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The Entrepreneur’s Shares: Mintz Levin’s Model Certificate of Incorporation for Start-Ups
A thoughtfully drafted set of formation documents will put founders in the best position possible when it’s time to raise capital. Mintz Levin has developed a model Certificate of Incorporation, using a special class of common stock dubbed the “Entrepreneur’s Shares,” that aims for a balanced approach, protecting founders’ control over their companies while still appealing to outside investors. Our model Certificate of Incorporation can be found here.
You can read more about the Entrepreneur’s Shares and our model Certificate of Incorporation here.
The New Rule 506: A Useful Crowdsourcing Tool
When the JOBS Act was passed in the Spring of 2012, all the “buzz” was about the imminent advent of “Crowdfunding”. But as legal practitioners, business persons, and pundits looked closer at the details under the Crowdfunding rules contained in Title III of the JOBS Act, it became readily apparent that Crowdfunding for equity was a long way off and might never be of significant value for emerging companies. What was overlooked in the JOBS Act by much of the press and public, however, was the proposed sea change in Rule 506 for private placements as contained in Title II of the JOBS Act. The SEC has now published the final rules for the new Rule 506 and that sea change (which may turn out to be a tsunami) is about to occur.
Effective as of September 23, 2013, Issuers of shares may use general solicitations to effect a private placement. The amount that can be raised is unlimited. There is no requirement for review of the offering by any State Securities Commission (blue sky laws) and there is no review of the offering by the SEC. Solicitations can be on-line or offline and made to any potential investor. The completed sales, however, must only be to “accredited investors” and the Issuer has the burden to verify that the investor is “accredited”. In effect, the new Rule 506 may well become the “crowdsourcing” tool that emerging companies have long been looking for.
Who Might Use The New Rule 506.
The new Rule 506 may prove to be a very effective tool for emerging companies to raise capital directly. No need to engage a middle-man; no need for a broker. If a Company has a strong affinity group or user base, it could simply email its registered users or customers and ask if they would be interested in learning about investing directly in the Company. A short video could be attached as part of the invitation. Or, a Company could simply have a link on its website inviting those interested in investing to click through to learn more. Using the Web or mobile apps, a Company could come up with some very creative solicitations. Of course, the Company will have to make sure that all solicitations are accurate and that they do not include puffery. Further, Companies will need to make sure that each potential investor receives a full private placement memorandum and the Companies will be required to verify that each investor is indeed “accredited”. Additionally, Companies will need to think about how to make sure that any confidential information included in a private placement memorandum remains confidential. But these limitations can be easily managed and raising capital directly from a Company’s user base could become a powerful form of crowdsourcing.
What Is Venture Capital?
Most of us go through our lives down a certain path. We grow up in our house or apartment; we go to school; we get a job; and eventually we grow up (one way or another) and live out our lives: sometimes happily, sometimes not so happily, and most times a little bit of both. In the course of this journey, many of us dream about starting something new, such as a new business based on a new concept or new paradigm. For many of us it is just a daydream. But for some, it is a call to action. Time and time again, an individual figures out a new way to look at things. Then from a scrap of an idea, and against great odds, this individual begins to build a new business. This creation of a business from the embryo of a concept is the genius of the entrepreneur. Instead of staying on the linear curve of what has been and what appears inevitable, a person jumps off the curve and ventures onto a new tangent. More often than not, that tangent leads to a dead end. But when it is successful, the financial rewards to the creator in our capitalist society are beyond most of our wildest dreams. In the crass terms of our capitalist society, the successful entrepreneur is able to turn a concept into cash.
The engine that drives this process is the capital invested in these new businesses. The term generally used for this type of capital is called venture capital, although a more apt name would be adventure capital. Each new idea turned into a business is an adventure and takes on a life of its own. More importantly, the capital invested in these new businesses help to create jobs, build dynamic companies, and fuel the growth of our economy.
Although many people believe that venture capital is a recent phenomenon, venture investing has likely primed new businesses in every culture that has a merchant class. For example, in Roman society, Marcus Licinius Crassus may have been the leading private investor of his times. During the reign of Julius Caesar, he was reputed to be the richest man in Rome. At that time, many of the buildings built in Rome were constructed of wood. Not surprisingly, these wooden buildings were susceptible to fire. Rome did not have a public fire department. In order to maximize his leverage in acquiring investment property, Crassus created his own fire department. Then, when a building caught fire, Crassus would send over his private fire department and offer to put out the blaze and, of course, offer to purchase the property at a steep discount. But Crassus's plan went one step further, bordering on true genius. If the owner refused, Crassus and his firefighters would simply leave without dousing the flames. At that point, the discount really became steep. Crassus was probably not only one of the first venture capitalists, but also one of the first vulture capitalists.
