New Venture Finance

New Venture Finance Quiz #1 Study Guide

Founders Agreement

Life cycle stage of successful venture

• Founders agreement

• Negative/very low revenues
• Developmental phase, approaching startup phase

Qualities of an attractive venture:

• Solving a large problem with an affordable solution
• In a fast growing industry
• Scalable

• Can be grown fast and without a lot of money

• High quality management team

• Numerous founders make it less likely for a founder to walk away
• Different capabilities

• High profit margins
• High probability of an investor exit opportunity

• Invest for 5-7 years, looking for high value creation

Legal organizational forms of start-up venture

Sole proprietorship

• Individual owns/operates a business by him/herself
• Receives all profits
• Individual is responsible for all taxes and liabilities of the business
• If a sole proprietorship is formed with a name other than the individual’s name:

• Fictitious Business Name Statement must be filed in the county of the principle place of business

• Unlimited liability

Partnership

• Two or more people join to carry on a trade/business
• Each person contributes money, property, labor/skills, and expects to share the profits and losses of the business
• Must file annual information return to report income, deductions, gains, losses, etc.
• Does not pay income tax, flow through
• Profits and losses are passed through to partners
• Partners include their share of the partnerships income/loss on his/her tax return
• Not employees, so not issued W-2
• Partnership must furnish K-1; K-1 partnership tax return

Limited partnership

• Has 2 classes of partners: general and limited
• General partners

• Full management and control of business
• Accept full personal responsibility for partnership liabilities
• Unlimited liability, their assets are at risk
• Can be an individual or corporation

• Limited partner

• No personal liability beyond their investment in the partnership interest
• Cannot participate in general management and daily operations without being considered general partners
• Ex: VC firms and real estate firms

Limited liability company (LLC)

• Hybrid structure
• Has limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership
• The “owners” are referred to as “members”

• Depending on the state, members can be a single individual, two or more individuals, corporations, or other LLC’s
• All members have the same rights and privileges
• Cannot issue multiple classes of stocks

• Not appealing to VC’s, because VC’s want to invest in companies if they have rights/privileges above the common stock holders
• Pass through income, profits are distributed to owners and taxes as personal income

S-Corp

• Pass income, losses, deductions, and credits through to their shareholders for tax purposes
• To qualify for S-corp status, corporation must meet the following requirements:

• Be a domestic corporation
• Have only allowable shareholders

• Individuals, trusts, estates
• May not include partnerships, corps, and non resident alien SH’s

• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation

C-corp

• Most flexible
• Double taxation; corporation pays income tax, then pays dividends on the after tax profits, and then shareholders pay tax on dividends

• Corporate charter

• Specifies who is on the BOD, # of BOD seats, number of authorized shares, number of shares to be issued to initial founders (relative to authorized shares)
• Only way to change corporate charter is if the BOD votes on the change

• Authorized shares

• Maximum number of shares the corporation can issue to its investors  
• If you want to change this, you will have to pay

• Ownership %

• = of shares owned/shares outstanding

• Issued shares

• Shares held by shareholders

• Different classes of stock

• Founders’ stock (restricted or non restricted)

• Number of shares given to the founders
• Restricted stock

• Subject to vesting over time; you receive it after certain conditions are met
• Keeps founders from walking away early, gives founders their portion of the company over time

• Common stock
• Preferred stock

Different classes of founders’ stock

• Class A

• One vote each; owned by public

• Class B

• Ten votes per share, owned by founders
• You can hold a small % of the outstanding stock, but hold a much higher % of shareholder voting power

• Class C

• No votes
• Issued to both class A and class B shareholders as stock dividend
• Used in employee stock incentive plans, acquisitions, and other stock sales

Founders agreement contains:

• Ownership/equity split
• Vesting
• Compensation
• Titles
• Responsibilities
• Intellectual property rights

Contributions in founders’ phase

• Sweat equity
• Cash
• Intellectual property

Sweat equity

• Ownership interest/increase in value that is created as a direct result of hard work of the owner
• Sweat equity caused the company to be worth more without actually giving it $
• Founders share of companies’ total worth – initial investment = sweat equity
• Sweat equity shares may or may not vest

• You don’t get full ownership until a certain period of time has passed

• Not taxed, therefore provided on a before-tax basis

Cash contributed by founders

• Easy to measure
• Buys ownership
• Invested by founders on an after-tax basis
• Equity granted for cash DOES NOT vest
• Imputed company value

• = Cash contributed/ownership % given

Vesting

• Restricted shares, reserved for issuance to a founder under future conditions
• Conditions may include:

• Time elapsed
• Founder or company performance milestones
• Full time employment with company

• Purpose:

