Preparing your Company for Investment – Angel and VC Term Sheet Negotiations – Post-Deal Relations

To get investment, company must put its house in order including capital, employee, IP issues. VC term sheet negotiations involve financial and control issues.

TiE SRA Leadership Workshop , June 21, 2008

By Robert A. Adelson

Business Due Diligence – Business Plan

  1. Market and customers
    • Sales Pipeline Documents
    • Customer references: validate need, willingness to pay
    • Growth and size of market
    • Sales cycle: revenue velocity
    • Distribution channel, channel partners
  2. Product and Service offering
    • Business plan, marketing literature
    • Customers – functionality; Technical Assessment & Demo
  3. Management team
    • Leadership, coachability, commitment, rolodex
    • Weaknesses or gaps in the team
    • Are they financeable by VCs?
  4. Competition
    • Customer & Alliance references and industry experts
    • Assess threats of players to company; positioning; strength focus, lead-time, financing, management team
    • Valuation – What are other deals priced at?
  5. Financials
    • Follow-on capital needs & likely sources; Milestones & valuations
    • Robustness of business model; sensitivity to driving assumptions
    • Capital structure; Previous investors
    • Realistic path to exit (time and valuation)
  6. Valuation
    • Determining the value of an asset or company
    • Size of the round? Tranches
    • Who gets diluted? Stock option pool
    • How does this fit into the overall plan of the company?

Legal Due Diligence 1 – Entity & Capital

  1. Form of entity
    • Choice of legal structure: Corporation or LLC
    • Domicile: Delaware or Local
  2. Corporate Records
    • Minute Book, Stock Ledger
    • Corporate Filing, Good Standing, Qualifications
  3. Corporate Governance
    1. Board of Directors: Size, Selection
    2. Board of Directors: Independence and Quality
    3. Board of Advisors
    4. Conflicts, Avoidance, and Disclosure of Directors’ Interests
  4. Equity structure
    • Founders’ Equity
    • Equity and Options for Employees, Contractors
    • Equity Pricing
    • Earlier Investor Equity – Preferred, Warrants, Debt
    • Shareholder Agreements
    • Securities Law compliance
    • Equity held by non-participants
    • Claims for Equity – documented / undocumented
  5. Debt Structure
    • Founder Loans
    • Friends, Family and other Loans
    • Bank Loans Collateral / Security Agreements
    • Factoring /Royalty Agreement

Legal Due Diligence 2 – IP and Other Assets

  1. Intellectual Property (IP) Rights & Protection
    • Protected Technology – Patents/Inventions
    • Protected Information – Trade Secrets – Copyrights
    • Protected Goodwill – Trademarks, Service Marks
    • Assignment of Ownership
    • Licensing Agreements
    • IP Prosecution; Vigilance against Infringement
  2. Company IP and Owner IP
    • Applications relevant to company business
    • Applications and platforms not related – Founder retention
    • Founders’ Assignment of inventions – clear demarcation
    • Investors like Focus on company
    • Founders’ Retention of post-exit IP rights
  3. Claims or potential claims against IP
    • Independent contractors – work for hire
    • Software development and distribution
    • Client & alliance contracts – IP clauses
  4. Other Assets
    • Real Estate
    • Franchises
    • Equipment, fixtures and inventory
  5. Other Liabilities
    • Claims against the assets or business
    • Litigation pending or threatened
    • State or Federal regulatory issues

Legal Due Diligence 3 – Employees & Contracts

  1. Recruitment, Retention, Incentives
    • Stock Options – ISOs and NQSOs
    • Restricted Stock
    • Phantom Stock
    • Pricing and Exercise Features
    • Employee stake in enterprise
    • Performance & loyalty incentives
    • Incentives for success events
    • Employee attrition
  2. Employee/Labor Due Diligence
    • Employment Agreements for Executives
    • NDAs, Confidentiality, Assignment of Inventions
    • Offer Letters and Hiring
    • Outsourcing/Staffing
  3. Employment Claims against company
    • History and pattern of claims, if any
    • Pending claims with MCLE or courts
  4. Commercial Contract Rights
    • Customer, Supplier Agreements
    • Warranties and warranty liability
    • Advertising or other service agreements
    • Office and Equipment Leases
  5. Strategic Contracts
    • Strategic Alliances and Partnerships
    • Strategic investment or revenue source
    • Rights of first refusal in sale of company