With the advent of the industrial revolution in the West, banks became a leading source of financing for business enterprises. Banks, however, generally loan money against assets. Often, new enterprises lack sufficient hard assets to pledge as security or are just too risky to qualify for typical commercial bank financing. Such new ventures usually require "risk capital," which generally takes the form of an equity investment. In the 19th and early part of the 20th centuries, the providers of such risk capital were usually wealthy individuals. Over the last century, however, merchant bankers and then venture capitalists emerged as significant providers of the risk capital needed for new investments.
In the United States after World War II, a new group emerged to finance these ventures. The new group is the professionally managed venture capital funds. These funds are set up solely to invest in new enterprises. This group is largely responsible for the explosive growth of new enterprises in America. In 1980, about $2 billion was raised for venture capital funds. Just 20 years later, in 2000, there may have been more than $100 billion raised for venture capital funds.
Today in the United States, new businesses are funded by a combination of wealthy individuals (often called angel investors), merchant banks, venture money from large, legacy corporations, and professionally managed, private venture capital funds. The driving force in this process and the opinion leaders in this arena are the professionally managed, private venture funds. Typically, in the United States, the most successful new enterprises will, at some point in their economic cycles, receive funding from a venture capital firm.
One way to measure the impact of venture capital is to look at the percentage of venture backed companies in the context of the overall public stock market. According to Professor Paul Gompers at the Harvard Business School, by the end of 2000, venture-backed firms that had gone public made up over 20% of the total number of public firms in existence in the United States at that time. Further, at the end of 2000, such publicly traded venture backed companies had a market value of $2.7 trillion, representing approximately 32% of the total market value of public companies in the United States?
Venture Capital as we know it today in the United States is truly a phenomenon of the post World War II economy. Arguably, the first modern venture capital firm in the United States was established in 1946 by General George Doriot, then a Harvard Business School professor. Doriot started a company called American Research and Development (ARD). ARD's goal was to finance commercial application of technologies that were developed during World War II. ARD's biggest success was its investment in Digital Equipment Company (DEC). In 1957, ARD invested $70,000 for a 77% stake in DEC. Over the next 14 years, the value of ARD's investment increased to $355 million. Thus, began the concept of hitting a "home run" in venture investing. The year 1957 was also the year that a fellow named Arthur Rock, then an investment banker at Hayden, Stone & Co. in New York City, traveled to California to look at investing in a silicon chip company. Rock's efforts eventually led to the funding of Fairchild Semiconductor and the beginning of the rapid growth of the Silicon Valley economy. Rock subsequently moved to California and formed two of the earliest venture capital funds based in California. His investments in such leading companies as Intel, Telethons, and Apple are testament to his influence. There is little doubt today that the venture funds play a major part in driving the economy of the United States.
I have started out with this discussion of venture capital and its history because it is critically important for the entrepreneur to fully understand the nature of the venture capital business. Unless an entrepreneur is able to fund the enterprise by himself or herself, learning to work with the venture capitalists is imperative to the success of his or her business. What the venture capitalist is looking for is the next new big thing. The venture capitalist's job is to look around the corner and place big bets on potential big winners. What the entrepreneur must do is position his or her company in such a way, that the venture capitalist is willing to make that big bet on the entrepreneur's business. Together, the founder's ideas as fueled by the dollars of the venture capitalist will enable a new business to take on a life of its own; and hopefully such "adventure" will prove hugely successful and financially rewarding.
 Venture Economics/National Venture Capital
 Gompers, Paul. "A Note on the Venture Capital Industry". HBS 7.12.01
 Gompers, Paul. "A Note on the Venture Capital Industry". FIBS 7.12.01
What Makes a Good Business Plan?
The way most businesses are initially funded is by the three Fs. That is, by "friends, family, and fools." After all, who else would provide the initial seed capital to start a new enterprise? But self-funding (or relying on friends and families) will only take you so far in building out your new business.
Clearly, the longer a founder can develop the business without the infusion of outside professional capital the more control and ownership will be retained by him or her. That is why many founders choose to "bootstrap" their enterprise as long as possible. Often founders will max out their credit cards or take out second mortgages against their homes in order to fund their new businesses. Sometimes founders are fortunate to attract wealthy individuals, commonly known as "angels," who can help them with start-up capital. At some point, however, in order for an enterprise to create significant and meaningful value, it will likely need the fuel provided by large sums of capital that is available from professional venture capital investors. But how does one go about presenting the new business to the venture capitalist?
