Firm at 512-850-4529 or info {at} copelandfirm(.)com. Whether you are a startup or an investor, we offer a wide array of services, and would be happy to discuss all of your available funding options.

1. Multiple Business Partners. With multiple business partners or founders, the greater the necessity of getting a written agreement in place that outlines the rights and obligations each has to the other, and how much of the company each founder owns. Incorporating and issuing founders’ shares according to a vesting schedule will help prevent the misunderstandings common among founders when it comes to ownership splits. Trying to clean up pre-incorporation promises to ownership in a startup company is a difficult, time consuming and expensive task, especially if one or more founders leaves before formal documentation is in place.

For more information see our post on splitting up founder equity.

Please be aware that the documents from do-it-yourself online incorporation services do not contain founders restricted stock purchase agreements with vesting.

2. Product or Service Launch. Often the main reason cited for incorporation is to protect founders and other shareholders from personal liability for debts of the company. Therefore, we often counsel people to incorporate prior to launching a product or a service due to potential liability issues, as the potential for liability increases with customers or users, and the amount of liability depends upon the nature of the product or service.

3. Intellectual Property Creation and Holdings. IP needs to be owned by the company and not the individuals working for the company. Before IP is created by an employee or founder, the appropriate IP assignment agreements need to be in place so that upon creation of the IP, the ownership of that IP is automatically transferred to the company. Incorporating creates the place where all of the IP is then transferred, especially important when you have employees or multiple founders. You can run into problems if a founder or employee leaves the business before incorporation and the IP has not been assigned to the other founder or the entity. Subsequent use of IP created by the former founder may be problematic, potentially resulting in costly litigation or expensive assignment negotiations with the departing founder.

Examples of IP created in startups include program or website code, company or product names, trademarks and slogans, trade secrets, patentable products, and copyrights in code or marketing materials.

Again, please be aware that the documents from do-it-yourself online incorporation services do not contain IP assignment provisions for founders or employees.

4. Raising Money. If outside investors such as venture capitalists or angel investors want to invest in your company, you will need an entity to accept the investment and issue securities. In our experience, we consider it a best practice to incorporate early and then immediately issue shares to the founders at the lowest justifiable price (par value, if done immediately). The greater the separation in time between the issuance of founders’ shares and the first round of financing, the easier it is to justify the price difference between the founders’ common stock (ex: $0.001 per share) and the Series A preferred stock (ex: $1.00 per share).

5. Hiring Employees or Independent Contractors. Most founders will need to incorporate if they intend to hire employees or engage independent contractors. It generally makes sense to incorporate so that the employee or contractor enters into an agreement with the company instead of an individual founder. In addition, as discussed above, any IP created by the employee or contractor can be assigned to the company instead of an individual founder. This also has the added benefit of freeing up the individual founder for any personal liability incurred that is owed to the contractor.

Once again, please be aware that the documents from do-it-yourself online incorporation services do not contain IP assignment provisions and do not adequately deal with this situation.

6. Issuing Stock Options. Many startups do not have the cash to pay contractors or service providers and therefore may agree to fully or partially compensate the other parties by granting stock options or giving them the opportunity to purchase shares at highly discounted price. Although it is possible to have pre-incorporation agreements to grant equity upon incorporation, it is easier to incorporate and then grant the stock options or equity to satisfy these promises.

Once again, please be aware that the documents from do-it-yourself online incorporation services do not deal with this situation.

7. Obtaining Visas. If a foreign founder intends to work in the U.S. on a startup project, then the founder should work with an immigration attorney on a strategy to legally work in the U.S. Incorporating a company and demonstrating that it is a “real” business with sufficient capital is typically a prerequisite to a visa application.

8. Favorable Tax Treatment. If a founder sells stock of a company in a taxable transaction and it is held for more than a year, then the capital gains tax rate is 15% for founders in the 25% tax bracket and higher. If the stock was not held for a year, or if no company has been formed and only the assets are sold, the seller’s proceeds will most likely be taxed at the ordinary income tax level, which in the example above would be 25% instead of the 15% long term capital gains rate, an additional tax of 10% on the transaction.

Incorporation is not something to take lightly, as it is a serious step that results in out of pocket costs and ongoing tax and other filing obligations, and therefore we recommend it only when you are serious about your business or one or more of the above factors applies. Before deciding to incorporate, please seek the advice and counsel of an attorney with startup experience, as other factors may impact whether or not you can or should incorporate, such as if one of the founders is still employed by another company. In this case, the founder will need to have his employment documents carefully reviewed in order to determine if there are any issues with non-compete, non-solicitation, or confidentiality.