Negotiating the Angel / VC Term Sheet: Deal Terms – Financial

  1. Liquidation Preferences
    • Investor priority
    • Recoup principal (& often dividends)
    • “Participating Preferred” – return & upside share
    • Impact on Founders if insufficient IRR
  2. Dividends
    • Built in return – rates vary
    • Cumulate quarterly until paid out
    • No dividend on common until paid
    • Forfeiture on IPO/ voluntary conversion to common
  3. Anti-Dilution
    • If later rounds price dilutive, investor gets to re-price
    • Weighted Average – adjustment based on impact of new shares
    • Full Ratchet – if 1 share at lower price, all re-priced
  4. Participation Future Rounds / “Play or Lose”
    • Pre-emptive rights to participate, keep pro-rata share
    • Lose anti-dilution protection if not play – incentive to support
    • First offer – Go to current investors first
    • First refusal – Get to prevent new blood / Limits flexibility
  5. Redemption / “Put” Rights
    • Investor cash-out right – principal & return or appraised value
    • VC often seek redemption right within fixed time – 5-7 years, depends on stage of company, VC fund
  6. ROFR /Co-Sale on Founder Shares
    • Co-Sale – buyer must offer investors same cashout terms
    • First offer – Go to current investors first
    • First refusal – Get to scoop shares – chill offers to founders
  7. Drag-Along /Tag-Along Rights
    • Drag-Along: requires approval and sale of all stockholders on sale approval by % of preferred
    • Tag-Along: requires common to be allowed to also cash-out on preferred sale
  8. Vesting Founders Stock
    • Founders with cheap stock forced “re-earn” – vesting schedule
    • Forfeiture (repurchase at cheap price) unvested on termination
    • Effect of termination for cause or without cause, death, disability
    • Valuation of common & tax effect – income on re-earned shares
    • IRC §83(b) election – whether to take into income vesting shares
  9. Registrations Rights
    • Investor gains liquidity by “piggy-back” on to public offering
    • VCs include rights to demand registration of shares
  10. Board Composition
    • Investor representation follows the money
    • Importance of outside & independent directors
    • Management representation / “Martini” rule & board size
  11. Voting Rights/ Organic Changes
    • Investors rights to block mergers, stock issues, organic changes
    • Block rights should end if fall below fixed percent of shares
  12. Management Team/ Hiring Firing Rights
    • Pool of management shares
    • CEO and other hiring
    • Noncompete and post-termination covenants

Post-Term Sheet Documents To Complete Angel or VC Financing Deal

  1. Stock purchase Agreement
    • Preferred stock terms
    • Pricing
    • Company warranties
    • Founder shareholder warranties
    • Employment agreements
    • Post closing covenants
    • Conditions to the stock purchase
  2. Registration Rights Agreement
  3. Stock Restriction and Stockholders Agreement
    • Among founders and employee stockholders
    • Vesting terms
    • Restrictions on transfer
    • Co-sale and ROFL rights
  4. Disclosure Issues
    • State, Federal Security Laws
    • Preliminary Business Plans
    • Accredited Investors
    • Limit on Offers
  5. Disclosure Documentation
    • Private Placement Memorandum
    • Investor Questionnaires
    • Subscription Agreement and Documents
    • Audited Financials
  6. Standstill Agreement
  7. Key-person insurance & other closing conditions

Post Deal Relationship

  1. Angel Investors
    • Board seat or board observer seat – to actively advise company
    • Exploiting the Angel Group’s Network
      • Raise subsequent rounds of financing – either angel or VC
      • Recruit employees, establish customer/partner contacts
  2. Venture Capital
    • Board Seat & Help recruit key management
    • Introduce company to sources of follow-on financing
    • Guidance on financial strategy
    • Make key contacts for strategic partnerships / customers
    • Configure the company for an IPO or acquisition
    • Introduce bankers/lawyers/accountants
  3. Highlights importance of “Smart Money”
    • What besides money does investor bring to table
    • Experience of investor in helping companies like yours
    • Choosing investor value not necessarily highest valuation
  4. Operation as Angel or VC backed company
    • Collegial approach with board members
    • Importance of informed and engaged board – kept current
    • Financial statements and expected reporting
  5. Exit strategy – Implementation
    • Replacement of Founder CEO
    • Milestones to be met – consequences if not met
    • Positioning for IPO or Acquisition exit strategy
  6. Founder’s personal exit strategy
    • Role in CEO succession, post-CEO role in company
    • Protection of Founder’s equity & financial stake in company
    • Employment and Severance terms
    • Non-compete, non-solicitation
    • Retained rights and back-licenses of technology

ABOUT THE SPEAKER AND PRESENTATION

These materials were prepared by Robert A. Adelson, Esq., Partner at Engel & Schultz, LLP, 265 Franklin Street, Suite 1801, Boston, MA 02110, (617) 951-9980. Fax (617) 951-0048. E-mail: radelson@engelschultz.com Website: www.engelshultz.com Mr. Adelson is a graduate of Boston University, Phi Beta Kappa and Northwestern University Law School in Chicago where he was a member of Law Review. He also has an LL.M. degree in Taxation from New York University and is a member of the Massachusetts, New York and US Tax Court Bars.

