I had a chance to review the terms of the convertible debt documents used in the transaction.

Below are the major points:

Interest rate:  higher of 2% or AFR (applicable federal rate).  (I think the intention to keep the interest rate as low as possible.  In the past, interest rates on convertible debt seemed to be in the 7% to 10% range, but I recently saw a VC fund offer $500K of convertible debt at a 3% interest rate.)

Maturity date:  two years or maturity date of other convertible notes.  (This also seems to be fairly company favorable as most convertible debt seems to have a one year term.)

Automatic conversion:  on a $1M equity financing with no conversion discount and no price cap, provided that the transaction documents provide for a right to purchase a pro rata share of future financings.  (I don’t know how to get a better deal than this.)

Optional equity conversion:  on other equity financings with no conversion discount and no price cap.  (Once again, I don’t know how to get a better deal than this.)

Optional maturity conversion: into Series AA Preferred Stock based on a $5M valuation.  The Series AA has a 1x non-participating liquidation preference, weighted-average anti-dilution, basic protective provisions (adverse changes to the Series AA, number of shares of Series AA, or merger/asset sale), right to maintain proportionate ownership, ROFR/Co-Sale rights and basic information rights.  (Please note that these are generally the terms of the Series AA Preferred Stock financing documents that Y Combinator previously published.)

Optional change of control/IPO conversion:  into common stock at the lesser of (A) fair market value (based on change of control or IPO), or (B) $5M valuation.

I can’t think a good reason to turn down this deal, unless a company is never planning to raise outside investment.  Congratulations to the Y Combinator companies that are benefiting from these terms.

Update:  In the second batch of YC companies, a “most favored nation” clause was added so that StartFund receives the benefit of terms negotiated by later convertible debt investors.

Convertible debt with a price cap seems to be the preferred structure for early-stage financings

Over the last 12 months, I’ve noticed a trend where early-stage startup companies raise seed financings of between $250K and $1M using a convertible note with a price cap.  In fact, it seems very rare to see a convertible note without a price cap these days, although it was fairly common to raise convertible debt without a price cap a couple of years ago.

Paul Graham has sparked some discussion on the topic in August 2010 when he tweeted “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

Seth Levine asks, “Has convertible debt won?“  Seth points out that “the convert cap reflects a premium to the current fair market value of the business. One super-angel I talked to told me that while a year ago these caps “approximated what I’d pay in equity” that they’re now “33% higher than what I’d normally agree to pay now.”

I have also heard that many of the companies in the YC batch that Paul Graham was referring to have been dictating convertible debt terms with price caps in the high single digit million range when pitching to angel investors.  This leads me to believe that there is a mini-bubble in the early stage financing universe.

Is a priced Series A financing a valid alternative?

A logical alternative to convertible debt is a priced Series A preferred stock financing. Mark Suster does a good job analyzing whether convertible debt is preferable to equity, and concludes that convertible debt is better. I’ve pondered the issue of convertible debt vs equity and come to the same conclusion.  Most commentators generally seem to be concluding that convertible debt with a price cap is better than a priced Series A round.

However, Ted Wang points out that Series Seed documents are better than capped convertible notes.  (I’ve used the Series Seed documents twice in the last six months and have managed to keep company-side legal fees under $15K on both of the deals, although I suspect that the documents for the “real” Series A financing will end up being more painful to draft as the Series Seed documents don’t scale well in later rounds.)  Fred Wilson, while he doesn’t endorse the Series Seed documents, says that Union Square Ventures has never participated in a convertible note deal.  Jason Mendelson points out that the use of debt fundamentally changes the fiduciary duties of managers and board members of the company, as executives and directors of “insolvent” companies face potential suits from various creditors.

Tweaking convertible debt so that common stock (instead of preferred stock) is issued for the conversion discount in order to limit liquidation preference overhang

Given that convertible debt with a price cap seems to be firmly entrenched these days as a typical structure for early-stage financings, I’ve pondered some methods to make the structure more favorable to companies.

One issue that has bothered me is that the conversion discounts and price caps result in a company creating more liquidation preference than the amount of money that investors have invested.  For example, if the amount of money raised in the convertible debt financing is large (say $1M), and the conversion discount is 50% (or the price cap is 50% of the Series A valuation), then the company will end up issuing $2M (+ interest) of Series A preferred stock to investors that only paid $1M.  This Series A preferred stock will typically have a 1x liquidation preference, so $2M of liquidation preference overhang will be created as a result of the conversion discount/price cap.

Thus, a company is in a worse situation by using convertible debt with a price cap than if the company simply did a Series A financing at the price cap valuation instead of the convertible debt.

Please keep in mind that there are two principal economic features of preferred stock:  the liquidation preference, and the equity on an as-converted to common stock basis.  Convertible debt with a price cap preserves the investor’s “equity” ownership, but gives the investor extra liquidation preference.

In order to solve this problem, I have resorted to modifying the conversion discount formula in certain deals so that the conversion discount is paid in common stock.  In other words, the principal and interest on the convertible debt will convert into preferred stock with no discount, and the discount portion will converted into common stock valued at the preferred stock price. This is an attempt to make convertible debt with a price cap economically equivalent to a priced Series A financing.

One might note that this is not the exact economic equivalent, as the application of the anti-dilution formula on the preferred stock issued upon conversion of the debt will not be as favorable as if the convertible debt financing was originally done as preferred stock. However, many seed equity financings don’t provide for anti-dilution protection, as the valuations are low to begin with.

[Note: A better way to make convertible debt identical to a seed financing is to have the convertible debt convert into its own series of preferred stock.  In other words, the new investors would purchase Series A and the convertible debt would convert into Series A-1 with an aggregate liquidation preference equal to the principal and interest of the debt (and a liquidation preference per share lower than the Series A price per share).  However, most people don't like the messiness of creating an extra series of preferred stock.]

[Please also note: It probably doesn't make sense to entirely focus on the equivalent theme, as there are plenty of other ways that convertible debt and equity are different. For example, convertible debt has no voting rights, and typically don't have protective provisions. However, seed investors don't seem to mind the lack of these features.]

