Ask The Startup Lawyers
Venture investors insist upon board representation in connection with any investment they make. Typically, the terms of preferred stock provide the preferred stockholders with the right to elect, separately from the holders of common stock, a specified number of directors. These directors are called "preferred stock directors." The holders of common stock also are generally permitted to elect one or more directors, although it is usually the case that the holders of preferred stock will vote with the holders of common stock on an as-converted basis in such elections.
Although directors are, as a technical matter, elected by the stockholders of the company, the composition of the board of directors is largely pre-ordained in accordance with contractual arrangements among the company, the preferred stockholders, and other significant stockholders. This arrangement is called a "voting agreement" A voting agreement will afford specific investors or other stockholders the right to designate individuals for election to the board of directors, and will bind the parties to the voting agreement to vote their shares to elect any such designee.
Unfortunately the answer is it depends. This point is negotiated at the term sheet stage, and it can have significant economic effects. For example, an 8% cumulative dividend can turn a $10 million dollar investment into a $12.5 mm investment over three years and almost $15 mm over five years. In recent times, dividends have typically ranged around 6% per year. Some venture funds, particularly smaller funds may require dividends because they either pay or accrue dividends payable to their investors. Except in rare occasions, dividends accrue and are not paid currently. Dividends are then paid in the event of a liquidation or sale of the business or in the event of redemption. More often than not dividends are not either paid or converted into common stock upon voluntary or mandatory conversion.
Preferred stock typically has two types of voting rights. There are certain items as to which it votes separately from the common stock. These items include (i) so-called "protective provisions", which prohibit the company from taking certain actions without the consent of the holders of preferred stock, and (ii) the right to elect a specified number of directors. With respect to all other matters, the holders of preferred stock vote with the common stock on an as-converted basis (i.e., they are entitled to the number of votes into which their shares of preferred stock are convertible). Section 242(b)(2) of the Delaware Corporation Law requires that, unless the charter provides otherwise, the holders of common stock vote separately as a class on increases in the authorized number of shares of common stock. This provision can give the holders of common stock considerable leverage in future financings. As a result, appropriate provisions preventing this outcome are typically incorporated into the charter in connection with venture financings.
Whether or not to form a limited liability company, or LLC, is first and foremost a tax question. LLCs are treated as partnerships and are “pass through” entities federal tax purposes. As a pass through entity, the LLC itself does not pay federal tax on its profits nor does it get a deduction for its losses. The tax profits and tax losses are passed through to the owners of the LLC and are paid directly by them on their tax returns. In the case of a company that expects to produce large amounts of income, this arrangement eliminates the double taxation which occurs in a corporation. In the case of an ordinary corporation (a so-called "C" corporation), the corporation pays tax on its income and its stockholders pay tax when dividends are paid to them by the corporation. LLC's can be complex to form and complex to operate however. The overall cost of forming and operating an LLC may outweigh its tax treatment benefits. Another important consideration is that most venture funds cannot invest in LLCs for some important tax reasons. Thus, if you expect to obtain traditional venture funding avoid forming an LLC.
Delaware is thought by many to have a sophisticated, well developed and well understood body of corporate law, for these reasons it is the state where most companies are formed. In many cases, venture capitalists will require incorporation in Delaware in order for them to provide your company with financing. If you expect to obtain venture financing, you should consider forming your company as a Delaware corporation. That being said, if you are doing business in Massachusetts, and your company will only be controlled by one stockholder and you do not plan to obtain venture financing, forming your company in Massachusetts may be a good way to save on some start up costs as you will not have to bear the cost of qualifying your company to do business in Massachusetts.