Robert Adelson began his legal career in 1977 as an associate at major New York City law firms, first Dewey Ballantine and later Weil Gotshal & Manges, before returning home to Massachusetts in 1985, where he has been a partner at several Boston firms before joining his present firm as senior business law partner in 2004. Mr. Adelson is specialized in corporate, taxation, finance, commercial and technology contracting law. In those areas, he frequently represents startup and smaller companies in software, and other technology-based fields. He also represents executives or consultants in executive compensation and stockholder arrangements, incorporation and liability protection, intellectual property protection, and in vendor, client and subcontractor contracting arrangements.

Mr. Adelson’s law firm, Engel & Schultz, LLP, is a small but broad service law firm of 6 attorneys in Boston. The firm complements Mr. Adelson’s work in business and tax law with seasoned attorneys in litigation, real estate, family and probate matters.

Mr. Adelson is a frequent speaker at business forums. Additional information on the subjects on which he speaks is shown at – www.businessforum.com/raa01.html. Further information on Mr. Adelson’s background, including many of his past published articles, is available at his law firm website www.engelschultz.com.

The speaker thanks Hooman Hodjat, founder of iRelai, LLC for the invitation to speak,  for the TiE SRA Leadership Workshop on the topic of “Term Sheet Basics and Negotiating a deal” with my further prepared materials covering the “Fundraising Process: Due Diligence, Angel and Venture Capital Term Sheet Negotiations, Post-deal Relationships” at the 930 Winter Street, Waltham, Massachusetts, on June 21, 2008.

The purpose of these materials is to supplement class materials and offer rough outlines on the subject matter of the presentation to aid entrepreneurs seeking angel or early stage venture capital investment for early stage technology based or non-technology or service based businesses. Thus, it is hoped these materials will be informative to those in attendance. These materials are not legal advice and not intended as any substitute for professional advice or counsel in a particular case.

If Assets Need Protecting, Your Best Course May Be a Trademark

Before investing in a company or brand name, it’s wise to verify availability and file an ITU registration application to protect name and avoid infringement.

Boston Business Journal , May 2-8, 2008, page 12

By Robert A. Adelson

Your brand name can be an important asset.

As such, trademarks and service marks are recognized in common law and by statue to protect the goodwill in a brand name developed for a business, product or service.

Some brand names are just coined words – such as Kodak or Xerox – that take on great value as brand names because of millions of dollars spent in their promotion. Others can have value right from the start.

For example, say Jo Jones repairs APPLE computers.

If Jo calls the Business MacBetter Inc., instead of Jo Jones Inc., it tells about the business, suggests the nature of the business, without Jo ever meeting a customer.

That saves him money on advertising, as well as enabling potential customers to find and remember his business.

Suggestive trademarks along with associated goodwill can become valuable to consulting and service businesses as well as to businesses that market products.

Sometimes business acquisitions occur simply to obtain the rights to trademarks.

This happens where the acquirer desires to utilize the goodwill already associated in the trademark.  It also occurs where the acquirer believes a specially suggestive or memorable mark is one consumer or clients will remember and help the acquirer sell products or services.

ITU – To Preempt Your Trademark

It’s wise to first search and verify trademark availability, which is defined as nonuse by competitors.

If the name is available, consider filing an ITU, that is an Intent-To-Use application for registration with the United States Patent and Trademark Office.  For this filing, it is sufficient that you’ve thought of a brand name and intend to use it and represent that intention in your filing with the trademark office.

An Intent-To-Use registration application can hold a mark for several years before you actually market a product or service.

The ITU filing reserves exclusive rights to the mark.

Someone else might later decide to use the name and invest thousands, even millions of dollars in promotion, yet be barred from use because their new use of the trademark conflicts and thus infringes on your earlier filing.

Benefits in All 50 States

If you plan to spend much time and money to promote your product, business or service, you should conduct the search and file the ITU.

Also think about including any catchy slogan or attractive logo you plan to use.  These too can be part of your goodwill and may justify protection.

In addition, you will need to identity the products and services your mark covers or will cover.

In taking a trademark from the intent to use stage, also known as the reservation stage, to a final registration, where you have an enforceable mark, you must show use in interstate commerce – filing a specimen of use in two or more states.

Commerce in only two states or between the U.S. and a foreign state will be suffice.

The federal registration would then make the mark yours exclusively in the classes of good and services identified in all 50 states.