Delaware

Delaware is often chosen for many reasons, including: 1) insistence of investors and underwriters; 2) established and efficient corporate law and court system; and 3) favorable protections for directors and officers. These are discussed in more detail below.

If you plan on raising money from venture capitalists, private equity groups, institutional investors, or other sophisticated investors you should definitely choose Delaware. Often times these investors will force you to convert into a Delaware company before they invest, so you might as well do it in the beginning and save the added time and money of having to convert at a later date when it might hold up a financing. Also, if you might someday take the company public, the underwriter will most likely force you to convert into a Delaware entity prior to the public offering. If either of these is a possibility for your company, choose Delaware and do it right the first time.

Investors and underwriters insist on Delaware because it has a very favorable corporate law system. It is the home of 60% of Fortune 500 companies and 50% of publicly traded companies for a reason. Delaware courts have extensive experience in corporate law due to specialty courts designed to only handle corporate law issues. This is turn leads to a highly developed body of corporate case law that provides corporations and their counsel with excellent guidance and more certainty on matters of internal governance and liability. In short, corporations and investors know exactly what they are getting into with a Delaware corporation, and this added certainty makes it easier to do business for everyone involved.

Also, officers and directors of Delaware corporations are afforded a great deal of protection when it comes to making business decisions. Absent fraud or self-dealing, the courts will generally protect the good-faith business judgment of the decision maker, which makes it less likely that they will be sued by shareholders who don’t agree with their decisions. And if they are sued, the corporation can compensate them for any losses incurred in the defense. This makes it easier for the lawyers to advise directors and officers on their fiduciary duties in a Delaware corporation.

There are two drawbacks to incorporating in Delaware: 1) you must register as a foreign entity to do business in your home state; and 2) you must pay Delaware franchise tax in addition to your home state corporate income tax and/or franchise tax. Registering as a foreign entity in your home state usually incurs additional legal and filing fees (in Texas you can expect an additional $1000 or so, $750 of which is filing fees). Delaware has no state corporate income tax, but they do have a franchise tax. During the first years of a company with limited assets and few shareholders, the franchise tax is usually negligible and can be calculated using the Franchise Tax Calculator provided by the state of Delaware.

Home State

If you do not plan on raising money from venture capitalists or private equity groups, don’t plan on taking the company public, want to avoid the added expense of foreign registration in your home state, and want to avoid paying Delaware franchise taxes, then you should probably incorporate in your home state unless a large portion of your revenue will be coming from off-shore activities.

Off-shore

There are generally two reasons for incorporating off-shore: 1) some foreign investors are prohibited from investing in U.S. companies; and 2) tax savings on income received from abroad. If you do significant amount of off-shore business you should consider incorporating off-shore to minimize paying U.S. corporate tax on off-shore income. This is an extremely complicated matter of law, beyond the scope of this article, and should not be undertaken without specialized tax and legal counsel.

1.) Equally: each founder get the same amount of equity. For example, with 2 founders each gets 50%, with 3 founders each gets 33.33%, with 4 founders each gets 25%, etc. This method is most often used by first-time entrepreneurs because it seems more “fair” and is easy to get everyone to agree on it at the outset.

2.) Unequally: each founder gets a different amount of equity/shares depending upon various factors such as:

      i. Past contributions: Who came up with the idea for the business? Who helped refine the idea? Who put money into the company to get it started? Who helped find another co-founder or investor?

      ii. Current contributions: Who is doing the most work right now? Are some founders more in an advisory role while others are the boots on the ground getting things done?

      iii. Future contributions: What role will each person play in the early months? Will that person still be playing a key role later down the road? Who will still be working for the company at all?

      iv. Opportunity cost: Is one founder giving up a great job, while the other is currently unemployed? Is one founder dropping out of a good school, while the other is unemployed?

      v. Your relationship: Do you trust your co-founder to make things right at a later date if you end up feeling like you contributed more than he did? Are you willing to fight over the equity and potentially sacrifice your relationship with the co-founders in order to get additional equity?

Common Problems with Founder Splits

One Founder Leaves Early

What happens when one of your founders decides to no longer participate in the startup and they leave after only a few months? Should they be entitled to the same amount of equity as the CEO who sticks around, working day and night, sacrificing friends and family, all to make the company a success? If you aren’t careful with how you divvy up founders shares this is exactly the situation you can find yourself mixed up in.

One Founder Works More Than Others

What happens when all founders receive the same amount of equity, but later realize that one or more of the founders is doing more work than the others? This often leads to resentment and burn-out, which in turn can cause a founder to leave early.

