Capital Structure For Start-Ups: Part 2

By: Robert Hawn

As a business lawyer in the Silicon Valley area of California, I find that one of the most important issues founders of a high tech start-up company have to consider is its ownership, or capital structure. As you grow your company, it is important to understand your percentage ownership of the company. The different types of equity incentives and funding instruments will have varying impacts to your ownership, and you need to keep this in mind as you grant options to your employees and accept funding from your investors.

In the last blog in this series , I discussed some of the basic concepts of determining the number of shares of outstanding stock, and the number of shares of fully diluted stock, to help explain how investors look at ownership in a company. To summarize, the number of shares of outstanding stock equals the number that are issued and held by a shareholder. The number of fully diluted shares, however, are the number of outstanding shares, PLUS the number of shares that can be issued on exercise of contracts that enable the holder to purchase shares, such as stock options and warrants.

When you are dealing with the typical family business, or owner operated business, outstanding shares and options are about as deep as you need to get. When you are dealing with a typical high tech start-up which has gone through a couple of rounds of financing, the situation can get a bit more complicated.

Let’s first look at how a commonly used angel funding vehicle can affect the process of determining the number of fully diluted shares. In very early stage companies, where there is not even a product, much less revenues or profits, it is almost impossible to determine the value of the company. As a result, angel investors often provide funds through a “convertible note”. In a convertible note, a company borrows money from an investor and provides a note, essentially a promise to repay. The note, however, can convert into shares that are issued in the next round of funding. The rate at which the note converts is based on the value of the shares in the next round. Essentially, the investors forgive their debt under the note in exchange for shares. The idea here is that once the company has some history, it will attract venture investors who know how to value early stage companies. By converting into shares issued in a round led by venture capitalists, the angel investors will piggyback on the valuation determined by the venture investors. To compensate the angels for investing early on, they often receive a discount on the purchase price set in the venture round (although the venture investors may try to limit this).

Using convertible notes creates some difficult issues in calculating the number of fully diluted shares. First, you don’t know how many shares will be issued on the conversion of the notes. This is because the rate at which the notes will be converted into stock is based on the per share price in the next round of financing. The share price, in turn, is based on the value of the Company. Because the venture investors have yet to determine valuation, you don’t know what the purchase price of the next round is. As a result, you don’t know the conversion rate of the note or, correspondingly, the number of shares that will be issued once the note converts.

Second, founders often cannot be convinced that the interest payments under the note should not convert. If interest converts, the number of shares issuable under the note changes daily as interest accrues. This results in the number of shares allocated to the notes to increase slightly each day, and the percentage of shares held by other stockholders, such as the founders, to decrease each day.

Let’s fast forward. You’ve now grown your company and created enough value and buzz to close a serious investment round, and all of your convertible notes have gone away. You now have investors who have purchased stock from your company. The stock they have purchased, known as convertible preferred stock , however, is a little different from the common stock you likely hold. One major difference is that convertible preferred stock can convert into the same kind of common stock you hold. This is convenient, because it allows you to determine the number of fully diluted shares by applying the conversion rate of the preferred stock against the number of outstanding shares of preferred stock, and generate the number of common stock equivalent shares. If you have an option plan, you can assume all of the options are converted into common stock. Once everything is reduced to common stock, you can count up the number of shares and that is your number of fully diluted shares. Pretty easy, huh?

At this stage, yes, but let’s fast forward even more. Because of some misfortunes, you had to take in investment funds as part of a “down round” (so named because the price of the preferred stock was down from the previous round). One common feature of convertible preferred stock in a start-up context is a device that protects the investor if there is a later down round. The device, often referred to as price-based antidilution, will change the conversion rate of the preferred stock issued in the earlier round. The change will, as you might guess, result in relatively more common stock being issued for each share of preferred. So, if there has been a down round, you need to account for the impact of this antidilution feature in determining the number of fully diluted shares. You can imagine this can get pretty complicated if your company has already done a number of investment rounds, each with different purchase prices, some of which may have an antidilution provision triggered in connection with a particular subsequent round, and some of which may not.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

New California Law Allows Finders To Help With Start-up Financing

By: Robert Hawn

In representing start-up companies in Silicon Valley I have found that one of the biggest challenges facing founders is raising early stage capital. Emerging growth companies often do not have the necessary relationships that can lead to investment funding. To find these relationships, the company may retain a finder. A finder is an individual who can introduce the company to funding sources, typically in exchange for a commission. Because these finders were not licensed as broker-dealers of securities (essentially, someone who helps to sell securities of a company to investors), they were frowned upon by the law. A few years ago, stricter laws were enacted that created strong disincentives to start-ups to pay commissions to finders.

