sheppard mullin, 09/17, new york - legal and ip

8/20/2019 Sheppard Mullin, 09/17, New York - Legal and IP

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Startup Law 101 -How To Structure

YourStartup for Growth

Presentation to

September 2015



Aout Sheppard Mullin

!ull"ser#ice Gloal $%% la 'irm handlin(corporate and technolo() matters, hi(h sta*esliti(ation and comple+ 'inancial transactions

#er -%% la)ers in $ o''ices in

/orth America, Europe and Asia $%0 la)er corporate (roup is #er) stron( in

– Startup representation 1on the company side2

–

3enture capital and other pri#ate 'inancin(s – Liquidit) transactions 1M&A and 4Ps2

5



Aout Sheppard Mullin

$5%0 la)er 4P (roup has specialists in e#er)technical 'ield, handlin( – Patent prosecution – 6rademar* prosecution –

7op)ri(ht prosecution – Liti(ation – Licensin(

Representati#e clients include –

Ali8aa – Lendin(6ree – /orthrop Grumman – Samsun( & Samsun( 3entures – 9ahoo:



Aout Joe Daniels

Partner in the 7orporate & 7apital Mar*ets Groups andMemer o' Emer(in( 7ompan) and 3enture 7apitalPractice at SheppardMullin

!or $; )ears 1includin( < in 7A durin( dot.com da)s2

has represented – Startup to mature pulic companies 1e.(., Atmel, Autodes*,4n'ormatica, Pol)com, Monster =orldide2

– Pri#ate equit) and #enture capital 'irms1e.(., Alpha Prime, Sorrento, =alden, +'ord, 6hird =a#e2

– 4n#estment an*s 1e.(., 7redit Suisse, Mor(an Stanle)2

4n#ol#ed in hi(h"(roth sectors, such as technolo(),li'e sciences and consumer



Aout Joe Daniels 17ont.2

Areas o' 'ocus ha#e een – Gettin( companies 'unded in an(el, 37 and other pri#ate

rounds o' 'inancin(

– 4Ps and other pulic o''erin(s o' equit) and det

–

All sorts o' mer(ers, acquisitions, partnerships and >oint#entures

– ther usiness deals 'rom 'ormation to liquidit), li*elicensin( or >oint de#elopment

– Actin( as outside (eneral counsel to companies

– 7urrentl) represent %"?% startups and #enture 'undsorldide

Independent – Mostly company-side work, and not owned by VCs



Aout James Gatto

James@



A(enda

A#i 9aschin 'ounder & 7E o' 7leanEdison Essential 'ormation, equit) and 4P documents

– 6)pe o' entit) 1corporation #s. LL72

– Equit) documentation

– Protectin( 4P hen addin( personnel

Raisin( 7apital – 6)pical /ote and Seed Round 6erms

–

=hat is the A Round@ – 37 'undraisin( process o#er#ie

– 6)pical Series A pre'erred stoc* term sheet terms

Buestions and ansers



A#i 9ashchin !ounder & 7E o'7leanEdison 1Acquired ) Caplan2

4ntroduction o' A#i =hat does a ne !ounder need to *no aout

the la to launch a success'ul startup@

Ho do )ou pic* a la 'irm to or* ith@

Ho do la)ers help set up a compan) and helpith 'inancin(s and e+its@

=hat are some common le(al mista*es@



7orporation #s. LL7

7 7orporation1est choice 'or #enture model compan)2 – Pre'erred ) 37s and most an(els, ho do not ant

pass"throu(h (ainloss

– Eas) to use equit) 'or ser#ice pro#iders and acquisitions – Las (o#ernin( 7 7orps are much clearer than LL7 la

– !ast (roth companies do not pa) di#idends andinstead rein#est, so the ta+ ene'it o' LL7 and S"

7orporation is not rele#ant – 6a+ loss ene'its o' LL7 or S 7orporation usuall)

e+ceeded ) hi(her le(al costs 'rom operatin(a(reement to equit) (rants and con#ertin( to a 77orporation 'or 'inancin(



