Brette Simon on Legal Issues for VC Backed Firms
June 18, 2010 · Print This Article
Session 5, Brette Simon on Legal Issues for VC Backed Firms
EO/MIT Entrepreneurial Masters Program
Year Two, June 18, 2010
Brette Simon of Jones Day is talking about legal issues for VC backed firms. She did a great job and this was a really good refresher. Here are my notes from the session…
Part I – Dos and Don’t for VC Backed Companies
(or Companies that want to be Venture Backed)
Not having these things buttoned up can cause investors to not want to invest or provide lower valuations.
- Shareholder Agreement – Have a shareholders agreement (buy/sell agreement)
- Corporate Records - Maintain corporate records (make sure you keep Board meeting records, Board approvals, a copy of stock certificates)
- Board Minutes - If you hold a Board meeting, take minutes, put the minutes in the record book
- Shareholder Loans - If you loan money to shareholders, paper them (interest rate, amount, maturity date)
- Buy-back rights - Make sure the company has the right to buy back options or restricted stock if they leave the company (repurchase right).
- Series of Shares - Minimize the number of series of shares (Series A-H might scare investors)
- Types of Options – There are Incentive Stock Options and Non-Qualified Stock Options. Each has different tax treatment.
- Phantom Stock – Consider using Phantom Stock – gives economic value without giving away voting rights (no exercise price and can be better than options as easier to exercise prior to liquidity event)
- Intellectual Property Protection – use proprietary information and assignment of inventions agreement to ensure the company owns everything employees created. Without it being signed, original investor can come back and claim right to royalties to assets of the company. Have each employee sign when they start.
- Personal Expenses - Do not run your personal expenses through the business. It’s not good for investors to see. You don’t want things coming out of due diligence that don’t look right. Can allow the IRS or a creditor to pierce the corporate veil and go after shareholders individually if you co-mingle personal and business because you didn’t honor and respect the corporate entity. Travel & Entertainment line item is getting attention from IRS right now.
- Staff Classifications – Proper classification of overtime and 1099 contractors vs. employees. If you’re controlling what time folks show up and they’re working 40 hrs/week, likely need to be treated as employees.
- Employee Handbook - Have an employee manual and handbook that sets forth the rules and regulations and protocols, and have it signed by each employee. Have each new hire verify in writing they have not taken any IP from their former employer.
- Termination Release – When employees leave/quit/are fired have them sign a release. You have to give consideration for the release (some severance).
- Employment Contracts – Avoid long term employment contracts (use at-will employment letter)
- Insurance – Get EPLI insurance (employment practice liability insurance), difference from Errors and Omissions (E&O) and Director & Officers (D&O) insurance. EPLI protects against sexual harassment claims and wrongful termination.
- Long-Term Contracts - avoid long term contracts without ability to terminate relatively quickly. Negotiate in 60 day termination clauses into 12 month contracts.
- Rights of First Refusal (ROFR) - Make sure people don’t have the right of first refusal to buy your company as this can block the sale of a business even if they are minority.
- Integration & Merger Clause – make sure in all your agreements. Says anything we talked about before this final agreement (oral agreements, etc.) is gone and all that matters is what is in this document.
- Attorney Fees – In contracts have attorney fee provision that says loser pays attorney fees in any litigation.
- Arbitration vs. Litigation - Benefit of arbitration is all private. Everything in a court is public. Litigation is more expensive. Arbitrators tend to split the baby and meet in the middle. ‘Mediation’ can be good to put in document prior to binding arbitration, which is non-binding and less expensive.
- Financial Reporting Systems – critical for investors. A good controller or CFOs is worth their weight in gold. Investors what to know revenue and profit data broken out as much as possible (by product, region, SKU, etc.). You need to close your books once per year and give monthly data. Clean up your old bad receivables.
- Audits – Investors preferred audited financials once the company reaches any scale (>$1M/yr in revenue). Can cost around $15k-$30k. If you don’t have audited financials, need really solid CFO. Without these investors will look for things that are wrong and give a haircut to the price. Minimize reasons investors can haircut valuation.
- SAS 115 letter – Make sure the auditor gives you this after audit if you do one to tell you about your financial controls (aka management letter)
- Management Team & Succession Planning – The company needs to be able to succeed without you. Make yourself irrelevant over time. Don’t have ‘founderitis’ where it is all you that has the operational control or critical sales relationships. Try leaving for 3 weeks and see what happens.
- Customer Concentration – Make sure your largest customer is no more than 20% of your total revenue to reduce investor concern. Particularly of concern to a financial buyer who raises debt to buy your business. They lever the acquisition using debt capital. Not as concerned to a strategic buyer.