On October 10, 2015, the Governor signed into law AB 667 , a bill sponsored by Assembly Member Wagner, which creates exemptions to the broker-dealer laws for finders and their client companies. The act, which added Section 25206.1 to the California Corporations Code, provides a balance between protecting investors while easing requirements for fund raising by small companies. Because the law was passed during regular session and not an urgency measure, it will likely become effective January 1, 2016.

So, What Does The Bill Do?

Before the new law, any finder who was not licensed by the State as a broker-dealer of securities could not introduce any company, start-up or otherwise, to potential investors. If an unlicensed broker-dealer provided an introduction, among other things, the investor could get their money back from the company and from the unlicensed broker-dealer, who would be personally liable for the investor’s money.

Under the new law, an unlicensed finder can make an introduction if certain requirements are met. Among them is the requirement that the finder can only introduce “accredited investors”. These are investors who satisfy income or wealth thresholds, have an executive position with the company, or are certain types of entities. Among other requirements, the finder can’t (i) provide an introduction where the aggregate sale price of the securities is more than fifteen million dollars, (ii) participate in negotiating any of the transaction’s terms, or (iii) provide any advice regarding the value of the securities purchased. The law sets forth the only information the finder can disclose regarding the company. The finder also is required to make a filing with the Department of Business Oversight and pay a $300 filing fee, which must be renewed each year and filed with an additional $275 filing fee. There are other requirements that have to be satisfied, including specific disclosures to be made to the potential investor.

Positive Aspects To The New Law

There are a number of positive aspects to this new law. First, start-up companies can now use finders, and finders can now get some value from the relationships they may have with high net worth individuals, or companies, which may want to invest in start-up companies. Second, lawyers like me who are asked about using finders now have a relatively clear direction of how start-up companies can use them.

As with anything in fundraising, this new law is just one part of a large and somewhat technical body of securities laws that need to be reviewed with your lawyer to make sure your company is in compliance. Failure to comply with these laws can expose anyone who runs one of these companies to personal liability for the amount of the investment. That’s why it’s really important that before you start any kind of fundraising activities, you should confer with a lawyer that works in the fundraising area.

As a former chair of the State Bar’s Business Law Section , I can’t help but note that this bill came about as the result of the hard work of many members of the Section’s Standing Committee on Corporations. They are to be congratulated on their hard work in bringing clarity and rationality to start-up fundraising activities.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Funding Your New Company

As business lawyers dealing with start-ups in Silicon Valley, we often meet founders with great ideas but without a fundamental understanding of how their company can raise funding for their new business. Start-up companies and small businesses hoping to expand are considered high-risk businesses. It can be difficult for entrepreneurs to turn their ideas into reality. This is why venture capital plays such a critical role in business development .

Venture capital refers to capital that is invested in a high-risk project. When seeking venture capital, it is very important to consult an attorney at a corporate law firm for legal advice regarding whether your idea is suitable for venture investment. If you decide that you do have a fundable idea, the attorney can help guide you on structuring your company to accept investment, and the types of agreements required for investment at each stage of growth.

As you’ll learn by watching this brief video from Capital News Online, when a venture capitalist agrees to invest funds in a risky project, he or she is likely to place conditions on the investment. In the example given in this video, the venture capitalist insists on owning 60 percent of the company and on having the authority to make all major decisions for the business. There are often other conditions, such as membership on a board, approval rights over subsequent financings, and requirements over how a founder can vote and transfer their stock. Because of this, it’s essential to seek the counsel of a corporate attorney to help guide you through the adventure of starting your new company.