7orporation #s. LL7 17ont.2

S 7orporation – Same t)pe o' entit) " >ust an election 'or pass"throu(h

ta+es

– Ma) ma*e sense to elect S 7orporation status in

loss )ears – /ot eli(ile 'or S 7orporation status hen )ou ha#e

an) other entit) or a 'orei(n person as stoc*holder orha#e more than one class o' stoc* or $%% SH

Delaare 1the $st state2 is the state in hich toincorporate – People most trust DE

– Man) in#estors ill 'orce a sitch



Limited Liailit) 7ompan) 1LL72

Limited Liailit) 7ompan) 1LL72 – Good 'or li'est)le usinesses that ill ma*e periodic

distriutions o' pro'its1instead o' rein#estin( in the usiness2

– FPass"throu(h or sin(le"le#el ta+ – 3enture capital 'irms and some an(els ma) require

con#ersion to 7 7orporation 'or 'undin(

– 7umersome 'or (rantin( equit) to ser#ice pro#iders

– More comple+ to use LL7 equit) ascurrenc) 'or acquisitions

– Delaare is the state 'or an) LL7 'ormation



Equit) Documentation

Doin( the paperor* shoin( equit) (rants earl)is important

$. 6a+ issue i' )ou paper (rants too close to an equit)round, )ou create potential ordinar) income ta+es 'or

the (rantee and the compan)5. !ounder disputes hen equit) is not adequatel)

papered, and 'ounders no lon(er (et alon(, it can leadto dran out disputes that hinder the compan)

. 4n#estors ill require all equit) to e correctl) paperedprior to the closin( o' an) 'inancin(



Equit) Documentation 17ont.2

I. 3estin( all 'ounders shares should #est, ecause an)could lea#e an) time – 6)pical 'ounder #estin( is )ear $ )ear cli'' 'rom the time

)ou start or*in( on the compan)

.

Prior to )our 'irst equit) round, paperin( equit)(rants is simple – 6his >ust requires a oard consent, restricted stoc*

purchase a(reements and 'ilin( <12 elections, or optiona(reement a'ter )ou#e done a seed rounds

– Most la 'irms that practice in this area, includin(Sheppard, o''er a pac*a(e deal to 'orm companies,includin( the equit) (rants, that is totall)ine+pensi#edoale



4ntellectual Propert) Jim Gatto

Mr. G@



Protectin( 4P =hen Addin( Personnel

Essential to loc* up all 4P in the compan) aspeople >oin ith Service Agreements – 4P includes in#entions

1e.(., a ne and use'ul usiness processes2,

• 7op)ri(hts 1e.(., epa(es2• 6rademar*s 1rands2

• 6rade secrets

• Etc.

– All 'oundersother personnel should a(ree to assi(ne+istin( and to"e"de#eloped 4P rele#ant to theusiness



Protectin( 4P =hen Addin( Personnel 17ont.2

–Kse a consulting agreement that maintainscon'identialit), assi(ns in#entions & has non"solicitation pro#isions 1so someone lea#in( cantsolicit compan) personnelcustomerssuppliers2

– 6he duties in the ser#ices a(reement can also e tiedto #estin(

– A'ter )ou start a pa)roll all emplo)ees should si(n anoffer letter and confidentiality, invention

assignment and non-solicit agreement

A round 4n#estors ill ant all current and former

consultants and employees to ha#e si(ned sucha(reements



!irst Seed Round 6erms /otes &Series Seed

Prerequisites – 'ten >ust stron( 'ounders and initial product plan

Purpose o' 7apital• 'i(ure out product,

• determine the mar*et and user ase,• scale past the initial 'ounders, and

• uild an earl) product

5%*" 5MM 'or N"N o' the compan)

4n#estors are An(els and earl) sta(e 37s1compan)"led, so the compan) proposes terms2

=or* ith counsel to create a term sheet



7on#ertile /otes

Ala)s etter cheaper 'or the 7ompan) than an)Pre'erred Stoc*, as lon( as the terms are ri(ht h)@

/ote con#erts automaticall) hen minimum raised, h)@

4deal loest possile discount, no cap, or hi(h cap

4ts etter to 'i+ the con#ersion price than a(ree to a cap,ecause ith a cap, i' )ou raise at less 1a'ter discount2,in#estors (et loer price

