Tom Eckmann ENTRE 440-540 – Business Plan Practicum 1

ENTRE 440/540 – Business Plan Practicum

• Clearly state your name!

• What do you need?

• Join a team? - what kind? what do you have to offer?

• Another team member? – What skills or experience?

• Resource Help? - Market data? Introduction?

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ENTRE 440-540AB Business Plan Practicum

“On-ramp to the 2015 U.W. Business Plan Competition”

Tom Eckmann 206-441-2067

Teckmann@UW.edu

Welcome!

ENTRE 440-540 – Business Plan Practicum Tom Eckmann 3

January 8 “Is entrepreneurship for you?” and “Good business ideas”

Business models and financial projections

Legal basics for startups

Insights from past BPC participants

Bootstrapping a startup

Raising investor capital

Business planning and risk assessment

Markets, competition and “uniqueness”

Lean Startup, library resources, and “networking night”

Course Journey

January 15

January 22

January 29

February 5

February 12

February 19

February 26

March 5

March 12 Dreaming Big! (who says the sky’s the limit?)

Tom Eckmann ENTRE 530 - Entrepreneurial Decision Making 4

When should you get help from an attorney?

You get serious about the business and have co-founders.

It’s time to form an entity.

You have IP to protect (patents, trademarks).

You must negotiate an important contract (lease, purchase agreement, partnership, other).

You’re raising capital.

You get sued or receive a “cease and desist” letter.

A patent troll comes knocking.

You hire employees (or contractors).

You encounter regulatory issues or need to deal with govt. agencies.

Someone wants to buy you!

Tom Eckmann ENTRE 530 - Entrepreneurial Decision Making 5

Working with Attorneys (1)

• Choose a “lead” attorney as your “go to” legal advisor

You’ll need more than one attorney

“Lead” usually specializes in corporate law

Directs you to more specialized attorneys as needed

• How else can they help you?

Provide strategic advice.

Recruit board members and advisors

Provide advice on board and governance issues

Introduce you to investors and partners.

Keep you out of court (or jail!)****

****Corp. attorneys represent company and shareholders, NOT YOU!

Tom Eckmann ENTRE 530 - Entrepreneurial Decision Making 6

Working with Attorneys (2)

• How do you find and choose a lead attorney?

Look around at BPC!

Actively network in the entrepreneurial community

Initial screening meeting (no charge!)

o Discuss expected scope of work

o Listen - does s/he understand startups, your business and industry and you?

o Are they “connected” in the entrepreneurial community?

o Do you like him or her?

See how the relationship works!

Tom Eckmann ENTRE 530 - Entrepreneurial Decision Making 7

Working with Attorneys (3)

Some tips…

Don’t hire too soon (or too late)!

Agree on scope of project and get an estimate in advance

Don’t lose control – they work for you!

Minimize spend (especially in early days)

Today’s Agenda

ENTRE 440-540 – Business Plan Practicum Tom Eckmann 8

1. Legal Basics for Startups

• Bill Bromfield, Fenwick & West

2. BOA discussion

3. Wrap-up and next week

UW Foster School of Business ENTRE 440/540: Business Plan Practicum February 12, 2015

William H. Bromfield Fenwick & West LLP

Fenwick provides full legal service exclusively to technology companies

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• One of the original Silicon Valley law firms

• 300 attorneys focused on technology

Top Seven Ways to

Screw-up your

Startup:

Legal Essentials for Startups

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1. Fail to form an entity for your

startup, form it too late or form the

wrong type of entity

Top Seven Ways to Screw-up Your Startup

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Why Form Entity?

• Limit Liability

–Protect Founders from outside claimants

• Depository for IP

–Capture all IP being developed (e.g., software being coded); Company owns all technology / IP

–Founders generally assign business plan, code, patent application, etc. to corporation in exchange for stock

• Allocate Economic Interests

–Issue stock to Founders

–Sell stock to Investors

–Grant options to employees/consultants

• Vehicle for Transactions

–Company, not founders, enters into contracts

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When Form Entity?

• When significant IP is created

• When Founders become committed to enterprise

• When ownership among Founders needs establishing (keep pricing low)

• Before contracts or other liabilities emerge

• When second equity participant joins

• Before company releases product/services to public

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Types of Entities

Limited Liability Companies

• Often used for consulting businesses or closely held businesses. Not typically used for VC-funded companies; formalities of corporation not required; can structure management similar to corporation.

