FAQs

General

Q: How much will a basic incorporation cost and how much time will it take?

A: Assuming that you want a "plain vanilla" company and are willing to use standard form documents, we can incorporate a company for you in a few hours. You will need to make a few basic decisions such as whether to incorporate in Massachusetts or Delaware and how much stock to authorize. You will also need to pay incorporation fees to the state of incorporation. These fees are likely to run a few hundred dollars. If you incorporate in Delaware, you may need to qualify your corporation in Massachusetts. Again, this qualification can be a simple procedure and requires a payment to Massachusetts. This payment is also likely to run a few hundred dollars.

Q: What are the basic things I need to form my company and get started?

A: You will need to form the company by filing a certificate of incorporation in Delaware or articles of incorporation in Massachusetts. Additional requirements include (a) the initial consent of the incorporator (which can be your lawyer) appointing the initial director or directors, (b) the initial consent of directors approving the bylaws, the form of stock certificate, and certain other basic matters, (c) the stock certificates representing your ownership, and (d) a corporate seal. At the time of incorporation, you should also apply for an employer identification number. In addition, depending on the circumstances, you may also need to make as Subchapter S election or a Section 83(b) election under the Internal Revenue Code.

Q: Do I need an advisory board?

A: Whether or not a business will benefit from an advisory board depends on a number of factors, including the experience of the management team, the nature of the business and the extent to which it depends on complex technologies. A company with a seasoned management team and a sophisticated board of directors is less likely to need additional counsel with respect to the operation of a business. For businesses that are heavily reliant on the development of highly complex technologies for their success, particularly in life sciences and biotech, scientific advisory boards are commonly used to augment the internal capability of the business, regardless of the experience of management. Additional considerations might be the technical expertise of the company's directors (which might render an advisory board redundant).

Charter

Q: Should I incorporate in Massachusetts or Delaware?

A: If you are doing business in Massachusetts, plan to form a company that is controlled by one stockholder and do not plan on obtaining venture financing, you may save some money by forming your company as a Massachusetts corporation. These savings consist primarily of the cost of qualifying your company to do business in Massachusetts. Delaware is widely thought to have a sophisticated, well developed and well understood body of corporate, and, for this reason, it is the jurisdiction of choice for most companies. In many cases, venture capitalists will require incorporation in Delaware in connection with their financing. If you expect to obtain venture financing, you should consider forming your company as a Delaware corporation.

Q: Should I use a Limited Liability Company?

A: Whether or not to use limited liability company, or LLC, is first and foremost a tax question. LLCs are treated as partnerships for federal tax purposes. LLCs are so-called pass through entities for federal tax purposes. 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 double taxation - it eliminates taxation of the income at the corporate level. In the case of an ordinary corporation (a so-called "C" corporation), the corporation would pay tax on its income and its stockholders would pay tax upon any dividends paid to them by the corporation. LLC's can be complex to form and complex to operate. For this reason, the cost of forming and operating and LLC may outweigh the benefits. Furthermore, for tax reasons of their own, most venture funds cannot invest in LLCs. For this reason, anyone expecting to obtain traditional venture funding should not use an LLC.

Q: What is Blank Check Preferred Stock?

A: 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.

Q: Does Preferred Stock Get a Dividend? When are Dividends Payable?

A: Unfortunately, the answer is sometimes. 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.

Q: What is a "Participating Preferred"? What is a "double dip"?

A: A participating preferred stock is one that participates with the common stock in receiving the proceeds of a liquidation of the 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 going 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) and, once that preferential return is paid, the right to participate in 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.

Q: What is a typical liquidation preference?

A: 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.

Q: When do holders of preferred stock get a liquidation preference?

A: A liquidation preference is received upon liquidation and dissolution of the company. The issue for entrepreneurs to understand is that liquidation means both a negative outcome (in which the company is liquidated in the bankruptcy sense) and a positive outcome (in which the company is sold at a large gain in what is a liquidity event for the investors). The definition of "deemed liquidation" (or similar words) is universally drafted to include the positive event of a profitable sale of the company. Typically, the investors do not receive a liquidation preference in the event of voluntary or mandatory conversion (i.e. in an IPO). For example, in a company in which investors have invested $10 million is sold for $100 million, if the investors have a 1x participating preference, they will receive $10 million and then participate pro rata on an as converted basis with the holders of common stock in the remaining $90 million.

Q: What percentage of the preferred stock is usually needed to waive a protective provision?