Must con#ert at acquisition, and ideall) at maturit) too

6r) to use one"o'' notes so )ou can chan(e terms 'oreach in#estor 1i.e., no note purchase a(reement2

7onsider settin( lo interest 1e.(., 5N2 and pa)in( itinstead o' con#ertin( it to (i#e aa) less stoc*



Series Seed Pre'erred Stoc*

–

Series Seed is li(ht pre'erred stoc* ith minimum'a#orale ri(hts

– Most important term is the pre"mone) #aluation1same tric*s ith equit) pool & note con#ersions asdiscussed elo under Ser. A2

– 7ompan) t)picall) creates a 5 pa(e term sheet androunds up the earl)"sta(e 37s and an(els

– Do not use SA!E ecause it creates too man)separate series and ne in#estors or )ou ma) notant SA!E round in#estors to ha#e the same ri(hts

– Do not use seed pre'erred that con#erts into the A round 'or the same reason



Series Seed Pre'erred Stoc*

–

=hat is light preferred stock • Simple non"participatin( pre'erred

• /o oard seat ri(hts 1or at least not control2

• Limited in#estor loc*in( ri(hts 1ma)e alloin( 'orequit) raises and acquisitions o#er certain #aluationamounts2

• 3er) limited re(istration and in#estor ri(hts and re(ularR!R.co"sale ri(hts

After term sheets are signed or* ith counselto dra't note or seed pre'erred documents &close the 'inancin(.



=hat 4s 6he A Round@

6he A round is usuall) the 'irst institutional equit)round – Di''erent prereqs #s. seed round product and

userase are de'ined plus )ou sho si(ni'icant

traction hat are traction e+.s@• Social media app lots o' users plus user (roth

• 6ransaction plat'orm numer o' deals and dollar#olume plus mar(in

•

Enterprise so'tare i( customers pa)in( i( 'ees, lotso' and (roin( numer o' SMEs pa)in( small 'ees, etc.

• 7an not 'i(ure it out tr) re#enue and E846DA1$%mm$MM2



=hat 4s 6he A Round@ 17ont.2

–

Purpose scale distriution, scale (eo(raphicall) andper'ect the usiness model1meanin( determine ho to actuall) ma*e mone)2

– Amounts 5 $MM 1or moreO2

–

4n#estors Hope'ull) one lead 37 ith an(elsta((in( alon(



6he 37 !undin( Process

Goal is to (et an acceptale term sheet$. 6ar(et top $%"5% A round 37s ased on industr)

specialiation

5. Share list ith all ad#isors and (etschedule meetin(s

ith in to ee*s h)a2 7reates u 37s all tal* to each other

2 Auction d)namic ith e#er)one tal*in( aout )ou, the)ill mo#eca#e quic*er

c2 Helps )ou re'ine the pitchd2 9ou ill not (et a term sheet ee*smonths e'ore thene+t one i' )ou do )ou ill ha#e nothin( to comparea(ainst and the 'irst 37 ill (et pissed & ithdra



6he 37 !undin( Process 17ont.2

. 7reate an auctiona2 !ocus on (ettin( a term sheet 'rom each indi#idual 37

2 /e#er tell one 37 hich others )ou are tal*in( to or theterms the) are o''erin( >ust sa) the usual suspects, orthe) ma) literall) collude to loer the #aluation

c2 Do not let 37s create a s)ndicate, or )ou ill li*el) endup more diluted

d2 Entertain all term sheets 1*eepin( ac*ups2, compareith la)ers & ad#isors and choose

I. 4' at 'irst )ou dont succeed, (o ac* to a con#ertilenote or seed round

. Si(n the term sheet, 'inalie transaction documents,and close



Series A Pre'erred Stoc* 6erms $

3aluation 4ssues – Most important term the pre"mone) #aluation, determines

percenta(e o' the compan) sold 1e.(., MM on 5%MM Q5 Q 5%N2

– 5 ma>or terms e''ect the e''ecti#e #aluation, or price per share• Equit) plan increases )ou ant a nice post"mone) pool,

ecause )ou hope'ull) ha#e complete discretion to (rant options'rom that pool, ut do not ta*e all the dilution on it

