Decoding Legal Structures & Investment Terms

About The LawyerMark McLaughlin

- 10+ years of corporate legal experience- Counsels companies on legal formation

and initial rounds of investment- Represented clients in purchase, sale,

public and private securities issuances- Assists clients with daily business issues

such as employment agreements and license agreements

- Works with Golenbock Eiseman Assor Bell & Peskoe LLP and worked with a number of New York law firms including Weil Gotshal and Reed Smith

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About The VC

J. Skyler Fernandes- VC @ Centripetal Capital Partners,

invests $1-3M across industry sectors- VC Mentor @ ER Accelerator- Entrepreneur - co-founded a number

of internet startups- Leader Of Missing Middle Initiative,

launched at World Economic Forum

Connect With J. Skyler Fernandes:

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DisclaimerThis presentation is intended to be used for educational purposes only and not to replace independent professional judgment. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of any company or organization. Inside the Mind of Venture Capitalist and its speakers do not guarantee the accuracy or completeness of the information included in this presentation and accepts no responsibility for any consequence of its use.

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Choosing A Business Structure

Most Common Entities: • Sole Proprietors• Partnerships• Limited Liability Company (LLC)• Corporation (Inc.)

Issues to Consider:• Potential risks and liabilities of your business• Formalities and expenses involved in establishing and maintaining

the business structure• Income tax situation• Investment needs

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Limited Liability Company (LLC)(VC’s 2nd Choice)

For the majority of small businesses,

creating an LLC is the best choice

Protects: • Personal assets from debts & liabilities of the business

Requires:• Adequate capitalization, observe corporate formalities, create and

maintain separate bank accounts

LLC Profits Are Not Taxed:• Single level of taxation: only at personal level (i.e.

salary/distributions)

• Tax benefit of passing losses to investors during early stage

Flexibility:• LLCs are incredibly flexible = can make complex (for better/worse)

• Can be converted into a Corp, before going public (IPO)

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Corporation (Inc)(VC’s 1st Choice)

It Makes Sense To Create A Corporation When…• You expect to have multiple investors in your business or IPO in future• You want to provide fringe benefits to owners• You want to entice or keep key employees by offering stock options and

stock bonus incentives

Corporations Require… • formal record keeping and less flexibility in management structure and

method of distributing profits and losses• Less flexible, but more straight forward for stock option plans, creating two or

more classes of stock (Common, Preferred), transferability of equity, etc.

“C” corporation profits are taxed• Double taxation: the business and your salary/distributions • Tax gains / losses held within company, not passed through to investors

“S” corporation tax benefits• Shareholder may pay less self-employment tax than an LLC member with

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• Non-Accredited Investor (Ex. Friends/Family)

• Accredited Investors (Ex. Friends/Family/Angels)– A net worth of $1M+, not including primary residence– Made $200,000+ last two years ($300,000 with

spouse) and expect to make same amount this year– A general partner, executive officer, director or a

related combination for the issuer of a security 

• Qualified investor (Super Angels/VCs)– Qualified investors are individuals, trust accounts or

institutional funds with at least $5 million to invest

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Securities Regulation / Capital Raise

Securities Regulation / Capital Raise

• Investment Banking Fee vs. Referral Fee

• Seed Round (Friends/Family/Angels) (Up to $1M)– Equity (Ex. 3M-5M valuation)– Convertible Debt w/ Interest

• @ set share price after period of time• Into Series A• Discount price into Series A

• Series A (VC’s & Financial Institutions) ($1M+)

• Series B, C, D (Follow on rounds)

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Intellectual PropertyTypes Of Intellectual Property:

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PatentsTrade SecretsCopyrights /Trademarks

Copyright

• Covers original works of authorship fixed in a tangible medium

– Books, dance, movies, music, computer programs– Protects expression not ideas

• Term– Life of known author plus 70 years– Shorter of 95 years from publication or 120 years

from invention

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Right created to protect the identification of the source

or affiliation of goods

Covers:– Words– Symbols– Colors – Sounds

Term: Potentially unlimited if protected and not abandoned12

Trademark

Trademark• Strength is in distinctiveness

• Registered with the government

• Use it: – Affix it to goods, stationary, documents, etc.