An example of a term sheet provision to provide for the conversion discount to be paid in common stock and the math involved is below.

Term sheet excerpt:

CONVERTIBILITY:        In the event the Company consummates, prior to the Maturity Date, an equity financing pursuant to which it sells shares of its preferred stock, which are expected to be Series A Preferred Stock (the “Preferred Stock”), with an aggregate sales price of not less than $[1,000,000], excluding any and all indebtedness under the Notes that is converted into Preferred Stock, and with the principal purpose of raising capital (a “Qualified Financing”), then all principal, together with all accrued but unpaid interest under the Notes, shall automatically convert into shares of the Preferred Stock and the Company’s Common Stock at the lesser of (i) 80% of the price per share paid by the other purchasers of Preferred Stock in the Qualified Financing and (ii) the price obtained by dividing $5,000,000 by the Company’s fully-diluted capitalization immediately prior to the Qualified Financing (the “Discounted Purchase Price”).  The total number of shares of stock that a holder of a Note shall be entitled to upon conversion of such holder’s Note shall be equal to the number obtained by dividing (i) all principal and accrued but unpaid interest under such Note by (ii) the Discounted Purchase Price (the “Total Number of Shares”).  The Total Number of Shares shall consist of Preferred Stock and Common Stock as follows (see also example on Exhibit A):

The number of shares of Preferred Stock shall be equal to the quotient obtained by dividing (i) all principal and unpaid interest under the Note by (ii) the same price per share paid by the other purchasers of the Preferred Stock in the Qualified Financing (such price, the “Undiscounted Purchase Price,” and such number of shares, the “Number of Preferred Stock”).

The number of shares of Common Stock shall be equal to (i) the Total Number of Shares minus (ii) the Number of Preferred Stock.

Example:

Assumptions:

Principal + Interest    $1,000,000
Discounted Purchase Price    $1.00
Undiscounted Purchase Price    $2.00

Total Number of Shares:

Principal + Interest ($1,000,000)        =    Total Number of
Discounted Purchase Price ($1.00)        Shares (1,000,000 shares)

Number of Preferred Stock:

Principal + Interest ($1,000,000)        =    Number of Preferred
Undiscounted Purchase Price ($2.00)        Stock (500,000 shares)

Number of Common Stock:

Total Number of Shares             -    Number of Preferred          =    Number of Common
Shares (1,000,000 shares)            Stock (500,000 shares)    Stock (500,000 shares)

On April 7, 2010, the California Division of Labor Standards Enforcement (DLSE) issued an opinion letter addressing the requirements employers must meet in order to have unpaid interns in compliance with California law. Although widely published news reports, including a recent New York Times article analyzing the DLSE’s April 7th opinion letter, have raised hopes that California is relaxing its position with respect to the permissibility of unpaid internships, such optimism appears to be misplaced and employers must continue to exercise caution in this area.

The DLSE’s guidance is timely, as thousands of college graduates and students prepare to hit the job market in search of employment opportunities. Many employers offer internships for a variety of reasons, including providing useful “real world” experience to students seeking to learn more about a particular industry or profession, and trying to help the children of customers, business colleagues, or friends. However altruistic their reasons, employers must be aware that California and federal law severely limit the circumstances under which such internships can be unpaid.

In response to a letter from an attorney representing Year Up, Inc., (a program aimed at developing fundamental job and technical skills in information technology for 18- to 24-year-olds) about the classification of internships in California, the DLSE concluded that the interns enrolled in the internship program were not employees under California law, and therefore were exempt from coverage under California’s minimum wage law. In reaching its conclusion, the DLSE followed the federal Department of Labor’s (DOL’s) criteria for determining whether the interns were exempt from minimum wage coverage and examined the “totality of the circumstances” surrounding their activities. Ultimately, the DLSE’s opinion letter reiterated its longstanding position that California follows the same stringent federal factors in analyzing the classification of interns, and thus serves as a reminder to employers that improper classification of employees as unpaid interns can be costly.

The DOL has articulated six criteria to determine whether an “intern” or “trainee” is exempt from the Fair Labor Standard Act’s minimum wage coverage. In order to qualify as an unpaid internship, all six factors must be satisfied under state and federal law. The six criteria are as follows:

1. The training, even though it includes actual operation of the employer’s facilities, is similar to that which would be given in a vocational school.

2. The training is for the benefit of the trainees or students.

3. The trainees or students do not displace regular employees, but work under their close observation.

4. The employer derives no immediate advantage from the activities of the trainees or students, and, on occasion, the employer’s operations actually may be impeded.

5. The trainees or students are not necessarily entitled to a job at the conclusion of the training period.

6. The employer and the trainees or students understand that the latter are not entitled to wages for the time spent in training.

The DLSE’s new opinion letter concluded that all six criteria also must be satisfied in California. However, the agency now appears to take a more relaxed approach as to when an employer will meet certain aspects of the six factors. For example, in determining whether regular employees are displaced (i.e., the “non-displacement” criterion), the DLSE now takes the position that occasional or incidental work by an intern should not defeat the exemption provided such work does not intrude into activities that could be performed by regular workers and effectively displace them. As the stringent six criteria must still be satisfied, it will be difficult for companies, particularly for-profit companies, to have properly classified unpaid interns. The recent New York Times article regarding internships quoted Nancy J. Leppink, the acting director of the federal Labor Department’s Wage and Hour Division, as stating, “There aren’t going to be many circumstances [where for-profit companies can have unpaid internships and] still be in compliance with the law.”

Many companies have relied upon unpaid interns as a way to minimize costs and provide opportunities to eager workers who are willing to work for free in hopes of ultimately securing a paid position. Such an approach is risky, and employers must understand that the consequences of utilizing unpaid internships that do not comply with applicable law are potentially grave. As with misclassification of an employee as an independent contractor, employers with misclassified unpaid interns face potential liability for unpaid wages and violations relating to failure to pay minimum wage, which could be significant for a full-time intern. In addition to the wages due to unpaid interns, the employer could face potential liability for overtime and missed meal or rest periods. Moreover, the employer could be liable for various penalties under California’s Labor Code (including waiting-time penalties for failing to pay wages on a timely basis), as well as unpaid employment-related taxes owed to governmental agencies.