The first thing the entrepreneur must do is create a business plan. The business plan is an incredibly important tool for a number of reasons. If the founders cannot state the business case in writing as to why the enterprise is a viable commercial enterprise, they might as well quit before they start. The discipline of writing out a business plan in an organized and compelling form helps an entrepreneur to get focused on the truly important aspects of the enterprise. Further, it should provide a roadmap on where the business intends to go so that an entrepreneur has a clear idea of the trajectory of the enterprise.
Perhaps the worst business plan I ever read was created by a pair of Harvard MBA graduates. It was beautifully printed in color with wonderful diagrams and graphs and was at least 75 pages long. The problem with it was that the underlying business related to high-end gifts for pets and was not at all compelling. The market for high-end gifts for pets is clearly limited! In contrast, one of the best business plans I ever read was 1 1/2 pages long in broken English from an expressive Israeli entrepreneur who even misspelled the word "warehouse" as "whorehouse." But the underlying business concept was so compelling that the company immediately obtained venture funding and eventually went public. So the moral of this story is that to attract venture capital investors, substance counts considerably more than form.
In short, here is what a good business plan should describe:
- The market
- The unmet need in the market
- The solution
Or, to state it another way:
- Describe the opportunity of the market
- Describe the problem in the current market
- Set forth the solution (which is the business!)
The plan should be concise: 20 to 30 pages should be sufficient and should include a brief two-page Executive Summary. You should be able to describe the basic premise of the enterprise in three to five sentences. If you cannot, then you are not thinking clearly and focused enough, and the business is likely to fail.
The business plan must include data to support your contentions about the market and the problem in the market. The plan should also include proprietary aspects such as technology and patents, as well as the business's competitive advantages. Financial projections must be included, and for the first year, should be on a month-to-month basis. Financial projections should focus on at what point in time will the business be cash-flow positive or as I state it — self-sustainable. There is a huge difference in the valuation of a business when it needs capital solely for growth and not to cover its operating deficit. Most importantly, the financial projections must be believable. Outrageous or preposterous projections are a quick invitation to be "dinged" by the venture capitalist.
One of the critical issues for a venture capital firm is whether the opportunity is large enough to make it worth the bet. The venture capital funds are designed to obtain outsized returns on companies that can grow rapidly from a start-up to an enterprise of significant and meaningful value. Venture capitalists are not in the business to grow small businesses. The venture funds assume that many of their investments will not succeed so that the ones that do must succeed in a very large way. Many opportunities presented to venture funds are simply too small and will be dinged.
Another reason that a venture firm may pass on a company is that the business plan is unbalanced. If a venture firm feels that the founders are not being realistic about the business or the industry and neglects to discuss possible negative assumptions, such as potential competition, it raises a red flag to potential investors and diminishes the chance that a venture firm will invest. Sometimes a business plan is just too long and overwrought with too much irrelevant information.
Once the business plan is ready, the next task for the entrepreneur is getting it in front of the right venture capitalist and getting the opportunity to make that all important pitch. The key will be to find the right financial backer that shares your vision and will work with you as a partner as you create a sustainable business.
What Is a Term Sheet?
When a venture capital firm is interested in a company it will meet with the management team numerous times to understand fully the business model and to learn more about the management. At some point in the process, the venture capital firm will decide that the investment is worth pursuing and will present a Term Sheet to the company. The Term Sheet (which is a nonbinding letter of intent) sets forth the basic terms and premises upon which the venture capital firm would be willing to invest.
The Term Sheet does not address all of the issues and matters that may arise in the course of preparing a definitive investment or purchase agreement, but rather is intended as an outline of the material terms of the understanding regarding the proposed investment by the venture capital firm. Although not legally binding as to most provisions, the Term Sheet serves as the road map for the lawyers to draft the documents that will be binding on the parties. In the course of the final negotiations for the definitive documentation, the parties will often refer back to the Term Sheet for guidance. Accordingly, it is important that the Term Sheet be clear and that the most important terms and conditions to the investment be spelled out. One may ask why bother with a written Term Sheet if most of the provisions are nonbinding and subject to final documentation? The short answer is, as Samuel Goldwyn once said, a verbal agreement isn't worth the paper it is written on!