Solutions to Divvying up Founders Shares

In my experience, the best way to distribute founders shares is through unequal distribution with vesting. By getting all of the founders to sit down at the beginning to assess the relative value of their various past, present, and future contributions, often they come up with a more equitable (yet unequal) ownership split. If later on the founders all agree that things should have been distributed differently because their initial estimates were off, the situation can be remedied through the issuance of additional stock options to the deserving parties. These adjustment meetings can also be built into the founders shareholder agreement.

After the initial split is determined, the founders need to discuss the vesting plan. The typical vesting plan is setup so that a founder receives a certain amount of stock every month over a 4 year period. Depending on the circumstances, a few vesting plan options exist: (i) adding a “cliff”; or (ii) vesting a certain amount of stock up-front. A “cliff” is typically one year in length, and means that the founder doesn’t receive any shares until they have been with the company for that amount of time. Vesting a certain amount up-front is the opposite of a cliff, the founder receives a certain amount of shares right away, with the rest vesting over time. Between unequal distributions, adjustment meetings, stock options, and vesting, most problems that typically plague startups can be addressed at a time before the problems arise and when they are easiest address.

At the Copeland Law Firm, we love dealing with entrepreneurs and emerging growth companies, it is our passion. We have advised many entrepreneurs on the formation of new companies, capital structures, financing transactions, employment matters, intellectual property matters, as well as provided counseling on day-to-day legal issues that arise in startup companies. Our clients cover a wide range of industries including software, technology, energy, real estate, insurance, healthcare, manufacturing, construction, advertising & marketing, publishing, and retail.

We realize that not all startups are alike, therefore we offer a range of flat-fee packages and add-ons, so you only pay for what you need when you need it. We will help you figure out what is best for your individual company and we won’t sell you anything you don’t need.

Our most comprehensive startup package calls for the formation of a new Delaware corporation structured for a venture capital investment, registered to do business in the home state, and contains everything you see listed below. This comprehensive package is offered for an up-front fixed fee cost of $2,500 (plus out-of-pocket expenses, such as state filing fees in Delaware and the home state, if applicable). For an additional cost we can establish a payment plan or work out a deferred fee agreement.

Our startup organization package consists of the following documents and services:
• Incorporation and Organization
• Founders Stock
• Stock Option/Stock Issuance Plan
• Employment and Consulting Matters
• Intellectual Property Matters
• Consultations

Incorporation and Organization

• Reservation of corporate name, if necessary
• Preparation and filing of Delaware Certificate of Incorporation
• Preparation of Bylaws and Certificate of Secretary
• Preparation of Action By Incorporator

Preparation of Organizational Board Consent regarding the following matters:
• Ratify actions of Incorporator
• Approval of organization expenses
• Adoption of Bylaws
• Authorization of principal office, foreign qualification, fiscal year and Employer Identification Number
• Designation of the size of the board of directors and election of officers
• Designation of management powers
• Approval of issuance of Founder’s stock
• Approval of stock option grants to Founders, if applicable
• Approval of minutes books, corporate seal and stock certificates
• Approval of subchapter S election, if applicable
• Authorization to open bank accounts
• Approval of form of Proprietary Information and Inventions Agreement
• Approval of form of Indemnification Agreement for officers and directors
• Approval of Stock Option/Stock Issuance Plan and forms of Option Agreements

• Preparation and filing of Form SS-4 Application for Employer Identification Number (and state tax application for the home state where the business is located)
• Preparation and filing for registration as a foreign corporation in the home state where the company is located, if applicable
• Preparation of corporate records book

Preparation of Stockholder Consent regarding the following matters:
• Approval of form of Indemnification Agreement for officers and directors
• Approval of Stock Option/Stock Issuance Plan
• Preparation of form of Indemnification Agreement for officers and directors

Preparation and Issuance of Founder Stock

• Preparation of Founders’ Restricted Stock Purchase Agreements for up to four Founders (with standard vesting terms)
• Preparation of Stock Certificates and Receipts for up to four Founders
• Preparation of 83(b) Elections Memorandum for Founders
• Preparation and filing of state securities documents for stock issuances to Founders

Preparation of Employee Stock Option/Stock Issuance Plan

• Preparation of form of Early Exercise Stock Option Agreement
• Preparation of form of Standard Stock Option Agreement
• Preparation of form of Stock Issuance Agreement
• Preparation and filing of Form U-2 Uniform Consent to Service of Process (in connection with securities filings)

Employment and Consulting Matters

• Preparation of form of At-Will Employment Offer Letter
• Preparation of form of Proprietary Information and Inventions Agreement
• Preparation of form of Independent Contractor Services Agreement