Prosecution Costs and Requirements

Federal trademark registration is not cheap.  Filing costs are $325 per class or per mark.

The PTO currently recognizes 46 classes of goods and services.  Filings frequently involve juggling several classes as you seek broad coverage.  Attorney fees can be $1,000 or more.

Registration is not quick or automatic.

The PTO bars registrations for “generic” or “descriptive” marks.  It also bars marks if there is a likelihood of confusion with an existing mark or for various “informalities” such as unclear wording or need to disclaim common words.

The “prosecution” process of obtaining approval can take a year or longer.  Still more filings and fee payments are required after registration.

Marks are for 10 years – and subject to renewals – but filings are needed after five years to assure the PTO that the mark is still in use.

Yet patience in prosecuting a mark is vindicated by value added to your business as a whole.

© 2008 Robert A. Adelson

______________________________________________________________________

The article above – “If assets need protecting, your best course may be a

Trademark” appeared in the Boston Business Journal, Issue May 2-8, 2008, page 12 of the BBJ supplement “Law & Accounting Directory”

  • If you have any questions or comments on this article
  • If you or your company would like help to protect the brand name for a business, product or service, a slogan, logo or design or packaging
  • If your trade association or non-profit group would like to file a collective mark for the group or your members or to certify goods or services
  • Or if you have other questions or issues involving trademarks or a service marks or copyrights, trade secrets or other intellectual property

The author can be reached as follows:

Robert A. Adelson, Esq.

Engel & Schultz, LLP

265 Franklin Street, Suite 1801

Boston, MA 02110

Telephone: 617-951-9980

E-mail: radelson@engelschultz.com

Phantom stock gives family firms a leg up in luring key recruits

A phantom stock plan helps a family business recruit and retain non-family executives, giving them a stake in capital appreciation, liquidity and exit strategy.

Family Business Magazine , Autumn 2004, vol. 15, no. 4, pages 19-21.

By Robert A. Adelson

With the stock market apparently recovering from the “dot-bomb” crash of 2000-02, companies are again using their rising stock to lure top executive talent. If it’s time for your family business to recruit key technical employees or senior executives from outside the family, how can you compete with these non-family firms? What can you offer prospective employees instead of stock or options?

As employee appetites for stock and options rise anew, it’s important for family businesses to meet the competition by offering their own form of equity — without actually transferring ownership. The good news is that today’s tax climate has made it easier for family firms to compete in the recruitment wars.

There are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock, ways and means that are discussed in this article.

Recruiting talent from outside the family

Your business may not be able to grow or face tougher competition if there are gaps in your family members’ knowledge, skills or experience. The best way to fill in the missing pieces is by hiring non-family employees.

Even if there is no gap, it may be wise to recruit a senior manager to help train and mentor the next generation in preparation for a leadership transition — someone who would also be available to step in if illness, death or disability strikes a core family member.

Unfortunately, a family business’s stability and long-term perspective, while attractive, don’t go far enough to lure potential recruits. A non-family executive may fear that nepotism and family loyalty may supercede sound business judgment. Hopefully, if you are seeking non-family talent, your company can allay these concerns by citing its record of putting growth of the business before the personal concerns of the family owners.

Offering a stake in the upside

But even if you can show a track record of growth and sound judgment, there is something else that might make non-family candidates skittish about joining your company: the perception that as non-family members, they won’t get to share in the benefits of their hard work.

Because most family business owners want to ensure that their company stays in the family, they don’t offer their non-family employees the opportunity to own stock. But there are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock. The three strategies below — particularly the phantom stock approach — are powerful weapons in your arsenal. Recent changes in federal tax and securities laws have made these options even more attractive.

Non-voting stock and ‘rabbi trusts’

One option is to institute a non-voting stock plan for key non-family employees. Non-voting shares are allowable in LLCs, C corporations and even S corporations. This structure provides for all the capital appreciation of normal shares and permits shareholders to take advantage of the record low 15% tax rate on capital gains and dividends. Under this arrangement, non-family executives have no voice in the company’s operations and strategic choices.

The second approach is a non-qualified deferred compensation plan, which can provide a secure future payout to a key executive. Taxation to the executive is deferred via a “rabbi trust,” a trust that is set aside for the employee but remains subject to company creditors. (It was first used for a New York rabbi and the nickname stuck.) The plan can include “golden handcuffs,” or vesting arrangements in which benefits are lost if the executive leaves the company. It can also include “bad boy” provisions, in which benefits are forfeited if the executive violates confidentiality or non-compete agreements or other company rules and restrictions during employment or post-termination.

Phantom stock: The most far-reaching solution

The third approach — a phantom stock plan, taxed in the same manner as deferred compensation — combines the first two. As the most far-reaching and innovative solution, it offers the family firm a real advantage.