For more information about legal issues regarding interns, please contact Fred Alvarez, Kristen Dumont, Laura Merritt, Ulrico Rosales, Marina Tsatalis, Alicia Farquhar, or another member of the firm’s employment law practice.

• TechStars Model Seed Funding Documents (by Cooley)
• Y Combinator Series AA Equity Financing Documents (by WSGR)
• Founders Institute Plain Preferred Term Sheet (by WSGR – disclaimer, I represent the Founders Institute and was involved in drafting this document)
• Series Seed Financing Documents(by Fenwick & West)

My general opinion is that anything that makes the financing process faster and easier or otherwise educates entrepreneurs is a good thing.  (A reminder that anything I write on this site is only my personal opinion and does not represent the views of WSGR or anyone else from WSGR.)  In addition, I think that a “peace treaty” between early-stage investors and startup companies on standard terms (at least at a term sheet level) is a step in the right direction.

I previously wrote a post titled “How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?“  Much of the commentary on the Y Combinator documents is also applicable to the Series Seed documents.  (In fact, I recyled part of that post in writing this post.  I also reviewed the TechStars documents last year and they are similar in concept to the Y Combinator documents as the chart below indicates.)

This post assumes that you have a basic understanding of Series A financing terms.  If you don’t, please educate yourself on this site, Venture Hacks and the term sheet seriesby Brad Feld/Jason Mendelson, among other places. If you really want to understand the nuances in venture capital financing documents, please review the NVCA model venture capital financing documents. 

What situations should the Series Seed documents be used in?

The Series Seed documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. under $500K).

I was actually somewhat surprised that the following investors have agreed to use the Series Seed documents in certain of the their deals:  Baseline, Charles River Ventures, SV Angel (Ron Conway), First Round Capital, Harrison Metal Capital, Mike Maples, Polaris Venture Partners, SoftTech VC and True Ventures. In contrast, Fred Wilson says while he is ”hugely supportive of his intent here, I can’t and won’t get behind the Series Seed forms because they leave out some critical stuff that we simply won’t do a deal without.“ 

I think that there are certain situations where the Series Seed and other stripped down equity financing documents might be appropriate, but I know that there are lots of situations where early-stage investors probably wouldn’t agree to the Series Seed terms.

Recently, I have seen a lot of seed stage financings being structured as convertible debt with a price cap, which is an alternative to the equity financing contemplated by the Series Seed documents. Certain angel investors refuse to do convertible debt deals, but will be okay if there is a price cap. In fact, I have seen convertible debt used to raise up to $1.0 million, but it seems like the sweet spot is around $500K.  Convertible debt documents are generally much more simpler to draft and read than equity financing documents, so I typically recommend convertible debt for companies raising below around $750K.

In my experience, if a company is raising, say $1.0 million, the investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors.  Therefore, the Series Seed documents may not be acceptable in these situations.  I think that the Series Seed documents are probably most appropriate in a friends and family equity seed financing, as opposed to a round led by a professional investor.

Why is it called Series Seed?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  There is no real rule to what a particular series of preferred stock is called.

What rights does the Series Seed have?

Ted Wang explains most of the highlights of the documents.  The primary rights in these documents, ranked in order of importance in my opinion are:

• Non-participating preferred liquidation preference.  The investor receives their money back and the remainder goes to the common. 

• Limited protective provisions.  Among other things, the company can’t be sold without consent of a majority of the Series Seed.

• Future rights.  If new investors get better rights in a future equity financings (such as registration rights, price-based anti-dilution, redemption rights, etc.), then the holders of the Series Seed get these better rights.

• Right of first offer on future financings.  Self-explanatory.

• Board seat.  The Certificate of Incorporation gives the Series Seed a board seat, while the common get two board seats. 

• Information rights.  The investor receives unaudited annual and quarterly financial statements.

• Drag along.  The Series Seed documents include a fairly harmless drag-along provision, which requires the investors and the key common stockholders to vote in favor of a “deemed liquidation event” (which basically means sale of company transaction) if a majority of the holders of common stock, a majority of the holders of the Series Seed and the board approve the transaction.  Given the general theme of the documents to eliminate unnecessary provisions, it strikes me as somewhat odd that there would be a drag-along. If I represent investors in a later Series A financing, I would probably use the existence of the drag-along as an excuse to implement a more aggressive drag-along provision — which does not require the approval of the holders of common stock to trigger.

• Legal fees.  The company is obligated to pay $10K for investors counsel.  I suspect that this seems reasonable if there is basically no due diligence due to the early stage of the companies.  (By the way, the TechStars documents and the Y Combinator documents do not have a provision to reimburse counsel for the investors, probably on the theory that the situation where the documents are used don’t require counsel to review the documents on behalf of the investors.)

What are the primary rights that are missing from the these documents that would be in a typical Series A financing?

In the Series Seed documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet.

• Dividend preference.  Almost all startup companies don’t declare dividends, so deletion of a dividend preference is irrelevant to an investor.  The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.

• Registration rights.  As a practical matter, I don’t think that investors should really care about registration rights.

• Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series Seed is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series Seed is unlikely.

• Comprehensive protective provisions.  The Series Seed documents are fairly light on protective provisions compared to a typical Series A financing.

• Co-sale rights.  These rights are missing, which is probably okay since I have never heard of a co-sale right being used before.

• Voting agreement.  In a typical venture financing, there is a voting agreement that governs how specific board seats will be filled.  In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.

• Comprehensive representations and warranties.  The Series Seed Stock Purchase Agreement has fairly limited reps and warranties.  As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues.  In an early stage company, extensive reps and warranties are probably unnecessary.

• Legal opinion.  A company counsel legal opinion is missing in these documents.  A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.

