The process of getting an investment from a venture capitalist (VC) or an angel can sometimes be very difficult and will require you to provide many explanations, data and other materials and information about your new company (such as technology barriers, business risk, size of market and etc.) These entail many unknown details and many assumptions about the future of your business (as it should be). Once you get the initial approval for an investment and receive a term sheet, the last thing you want to happen is for the investment approval to become somehow at risk because of legal considerations. There are enough pitfalls along the way as it is.
Therefore, our recommendation is always to try to keep the legal matters in form and pursuant to industry standards. Keep your creativity for your business.
Here are five basic principles to follow with if you are looking to start a company that will raise VC/angel financing:
1. Delaware Only! Sometimes entrepreneurs in early stages choose to incorporate at their state of residence; they do that mainly for lack of knowledge or if they are looking to save the extra cost of paying state franchise tax for qualification to do business a foreign company in their state of residence ($800 minimum annually in CA). Since almost all VC backed companies are incorporated in DE, all the legal forms, templates and investment transaction documents are tailored to DE law and they have been used in the industry for years. If you incorporate in any other state, it has the potential to delay the investment process significantly as it may require a specific legal review for these state laws. An investor may also require you to change the state of incorporation and that could result in further delay and more legal fees. For more information please read “Why Should You Incorporate in Delaware”
2. Founders Vesting. Although somewhat counterintuitive, especially in the seed phase where you have no investors, it makes much more sense for the company and the entrepreneurs themselves to have a vesting mechanism for the founders. This is necessary for the relationship among the founders themselves. All of the founders are bringing value to the table and if a founder leaves or is found inadequate for the team then founders vesting will prevent her from leaving with all of their equity! If that is not reason enough, then you should also have founders vest simply because it will most likely be a requirement from your seed investor. If you implement a vesting mechanism from day one, you have the freedom to tailor it better (such as retroactive vesting date) and unless such tailoring is out of market, it will probably fly with your investor without any further changes. For more information please read “What is Founders Vesting” [LINK]
3. Founder Assignment of Technology. Sometimes in the early stages of the company, founders can just simply do the legal incorporation in the state of DE but not take care of the other legal documents and agreements that needs to be used and executed at that stage. A key example for that is the Founder Technology Assignment Agreement which basically assigns all intellectual property (IP) created or owned by such founder to the new company. If a founder does not execute this document and later leaves or gets into a dispute with the other founders, he may refuse to sign a departure agreement on the claim that he owns the intellectual property. This can greatly jeopardize the integrity of the company’s IP of the company and may raise significant concerns, especially by VC investors. As IP is the company’s main asset, make sure all IP is owned by the company from the beginning.
4. 83(b) Election. In a nutshell, assuming you are a U.S. tax payer, you start your company from scratch, and you are subject to founders vesting, then you are required to file to the IRS an 83(b) election within thirty (30) days from the date you executed your Founder Restricted Stock Purchase Agreement. This is a time frame set in stone and failure to timely file it could cause significant tax consequences and issues with the IRS. If you plan to relocate to the US, you should also take that into consideration since you will become a US tax payer. For more information please read “Founder’s 83(b) Election” [LINK]
5. Board Structure. The board structure is set forth under the company’s bylaws. It is important to make sure you understand the board structure of the new company. Especially with a large group of founders, you need to understand who controls the board, what is the majority required to nominate board members and if you are a board member at all. The board of directors is the managing body the company and can hire or fire executives even if they are founders. This is especially true if you are subject to founders vesting and can lose your stock if the majority of board members turn against you. Read and understand this structure carefully in order to protect your place in the company.