Part II – Raising Capital
- Friends and family round – often sell common stock to instead of preferred stock. Likely the only money you can get pre-prototype when you’re just getting started. If you can self-finance through this stage, do it.
- Angel/seed round – Between $25k and $500k. Invest at early stage.
- VCs – Invest sometimes pre-revenue but usually when firm is generating $500k-$50M of annual revenue.
- Private Equity – Investing in companies at a later stage when they have positive EBITDA. Looking for $2M+ annual EBITDA. PE firms use debt. In an Leveraged Buy Out (LBO), put in as little equity as possible and as much debt as possible.
- Types of stock – Common stock and preferred stock. Investors get preferred stock usually.
Key VC Terms
Work to get multiple term sheets at the same time so you have much more leverage in the negotiation. Run a disciplined process with a target timeline for each stage and give investors who express interest a target date for receiving term sheets so you get them close to the same time (same day ideally and definitely same week) and can negotiate.
- Participating preferred – Double-dipping for investors and very anti-entrepreneur. Investors get all their money back first then participate equally in the upside. Avoid in term sheets if possible and look for ’straight preferred’ (aka ‘vanilla preferred’). If you have to do participating preferred, say OK but cap it at 3x or 4x return and leave the rest to the common.
- Liquidation preferences – Also avoid liquidation preferences above 1x.
- Dividends – Sometimes there are dividends (~8%) in preferred stock that compound and accrue. Avoid this if possible.
- Anti-dilution protection – Comes into play when in a down round. Better to have a weighted average than a full-ratchet anti-dilution protection. Full-ratchet would give investor shares at the new lower price instead of something in the middle. Broadbased weighted average better than the narrow base for the entrepreneur.
- Mandatory Redemption – Forces company to buy-out investors shares at some point in the future.
- Right of First Refusal – If you are trying to sell your shares to someone else, the investor has the first right to buy those shares.
- Right of First Offer – If you issue new shares in a future round, the original investor has the right to buy in pro-rata to maintain their ownership percentage. You can put in a play-to-play position to flip on head and require investor to invest pro-rate or they may lose rights (like convert their shares to common).
- Investor Rights Agreement - Says that investors can force an IPO
- Board Composition - Usually investors will have seat on Board. Initially shoot for 3 person board with 2 internally members (founders or CEO/CFO) and investor. If have to go to 5 person board with 2 internal, 2 investors, and 1 independent nominated by common shareholders.
- Drag Along Rights – Helps investors get out if they are the majority shareholder. Investors have an end-game. In 3-5 years they usually want to be out. This is a right that enables majority shareholder to force minority shareholder to allow the sale of the company.
- Reverse Vesting – Investors can unvest shares you already own and force you to vest shares over additional years. A customary term, be aware of it.
Stages of raising capital (4-6 months)
Adding this in from my own experience. Brette only mentioned this timeline lightly. This is for running a competitive process and getting multiple term sheets, which is ideal but not always possible.
- Decide whether to hire an investment banker or not to help raise the funds (usually costs 4-5% of the funds raised). Usually best to do yourself if early stage. Investors prefer non-ibanked deals. Investment banks can help a lot if later stage (post $25M in annual revenue) or if raising large round of more than $20M.
- Create executive summary (3-4 pages) and teaser deck (~25 slides)
- Determine firms who would be good investors
- Reach outs with teaser/exec summary
- Schedule calls with investors who are interested
- Schedule meetings (at their office usually or on-site at your office for later stage firms)
- Ask for indications of interest
- Execute NDAs/Confidentiality Agreements if later stage. Make sure you can assign/transfer NDAs to any buyer of your business. Early stage investors often won’t sign NDAs.
- Allow access to data room of initial diligence materials if there is one
- Set date target for receiving term sheets with interested parties
- Receive term sheets. Get them to be as detailed as possible.
- Negotiate term sheets
- Sign term sheet with investor you select, go exclusive with them
- Complete final diligence items (30-45 days ideally)
- Sign final documents
- Get funds wired
Recommendation reading on investing is book Growth Company Guide 4.0 by Clinton Richardson. Remember the specific person who will be joining your board is just as important as the firm itself.
If you’re considering selling the company, recommended to hire an investment banker to help you focus on running the business and making sure the results come in. They know what market terms on. They do it for a living. They help create an auction process. You’ll usually pay between 2%-5% of the sale price to the banker. Get a lawyer involved to help.
- Restricted Stock Units (RSUs) vs. Options
- 83(b) elections
- When you exercise Incentive Stock Options (ISOs), when do you pay cap gains and when do you pay ordinary income tax?
- When is Alternative Minimum Tax (AMT) triggered?