Why will or why won’t people adopt the Series Seed documents?

• Investor pressure.  The only way that the Series Seed documents will be widely used is if investors demand use of the documents.

• Investors want additional protections. I suspect that things like lack of anti-dilution protection, a desire to have participating preferred stock and weak protective provisions will make it difficult for some investors to agree to use the documents without modification.  Once you start making substantial changes to the forms, then I think some of the value of standardization goes away.

• Law firm resistence.  As a reference point, WSGR generally does not use the NVCA documents in a Series A financing when it represents the company unless the investor specifically demands that the NVCA documents be used.  This represents approximately 20% of all venture financings in the U.S. I’ve read the WSGR form Series A documents hundreds of times (and probably have most of the provisions memorized).  I think I’ve only come across the NVCA forms a couple of times, and both times were on deals with Boston-based company counsel, where use of the NVCA documents is more widespread.  In addition, WSGR’s Series A documents can be created using the document automation software behind the WSGR term sheet generator. Therefore, using WSGR form documents when I represent a company is much more efficient than using the NVCA documents.

• Drafting issues in later rounds. One thing that I don’t like about stripped down documents is that adding provisions in the future is painful — especially if the documents are not written in a modular fashion.  For example, adding in the anti-dilution provisions into the Series Seed documents requires the insertion of a couple of pages of text into the Certificate of Incorporation.  It’s somewhat painful to ensure that all of the section references (including Microsoft Word auto-reference codes) and defined terms work properly.  Therefore, in my opinion, it’s actually more difficult to add the modular sections than it would be to start from a new robust template and tweak it to fit the term sheet.  I’d encourage the Series Seed project to have redlines of at least the Series Seed Ceritificate of Incorporaiton against the form of Series A Certificate of Incorporation that it was based on in order to show that the documents can easily be modified in a Series A financing to include anti-dilution and other provisions.  (It seems like the Series Seed Certificate of Incorporation is mostly based on the NVCA form of Certificate of Incorporation with various formatting and simplification-related changes.)

• Use of different forms for later Series A financing.  As a practical matter, in a typical Series B financing, the Series A documents will generally be tweaked slightly for the Series B, and company counsel will send redlines to investor counsel to show changes from the Series A (which are typically minimal).  When a company does a Series A financing and the Series Seed documents are in place, the Series Seed Stock Purchase Agreement and Investors Rights Agreement will probably not be re-used.  As discussed above, the Certificate of Incorporation will need to be amended and restated and various provisions will need to be plugged in.  (By the way, restated means that the entire document is redone in its entirely, as opposed to just an amendment, which might refer to discrete sections like: “Article IV shall be amended such that the number of shares of Common Stock shall be 15,000,000.”)  The Series Seed Stock Purchase Agreement has no lingering obligations, so Series A investors will want a more traditional stock purchase agreement with closing conditions and closing certificates — and it is much easier to use a typical Series A Stock Purchase Agreement than modify the Series Seed Stock Purchase Agreement.  In addition, there will be so many new provisions added to the Investor Rights Agreement (such as registration rights) that starting from a more robust form is easier than adding provisions to the Series Seed Investor Rights Agreement.

What’s the difference between the Series Seed documents, the TechStars documents, the Y Combinator documents and TheFunded Plain Preferred term sheet?

The Y Combinator documents were released in August 2008.  The TechStars documents were released in February 2009. TheFunded released their “Plain Preferred” term sheet in August 2009.  The Series Seed documents were released in March 2010.  Below are some of the material differences between the Series Seed, Y Combinator and TechStars documents.  (I won’t bother outlining the differences in TheFunded term sheet, as it was more intended for a typical Series A institutional venture capital financing, as opposed to the seed stage contemplated by the other documents.)

What would you change about the documents?

I’m still pondering and will update this post later after I speak to some early-stage investors.

In response to the problem of worthless common stock, some companies have implemented employee retention plans, which are also referred to as M&A carveout plans. This was particularly common from 2001 to 2003, after the dot-com crash when companies had raised a large amount of venture financing at high valuations.

Below are some common structures for employee retention plans and issues related to each alternative.  I have intentionally not covered all of the corporate law implications of designing and implementing a retention plan or provided a comprehensive analysis of any particular tax or accounting issues, as they are fairly complex and depend on specific facts.  A company’s board of directors will need guidance from counsel on meeting their fiduciary duties when implementing a retention plan.

1. Change of Control Bonus Plans

Under a change of control bonus plan, eligible employees are entitled to certain benefits upon change of control transactions as specifically defined in the plan documents.  This can be simple as an agreement with an individual employee that says “if you are still employed when the company is sold, you will receive $X.” 

More complex plans set aside a pool of money for employees and a mechanism for dividing the pool.  In addition, the plan could pay a fixed amount under the plan to the individuals, regardless of the value of the triggering event.  Alternatively, the plan could pay a percentage of the proceeds from the triggering event (e.g. 10% of the size of the deal). In some cases, the payout may be a sliding scale (e.g. 10% of the first $5M in proceeds, 15% of the next $5M in proceeds, and 20% of the amount over $10M).  In plans where the size of the payout is dependent on the size of the transaction, the definition of the transaction value needs to account for situations such as assumption of debt by the acquiror, earnouts, escrows, and illiquid stock as acquisition consideration, among other things.  In addition, given that the plan is intended to solve for situations where common stock is worthless, they should terminate above certain transaction values, or payouts should take into consideration the value of the common stock.

2. Straight Retention Plans

Under straight retention plans, eligible employees are entitled to certain benefits or payments that are not contingent upon any triggering event, such as a change of control.  These bonus payments may be paid as long as the employee is employed on a certain date (i.e. 50% of base salary if still employed 6 months later).

The following issues relate to both change of control bonus plans and straight retention plans:

• Currency. The company must determine the currency with which to pay the eligible employees. Typically, employees receive stock, cash or a combination thereof.  A retention plan that pays employees in acquiror stock is less common than a cash payment plan as payment in acquiror stock will be ordinary income to the employee, and receiving illiquid acquiror stock in a taxable transaction is not desirable in most situations.