• Protects ownership rights from walking out the door without the value that was expected when ownership was granted
• Fosters a commitment to the venture

• Time-based often has a cliff:

• Often one year—the founder must be with the company for a year to vest the first increment
• Once you reach the cliff, monthly (etc.) vesting occurs for the remainder of the vesting period

• Acceleration provisions

• Single trigger

• A single event that would trigger acceleration of vesting so that a founder immediately receives all unvested shares
• Examples:

• Successful testing of a product
• Company revenue reaching a certain milestone
• Company being acquired or having an IPO
• Termination without cause

• Double trigger

• Two events need to occur to trigger acceleration

Intellectual property

• Creations of the mind, such as inventions, literary/artistic works, designs, symbols, names, and images used in commerce
• Legally protected by patents, copyright, and trademarks; enables people to earn recognition or financial benefit from what they invent/create
• Patents, trade secrets, trademark, copyright, geographical indications

Patents

• Exclusive right granted for an invention; which is a product/process that provides a new way of doing something or offers a new technical solution to a problem
• To get a patent, technical information about the invention must be disclosed to the public in the patent application
• Patent owner has exclusive right to prevent/stop others from commercially exploiting the patented invention
• Patent protection means the product cannot be made/used/imported without the patent owners consent
• Patents are territorial rights; the rights are only applicable in the country or region in which the patent has been filed and granted
• Protection is granted for a limited period, generally 20 years from the filing date of the application
• 4 types:

• Utility patent

• Protects any new useful process, machine, manufacturing items, or any new and useful improvement
• Protects the way something is made or used

• Design patent

• Protects new, original, and ornamental design
• Protects the way something looks
• 14- year protection

• Plant patent

• Protects biotechnically engineered plants

• Business method patent

• Protects the specific way of doing business and the underlying computer code
• Protects the way the software works, what the program does
• The code is not protected

• 3 criteria to determine the granting of the patent: Invention must be:

• New

• Cannot be exactly like something already in existence (prior art)

• Nonobvious

• At the time the invention was made, it would not have been obvious to one knowledgeable in the field

• Useful

• Performs the purpose of the invention and must be not be immoral, frivolous, or mischievous

Trade secrets

• Confidential business information which provides an enterprise a competitive edge
• Manufacturing or industrial secrets, commercial secrets such as sales methods, distribution methods, consumer profiles, advertising strategies, lists of suppliers/clients, manufacturing processes
• Unauthorized use of trade secrets by persons other than the holder is regarded as an unfair practice and a violation of the trade secret
• You forgo legal protection that the patent provides to keep your intellectual property out of the public domain, stays within the company
• 3 conditions to be a trade secret

• Information must be secret
• Must have commercial value
• Must have been subject to reasonable steps by the holder of the info to keep it secret, through confidentiality agreements

Trademark

• Loga

• Something the distinguishes a company from other companies

• Sign capable of distinguishing the goods/services from one enterprise from those of other enterprises
• A word, combination of words, letters, or numerals
• Drawings, symbols
• 3-D figures such as the shape and packaging of goods
• Sounds or fragrances
• Colors or shades
• Protection is obtained by registration; you must file an application with the national/regional trademark office by paying the required fees
• You have 10 years of protection, but you can renew it indefinitely by paying additional fees
• 2 options if you want an international trademark:

• File trademark application in EACH country in which you are seeking protection
• Use WIPO’s Madrid system

Copyright

• Rights over creative or literary works
• Works covered: books, music, paintings, sculpture, films, computer programs, databases, advertisements, architecture, maps, technical drawings
• Right to the way you expressed your idea, the right to your words
• 2 types of rights under copyright:

• Economic rights

• Owner gets financial rewards from the use of his works by others

• Moral rights

• Rights to claim authorship

• Right to oppose changes

• Could harm the creator’s reputation

• Copyright protection is obtained AUTOMATICALLY without the need for registration (some copyright offices provide registration for works, US)
• To qualify for copyright protection:

• The work must exist is physical form for at least some period of time
• The work must be original (authors own words, doesn’t matter if similar to existing works)
• Must be a result of creative effort
• Must be an original and creative expression, the idea is not protected
• Does not protect facts; any facts that the author discovers are public domain

• Length of protection

• For works created on/after Jan 1, 1978:

•  Copyright is protected for the authors life + 70 years after death

• For “joint work”

•  Copyright is protected for 70 years after the last surviving authors death

• For works made for hire, anonymous/pseudonymous works, and works created but NOT published/registered before Jan 1978:

• Copyright is protected by SHORTER of: 95 years from publication or 120 years from creation

• For works created, published, or registered before Jan 1 1978

• Copyright is protected for 95 years from the event

Geographical indications