Intellectual Property Matters

• Preparation of form of Unilateral Nondisclosure Agreement
• Preparation of form of Mutual Nondisclosure Agreement
• Preparation of Assignment of intellectual property from Founders to the company
• Preparation of Memorandum re Trademark Matters for a new company

Consultations

Up to five hours of consultation regarding all documents drafted as part of the package, to be allocated however you see fit but typically broken down as follows:
• One hour regarding Venture Capital, Angel funding, and Private Placement
• One hour regarding Founders’ Shares and Vesting
• One hour regarding Stock Options
• One hour regarding Intellectual Property
• One hour regarding Employment Matters

Par value is the minimum price that a share can be sold for. This is typically the price founders pay for their shares, although sometimes I recommend issuing founder shares at a multiple of par value (i.e. Par Value x 10) in order to avoid problems down the road if the company needs to execute a forward stock split and the value of the shares hasn’t increased much. This avoids the situation where a forward stock split would require the new share price to be below par value, something not allowed.

Par Value Price

For stocks, I typically recommend par value be set somewhere between $0.001 and $0.0001. Some states such as Delaware and Texas allow for issuance with no par value, but this can create other unintended consequences. For example, issuing shares without par value in Delaware triggers a different franchise tax calculation, usually resulting in a higher franchise tax burden. This can be easily avoided by setting a par value.

Example

For example, a startup company authorizes 10M shares with a par value of $0.0001, with 8M shares set aside for two founders, split 50/50 between the two. The lowest price each founder would have to pay in exchange for 50% of the shares is $400.00 (4M * $0.0001). Payment of the $400.00 could be made in cash, contribution of services, or contribution of property (real or intellectual), whatever the founders decide is fair for the situation.

It depends. The number of authorized shares only matters if you plan on issuing stock options to employees, raising outside money from investors, or taking your company public. If you plan on any of these, you need to pay attention to the capital structure of your company from the beginning because if setup correctly, it can save you significant time, effort, and legal fees in the long run. If you do not plan on issuing stock options, raising money from investors, or taking the company public, you can pick any number you want (but pay attention to possible tax and filing fee consequences) and divvy them up between the co-founders accordingly. Otherwise, we recommend authorizing somewhere in the neighborhood of 10M shares, with 8M to 9M set aside for the founders and if necessary, the rest set aside for an option pool.

Why?

The 10M shares number is derived by working backwards from the requirements of a successful IPO. Conventional wisdom suggests that a $300M market cap is the minimum needed for a successful IPO because many institutional investors will not even touch a company with less than a $100M market cap. To get there, one needs to assume that you have 20M outstanding shares priced at $15/share for the initial IPO price. Starting with 10M shares at authorization leaves plenty of room to authorize additional shares when needed during a later financing.

Monetary Consequences: Taxes and Filing Fees

Some states, such as Delaware base their filing fees and franchise taxes off of the number of initially authorized shares and/or initial capital, so generally the larger the amount of authorized capital, the higher the filing fee or franchise tax bill. On the other hand, Texas does not base filing fees or franchise tax on the number of authorized shares. Texas has a fixed filing fee, and the franchise tax (now called margin tax) is based off of revenue.

We offer flat fee, upfront price quotes ranging from $2,500 to $7,500 for either company counsel or investor counsel on a convertible note financing. With us, you know how much you will be charged from the beginning and won’t be shocked when you receive your legal bill. Many large law firms routinely charge in excess of $15,000 for the same service (See http://www.askthevc.com/blog/archives/2007/07/how-much-should-1.php). Prices vary depending on how many parties are involved in the financing, how much due diligence is expected or required, and how much corporate house cleaning needs to take place. As a general rule of thumb, the newer the company, the less the cost.

Contact us now to arrange for a free consultation and quote.

We offer flat fee, upfront price quotes ranging from $5,000 to $20,000 for company counsel on a Series A funding from a VC firm that agrees to use one of the model document sets. For investor counsel, our prices range from $2,500 to $10,000 for a Series A funding based on one of the model document sets. With us, you know how much you will be charged from the beginning and won’t be shocked when you receive your legal bill. Many large law firms routinely charge in excess of $50,000 for the same Series A service (See http://www.startupcompanylawyer.com/2007/12/08/what-should-legal-fees-in-a-series-a-financing-be/, and http://www.askthevc.com/blog/archives/2007/07/how-much-should-1.php). Prices vary depending on how many parties are involved in the funding, how much IP and regulatory due diligence is expected, and how much corporate house cleaning needs to take place. As a general rule of thumb, the newer the company, the less the cost.

Contact us now to arrange for a free consultation and quote.