– 7! all included in the post"mone) capitaliation, so it does note''ect per share price

» E.(., per share Q #aluationoutstandin( pre"mone) shares, sothe price is don i' the shares are up

– / split the plan hal' pre and hal' post, or some other compromise

– 4! all included in the pre"mone) calculation, sustantial decreasin(the per share price



Series A Pre'erred Stoc* 6erms 5

–

Ho to con#ert the con#ertile notes SA!E Fcon#ertileequit)@ "" a)s 1and in#estors ill (ame it2• 7! pre"mone) method calculate the price per share ased

on pre"mone) 1e.(., 5%MM pre 5%MM outstandin( Q $.%%2and then di#ide principal 1and ma)e interest2 ) this price

•4! percenta(e"onership method calculate the percenta(ethe cash in#estors should on ased on the pre"mone) andor* ac* 'rom there ta*es points aa) 'rom the 'ounders

• / dollars"in#ested method calculate ho much the cashin#estors 0 noteholders should (et ased on the pre"mone)

and or* ac*, so 'ounders onl) ta*e dilution on an)discount noteholders (et 1not as ad & ar(ual) more 'air2



Series A Pre'erred Stoc* 6erms

Liquidation pre'erence on sale o' compan) ordissolutionindin( up2 – =h) is this important@

• ne ma>or ene'it o' pre'erred stoc* is it (ets paid 'irst

on liquidation• Dependin( on the sales price, pre'erred ill either ta*e

their liquidation pre'erence or con#ert i' the) ma*emore con#ertin( 1$"'or"$ 'or common stoc*2

• So 'or a ran(e o' sales prices up to a certain amount,the liquidation pre'erence o' the pre'erred determinesho much mone) is le't 'or )ou and the other commonholders



Series A Pre'erred Stoc* 6erms I

–

7! 1mar*et2 non"participatin(, meanin( i' notcon#erted, pre'erred (ets $+ pre'. 0 declared &unpaid di#idends• 8asicall) this is (ettin( their mone) ac*

– So e#en in a lo price sale the) (et that

– 4! 1re>ect2 'ull) participatin(, meanin( in#estors (et$+ 0 'ull as"con#erted pa)out

– / 1re>ect2 participation ith a cap. E.(., $+ 0 up to 5+ased on as"con#erted pa)out

Most 37s are C ith non"participatin( in an A roundecause the) dont ant 'uture pre'erred in#estors to (etparticipatin( on top



Series A Pre'erred Stoc* 6erms

8oard Seats – 6he oard hires'ires 7E & other 7"le#els, issues

stoc*option and appro#es other ma>or co. action

– So, do hate#er )ou can to control the 8oard

• 9ou ma) still e #estin(, and oard can 'ire )ou• 9ou uilt it and run it da)"to"da), the) in#ested in )ou,

so *eep control o#er strate() and hirin(

– Ho to control outnumer the in#estors 1$, 5$, 52•

9ou need a completel) uni'ied (roup on )our side• Seats should e oned ) speci'ic indi#iduals and not

common stoc* as a hole, ecause pre'erred cancon#ert to common at an) time in their discretion.



Series A Pre'erred Stoc* 6erms ?

8oard Seats 17ontd2 – =hat to atch out 'or

• 5 'ounders, 5 in#estors, and one independent prolem independent can #ote ith in#estors

•

5 'ounders, 5 in#estors, ut one o' the 'ounder seats is'or the 7E. So i' the oard replaces )ou as 7E, the'ounders lose control.

• 5 'ounders, 5 in#estors, and )oure still deadloc*ed.