One of the key issues of negotiation will be the valuation of the company. That is to say, how much equity will the venture capital firm obtain for its investment in the company? Or, to look at it from the flip side, how much dilution will the current owners of the company experience when the venture capital firm invests? To help answer these questions, the venture capital firm will try and estimate what the company may be worth in five years. This is accomplished by considering reasonable assumptions as to revenue growth and expenses as well as basing the values against comparables of publicly traded businesses with similar business models or within similar business sectors. The venture capital firm is generally looking to obtain an eight- to 10-times' return on its investment over a five year holding period. For example, if a venture capital firm thinks it can sell a business for $100 million in five years, it may be willing to invest based on a post investment valuation of $12 million. The venture capital firm assumes that only about a third of its investments will be truly successful so that if it is able to obtain an eight- to ten-times' return on its winners, the winning investments will balance out the rest of the portfolio in which it may lose money or only generate small returns. Ultimately, on a portfolio basis, the venture capital firm is looking for returns north of 15%, and 20% returns or greater across its entire portfolio would be a very successful fund for a venture capital firm. Like a baseball player, if a venture capital firm gets a "hit" on one out of three investments, it would be hitting over 300 and would be considered a great success.
In addition to focusing on valuation, the venture capital firm is looking to own enough of the equity of the company so that it has a meaningful stake. Typically this will range from 15% to 25% of the equity ownership of a company. For example, if a venture capital firm is looking to invest $2 million into a company in return for 20% of the company, the valuation of the company after the investment would be $10 million. This valuation is called the "post-money" value of the company. You obtain the post-money valuation by multiplying the number of shares outstanding immediately after the investor invests, by the most recent per share price paid by the investors. The "pre-money valuation" is the value of the company immediately prior to such investment. This pre-money valuation is calculated by multiplying the total number of shares outstanding prior to the investment, by the per share price to be paid by the new investors. In the instant example, where the venture capital firm is looking to invest $2 million for 20% of the company, the post-money valuation would be $10 million and the pre-money valuation would be $8 million. If the stock were sold to the investors at $1 per share there would be 10 million shares outstanding after the investment was completed.
One point of contention on valuation is whether the shares reserved for the employee stock option pool should be included when making these calculations. The venture capital firm will almost always insist that the stock option pool be included. For example, if 25% of the equity is reserved for future issuance to employees in the stock option pool and the venture capital firm is investing $2 million for 20% of the company, and assuming that the stock is purchased at $1 per share, then at completion of the investment, the venture capital firm would own 2 million shares and 2.5 million shares would be reserved in the stock option pool. Only 5.5 million shares (not 8 million shares) would remain with the rest of the prior investors. The post-money valuation remains at $10 million.
From the entrepreneur side, the discussion not only involves valuation and dilution, but also how much cash does he or she need in order to reach either (i) a milestone where additional capital can be raised at a stepped-up valuation or (ii) cash flow break-even on an operational basis. If the entrepreneur raises too little money, he or she will risk needing to raise more capital later at a point in time when he or she will have very little leverage in the negotiation. If he or she raises too much capital, he or she will suffer more dilution of his or her ownership than is necessary. Generally, however, it is better for the entrepreneur to be willing to suffer a bit more dilution and to raise a little extra capital in order to enable the company some additional runway for success. Owning less of a successful enterprise is clearly preferable to owning more of an enterprise that is undercapitalized and doomed to fail.
After there is an agreement as to the valuation, the next issue will be the type of securities to be issued. The venture capital firm will generally insist on securities that are senior to the Common Stock. The venture capital firm wants to be able to have seniority as to a return of its capital in the event of a sale or liquidation (a "preference") and the right to certain "protective provisions" so that it can maintain some control over how the company is operated and whom may become a shareholder. Generally, the venture capital firm will be looking to receive Preferred Stock. However, if the investor is an individual such as an angel investor, he or she may want the enterprise to be formed as a limited liability company ("LLC") for pass through tax purposes and thus they would invest in some form of "Senior Membership Interest," which would have similar attributes to Preferred Stock.
The venture capital firm will want a preference as to its capital if the company is sold or liquidated. There are generally two types of preferences: a liquidating or ordinary preference (also known as a nonparticipating preference) and a participating preference. Under an ordinary preference, if a company is sold or liquidated, the venture capital firm would have a choice of receiving back its invested capital — that is its preference — or taking its pro rata share of the proceeds from the liquidation or sale by converting the Preferred Stock into Common Stock. The rationale behind the liquidation preference is that it is meant to be downside protection for the investor. By having a preference, the investor is more likely to at least get its capital back and will be entitled to its capital back before anyone else shares in the proceeds. If the sale or liquidation proceeds are large enough, however, the venture capital firm would opt to convert its Preferred Stock into Common Stock and to take its pro rata percentage ownership share instead. Thus the downside for the investor is protected while preserving the upside. Sometimes the venture capital firm will insist on a multiple return of its capital (such as two or three times) as the preference. Multiples of the liquidation preference can be problematic however, because the large preferences created may ultimately be a disincentive to attracting top management and employees who will not want their equity and options sitting junior behind the large preference of the investors in the event of a sale of the company.