A: The restrictions of protective provisions are generally waivable by holders of a majority or supermajority of the preferred stock, although the specific percentage is often a point of negotiation between the company and the investors and among the investors themselves. For instance, a particular investor may wish to insure that it has the ability to block a waiver and will seek to have this percentage mathematically require that particular investor consent to the relevant action. Suppose one investor intends to purchase 40% of the preferred stock. In order for that investor to have the ability to block a particular action, the investor may seek an approval requirement of 66-2/3% of the preferred stock. The company and the other investors will, if possible, seek to avoid a particular investor having this potential blocking ability.

Q: What is "optional" conversion and what is a "mandatory" or "automatic" conversion?

A: Convertible preferred stock, the type of preferred stock ordinarily issued in venture transactions, provides that the preferred stock is convertible into common stock in specified circumstances. First, each holder of preferred stock will have the right to convert its shares of preferred stock into common stock at any time, a so-called "optional conversion" feature. Second, the preferred stock will generally be subject to mandatory conversion into common stock, without any action on the part of the holder, upon the occurrence of certain events. The most common of these conversion events is the occurrence of an initial public offering of the company. Usually, a public offering will trigger a mandatory conversion only if the offering price per share and the aggregate size of the offering exceed specified thresholds. The preferred stock may also be automatically convertible into common stock upon the written election of the holders of a majority or specified supermajority of the preferred stock. Finally, if the terms of the preferred stock contain a "pay-to-play" provision, all or some portion of a preferred stockholder's shares may be converted if the stockholder fails to participate in the next round of financing at the level specified in the pay-to-play provision.

Q: What is "pay-to-play"?

A: A "pay-to-play" provision may be included in the terms of the preferred stock. A "pay-to-play" provision typically requires an existing investor to participate (or "pay") in a subsequent investment round to retain certain rights (or "play") or to avoid facing certain negative consequences. For instance, an investor's failure to purchase its pro-rata portion of a subsequent investment round may result in conversion of that investor's preferred stock into common stock or into another less valuable series of preferred stock with reduced rights.

Q: What is "redemption" with respect to preferred stock? What happens if a company can't redeem?

A: Redemption is a repurchase of shares by a company. Preferred stock terms typically provide for the mandatory redemption of the preferred stock by the company if requested by the investors (investors generally are not permitted to call for redemption until five years after the initial issuance of the preferred stock). The price per share at which the company must redeem the preferred stock is ordinarily equal to the price at which the preferred stock was issued plus a small guaranteed rate of return (e.g., accrued dividends). In practice, redemption rights are not often used; however, they do provide a form of exit for an investor (in the absence of an acquisition or IPO) and some possible leverage for the investors over the company in the future.

Due to absence of funds to repurchase the shares in compliance with statutory restrictions on redemption, it is unlikely that a company will be legally permitted to redeem. Investors will sometimes require that the terms of the preferred stock provide for certain penalties in such a situation. For example, the redemption rights provisions may instead require the redemption amount shall be paid in the form of a one-year note to each unredeemed holder of the preferred stock, and the holders of a majority of the preferred stock may become entitled to elect a majority of the company's board of directors until such amounts are paid in full.

Q: What is anti-dilution protection?

A: Anti-dilution provisions are used to preserve the economic value and voting interest of preferred stock (at the expense of the holders of common stock) in the event of issuances of additional shares of stock at a lower price per share than that paid by the holder of preferred stock. This protection is accomplished by increasing the rate at which the preferred stock converts into common stock. Convertible preferred stock is typically convertible into common stock at a ratio, the "conversion ratio," determined by dividing the purchase price of the stock by the "conversion price," which is initially the same as the purchase price. An anti-dilution adjustment is effected by reducing the conversion price, thereby causing an increase in the conversion ratio and, accordingly, the number of shares of common stock into which the preferred stock is convertible.

There are two main types of anti-dilution protection, "weighted average" and "full ratchet." The most common (and the most favorable to a company's founders and other holders of common stock) is weighted average anti-dilution protection. Weighted average protection takes into account the magnitude of the lower-priced issuance (i.e., the number of shares issued at the lower price) as well as price per share. In contrast, full ratchet anti-dilution protection (the most-investor friendly form of such protection) provides that if the company sells one share of its stock to someone for a price lower than the price previously paid for the preferred stock having such protection, the conversion price of the preferred stock will be reduced to that price per share.

The following example illustrates how each of these types of anti-dilution provision work:

The Dilutive Issuance

Assume that Company A has t