Under a phantom stock plan, the company sets a share value benchmark at the time phantom shares are issued (phantom strike price). The phantom stock contract issued to the executive provides a vesting and redemption schedule as well as a method of future stock valuation. If the executive does a good job and the family business prospers, when redemption occurs the executive will be paid an amount equal to the value appreciation. That is, the executive is paid the difference between the share value on the date of “sale” (phantom stock redemption or payout date) and the original phantom strike price. This spread is the same kind of payout the executive would achieve if he or she had conventional stock options in a non-family business.

A family company’s phantom plan not only offers key employees a share in the company’s growth but also can do so on far better terms than plans offered by non-family competitors. Here’s how.

Sarbanes-Oxley and phantom stock liquidity

Many small public companies are going private or delisting their securities rather than face the heavy costs of compliance with provisions of the Sarbanes-Oxley Act, passed by Congress in response to several high-profile corporate scandals.

Executives at those companies will now have equity that is illiquid. This gives closely held family businesses a distinct advantage in recruitment. A well-designed phantom plan provides liquidity (i.e., an exit strategy) for executives that small-capital companies no longer offer.

Phantom capital gains vs. incentive stock options

A phantom stock plan can generate both phantom dividends and phantom capital gains by taking advantage of the deductions available in the tax law and sharing the benefit with key hires.

Under the 2003 tax law, capital gains are taxed at 15%, the lowest rate since 1933. Dividends also are taxed at 15%, the lowest rate since the introduction of the graduated income tax in 1916.

Plans that provide incentive stock options rarely allow executives to take advantage of capital gains or dividend tax treatment. Under today’s tax law, this is a huge lost opportunity.

2004 Election:  Opportunities in new tax proposals

At this writing it is unclear whether the next administration will be Republican or Democrat, but the beneficial use of phantom stock appears likely continued and even enhanced regardless of the outcome of November 2004 election.

If the President and Congress are re-elected, the thrust of GOP tax policy in 2005-09 will be to make permanent the recent Bush tax cuts, including those for capital gains, dividends and marginal rates scheduled to sunset during that ‘05-09 period, with an added drive to eliminate all tax on dividends.  If there is a change to Democratic rule, the Kerry program would roll back those same tax cuts for families earning over $200,000 and create new tax credit incentives for high-earning employers to hire new workers.

As said a phantom stock plan that generates phantom dividends and capital gains is well positioned for these currently planned 2005-09 GOP tax initiatives. However, the well-designed plan can cope and even utilize the Democrat policy shift.  The income deferral embedded in phantom plans allows beneficiaries to spread income.  So, the Kerry $200,000 family income safe harbor is obtainable.  Also, to the extent phantom stock aids hiring it gains the family business owner a tax credit, to benefit from tax changes.

A case example

An established family business (FamCo) has outgrown its current management and wants to recruit a chief operating officer from outside the family. The top candidate knows the industry, has managed a larger workforce with multiple offices and has proved his ability to take a company to a new level.

The current family CEO, at age 70, is looking toward retirement. The prospective COO, Bill Wilson, is 55 years old. Hiring this key player would bring new vigor to the company. The parties hope to see FamCo grow from its current valuation of $5 million to $10 million over the next decade.

FamCo offers Bill Wilson phantom stock that matches his annual salary of $200,000. During each year of a five-year contract, Wilson receives phantom stock units at a strike price of $5 per unit with the units vesting annually at 20% (half the vesting based on his remaining with FamCo and half based on achievement of his performance goals). In ten years, when Wilson retires, the company would again be valued and Wilson paid on the growth of his vested units, with a buyout over ten years.

Thus, if Wilson stays with FamCo 4 1/2 years, he accumulates 160,000 units. In that time, for example, if he achieves half his business targets, he’ll vest 60% of these units (vesting 80% based on four years’ tenure and 40% based on meeting half his targets). When he leaves after 4 1/2 years, 96,000 phantom stock units are vested (equivalent to almost 1% of the company) at the original $5 per unit. Wilson has no voting rights or rights to stock, but — assuming he doesn’t violate company covenants — he will receive a future payout for the units.

Now suppose that because of Wilson’s achievements over those 4 1/2 years, FamCo grows from a $5 million company to a $15 million company by 2014. The stock price (and, thus, the phantom unit value) grows to $15 per share. Under the plan, Wilson would be paid off at the spread between the $5 original strike price and the $15 current market price in 2014. With a $10 spread per unit, the payout on Wilson’s vested units would be $960,000, which would be paid over ten years with interest on the $960,000 note at the Wall Street Journal prime rate. With phantom income spread over 10-years at $96,000 per year, this plan is well designed to be taxed at lower rates even if Kerry plans for a roll-back in tax rates occurs for families earning over $200,000 per year. Under a phantom capital gains plan, the tax deductions generated by this payout would be shared between FamCo and Wilson to reduce his tax from 35% to 15%, thus achieving effective capital gains treatment on the payout, in line with low capital gains rate achieved by the Bush administration tax cuts.