A participating preference provides the venture capital firm with both downside protection and potential upside gain without having to make any calculations as to whether to convert to Common Stock if there is a sale or liquidation. Under a participating preference, the venture capital firm receives back its capital first and, additionally, is then able to participate as a Common Stockholder in its pro rata share as to the remaining proceeds. This is the best of all worlds for the investor and why some entrepreneurs call a participating preference a "double dip." Often, as a compromise between the company and the venture capital firm, the parties will agree to a participating preference but with a cap as to its participation at two or three times its capital invested. With a participating preference with a cap, the venture capital firm could choose to take its participating preference (where it would receive its capital back first and then its participation as a shareholder subject to the cap), or if the proceeds from a sale are large enough, it can opt to convert to Common Stock immediately and forego its preference and take its pro rata share of the proceeds without the limitation of a cap.
The venture capital firm will also want a preference as to dividends. By attaching a set dividend rate to the Preferred Stock the venture capital firm can add extra returns to its investment. The dividend is often cumulative, which means it accrues each year even though it is not paid. Additionally, the venture capital firm may request that the dividend be paid in kind (known as a PIK). This means that the dividend is paid in more shares of Preferred Stock or Common Stock. This can be helpful for a company that is concerned about its cash position and at the same time will add to the ultimate returns of the venture capital firm.
Most venture capital firms will also want to focus on the protective provisions. The protective provisions are terms that will be written into the company's charter that expressly state that the consent of some percentage (typically a majority) of the holders of the Preferred Stock is required in order for the company to take certain actions. These provisions are often subject to much negotiation, although it is difficult for a company to argue persuasively against any provision that protects the holders of the Preferred Stock as to seniority and preferences. The typical protective provisions are likely to require consent for the following actions:
- Merger or sale of the company or sale of substantially all of the assets of the company.
- A modification of the rights, preferences, or privileges of the Preferred Shares.
- An increase in the number of authorized Preferred Shares.
- The creation of any class of shares senior to or on parity with the Preferred Shares.
- The issuance of any securities that convert into Common Stock at a price per share less than the purchase price for the Preferred Stock.
- The reclassification of outstanding capital shares of the company.
- The modification of the company's charter or bylaws, if such action would materially alter the rights of the Preferred Shares.
- The incurring of any debt outside the ordinary course of business.
- The filing for bankruptcy protection or an assignment for the benefit of creditors.
One other area of much discussion in Term Sheets is price protection for the venture capital firm. What the venture capital firm does not want to do is invest in a company and later have other investors invest at a lesser price. In order to protect against this scenario, the venture capital firm will want some provision relating to price protection. The two types of price protection are called "full ratchet" and "weighted average." Under full ratchet, the price per share purchased originally by the venture capital firm is adjusted to an amount as if it had paid the lesser price originally and, accordingly, the venture capital firm will receive additional shares. Under weighted average price protection, the venture capital firm's shares are adjusted to match an average of the price per share paid to the company weighted with respect to the number of shares issued. Companies will invariably argue vigorously for weighted average and most venture capital firms are willing to give on this point. That said, companies should be aware that the protective provisions usually give the venture capital firm a blocking right as to the issuance of additional Preferred Shares and as a result the venture capital firm can later block the issuance of Preferred Shares at a lower price if it does not have its own shares re-priced to that lower valuation. As such, perhaps the venture capital firms are not being so generous when they "give in" on the weighted average type of price protection.
Another issue that is discussed in the Term Sheet is the composition of the board of directors. Many venture capital firms will prefer a smaller board of directors so that a core group of professionals can move quickly to make decisions. Often, venture capital firms will desire control of the board, but unless the venture capital firm owns 50% or more of the company, this is clearly a reach by the venture capitalists. Typically, the parties will agree to a board that consists of some members from the company and some members from the investor groups and one or more independent directors to be mutually agreed upon. The independent directors are particularly helpful if the company anticipates the need for additional rounds of financings. The independent directors can act as a balance between the varying interests of the investors and the management. Sometimes where there are a limited number of board seats available, certain investors may be granted "observer rights." What this means is that a person may attend the board meetings but has no right to vote. This use of the board observer is often helpful where a company is trying to assemble a group of investors for a large financing and every investor wants a seat on the board. Most corporate governance experts recommend an odd number of directors so as to avoid any potential deadlocks in voting. That said, I have rarely seen a board act if there was not a consensus or a decisively clear majority. If a board is down to deciding major decisions by the difference of one vote, it is probably a dysfunctional board and the company is likely to be in trouble. Good directors are able to work together towards a consensus in a bipartisan way. Boards of directors that resemble the US Congress are doomed to fail.