• Participation. The company must determine which employees are eligible to participate in the program. Executive management is typically the key participant, however, participation may be determined by time of service or benefits can be given to all employees.

• Allocation. Once the company has determined who is eligible, they must further determine how to allocate the units or stock to be issued to the employees. Alternatives include position, time of service, current equity holdings or other metrics as determined by the company’s board of directors.  The board can set aside some of the “retention pool” for future issuances. However, it must determine when establishing the plan what will happen to the pool upon certain triggering events.

• Vesting. The company must determine whether the stock or cash distributed will be fully vested at the time of grant or will vest over time. The company must further determine which, if any triggers, will accelerate vesting and to what degree.

• Last Man Standing. Related to vesting issues, the company must also determine whether benefits will be forfeited if employees are terminated within a certain period of time of the change of control and whether the forfeited benefits will be redistributed to remaining employees.  If the employee needs to be employed at the time of the change of control transaction, this may lead to a perverse incentive for company management to terminate employees, especially if the forfeited benefits are redistributed to remaining company management.

3. Junior Preferred Stock

Some companies have implemented junior preferred stock, which often receives a certain percentage liquidation preference on the sale of the company.  The junior preferred can be created as an option plan or sold directly, with or without vesting.  The junior preferred is often junior to existing preferred stock, but senior to common stock, in order to provide liquidation preference for certain classes of employees, senior to common stock.  Participation, allocation and vesting issues are similar to those described above.

Observation 1 — Convertible debt is a bad deal for angel investors

I think many sophisticated angel investors realize that convertible bridge notes do not adequately compensate angel investors for the risk that they take in funding early-stage companies. For example, typical provisions in a company-friendly pre-Series A convertible bridge note financing may include a 20% conversion discount from the Series A price and a 2x return on a sale of company.

Assume the angel investor invests $500K. If the company eventually raises $50M in a Series A financing at a $100M valuation, a 20% discount from that price is not particularly attractive compensation for that investment risk, as the investor would only own about 0.4% of the company after the financing (assuming that the shares issued upon conversion of the bridge were not included in the pre-money fully-diluted share number). Similarly, if the company is sold for $100M, the investor would only receive 2x their investment back (plus interest), or a total of $1M, which would only be 1% of the sale price.

If the investor had invested $500K in a Series A Preferred Stock at a $4.5M premoney valuation, then the investor would own 10% of the company. If the company raises $50M in a Series B financing at a $100M valuation, the investor would own 6.67% of the company post-Series B financing.

Similarly, if the company was sold for $100M before another round of financing, the investor would receive 10%, or $10M.

Observation 2 – Angel investors realize convertible debt is a bad deal so they demand price protection provisions (i.e. a price cap)

Due to the economic results described above, many sophisticated angel investors refuse to do convertible note bridge financings unless the conversion price on the debt is capped.  In other words, an investor may request that the conversion price is the lower of (i) a 20% discount from the Series A price, or (ii) the price per share determined if the valuation was $[X]M.  Typically, the valuation might be some reasonable projection of the valuation range in the eventual Series A financing.  The valuation is typically higher than what would be set if the investor and the company negotiated a valuation at the time of the convertible debt financing, but lower that the expected Series A valuation if the company achieved their objectives.

Similarly, in the event of a sale of company before a Series A financing, a sophisticated angel investor may request that they receive the better of (i) 2x their investment back (plus interest), or (ii) the return if they had invested their money at an $[X]M valuation.

In any event, I think that convertible debt financings are still easier to complete than a Series A financing, so a convertible note with a cap achieves the investor’s objective without the complexity of a Series A financing.

Wilson Sonsini Goodrich & Rosati provides a powerful online tool that provides clean technology entrepreneurs and companies with a searchable, easy-to-use source for federal and state government funding opportunities and guidance on how to apply.

The publicly available tool aggregates and frequently updates the numerous financing opportunities, such as grants, loan guarantees, tax credits, and other programs, being offered by federal and state governments. Users are able to search by industry sector, as well as by state-by-state resources. The tool also includes articles by Wilson Sonsini Goodrich & Rosati attorneys on how to take advantage of governmental funding opportunities, links to useful federal and state websites, and additional firm publications such as The Clean Tech Report and relevant WSGR Alerts and press releases.

The tool may be accessed through the Wilson Sonsini Goodrich & Rosati website at http://www.wsgr.com/cleantech.

Founders of startup companies often wait to incorporate a company until they are confident that their concept is viable or fundable.  At some point, however, an entrepreneur will need to formally incorporate a company.  Several reasons exist for taking the step to incorporate.

• More than one founder.  If there is more than one founder, the likelihood of an argument about how the equity should be split in the new company increases dramatically.  Incorporating a company and issuing stock to the founders will help prevent misunderstandings among the founders about equity splits.  Trying to clean up pre-incorporation promises to grant equity in a startup company is a painful task, especially if founders part ways before there are formal documents in place to deal with the situation.  Please keep in mind that even if a company is incorporated, founder stock purchase agreements with repurchase rights over unvested stock if founders leave are not included with the documents from typical online incorporation services.

• Creating intellectual property.  If there is any IP created and there is more than one founder, then incorporating an entity and assigning IP to the entity is important.  Otherwise, if a founder leaves before incorporation and IP has not been assigned to the other founder or an entity, then use of IP created by the former founder may be problematic.  Once again, please keep in mind that the documents from typical online incorporation services do not contain IP assignment provisions in connection with the purchase of founders stock or separate IP assignment documents.

• Hiring employees or third party contractors.  Although I’ve run into a situation where the former CEO of a Fortune 500 company personally paid an “employee” out of his own pocket for a year prior to incorporation while incubating an idea, most founders will need to incorporate a company if they intend to hire employees.  In addition, if an entrepreneur needs to engage third party contractors, it generally makes sense to incorporate a company so that the third party enters into an agreement with a company instead of an individual.  In addition, any IP created by the contractor can be assigned to the company instead of an individual founder.