– Mar*et 'ounders control a'ter A. 4' in#estors arentu)in( %N o' the compan), h) should the) controlor e#en ha#e equal representation on the oard@



Series A Pre'erred Stoc* 6erms -

Di#idend Pre'erence – Generall) not rele#ant ecause startups dont pa)

di#idends, 8K6 mentioned Ith ecause 37s illsometimes as* 'or cumulati#e di#idends, and )ou

need to *no to 'i(ht it – 7! di#idends paid on pre'erred on as"con#erted

asis hen, as, and i' paid on common stoc*• i.e., pre'erred stoc* (ets the same as common stoc*



Series A Pre'erred Stoc* 6erms <

Di#idend Pre'erence 7ontd – / 1mar*et2 non"cumulati#e di#idends in an 'i+ed amount

per share 1e.(., I"<N o' the price per share2 paid onpre'erred hen and i' a di#idend is paid on common• 6his can also e participatin( 1i.e., a'ter pre'erred (ets the

minimum per share, it also (ets the di#idend the common is(ettin(2

– 4! 1re>ect2 7umulati#e di#idends 1e.(., I"<N per annum2 0participation in an) di#idends on 7ommon Stoc*

– 6he accrued di#idend is usuall) pa)ale upon the sale o'the compan) or 4P• 6he prolem ith this is that it increases the amount o' the

compan) the in#estors on on a dail) asis

• 4ts especiall) ad i' the accrued di#idend compounds



Series A Pre'erred Stoc* 6erms ;

FProtecti#e Pro#isions or 8loc*in( Ri(hts requires holderso' a ma>orit) or superma>orit) o' the A 'or the 7ompan) to ta*ema>or actions

– Sell/merge, liquidate/dissolve/windup the Company 1mar*et2

• 6his is included in almost e#er) deal• 9ou can sometimes ne(otiate that in#estors cant loc*

a sale o#er a certain amount

• Oespeciall) here a strate(ic in#estor holds a lar(e

percenta(e o' the pre'erred



Series A Pre'erred Stoc* 6erms $%

Protecti#e pro#isions contd

– Amend, alter, or repeal any provision of the Certificate ofIncorporation or Bylaws [in a manner adverse to the

preferred stock

• 7! Q rac*eted included 1mar*et2, does not loc* seniorequit)

• /4! Q not included

– !aising equity " create or authori#e the creation of or issue

any other security converti$le into or e%ercisa$le for any

equity security, having rights, preferences or privileges

senior to [or on a parity with the preferred • 7! Q rac*eted included

• /4! 1mar*et2 Q not included

• ld mone) usuall) has to appro#e ne mone), ut )ou canoccasionall) ne(otiate a #aluation cap, esp. ith strate(ics



Series A Pre'erred Stoc* 6erms $$

Protecti#e Pro#isions contd

– &urchase or redeem or pay any dividend on any capital stock prior to the

preferred stock , e+cept repurchases 'rom departin( ser#ice pro#iders

• Ksuall) included in e#er) deal

• 4n#estors do not ant )ou spendin( mone) repurchasin( stoc*

– Create or authori#e the creation of any de$t security i' the 7ompan)s

a((re(ate indetedness ould e+ceed $,%%%,%%%other than equipmentleases or an* lines o' creditunless such det securit) has recei#ed theprior appro#al o' the 8oard o' Directors, includin( the appro#al o'TTTTTTTT Series A Director1s2

7! Q e+clude alto(ether, / 1market 2 Q include the $st and 5nd rac*etedlan(ua(e so )ou can do rid(e notes, and 4! Q include the 5nd and rd rac*eted lan(ua(e.

Increase or decrease the si#e of the Board of 'irectors( Mar*et, ecauseoth sides ant to 'i+ it.



Series A Pre'erred Stoc* 6erms $5

7on#ersion – Most pre'erred stoc* starts out con#ertin( $$ into

common stoc*

– 7lassic pre'erred stoc* terms include anti"dilutionad>ustments to the con#ersion price o' the pre'erred stoc*

in an) Fdon"round 'inancin(• 7! t)pical ei(hted a#era(e ad>ustments are most

common 1market)

– 6his 'ormula ad>usts the con#ersion price don 1so thepre'erred con#erts into more shares2

– 8ut not so 'ar as the price o' the diluti#e issuance » Just to re'lect the ei(hted a#era(e e''ect o' the diluti#e

issuance ased on the price per share and amount o'mone) raised




7on#ersion contd

• 4! a 'ull"ratchet ad>ustment ta*es the pre'erred con#ersionprice don to the e+act price per share at hich the diluti#eround as made, no matter ho much mone) as raised