One final issue in the Term Sheet worth discussing is known as the "Standstill Provision." Basically what this provision says is that the company will not look to raise any capital from any other party until the venture capital firm completes its due diligence. It is in the interest of the venture capital firm to lock up the company for as long as possible to enable the venture capital firm to make a thorough investigation of the company. During the due diligence phase, the venture capital firm may learn of things about the company so as to want to renegotiate the purchase price. Clearly it is in the venture capital firm's interest to provide as long an exclusivity period as possible; and just as clearly it is in the company's interest to limit the time frame of this period and move quickly to a final deal.
What Is the Right Relationship Between an Entrepreneur and a Venture Capitalist?
One of the hardest lessons for most entrepreneurs to learn is that they need to work in partnership with their financial investors. If the entrepreneur and the financial investor cannot get on the same page, the company is bound to fail. Thomas Friedman, the insightful columnist for the New York Times, once wrote a great piece on what he called "the theory of everything." That is, he tried to explain in one unifying theory how all political events worked in today's world. Here is my take on "the theory of everything" but as it applies to investments in start-up companies.
The most successful start-up ventures are companies where the varying economic interests are sufficiently aligned so that a new enterprise can not only be created, but also grow to become commercially viable. The founders are usually what I call the Messiah and three nerds. The Messiah has a creative vision and genius and he is able to convince a number of his buddies to join and follow him to the Promised Land. The investors, usually the venture capitalists, are willing to invest in the founders provided that they have reasonable protections and believe they can make a financial return commensurate with the risk. The employees or regular workers need to be incentivized to work long hours at lower wages by getting an ownership stake through the issuance of options. Often, professional management needs to be brought in and they too need to be incentivized properly with an ownership stake. Finally, outside directors need to be brought into the mix so that the enterprise stays within the accepted business norms, and to add credibility to the enterprise within the entire financial community. Those companies that do not properly align all these interests invariably blow up or fall apart. The unifying factor I have found is that where everyone stands to gain ECONOMICALLY and feels like they have an OWNERSHIP stake in the enterprise, the venture is much more likely to succeed. Generally, everyone's unifying interest to better themselves economically will override each individual's own personal emotional and power issues. Or as I often state it, greed will generally trump personal stupidity.
Unilateral action by the financial investors leads to a failed enterprise over the long run. When the venture capitalists take action solely because they can, the enterprise will usually fail as management and workers will either leave or work at less than full capacity. The venture capitalists, having the ultimate power of the checkbook, generally can write the rules on how to run the enterprise. When the investors overreach and act unilaterally and solely for their own benefit the enterprise almost always fails. In contrast, if they use their money as an incentive for the other parties to follow a certain discipline of business rules, then the enterprise has a much greater chance of success and the chances of monetary gain is greatly increased for all.
As the entrepreneur begins to assemble the pieces to a successful business, it is imperative that he remember that it requires the maintenance of a careful balancing act among all the parties involved. The successful evolution of a company from a start-up to a self-sustainable business enterprise depends, in large part, on the interaction of the various parties participating in the enterprise. A team that works together has a chance to succeed. A team pulling in many different directions is a recipe for failure.
 Friedman, Thomas. "A Theory of Everything" The New York Times June 1, 2003
Why Does a Company Issue Stock Options?
One of the critical keys to a successful venture is aligning the interests of the employees and management with the interests of the shareholders/investors. After all, perhaps the greatest asset of a company is its people. Without a competent and motivated workforce, a venture is unlikely to succeed no matter how great an idea or business concept is involved.
One way to align the interests of the employees with the investors is to create a culture of ownership. Many start-up enterprises have limited capital and need to conserve their capital spending until they become cash-flow positive from operations. Accordingly, most start-ups are not able to pay wages that are equivalent to large, legacy companies. Further, since many start-ups may not succeed, taking a job with a start-up enterprise is more risky than taking a job with an established company. So why would anyone take a job with a start-up enterprise? The answer is equity! By joining a start-up an employee has the opportunity to obtain an equity stake at a low valuation in the enterprise with the hope that one day that equity stake will be worth a significant amount. By granting equity rights to the employees, the employees are no longer just workers — they are also owners. When you are an owner, your work is not "just a job," and you are more willing to take on responsibility and take pride in your work-product.
The most typical way of granting employees an equity ownership in a company is by the issuance of stock options. A stock option gives an employee the right to buy a fixed number of shares in a company at a fixed price over a certain period of time.
There are two types of stock options granted to employees: Incentive Stock Options ("ISOs") and Non-Incentive Stock Options ("NISOs or "Non-Qualified Options"). Historically, ISOs were created to provide a tax-efficient way of granting equity to employees. The operative provisions relating to ISOs is Section 422 of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"). A Non-Qualified Option is any option that does not fit within the specific criteria of an ISO spelled out in Section 422 of the Internal Revenue Code.