• Issuing stock options.  Many entrepreneurs do not have the cash to pay third parties and may partially compensate third parties by granting stock options or giving them the opportunity to purchase equity at nominal prices.  Although it is possible to have pre-incorporation agreements to grant equity upon incorporation, it is simply easier to incorporate a company and grant stock options or equity to satisfy these promises.

• Launching a service/product and general liability issues.  One important reason for incorporating a company is to protect the stockholders against personal liability.  If a company complies with corporate formalities, creditors of the company generally cannot reach the stockholders to satisfy the company’s liabilities.  Thus, a company should generally incorporate before launching a product or a service due to potential liability issues, as the risk of liability to a founder increases with customers or users.

• Obtaining visas.  If a non-U.S. citizen/non-permanent resident 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.

• Starting capital gains holding period in the event of a stock sale.  If a founder sells stock of a company in a taxable transaction and it is held for greater than one year, then the capital gains tax rate is 15% for founders in the 25% tax bracket and higher. These days, it is fairly easy to develop a hit iPhone app or Facebook app and sell a company fairly quickly.  I represented a couple of Facebook app companies last year that were sold in taxable transactions.  One app was sold by an individual founder and the app was only several months old.  Unfortunately, the founder was unable to receive the benefit of long-term capital gain tax treatment on the asset sale (and ended up paying the same tax rate as ordinary income on the sale proceeds).  The other app was sold by an individual founder and the app was only several months old, but he had the foresight to incorporate a company more than a year prior to the sale and assign IP to the company.  The buyer bought the stock of the company as opposed to the app itself.  Thus, even though the app was less than one year old, the shares of stock of the company were held for greater than one year, and qualified for long-term capital gain tax treatment.

• Funding.  Obviously, if third party investors want to invest in a startup idea, there needs to be an entity to accept the investment.  Generally, I prefer to incorporate and issue founder’s stock at nominal prices well in advance of a Series A preferred stock financing because it is difficult to justify that common stock should be priced at $0.001 per share while Series A preferred stock is issued at $1.00 per share.

Incorporating a company is a serious step that results in out of pocket costs and ongoing tax and other filing obligations. In addition, if a founder still has a day job as an employee of another company, then the founder will need to review the founder’s employment documents carefully in order to determine if there are any issues. The first step in deciding whether to incorporate or not is to discuss the situation with a competent attorney.

The budget proposal would modify IRC Section 1202 to provide for a complete exemption from capital gains tax for qualified small business stock issued after February 17, 2009 and held for five years, and the amount excluded would not be added back for alternative minimum tax purposes. If enacted, this would significantly enhance the tax incentives currently available for qualified small business stock. Under current law, the exclusion for purposes of the regular income tax system of 50% of the recognized gain on the disposition of qualified small business stock (which was increased by the recent American Recovery and Reinvestment Act to 75% for issuances in 2009 (after February 17, 2009) and in 2010) is substantially undercut by the combination of the high rate of tax (28%) applicable to the non-excluded portion of the gain under the regular income tax and the interplay between the AMT rules and Section 1202. Thus, historically, the principal federal tax benefit of qualified small business stock has been the ability to achieve “rollover” treatment of the proceeds from the sale of qualified small business stock under IRC Section 1045.

In light of the potential for this significant benefit associated with qualified small business stock, all venture financings should be analyzed very closely from a qualified small business stock standpoint. In addition, post-financing transactions, particularly stock redemptions, that potentially could undermine qualified small business stock status should be carefully reviewed.

The relevant provisions of the summary of the budget proposal related to qualified small business stock are below.

ELIMINATE CAPITAL GAINS TAXATION ON INVESTMENTS IN SMALL BUSINESS STOCK

Current Law

Taxpayers other than corporations may exclude 50-percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for at least five years. Under ARRA the exclusion is increased to 75 percent for stock acquired in 2009 (after February 17, 2009) and in 2010. The taxable portion of the gain is taxed at a maximum rate of 28 percent. Under current law, 7 percent of the excluded gain is a tax preference subject to the alternative minimum tax (AMT). The AMT preference is scheduled to increase to 28 percent of the excluded gain on eligible stock acquired after December 31, 2000 and to 42 percent of the excluded gain on stock acquired on or before that date.

The amount of gain eligible for the exclusion by a taxpayer with respect to any corporation during any year is the greater of (1) ten times the taxpayer’s basis in stock issued by the corporation and disposed of during the year, or (2) $10 million reduced by gain excluded in prior years on dispositions of the corporation’s stock. To qualify as a small business, the corporation, when the stock is issued, may not have gross assets exceeding $50 million (including the proceeds of the newly issued stock) and may not be an S corporation.

The corporation also must meet certain active trade or business requirements. For example, the corporation must be engaged in a trade or business other than: one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more employees; a banking, insurance, financing, leasing, investing or similar business; a farming business; a business involving production or extraction of items subject to depletion; or a hotel, motel, restaurant or similar business. There are limits on the amount of real property that may be held by a qualified small business, and ownership of, dealing in, or renting real property is not treated as an active trade or business.

Reasons for Change

Because the taxable portion of gain from the sale of qualified small business stock is subject to tax at a maximum of 28 percent and a percentage of the excluded gain is a preference under the AMT, the current 50-percent provision provides little benefit. Increasing the exclusion would encourage and reward new investment in qualified small business stock.

Proposal

Under the proposal the percentage exclusion for qualified small business stock sold by an individual or other non-corporate taxpayer would be increased to 100 percent and the AMT preference item for gain excluded under this provision would be eliminated. The stock would have to be held for at least five years and other provisions applying to the section 1202 exclusion would also apply. The proposal would include additional documentation requirements to assure compliance with the statute.

The proposal would be effective for qualified small business stock issued after February 17, 2009.