• Flow Through taxation: income taxed directly to members

• Option Plan/equity incentives more complicated – Not understood by employees; much administration needed

C corporation

• Flexible capital structure – founders get common stock, investors get preferred stock; inexpensive to set up; familiar to investors

• Equity compensation relatively easy to implement and understand

• “Double Taxation”: Corporate earnings taxed at corporate rate; dividends to shareholders taxable

• Corporate formalities required to ensure limited liability

S corporation

• Similar features to C Corp except treated as partnership for tax purposes

• Significant restrictions on number and type of shareholders and filing requirements

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Is entity expected to generate near-term cash or will cash

be “plowed back” into entity?

Certain entity forms, such as limited liability companies,

can add extra complexity/cost

Future Funding Considerations

• Corporations can offer flexible capitalization

–Common Stock and Preferred Stock

–Stock Options

• Most potential investors are most familiar with corporations

–Required form of entity for most institutional investors

Other Considerations in Selecting Form

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2. Make the capitalization (or equity

structure) of your company WAY

too complicated or messed up

beyond repair

Top Seven Ways to Screw-up Your Startup

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Capitalization of the Start-Up

Common Stock and Preferred Stock

• Founders receive Common Stock

• Investors typically purchase Preferred Stock

– Separate class of stock with special rights, purchased by

investors for higher price than founder / employee common

– Newly created as part of a financing

• With dual class structure, able to preserve lower priced common for

employees / optionees

• “Control” big issue; majority of shares typically makes decision

Equity Incentive Plans:

• Employees of technology companies expect to receive equity

compensation

• Also possible to grant restricted shares in addition to stock options

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Allocation of Equity

Allocation of Initial Equity:

• When there are multiple founders, how should ownership be distributed? All founders are not all equal.

–What is each founder contributing at formation and going forward?

>IP central to the business

>Business plan and know-how

>Contacts

>Cash

>Time

• Equal ownership may well not be the right answer. Honestly assess relative contributions and roles going forward

• Key question should not be “how many shares,” but instead “what % of the company”

• However, don’t get caught up arguing over percentages (vesting is key)

Some resources:

• www.slicingpie.com

• http://www.andrew.cmu.edu/user/fd0n/35%20Founders'%20Pie%20Calculator.htm

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Basic Capitalization Considerations

Keep it simple and conventional

Don’t forget to issue stock to founders or irrationally

allocate ownership

Don’t offer to sell securities in violation of (or in ignorance

of) securities laws

• Don’t promise stock options or stock to friends, family members and potential employees before adopting plan and setting capital structure

• All issuances must comply with State and Federal Securities Laws

• No such thing as a “friends and family” exemption

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Stock Option Gotcha!: I.R.C. 409A

US tax law imposes severe penalties on “deferred

compensation arrangements”

• 20% excise tax imposed by IRS; states impose similar taxes

Treats any stock options granted with exercise price at

less than fmv as deferred compensation arrangements;

IRS will use 20-20 hindsight

Acquirers/Investors care deeply about 409A compliance

May obtain a valuation report to shift burden of proof - not

practical for new, pre-funding start-up

Various alternatives to minimize risk (talk to counsel)

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3. Fail to establish “ground rules” with

co-founders

Top Seven Ways to Screw-up Your Startup

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Agreements Among Founders

Importance of Agreements Among Founders – “Prenuptial” Agreements

• Founder Vesting/Right of Repurchase that “lapses” over agreed vesting schedule

• Restrictions on Transfer

• ROFR on vested shares (right to match sale offers)

• Voting Agreements

• Buy/Sale?

• Board of Directors composition (avoid even boards)

Bottom-line - Choose your co-founders carefully

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Capitalization of the Start Up - Founder Stock Terms: Vesting and 83(b) Elections

Why impose vesting?

• Avoid “free riders” (e.g. co-founder leaves; you keep working …)

• Company may need the equity back for future hires

• Repurchase at cost upon separation

• VCs will require vesting

Tax Gotcha!: File 83(b) elections!

• General tax rule: a service provider has ordinary income on account of the

transfer of property on the first date the property is no longer subject to a

“substantial risk of foreclosure,” and amount of the income is amount of

spread on that date

• 83(b) Election: “tax me today, on date of transfer, instead”

• Must be filed within 30 days of date of sale of stock

• To the extent IRS can later show value was actually greater than what you

paid, then income tax risk to you

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Capitalization of the Start Up - Founder Stock

Terms: Acceleration

Which happens if the Company is acquired or if

you are fired before you have fully vested??