The tax advantage of an ISO is that there is not tax on the date of grant of the option and there is not tax on the date of exercise. That said, the tax benefits attributable to ISOs may in fact be somewhat illusory. Although there is no tax on the date of exercise, the amount of gain between the exercise price and the fair market value will be considered for AMT (alternative minimum tax) purposes by the IRS. Thus, an employee who exercises his option may have to pay taxes under the AMT provisions, even though he or she may not have realized any cash yet from his or her options if he or she has not in turn sold the stock received upon exercise of the options. Secondly, in order to obtain long-term capital gains treatments on the options, the employee must hold the stock received upon exercise of the option for at least one year before selling. As such, the employee will have to bear the market risk that the stock price may go down below the exercise price of the stock options before he or she sells his stock. This set of circumstances may result in the employee actually losing money on the options! Because most employees do not wish to take the market risk that the stock received will go down in value, most employees exercise the options and sell the underlying shares on the same day. The result of this is that the employee receives short-term capital gains treatment on the sale of the stock, which is the same taxable rate as ordinary income. Since the ordinary tax rates are significantly higher than long-term capital gains rate, the purported tax benefit of obtaining ISOs is often nonexistent.
One of the most vexing problems for companies (and their board of directors) is determining the fair market value of its Common Stock for purposes of calculating the exercise price. In a public company, determining the fair market price of stock is made quite easy by looking at the closing price on the company's stock as quoted on the appropriate exchange or electronic market. For private companies, the task is not so simple. Stock options are generally granted for shares of Common Stock. The shares purchased by a venture capital firm are for Preferred Stock. By the terms of the Preferred Stock, it is senior in liquidation and in dividends to the Common Stock. Because the Preferred Stock is senior in terms of liquidation and in dividends, the Common Stock is less valuable than the Preferred Stock. In many instances, upon a liquidation or sale of a company, the preferences of the Preferred Stock may use up all or nearly all of the proceeds leaving very little consideration attributable to the Common Stock. Thus, in many early-stage companies, the fair market price per share of the Common Stock should be at a significant discount to the price per share of the Preferred Stock. The employees would like the board to determine the discount to be as great as possible, and it is not atypical for early-stage companies to have stock options priced at a 90% discount to the price of the Preferred Stock. As the company matures, however, the difference in value between the Preferred Stock and the Common Stock should narrow, as there should be sufficient proceeds attributable to the Common Stock for the holders to be made whole as the company hopefully accretes in value. Further, if the company is nearing an initial public offering, where all the Preferred Stock will have to convert to Common Stock when the company goes public, there should be relatively no difference in fair market value between the price of the Preferred Stock and the price of the Common Stock. The problem for the board of directors is how to make these valuation decisions and when. To further complicate the situation, Regulation 409A of the Internal Revenue Code, places an excise tax on the employees if the valuation is too low and cannot be substantiated. Generally, the board will engage an independent valuation expert to provide what is now commonly known as a “409 Valuation.”
One of the key issues for boards of directors to consider when issuing stock options is the vesting schedule. Vesting refers to the timing during which an employee can exercise his or her options. What the company wants to set up is the business dynamic whereby the employee feels he or she needs to remain with the company in order to obtain significant economic upside. Sometimes this is referred to as a "golden handcuff." What a company does not want to do is grant a large equity stake to an employee on Day One and see that employee leave for another opportunity but continue to own a large equity stake in the company. Accordingly, smartly managed companies set up vesting schedules for options so that the employee must stay some set minimum period of time before any options vest and are exercisable. Typically, options will be fully vested over three to five years.
Many companies set up something called "cliff vesting." What that means is that options do not vest for a period of time — say one year — but after that point in time, the entire year's worth of options will vest. After the initial cliff period, the remaining options will continue to vest regularly on either a monthly or quarterly schedule.
What Are the Typical Exit Strategies for a Start-Up?
One of the underlying tensions within a venture-backed enterprise is that the management and the venture capital firm may have divergent exit goals. For the venture capital firm, the primary goal is a return on its investment. The venture capital firm has a fiduciary duty to its own investors to maximize its returns and the manner in which a venture capital firm achieves this goal is by a liquidity event or an exit from the investment. In contrast, management's goals may include issues beyond monetary rewards. An executive may be seeking to make his or her mark as a "captain of industry" or "leader of men" or perhaps something as mundane as having a steady job. Whatever the motivation of the management team might be, at some point in time, the venture capital firm will be moving towards positioning the company for an exit. How that liquidity event or exit is facilitated and managed is vitally important to realizing full value for the enterprise.