• / a compromise is the narro ei(hted a#era(ead>ustment, hich is more se#ere 1in#estor 'a#orale2ecause options are e+cluded 'rom the 'ormula

• Carve"outs* 'or option (rants 1-%N discount2, an* and#endor arrants, and other customar) items



Series A Pre'erred Stoc* 6erms $I

Redemption Ri(hts in#estors ri(ht to ma*e compan)u) ac* their shares. – 7!/ 1market 2 Q /o redemption ri(hts

– 4! Q ri(ht to ha#e shares redeemed " )ears out i' ama>orit) or (reater N o' the pre'erred request it, includin(

an) accrued & unpaid di#idends




Representations and arranties – 6he compan) and not 'ounders should (i#e standard

repsarranties

– 8e o#er"inclusi#e ith disclosure schedule, and read it:

7ounsel and e+penses – 9our 1compan)2 counsel should dra't docs to limit un'a#orale

pro#isions

– E+pect to pa) up to $"5C 'or in#estors counsels 'ees

– 6he loer the cap, the less comments and dili(ence questions

)oull (et 'rom in#estors counsel



Series A Pre'erred Stoc* 6erms $?

Re(istration ri(hts – 6hese are seldom used, so no need to 'ocus on thein#estor as* too much let compan) counsel handle it.

– 4deall), pro#ide pi(()ac* and S" ut not demand.

Mana(ement and 4n'ormation Ri(hts – E+pect to promise to deli#er some unaudited 'inancials on

an annual, quarterl), and e#en monthl) asis, ma)e itha ud(et and reconciliation so )oull need acct. so'tare

– 7PA that 'iles )our ta+ returns can help )ou set it up

– 8e care'ul that )ou dont a(ree to deli#er them too soona'ter period end 1$5%, ;% and % da)s2

– 6r) to a#oid a(reein( to audited 'inancials, and limitdeli#er) oli(ation to ma>or in#estors



Series A Pre'erred Stoc* 6erms $-

Participation ri(hts – E+pect to pro#ide ma>or in#estors 1e.(., %%C or more2 theri(ht to u) a pro rata share o' 'uture 'inancin( rounds• Pro rata share meanin( the same percenta(e o' 'ull)"diluted that

the) on a'ter the A round

Matters requirin( in#estor director appro#al – List o' thin(s that cant e done ithout the in#estor directors

appro#al

– !or the in#estors this is a second pass at loc*in( ri(hts

– 6r) to eliminate or limit them as much as possile



Series A Pre'erred Stoc* 6erms $<

Ri(hts o' $st Re'usal, 7o"Sale and Dra("Alon( – Ri(ht o' $st re'usal ri(ht o' compan) and then in#estors tou) 'ounders stoc* hen )ou ant to sell• 6his is mar*et so prepare to (i#e it up

• 9ou can also ne(otiate ri(hts to u) a pro rata share hen

other 'ounders sell – Ri(ht o' 7o"Sale ri(ht o' pre'erred holder to sell a pro rata

share ith the 'ounder i' the) sell• A(ain this is mar*et so >ust a(ree

• A(ain )ou can ne(otiate the ri(ht to sell a pro rata share ithother 'ounders



Series A Pre'erred Stoc* 6erms $;

–

Dra( Alon( ri(ht o' a ma>orit) o' the pre'erred toma*e all stoc*holders #ote to sell the compan)• 6r) to limit this ri(ht to hen the 'ounder1s2 a(ree

• As a compromise a(ree to limit the ri(ht to hen theoard appro#es 1another reason to control the oard2

• As a last resort require holders o' a ma>orit) o' commonstoc* to appro#e



Questions?



Thank you!

Joseph "aniels

Partner

% Roc*e'eller Plaa/e 9or*, /9 $%$$5

6 5$5.?.<$-5

! 5$5.?.$-?I

>danielsUsheppardmullin.com

sheppard mullin, 09/17, new york - legal and ip

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