“Double Trigger”: If Company is bought (first trigger) and if you

are terminated w/o “cause” or “constructively” within a

specified period of time (typically 12 months) after the

acquisition (second trigger)

• How much vesting accelerates?

• Definition of “cause” and constructive termination (i.e., “good

reason”)?

“Single trigger”: If Company is bought, vesting is triggered

• Can be problem for management flexibility, potential buyers and

investors

Different VCs have different hot button acceleration terms

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4. Lose the rights to the company’s

IP

Top Seven Ways to Screw-up Your Startup

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Intellectual Property Basics

IP is any innovation, idea, know-how or invention, whether commercial or artistic, or any unique name, symbol, logo or design used commercially.

• Includes designs, original works of authorship, formulas, processes, composition, computer software programs, databases, and confidential information

You create something that falls within a class protected by the law.

For some classes, you get protection automatically. For other classes, to get protection, you should/must go through a registration, application or examination process.

“Protection” is a negative right. The law does not give you the right to use your creation. It only gives you the right to stop others from using your creation.

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Basic types of IP Protection

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Protecting Your IP

Company value may be tied almost exclusively to rights in certain IP

• Any clouds on title of IP will adversely affect value of the company

Need to demonstrate to investors/future acquirers that all rights in IP have been secured/protected

• Obtain licenses

• Use Nondisclosure Agreements

• Use proper IP assignments (employees and contractors)

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Ownership of Vital Intellectual Property

Did your consultant sign a consulting agreement assigning

his/her IP to you?

• For consultants, there must be a written agreement for the assignment to be effective

• Without a written agreement, the consultant owns all IP created by the consultant

Even with an agreement, IP created by an employee is

owned by the employee as long as:

• No equipment or property of the company was used;

• IP was developed entirely on employee’s own time;

• IP does not relate directly to the company’s business; and

• IP does not result from any work performed by employee for the company

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Issues When Leaving Existing Employer

• Continued IP ownership by former employer

–IP created by employee on employer’s time and using employer’s equipment is “owned” by employer

• No Moonlighting Clauses

–Prohibits employee from engaging in other business activity during employment

• Nondisclosure Clauses

–Prohibits disclosure of certain aspects of employer’s business

• Noncompetition Clauses

–Prohibits employee from engaging in certain business activities in a particular area for a period of time

• Nonsolicitation and No-Hire Clauses

–Prohibits hiring employer’s other employees or pursuing employer’s customers and/or suppliers

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5. Misclassify employees as

consultants (and vice versa)

Top Seven Ways to Screw-up Your Startup

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Employment Issues: Employees Versus Independent Contractors

Advantages of Independent Contractor Classification

• Complies with minimum wage, workers’ compensation, and unemployment compensation obligations

• Healthcare and other benefits are not required

• Social Security and Medicare taxes not required

Classifying Someone as an Independent Contractor

• Degree of control exercised by employer

• Extent that contractor’s duties are fundamental to the company’s business

• Intention of the parties as evidenced in a Consulting or Independent Contractor Agreement

• Many other factors

Failure to Properly Classify

• Can result in personal liability for failure to pay wages

• Can result in fines and taxes

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Top Seven Ways to Screw-up Your Startup

6. Fail to document transactions

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Document Your Deals

In all of the foregoing, always clearly document

deals/transactions

Important to investors, potential buyers and you

• Founder stock arrangements

• Deals with advisors

• Independent Contractor Agreements

• Employee Invention Assignment Agreements

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7. Wait to address any of the

foregoing problems until you have

cash in the bank and when the

company is valuable

Top Seven Ways to Screw-up Your Startup

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Potential Pitfalls: Going it Alone

Free legal resources available on the internet may not be entirely applicable to your circumstances

• May omit major issues that should be set forth in your governing documents

• However, there are some relatively good resources:

http://contractual.ly/ (look under “resources” for form agreements)

www.legalzoom.com

www.clerky.com

Significant filing and reporting obligations required under

• Securities laws

• Tax laws

• Corporate laws

• Employment laws

Consequences for failure to comply with these obligations can include personal liability for the founders

Cost of up-front legal services less than the cost of correcting errors

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Questions/Discussion

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Business Opportunity Assessments

Final due March 6 (3 weeks)

• Answers to 15 questions

• PowerPoint presentation (7 slides)

Tom Eckmann ENTRE 440-540 – Business Plan Practicum 40

Recap

1. Network and find a lead attorney who knows your business and you want to work with

2. Don’t wait too long

3. Minimize spending on legal fees early on – money better spent on building the business.

Next Week

Insights from past business plan competitions