This example works for any family business in any American industry, whether the business valuation is $5 million or $5 billion. Although the company must incur the cost of paying out phantom stock, it derives a much greater benefit from growth. These plans give family-owned companies the ability to recruit and retain key talent, which more than offsets the cost involved.

Robert A. Adelson, J.D., LL.M, a partner in the law firm of Engel & Schultz LLP in Boston, is a corporate and tax who represents closely held and family businesses and executive employees.

© 2004 Robert A. Adelson

______________________________________________________

Robert A. Adelson, Esq. can be reached at Engel & Schultz LLP,

265 Franklin Street, Boston MA 02110  radelson@engelschultz.com

(617) 951-9980 ext. 205

Structuring and Allocating Equity for Startup Success

Equity allocation in a startup company should be based on contributions made with performance-based vesting for work to be accomplished.

Boston Business Journal , May 4-10, 2007, page 52

By Robert A. Adelson

Are you one of the founders of a startup company? Has your startup formed a legal entity? Have you divided your equity among the founders? If you or a friend or colleague is in this situation, you may also ask – what is the best way to structure our new venture for success? Early stage companies face great hurdles in building management teams, marketing and selling product and keeping and gaining financing for growth. This article discusses two ways in which startup companies can enhance their chances for success: selection of legal entity and allocation of equity among the founding members.

Corporate Entity

The creation of a corporation establishes credibility, allows division of equity, sets a series of rules and at the same time provides limited liability for founders, officers and directors. The limited liability company (LLC) is another entity that startup companies often use. It is quite fashionable and provides limited liability without the requirements of a corporation. It is quite attractive in real estate, investment and estate planning for its flexibility in allocation of tax attributes.

However, where multiple founders will provide services and they will likely employ others, using company equity to aid recruitment an S corporation is often a better choice of entity than an LLC. The tax flexibility and centrality of control, benefits of the LLC, are not necessary. However, the legal restrictions and rules and share liquidity that a corporation offers can be quite attractive for service-based entities.

The S Corporation offers the single level of tax, which is a benefit of LLCs that S corporations also offer. Yet the rules of S corporations – one share, one vote and equal allocations of tax attributes – give the members a greater feeling that they have a fair and important share in the venture to merit their commitment.

Equity Allocation

Founding groups often divide equity equally among the founders. While this seems fair, it misses the chance for non cash compensation to reward contributions to the startup venture.

Equity awards should instead be structured to reward contribution in the following areas:

  • Inventions and technology contributed by founders
  • Facilities and equipment contributed
  • Seed capital and expenses paid for the venture
  • Services including contacts made available to the startup venture

The award of capital should take into consideration the past services and contributions, the current services and contribution being made, and those expected in the future. It should also take into consideration the capital that will need to be available to incentivise, award and recruit others to the venture.

Vesting of Performance-Based Equity

For future services, the award of equity, whether in the form of stock or stock options, should be conditioned upon the contribution of assets or the provision of services, and also be conditioned on success of the venture.

The structure of equity, whether a stock, options or phantom stock, and the qualities of that equity can have important tax implication. These include important tax elections, such as a Section 83(b) election, which allows the recipient of equity to take his shares into income and establish a tax bases. However, such an election also means immediate taxation, so there are various issues that need to be parsed in considering that election, as well as the other tax implications of how the equity is structured.

Other Shareholder Terms

Additionally, where equity is allotted and shares are issued among the founding members, these two should be conditioned upon the parties entering into a shareholder agreement. Among the issues that should be considered for such an agreement are

  • Disposition of shares on death or disability
  • Right of first refusal on the sale of shares to a third party
  • “Tag along” rights in the event of a third party sale
  • Rights to financial statements and other information

The careful documentation of stock issued as well as the existence of the shareholder agreement can become important as a venture grows and seeks outside investment. The position of the original stockholders and the terms of their offering will be disclosed in due diligence and the failure to fully document stock issued or to have appropriate shareholder agreement can cause important delays or eliminate the opportunity for financing.

As said, selecting the appropriate entity and allocating equity and providing for a contract among the shareholders, the founders should engage corporate and tax law expertise. Utilizing the right expertise will not only avoid costly mistakes but may enable the corporation to use a beneficial structure and an attractive equity format which can enable it to recruit and retain key personnel and allow for growth even when a company is cash poor in its beginning stages.