Venture capital investors require provisions prohibiting the company from taking certain actions without the investors' prior approval as stockholders. These restricted actions typically appear in the terms of the preferred stock and include: (1) liquidation, dissolution or sale of the company, (2) changes to the certificate of incorporation or bylaws (particularly changes that are adverse to the preferred stock), (3) repurchases of shares of stock, (4) increases or decreases in the size of the board of directors, (5) grants of licenses to intellectual property other than in the ordinary course of business, (6) changes to the company's basic business, (7) acquisitions of other businesses, (8) authorization of preferred stock (or other securities) senior or equal to the investors' preferred stock, and (9) transactions with insiders. In addition to these provisions, which require investor approval as investors, investors often require that certain transactions may only be approved by the affirmative vote of the directors, including the affirmative vote of one or more of the directors elected by the holders of preferred stock (see How are directors typically elected?). These actions typically include: (1) adoption of the annual business plan, (2) incurring indebtedness, (3) guaranteeing indebtedness, (4) granting security interests, (5) making loans, and (6) hiring and firing the CEO. It is black letter law that directors generally have a fiduciary duty to the holders of common stock but that other stockholders do not. As a result, investors, in their capacity as stockholders, can approve or disapprove actions based narrowly on their own investment interest. In their capacity as directors, they must consider their duty to others.
Conditions to closing are those matters which the company must satisfy (or which must be waived) prior to closing in order to trigger the investors' obligation to purchase the shares being sold by the company. The two most essential conditions to closing are (a) filing of the amendment to the company's certificate of incorporation containing the terms of the new preferred stock being purchased with the secretary of state of the state in which the company is incorporated; (b) that all of the representations and warranties made by the company in the stock purchase agreement are true at the closing and (c) that the company has complied with or performed all agreements, obligations and conditions contained in the stock purchase agreement that are required to be performed or complied by the company prior to the closing. Other typical closing conditions include:
1. Execution of an employment agreement between the company and each founder;
2. Delivery of a legal opinion in connection with certain matters relating to the financing by legal counsel to the company;
3. Delivery and approval of an annual budget;
4. Execution of intellectual property assignment and confidentiality agreements by each of the company's employees;
5. Obtaining of key man insurance on the life of each founder;
6. Delivery of a management rights letter to one or more investors;
7. Creation of a new board of directors of the company in the size and composition required by the new investors; and
8. Execution of ancillary investment documents by the company.
A participating preferred stock is one that participates with the common stock in receiving the proceeds of the liquidation of a company. This participation can be contrasted to a preferred stock that has a fixed return that is paid ahead of any money to be paid to the holders of common stock. For example, one company that we are aware of has issued a preferred stock with a fixed return, commonly referred to as a preference, that provides for a payment of five times the amount invested. If, upon a liquidation, the company has more than that amount, the return to the holder of preferred stock is limited to five times the invested amount with the excess being distributed to the holders of common stock. If, upon a liquidation, the company has less than that amount the holders of preferred get everything and the holders of common stock get nothing. By way of contrast, a venture capital preferred stock may have a preference and a participation. In the typical situation upon liquidation, the venture investor may have a preference equal to its initial investment, referred to as a 1x return. Once that preferential return is paid, venture investor also has the right to receive payment from any additional amounts available for distribution on an as converted basis with the common stock. Such an instrument is referred to as a participating preferred. The double dip is that it gets both the preference and the participation. [Participating preferred stock is not the only way to structure an investment. The exact economic rights should be addressed at the term sheet stage.]
Liquidation preferences are very common, almost universal, features of venture investments. A liquidation preference provides, in the event of a liquidation or sale of a company, that the holder of preferred stock will be paid an amount, often an amount equal to its initial investment plus accrued and unpaid dividends, before the holders of common stock are paid anything, referred to as a 1x return. As of this writing, typical market terms call for a 1x return.
Blank check preferred stock is a term used to describe a provision of a company's charter that permits the board of directors to issue preferred stock with rights and preferences as determined by the board without a shareholder vote. These provisions were established to streamline the offering process, and they are very often part of the charter provisions public companies. However, these provisions also give the board a tremendous amount of discretion. For this reason, they are not normally part of a venture financed company's charter. Sometimes blank check powers are included in the charter for a start up company. In this case, the power can be used in connection with the issuance of preferred stock to venture investors