• Indicate that it is a protected mark– TM and SM indicate federally registered marks– [circle R] not federally registered but still protected mark

• Abandonment– Failure to protect as outlined above– License the mark alone without other assets – License the right to control the mark

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Trade Secret• Covers: Proprietary information

­ Customer lists­ Training methods­ Business strategy­ Formula for Coke and Pepsi

• Property of the business

• Subject to confidentiality protections

• Not registered or filed

• Proprietary (not in the legal sense) can also be…– Team / Individuals (There is only one of YOU!) – Experience (Unique insight)– Network (Able to reach /execute where others cannot)

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Patent• Covers

– Non-obvious new and useful inventions– Description, drawings and claims

• Comprises exclusive rights - Make, sell or offer those inventions

• Term - 20 years from filing a patent

• Process can be long and expensive - Consult IP attorney

• Design - Visual (non-functional) features of manufactured goods

• Utility - Protects process, machine, manufacture, or composition

• Non-provisional - Establishes filing date and begins examination

• Provisional - Only establishes filing date and expires after one year

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• Preparing Patent Application

• Filing Application – Secure filing date, claimed invention is officially “patent pending.”– Filing fees may be in the range of $500-$1,000

• Prosecuting Your Patent Application– Assigned patent examiner to review, searching relevant prior art,

make any objections and rejections of claims– Lengthy/Expensive process 

• Allowance / Issuance – Utility: $1,510, Design:  $860 (Half price for small entities)

• Maintenance– Maintenance fees 3.5 ($980), 7.5 ($2,480) and 11.5 ($4,110) years– Half price for small entities

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Patent

Intellectual Property – TipsProtect brand by staking out Online / Social Media Real Estate:

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Web URLs

Valuation• Valuation Should Be Reasonable

– Not to high too, not too low (Build value)– Investors ultimately determines valuations NOT Entrepreneurs– 2-3+ rounds before exit, don’t want to do a down round

• Size of Capital Rounds– Too much capital is just as bad as not enough capital (Dilution)

• Terms of current round is built on results from previous round

• If company doesn’t meet expectations – Next round investors will require higher return and more rights

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Equity• Common Shares

– Indicates ownership of a company

– Right to company’s assets AFTER company pays debt & preferred shares

• Preferred Shares (Special rights)– Liquidation Pref, 1x, 2x, 3x principal capital invested (prior to common)

– Warrant Coverage (Cash/Cashless Preferred or Common shares)

– Anti-dilution (Weighted Average, Full Ratchet, Not price based)

– Blocking rights (Company sale, equity financings) / Demand Sale or IPO

– Rights to invest on a pro rata basis in future equity financings

– Information & inspection

– Voting: Rights to approve certain corporate actions / Board Members

• Participating / Convertible Preferred Shares– Special Rights & Voting

– Dividends: Rights to payment prior to Common (% of Investment)

– Converts to common stock  (Double Dipping) 19

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Preferred, Liquidation Pref

1x-2x

Dividends + Preferred

Converted To Common

Waterfall

Waterfall

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Exit Value 90,000,000$ 14,250,000$

Date Preferred Return Invested Liquidation Pref Preferred Return Preferred Return2005 Series B - Venture Fund 5,000,000$ 2x 10,000,000$ 10,000,000$

Series B Dividends 1,000,000$ 1,000,000$ 2003 Series A - Venture Fund 2,500,000$ 1x 2,500,000$ 2,500,000$

Series A Dividends 250,000$ 250,000$ 2002 Founders Shares 500,000$ 1x 500,000$ 500,000$

Total Preferred Return 14,250,000$ 14,250,000$

Remaining Cash 75,750,000$ -$

Common Return Invested Ownership Common Return Total Return Multiple Common Return2002 Investor A 500,000$ 5.00% 3,787,500$ 3,787,500$ 7.6x - 2002 Investor B 500,000$ 5.00% 3,787,500$ 3,787,500$ 7.6x - 2002 Investpr C 500,000$ 5.00% 3,787,500$ 3,787,500$ 7.6x - 2002 Investpr D 500,000$ 5.00% 3,787,500$ 3,787,500$ 7.6x - 2002 Investor E 500,000$ 5.00% 3,787,500$ 3,787,500$ 7.6x - 2003 Venture Fund A 2,500,000$ 30.00% 22,725,000$ 25,475,000$ 10.2x - 2005 Venture Fund B 5,000,000$ 20.00% 15,150,000$ 26,150,000$ 5.2x - 2002 Founders 500,000$ 25.00% 18,937,500$ 19,437,500$ 38.9x -

Total Common Return 10,500,000$ 100.00% 75,750,000$ 90,000,000$ -$

X

Dividends• Accruing Dividends for first 1-2yrs (early stage companies)

• PIK = Paid-In-Kind (via stock), when unable to pay cash

• Carrot (cash) & Stick (dilution)

• Cash along the way vs. just as the end

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Key Terms for Founders / Employees/Advisors

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• Founders (Uneven ownership is best)• Employees (Salary + equity)• Advisors (0.25%-1%, with milestones that lead to revenue or capital)

• Vesting, single-trigger, 4yrs, termination clause

• Deferred salary with interest, catch up upon exit (above common upon liquidation)

• Upon Hitting Milestones – Additional Options / Warrants (Adding shares)

– Clawbacks (Reducing / Transferring shares)

• Employee Bonus Pools– Created before or after investment rounds

ExitsLiquidation: the exit strategy

– IPO– Strategic Sale (Competitor / Partner)– Financial Buyer (PE - Strong cash flows)– Merger– Management Buyout

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