Robert A. Adelson, Esq. is a partner at Engel & Schultz, LLP in Boston.

The attorney and author of this article represents founders, entrepreneurs and startup companies. He can be reached at (617) 951-9980 or radelson@engelschultz.com

Negotiating the Terms of Executive Employment: Getting What You Deserve

The executive should negotiate key employment terms including bonus, meaningful equity, position, severance and non-compete.

The Culpepper Letter , September 1997, page 6

By Robert A. Adelson

If you are a software executive changing jobs, you could lose a lot of money or “crater” your career if you aren’t aware of opportunities in negotiating your new employment contract.  If your skills and experience are what the company needs most, then you deserve – and can negotiate – terms and commensurate with your value.

On the other hand, if you’re a corporate executive trying to recruit top talent, and your prized candidate says “show me the money” and you don’t have it, you need to know a smart way out of the box.  It’s increasingly important to know how to use the employment contract as an attractive recruiting tool without giving away your company.

Negotiating Opportunities

While CEOs and other senior executives may be great negotiators when it comes to putting together acquisitions or partnerships, they often neglect negotiating the terms of executive employment.

The best time to negotiate these employment terms, including compensation, benefits, relocation, tax gross-ups, stock and options, is before an offer is made or accepted.  There are 10 critical areas that executive candidates and software companies should consider negotiable.   During negotiations, issues in these areas need to be raised, discussed and resolved to assure that both parties are being treated fairly.

There are always two perspectives in negotiations.  Let’s consider the following 10-point checklist from both the negotiating executive’s point of view and also from what these candidates are apt to encounter in software company negotiations.

Top Ten Negotiable Terms

1. Signing Bonus

Negotiating Executive:  “The company should pay me something up front when I sign on.  This bonus should at least make me whole for the vesting options, bonus, and other benefits I would lose in switching jobs.”

Corporate Reality:  What a company pays up front can vary, depending on its need and perceived immediate value.  This bonus, earnest money or deposit paid, demonstrates a joint commitment and cements the legal and psychological bond between the potential executive employee and the company.  Its purpose is to cover any known or foreseeable risks.

Signing bonuses have become more common in recent years.  Today executive bonuses can include 15-25 percent of annual cash pay, 20-35 percent vesting of options, below-market stock, a retirement annuity, and other considerations.  Creative negotiators will arrive at a signing bonus package that is attractive to the talent it wants, but within the company’s budget and financial structure, present or projected.

2.  Meaningful Equity

Negotiating Executive: “The company should reward me for my management and individual achievements with a real stock stake in the enterprise I help build.”

Corporate Reality:  The company can structure stock or options comparable to industry standards.  Equity recognition can be made even more valuable by the offer of a “full rights” package for the executive stakeholder, including anti-dilution, registration and cash-out protections, vesting and change of control protections, and extended exercise of options on employment termination.  Usually, executives gain these protections in advance, but these packages can develop over time as executives prove their worth.

3.  Tax-favored Equity

Negotiating Executive:  “I want to leverage my future pay-out, so I want to structure equity to be taxed as low as possible and boost my take-home pay.”

Corporate Reality:  Here, the rule of thumb is that options are the best way to go for high-value equity, and stock is more appropriate for low-value equity.  But the best way for both the executive and the corporation, according to current federal tax laws, is to maximize the executive’s potential use of the 50 percent “deduction” for ordinary capital gains and, where possible, the 65 percent “deduction” for certain long-term gains in smaller software companies.

Tax advice needs to assure the right mix of equity for both the executive and the corporation.  This mix can include:  stock, incentive stock options qualified under the tax code (ISO), options not tax qualified (NQSO), stock appreciation rights (SAR), or Phantom Stock arrangements, each carefully structured to avoid ruinous “tax surprises” down the road.  For example, tax on low valued stock, at cash out, will be 14 percent using the lowest current capital gains rate.  On the other hand, use of the non-qualified options or failure to make appropriate tax “elections” increases tax to 42 percent in the same situation.  This executive’s disaster is a bonanza for the company that deducts stock income.  Here also the company should plan to make use of this windfall.

4.  Relocation Assistance

Negotiating Executive:  “I don’t want to shoulder the cost of moving my family, but if the company moves me, neither do I want to pay more taxes on the relocation reimbursement, when I’m receiving no more real income.”

Corporate Reality:  Companies should expect to pick up the executive’s tab for the cost of a family and professional relocations, including quantifiable out-of-pocket cash expenses of temporary living, storage, moving and perhaps dual mortgages and cost of home sale and purchase.

