Initial Intellectual Property Protection and Contractor Relations
(i) Mutual Non Disclosure Agreement, or NDA, which protects your trade secrets, as well as those of the people you’re dealing with. You can make this “one-way,” meaning that only your start-up’s confidential information is protected, but anyone experienced with her own IP on the other side will want a mutual NDA.
(ii) Consulting Agreement with an independent contractor, including a mutual NDA and a Proprietary Information and Innovation Assignment Agreement. The latter seeks to ensure that your company, the entity paying for the contractor’s services, obtains their benefit in terms of any intellectual property resulting from those services
(iii) Offer Letter for employees, and related Invention Assignment Agreements. Early stage start-ups are not always in a position to begin employing people right away, because of the administrative and financial burdens of doing so relative to engaging independent contractors. If you do, Offer Letters and related Proprietary Information and Innovation Assignment Agreements come with the package.
If you have two co-founders, you may well wish to share the initial equity in your corporation equally among the three of you. All very fair and balanced.
But what happens if one of you loses interest, or finds an alternative path that interests him more, in other words, what happens if one of you leaves?
It happens all the time, and is only unfair if the departing founder keeps all her stock despite leaving while the others work on for months or even years without her. Where does the equity come from for the person who assumes her functions?
A Restricted Stock Purchase Agreement fixes this problem essentially by having each founder’s shares vest over time. Again, simple to state, difficult to implement. For example, the shares are deposited in escrow during the vesting period, and a neutral escrow agent needs to be appointed.
Stock Certificates will be created for each Founder.
Section 83(b) election. Very important. Must be filed with the IRS by each founder within 30 days of purchasing restricted stock. Don’t blow this one! If you do, it can’t be fixed.
State “blue sky” filing. In California, Section 25102 (f) filing.
I will walk you through both the contacts and the logistics of implementing them.
This Shareholders Agreement ensures that their deal is only changed if they all agree.
If one founder receives an offer for her shares, she can only accept it if her co-founders agree or if her buyer also agrees to buy their shares.
No founder can replace herself without the agreement of her co-founders. They are dealing with her, and may not share her enthusiasm for her replacement.
These sorts of issues need to be regulated. The human element often brings down even the best ideas with the most hard-working team. No-one can remove all of the risks of the human element, but some important ones are taken care of by the Shareholders Agreement.
Just as the upside is not guaranteed, neither is the exit which enables your people to share in it. Unless your start-up is going to achieve a FaceBook or Tesla level of success, the gain in options will only be realized when your company is acquired or experiences an initial Public Offering, or IPO. Long odds.
In some ways, those are the same odds that you founders face, and to that extent you are all in the same boat.
Even though the return on options is far from assured, tradition says that an early stage start-up conserves cash by granting employees and others options instead of full salaries.
Here are the basic steps in implementing an Option Plan.
(i) First, the existing shareholders need to consent to and approve the Plan, and in particular the number of shares that will be in the initial option pool. The shareholders need to be onboard, because the Plan “uses” the corporation’s shares into which the options may be exercised. In other words, because it dilutes the shareholders. It is a good idea to adopt the Plan before much time passes, because only the Founders are shareholders early
In the corporation’s life. As more people become shareholders, more people need to agree to the Plan.
(ii) The Equity Incentive Plan itself is prepared in accordance with the shareholders’ wishes. For the price that i am offering, it will not have all the bells and whistles that big law firms include. Rarely used, they offer little benefit to the Corporation. The Plan will enable grants of options and stock purchase rights.
(iii) The Board too approves the Plan, and grants options in accordance with it. This package includes a Board consent to the grant of options to up to five people, which will serve as a model for future grants. All grants are made by the Board during the early stages of a Corporation’s life. The key action taken by the Board here is valuing the corporation, because the exercise price of the options must be based on an accurate valuation.
(iv) A form of Option Agreement will be prepared, and tailored to the initial grants. We will collectively decide on vesting schedules and the like. These agreements are themselves somewhat complex, because they include documents to be signed upon exercise of the options.
(v) A simple form of option tracker will be prepared. As the number of grantees increases over time, keeping track of how many options are outstanding involves keeping track of both new grants and retired options. Options are retired when their grantee terminates service for the Corporation.
(vi) Follow-on administrative work, like a State Blue sky filing covering the shares in the Plan.
The one area which used to be difficult in friends and family financing was valuing the company. If they were putting in $100K collectively, did that give them 2%, 10% or 25% of the company? To put it another way, was the company worth $5 million, $1 million or $400K? Precisely because of the close personal relationship between those bargaining, the agreed valuations were notoriously unreliable.
Enter convertible notes. Essentially these defer the valuation decision until more professional investors are involved. They have no problem fighting it out with the founders, and neither side has any reserves based on their personal relationships.
Friends and Family initially loan the corporation money, on favorable terms, and with no meaningful security of being repaid. The loan converts into equity when a professional financing occurs, at a predetermined rate which gives friends and family more shares for their buck than the later investors. The investors accept that disparity because friends and family took more of a risk by investing earlier.
Doing a convertible note deal involves:
(i) deciding whether the investors will have a rep on the Board. Normally, friends and family do not feel competent to assume such a role. But at times, someone wants to. To be discussed
(ii) a Note Purchase Agreement covering the sale of the Notes by the corporation to participating friends and family. This needs to alert the investors to some risks of the corporation, although the fact that it’s an early-stage start-up makes the whole investment very risky. To be discussed. This is signed by all investors and the corporation
(iii) the Convertible Notes themselves made by the corporation to each investor
(iv) some form of Investor Rights Agreement. What’s in here depends to some degree on the status of the corporation, but the basic functions of this Agreement are similar to those of the Shareholders Agreement described above
(v) Board minutes approving the deal, and in particular the terms of the Notes. Various administrative formalities, including creating the stock certificates and State “blue sky” filings.
2. Fill in the gaps. Within reason!