UPDATE (the following is from a WSGR client alert dated October 7, 2010)

The recent enactment of the Small Business Jobs and Credit Act of 2010 (SBJCA) may provide a substantial tax benefit to investors who acquire qualified small business stock (QSBS) on or after September 28, 2010, and before January 1, 2011. Entrepreneurs and investors considering forming or making investments in qualifying corporations, including owners of unincorporated businesses considering incorporation, should be aware of the potential advantages of acquiring QSBS during the relevant time frame.

Under the law prior to the enactment of the SBJCA, Section 1202 of the Internal Revenue Code of 1986, as amended, allowed an individual taxpayer to exclude 50 percent of any gain from the sale or exchange of QSBS held more than five years. This exclusion was increased to 75 percent for QSBS acquired after February 17, 2009, and before 2011. A portion of the excluded gain has been treated as an item of tax preference for alternative minimum tax purposes.

Under the SBJCA, an investor may exclude 100 percent of the gain from the sale or exchange of QSBS held more than five years that is acquired after September 27, 2010, and on or before December 31, 2010. Importantly, such gain is also eligible for exemption from alternative minimum tax, thus effectively eliminating tax on such gain.

QSBS Background

Stock of a small business generally qualifies as QSBS if the stock meets certain requirements, including: (i) the small business is a domestic C corporation; (ii) the taxpayer acquired the stock at its original issue in exchange for money or other property (not including stock) or as compensation for services; (iii) the small business is engaged in a qualified trade or business and uses 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses; (iv) the aggregate tax basis of the small business’s assets on the date after the stock is issued (including proceeds received in exchange for the stock) is $50,000,000 or less; and (v) with certain de minimis exceptions, the small business has not made any repurchases of stock within the two-year period starting one year prior to the date the stock was issued. A “qualified trade or business” is defined as any trade or business other than (i) any trade or business involving the performance of services, such as accounting, engineering, or consulting, or any other trade or business where the principal asset is the reputation or skill of one or more of its employees; (ii) any banking or financial business; (iii) any farming business; (iv) any mining or oil or gas business; and (v) any business of operating a hotel, motel, restaurant, or similar business.

In addition to the exclusions described above, under Section 1045 of the Internal Revenue Code, a taxpayer who (i) holds QSBS for more than six months (the original QSBS); (ii) sells the original QSBS in an otherwise taxable transaction; and (iii) during the 60-day period beginning on the date of such sale, purchases new QSBS (replacement QSBS) generally will recognize gain on its original QSBS only to the extent that the proceeds from such sale exceed the amount invested in the replacement QSBS.

FURTHER UPDATE (December 17, 2010)

The 100 percent exclusion was extended to QSBS acquired before December 31, 2011.

Adeo Ressi, the founding member of TheFunded, recently announced the establishment of TheFunded Founder Institute.

The Founder Institute helps founders launch innovative companies by providing training, services, and company-building assignments, such as incorporating the business, filing provision patents, and setting up books and records. The Institute offers a four month program, called a Semester, hosted initially in the Bay Area and then expanding to locations around the world. The program participants, the Founders, receive extensive training in weekly sessions overseen by three Mentors – two seasoned CEOs and one domain expert for each topic.

The driving beliefs behind the Institute are that (1) great founders are often overlooked by the current entrepreneurial ecosystem, and that (2) innovative startups have a dramatic positive effect on the global economy. Startup companies consume resources intelligently, put people to work in efficient ways, and produce market driven products at lower costs. Helping smart people start new companies should, in fact, help the global economy.

TechCrunch initially reported on the Founder Institute in March 2009.  The Founder Institute has recruited 25 executives to serve as mentors for the founders participating in the program.  The mentors will also lead weekly evening training sessions on company-building tasks.  Founders are not expected to quit their day jobs to participate in the program, which starts on May 19, 2009 and ends on September 8, 2009.  Sessions will be held in the San Francisco Bay Area at locations such as Stanford and Wilson Sonsini Goodrich & Rosati.  Class sessions and course material will be available online.  Although founders outside of the San Francisco Bay Area are welcome, founders in the Bay Area who are able to attend sessions in person are likely to benefit the most from interactions with mentor and other founders.  Future semesters are expected to be held in other locations.

The Founder Institute will assist founders in setting up meetings with potential investors and other parties throughout the semester.

Applications

The Founder Institute intends to accept between 75 and 100 founders for the initial semester, although the size may be limited.  Applications are due by May 10, 2009.  Applicants must:

• Have a preliminary idea and a passion to build something
• Have not yet incorporated, though the Founder Institute will make some exceptions for existing businesses
• Focus on a high tech or innovative sector, such as biotech, cleantech, and information technology
• Possess reasonable training or domain expertise
• Pass basic background and reference checks

The application fee is $50, which only partially offsets costs associated with processing applications.  If accepted, the founder must pay a $450 course fee to cover material and administrative costs.  Microsoft BizSpark has provided a limited number of scholarships to the program.  If a founder’s company raises more than $50,000 in debt or equity financing, excluding funds from the founder, within 18 months of formation, then the founder must pay a tuition fee of $4,500, which is used to cover the Institute’s expenses in providing the program.

Mentors

The Founder Institute has assembled 25 executives to serve as mentors for the participants and to lead weekly sessions.  Mentors for the Summer 2009 Semester include:

• Trip Adler – CEO, Scribd
• Michael Arrington – TechCrunch
• Joe Betts-LaCroix – CTO, OQO
• Jason Calacanis - CEO, Mahalo
• Russ Fradin - CEO, Adify
• Scott Heiferman - CEO, Meetup
• David Higly - CEO Higley & Company LLC
• Jay Jamison – Founder, Moonshoot
• Philip Kaplan – Entrepreneur
• Eugene Lee – CEO, Socialtext
• Bubba Muraka – Business Development, Facebook
• Scott Painter – CEO, Zag
• Aaron Patzer – CEO, Mint.com
• Peter Pham – CEO, BillShrink
• Mark Pincus – CEO, Zynga
• Alain Raynaud – CEO, FairSoftware
• Ken Ross – Founder/CEO, ExpertCEO
• Munjal Shah – CEO, Like.com
• Jen Shelby – Managing Director, Astia
• Jeff Stewart – CEO, Urgent Career
• Brian Thatcher – CEO, Empressr
• Joe Zawadzki – CEO, MediaMath

Additional mentors will be announced shortly.