Companies can write contracts that avoid taxable income for the executive or that allow for tax gross-up, as needed.  Increasing the length of temporary living arrangements can benefit both executives and companies by allowing each to try their relationship before making the larger commitments.

5.  Position, Duties, Support

Negotiating Executive:  “I want to know exactly what I will be responsible for and ensure I have the resources I need.  Also, I want a position visible enough to keep me known in the industry.”

Corporate Reality:  It’s in the interest of both parties to confirm officer and/or board positions, expected responsibilities, known performance targets, organization authority, and reporting structures.  These duties and targets can be adjusted later.  To the extent understood, companies and executive candidates should also discuss staff, facilities, and budgets, and Director and Officer insurance.  The company should also permit outside board and advisory positions that don’t present a conflict of interest.

6.  Expense Payments

Negotiation Executive:  “I expect the company to support me in cultivating my professional status and skills.”

Corporate Reality:  In addition to paying or reimbursing usual corporate perks and direct business generation activities, companies will often underwrite initiatives that keep executives current, visible and connected in their fields.  These include not only trade organization memberships and subscriptions to publications, but also support for speaking and attending national meetings, trade shows, and continuing education programs.

7.  Non-compete and Non-Disclosure Agreements

Negotiating Executive:  “I will agree to non-compete and non-disclosure agreements only to the extent that they involve current and future trade secrets and are based on specific parameters.”

Corporate Reality:  Companies must protect their existing and future trade secrets through non-disclosure agreements (NDA), but the NDAs should not reach into the candidate’s prior knowledge or information generally known in the trade.  Non-compete agreements should be separately calibrated for three concerns:  the executive taking a job with a customer or direct competitor; soliciting customers or prospects; or raiding employees after having moved to another company.  Whether the period is 12, 18, or 24 months, it should be measured by normal shelf-life of confidential information known and time needed for the company to re-establish itself and integrate a successor into the prior company’s knowledge.

8.  Term/Termination

Negotiating Executive: “I want to know exactly what will happen if the company changes its mind about my value to it.”

Corporate Reality:  Companies should provide a fixed-term contract and mutual early termination clauses, and with and without cause.  That way candidates and companies enter relationships knowing the guidelines when and if change is perceived value occurs in the future.  With-cause termination clauses should be based on matters under the offending party’s control.  Without-cause termination should require each party to provide a notice period and to give up with-cause contract rights.  Because without-cause termination allows either party to walk out of the agreement at any time of their sole choosing, they must give sufficient notice to allow the other to adjust and seek replacement.  This can include loss of rights sufficient to discourage at-will termination.

9.  Reasonable Severance

Negotiating Executive:  “If termination occurs, I want a financial safety net severance package.”

Corporate Reality:  Severance is a candidate’s protection against the company’s normal right to terminate without cause while also holding an executive responsible for the non-compete clauses on termination.  These vary by position.  Six-months to one-year severance is most common, often phased on period of service with the corporation.  This ballast, along with a requirement that any disputes be settled by less expensive binding arbitration, that attorney’s fees be awarded to the prevailing party, and similar contract enforcement terms, gives both the executive and the company added confidence that the contract will be followed.

10.  Good Vibrations

Negotiating Executive:  “I want to work with people I like and respect, and who, in turn, respect me and value my contribution.”

Corporate Reality:  Personal compatibility with the corporate culture and the company’s need for skills are key to the success of the executive/company partnership.  In fact, the company’s conduct in negotiating the terms of employment can offer valuable insight into its decision-making process, motivations, and flexibility.  From this candidates can estimate their potential fit.

All’s Well That Blends Well

Both parties should never fear the word “no” in negotiations.  It avoids creating a poor fit that would cause turmoil later down the road.  However, creating a good contract does not—necessarily—ensure a good job choice.  There is still no substitute for doing homework.  Executives need to know the company’s present and future business prospects; companies need to check the background of the executives they are pursuing.  But, by thoughtfully negotiating in these “Top Ten” areas, each party will gather insights that will help them make better choices.  The resulting employment contract should reflect the above-board style and approach of both parties and lay a foundation conducive to getting the best for all concerned.

© 1997 Robert A. Adelson

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Robert A. Adelson, Esq., the attorney and author of the above article, continues to represent senior executives, including CEOs, COOs, CFOs, Presidents, Vice Presidents and directors.  If you have questions on this article or if you  are an executive in need of representation, whether negotiating a new position, renegotiating employment terms, or dealing with severance, termination or relocation, Mr. Adelson can be reached at his Boston law firm, Engel & Schultz, LLP, radelson@engelschultz.com ♦ 617-951-9980 ext 205 ♦ www.engelschultz.com