There are basically two main types of exits for a venture-backed enterprise: (i) an initial public offering ("IPO"), and (ii) a sale or merger to or with another company. For most companies, going public through an IPO is the "holy grail" because the valuations are often based on growth and thus may be substantially higher than what would be paid in a sale or merger. That said, most liquidity events are through a sale or merger as the public markets for technology-based companies have been anemic in recent years.
There are a number of advantages to exiting through a public offering. To begin with, it enables the company to raise large amounts of capital at higher valuations. The large amount of capital will enable the company to execute on its business plan and to initiate additional growth strategies. The limitation of capital will no longer be an excuse for not achieving a company's business goals. A second advantage is that it enables a company to continue to access large amounts of capital. Assuming it operates successfully once public, a company will be able to raise large amounts of funds by having additional offerings. A third advantage is that by going public, the company is then able to use its own stock as currency to acquire additional companies. As a public entity, the company can issue its own currency (its stock) in an acquisition. Perhaps the ability to use its own stock as currency is the most intriguing aspect of going public. Finally, by going public, the investors can begin the process of gaining liquidity.
One thing that everyone should be clear about is that the fact a company is public does not mean that you can just simply sell your stock and liquidate your investment position. The underwriter of the public offering will generally require that no insider or major stockholder can sell any stock for 180 days after the date of the IPO. The reason for this is that the underwriter would be unable to raise the capital in the IPO if the insiders and large stockholders were immediately selling and dumping their stock. It does not say much positive about a company if the people involved in the company are sellers rather than buyers. Moreover, there is a myth in America that if a company is public then all the shares are free to be traded. This is simply not true. The venture capital firm that invests in a private company receives unregistered shares. These shares remain unregistered notwithstanding that the company is public. In order to sell the shares, the venture capital firm either needs to sell its shares pursuant to an exemption from registration, such as Rule 144 — which may have applicable volume limitations — or pursuant to a registration statement—which is both timely and costly.
One other advantage to going public is that management will have the ability to control its own destiny. Of course, management will be answerable to the public. But such accountability is nothing compared to selling your company to another company and working for somebody else. It is the exception rather than the rule where the management of the acquired company is still actively involved in the business three years after the acquisition.
As to why a company may choose NOT to go public, there are three main reasons: 1) it is expensive; 2) it is very expensive; and 3) it is unbelievably expensive. The process is costly not only in terms of the initial expense of filing, but with the passage of the Sarbanes Oxley laws ("SOX") it is exceedingly costly to remain in compliance once a company is public. Additionally, beyond the monetary expense in paying lawyers and accountants, it is very costly in terms of time. From the time a company decides to go public until its shares are sold to the public, the process is likely to take close to half a year. During this process, senior management's time will be diverted from managing the business to managing and orchestrating the financing transaction. Often, this may result in management taking its eye off the ball and sales or revenue not growing at the same pace as prior to filing for the offering. It is not surprising that the financial results published by many companies for the quarter after they go public are often disappointing.
One other reason that a company may choose not to go public is a reason that is rarely discussed. That is, once public, a company is subject to quarterly reporting to the public and its stock price will be judged in large part on a quarter by quarter basis. As such, the time frame for building a business or making the investment required for new long-term initiatives is quite limited. Arguably, the limitations imposed by quarter to quarter reporting inhibit the creation of additional value to the enterprise.
While the goal of many companies is to go public, the reality of the situation is that the major liquidity event for most companies is through a sale or merger. Good companies are bought and not sold. That is to say, a successful start-up company will catch the eye of a competitor or larger company and it will make economic sense for the larger company to acquire the smaller start-up venture. For the venture investor, a sale is welcome because it provides a finite way to realize on its investment, without the wait of liquidating its shares over time in the public markets. Further, a sale is not dependent on the ups and downs of the stock market where the whims of the marketplace can cause the public markets to close for months at a time for new IPOs.
The sale of a company is often accomplished through a share for share merger or by a combination of shares and cash. If the consideration is 50% or more consisting of stock, the stock portion can be structured as a tax-free exchange. The big issue for the party being acquired is whether the shares received will be freely tradable. If the acquiring company is a public company, the shares paid to sellers can be registered and made freely tradable as part of the merger. If the shares are not registered pursuant to the merger, then the sellers will either need to get the shares registered or sell pursuant to an exemption such as Rule 145 or Rule 144. In either event, the seller will have to bear the market risk that the value of the shares may decrease before they are freely tradable.
Of course, the other way to sell a company is to sell it the old fashioned way — that is, for cash. It certainly makes the entire sale transaction a lot less complicated and the sellers never have any problems calculating the value of the deal or how to allocate the consideration.