Curriculum

The evening training sessions will be held weekly with various company-building “homework” assignments.  The curriculum is as follows:

Your Vision & Idea Types
May 19th, 2009: Identify a vision for your business
Description: How to articulate your vision and your passion. Does it involve intellectual property, model innovation, speed to market, market positioning? What is required for different types of ideas?
Mentors: Trip Adler | Philip Kaplan | Mark Pincus | Paul Harkins |

Basic Research
May 26th, 2009: Validate your idea with industry professionals
Description: Know your market, your competitors, and your idea. Can it be done? Will it work?
Mentors: Trip Adler | Mark Pincus | Jason Calacanis | Joe Betts-LaCroix |

Naming
June 2nd, 2009: Name your future business
Description: What’s in a name, and how do you choose a good one?
Mentors: Bryan Thatcher | Mark Pincus | Jay Jamison |

Intellectual Property
June 9th, 2009: File your provisional patents
Description: Practical strategy to getting your first patents quickly, cheaply, and with the necessary protections.
Mentors: Alain Raynaud | Eugene Lee | Joe Betts-LaCroix |

Roadmap
June 16th, 2009: Develop a plan to build your idea
Description: What it takes to get from an idea to an offering. What are common planning mistakes and how do you to avoid them?
Mentors: Trip Adler | Philip Kaplan | Munjal Shah | Jason Calacanis | Bubba Murarka |

Revenue
June 23rd, 2009: Create a revenue model for your business
Description: How to get it. How to grow it. How to track it. How to scale from the first sale to the millionth.
Mentors: Munjal Shah | Eugene Lee | Jay Jamison | Jen Shelby |

Books and Records
June 30th, 2009: Set-up accounting practices
Description: Set-up an accounting system to grow with your needs. What do you start with? Where do you end up after scaling?
Mentors: David Higley | Ken Ross |

Budgeting and Cash Flow
July 7th, 2009: Develop budgeting practices for your model
Description: What is right for a new business: annual, quarterly, or monthly budgets? What does a good budget process look like?
Mentors: Joe Zawadzki | Ken Ross |

Hiring and Firing
July 14th, 2009: Implement hiring policies and practices
Description: When to hire and when to fire? When is it ‘too late’? Choosing co-founders, and forming a founding team with a well-rounded skill set…
Mentors: Scott Heiferman | Joe Zawadzki | Jay Jamison | Paul Harkins |

Recruiting Success
July 21st, 2009: Identify world-class talent
Description: Who are the best in your field? Can you sell them on your vision?
Mentors: Jeff Stewart | Scott Heiferman | Russ Fradin | Bubba Murarka |

Exit Strategies
July 28th, 2009: Build a value generation plan
Description: How to prepare for an exit long before it happens. How to keep your start-up in the sights of both partners and buyers. How to build enterprise value every day. Don’t get caught off guard with an opportunity.
Mentors: David Higley | Peter Pham | Russ Fradin |

Vendors
August 4th, 2009: Select key vendors
Description: What to in-source. What to outsource. How to hire the best vendors for the best rates. What tools does the business need?
Mentors: Munjal Shah | Alain Raynaud | Peter Pham | Joe Betts-LaCroix |

Incorporation
August 11th, 2009: Incorporate the business
Description: How to set-up the right company structure to attract great employees and investors. What corporate formalities are required, and when?
Mentors: Ken Ross |

Marketing
August 17th, 2009: Create a messaging plan
Description: How to sell the story of your company and your offering.
Mentors: Bryan Thatcher | Scott Painter | Bubba Murarka | Joe Zawadzki | Jen Shelby |

Publicity
August 18th, 2009: Start outreach to key media sources
Description: Getting your vision and company name out there. From blogs to radio, what works and what does not?
Mentors: Philip Kaplan | Jason Calacanis | Peter Pham | Bubba Murarka |

The Funding Lifecycle
August 25th, 2009: Create a funding plan with targets
Description: What are the typical stages of the funding life cycle for different types of startup businesses? What kind of specific milestones should one expect to meet in order to progress through those funding stages?
Mentors: Scott Painter | Scott Heiferman | Russ Fradin | Paul Harkins |

Presentation
September 8th, 2009: Create a perfect pitchdeck
Description: How to explain and present your business to target partners and investors.
Mentors: Bryan Thatcher | Scott Painter | Eugene Lee |

Warrants and Bonus Pool

Each founder participating in a semester’s program will sign a Founder Agreement, which includes an obligation to grant a warrant to the Founder Institute to purchase 3.5% of the founder’s company’s fully-diluted capitalization immediately after an initial equity financing raising greater than $100,000.  The exercise price will be the price per share to other investors in the financing.  The founder’s company may terminate the warrant on or prior to the initial equity financing by paying the Founder Institute $100,000.  In addition, if the founder is removed or resigns as a director and does not certify to the reasonable satisfaction of the Founder Institute that such resignation or removal was voluntary, then the founder’s company must pay the Founder Institute $100,000.  Forms of the Founder Agreement and the warrant are available on the Founder Insititute website.

30% of the proceeds from the warrants received within five years from the start of a term shall be set aside in a bonus pool for the founders participating in a particular semester.  In addition, another 30% of the proceeds will be set aside for the mentors, with a portion of that based on founder reviews.

Founder friendly documents

The Founder Institute has developed Class F common stock, which provides founders with a maximum amount of control over the founder’s company.  TechCrunch and VentureBeat recently reported on this innovation and Adeo Ressi provided his thoughts in PEHub.  A form of Certificate of Incorporation that includes provisions for Class F common stock, along with a form of restricted stock purchase agreement are available on the Founder Institute website.  The Founder Institute requires founders to use these documents, or other documents approved by the Founder Institute, when forming a company.

[Disclaimer:  I represent the Founder Institute.]