Hacking Startup Law

Hacking Startup Law

LawTrades’ Commitment
to Helping Startups.
By Raad Ahmed, CEO
A little about ourselves - we’re the go-to online platform for legal services
on demand. We make it simple, efficient and cost-effective to find,
connect and work with talented lawyers to meet your company’s needs.

After years of exposure to the startup world, we feel it’s our obligation to
share what we know. Too many startups make legal mistakes and it makes
sense. With little money to spare, bootstrapped startups are routinely
forced to figure things out on their own utilize boilerplate templates
found online.



Although startups are encouraged to use this e-book as a helpful
resource, it shouldn’t serve as your company’s general counsel. This
guide contains a ton of generalities, some of which may not apply to your
particular startup. That’s why advice from an attorney is always
recommended.



Please do us a big favor - don’t share this book or rip off any content or
imagery in it without giving some credit and a link to our site!

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Contents.
Prologue.

Chapter 1: Start.

Chapter 2: Creating and Protecting Intellectual Property.

Chapter 3: Raising Money.

Chapter 4: Building a Team.

Chapter 5: How a Strong Board of Directors and Advisors Can Help You
Grow.

Chapter 6: Citizenship and Residency.

Chapter 7: The Exit.

The Startup Dictionary.


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Prologue.
This book is about breaking down barriers. It is about clearing obstacles,
creating connections, initiating positive change, and promoting
opportunities.

It is about disrupting the status quo so that access to critical resources is

expanded for bootstrapped entrepreneurs - especially legal resources.

Many entrepreneurs find themselves facing financial and legal hurdles

that can deter them before they even begin. Others start, but are derailed
by unexpected obstacles.

It is extremely frustrating to have a promising idea, but little to no capital

to start a business. Those who are determined often find themselves
reaching for their own wallets to finance their startup business.

The discovery that a reliable business attorney is a necessity may not be a

dealbreaker, but it could lead to some pretty risky decisions. For instance,
what do you if protecting intellectual property - e.g., patents and
trademarks - is critical to your company’s success, but you are unable to
afford a lawyer to help you file the registrations? Some people might
decide to use standardized legal forms and do it themselves, only to
learn costly mistakes later down the road.

The intention of this book is to help give you the tools that you need to
successfully start and operate a new business. Whether you are starting a
small company with few or no employees, or a medium-size business
with a larger staff, there are things you will need to do that are common
denominators for all. These tasks can be assembled under three general
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categories: (1) business decisions, (2) legal compliance, and (3) business-
based legal decisions.

Some actions will be purely business decisions, such as creating a

business plan or securing insurance coverage. Other responsibilities
involve legal compliance, including adhering to employment law and
environmental regulations. Some legal decisions will be based on
financial and business considerations, such as what type of business
entity you choose for incorporation or how you protect your proprietary
information and intellectual property.

The ride to building a business can be a bumpy one. But with the right
instructions and reliable tools, you will be able to build your company
without reinventing the wheel.

So are you ready to start?

You already have an idea for a business or you would not be reading this.
After running the numbers and determining that it is viable, you are ready
to get started. So what’s the next step?
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Chapter 1: Start.
There are a few baby steps every new business must take before it can
run. This list will help you launch and prepare your company for moving
to the next stage. Since these are foundational elements, it is in your
company’s best interest to ensure they are firmly in place before moving
on to the next phase.

The Business Plan

The importance of creating a business plan cannot be overstated. It is
vital to your business sustainability that you dive into the details. While
each business plan is unique, they all contain these core components:

Executive Summary

This summarizes the entire business plan by introducing the market need
you have identified, how you plan to address it, who your key managers
are, and what conclusions are most important for purposes of sound
decision-making

Mission Statement

This is your vision and your purpose

Company Synopsis
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This is about your products or services, your competitive advantage,

operations, distribution, and core competencies

Market Analysis

This discusses your marketplace, the competition, and how you fit in

Management

This describes your management team, their experience and

backgrounds

SWOT Analysis

This analyzes your Strengths, Weaknesses, Opportunities, and Threats

and reflects your realistic assessment of the challenges and opportunities
in your marketplace

Financial Assessment

This includes a cash flow statement to help you clarify current and future
needs so you can anticipate how cash flow could affect growth; revenue
projections, income statements, profit projections, budget and balance
sheets are all critical components

Strategy
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This describes how you plan to leverage opportunities, minimize threats,

and market your product or service

Action Steps

This states your goals and objectives and what steps you will take to
achieve them
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Choosing a Name: Building Your Brand Value

Many people often associate brand with a particular company, a logo, or
trademark. Coca Cola and Apple are two compelling examples.

What you need to know about brand is that it is more than that. Much
more. Brand is a company’s reputation. It is what people think or feel
when they hear the name of a company. It is about the value and benefits
that a company stands for.

Accordingly, choosing a company name requires careful consideration.

Deciding what feelings or key characteristics of your business you want to
reinforce will help steer you in the right direction.

Another consideration is to aim for something short. The more concise

the name, the more effective it usually will be. Again, think Apple. Virgin,
Google, Skype, Facebook and Twitter.

Shorter names are not only more memorable, but will make practical
aspects of your branding easier when printing stickers or claiming a
twitter handle.

Remember: you are creating a brand, not a name. So getting it right from
the very beginning is a crucial part of your overall marketing strategy.

Once you have chosen a name, you need to make sure it is not already
being used. It is imperative to check the name availability at both the
state and local levels. Here are a few easy steps you need to take:

▪ Search the U.S. Patent and Trademark Office (USPTO) database for the name
you want to use

▪ Search the online business records of the Secretary of State in the state you are
incorporating in for name availability

▪ Search the Internet

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▪ Search domain registries

When you have a name that is available, you can file a Statement of
Trademark with your state’s Secretary of State office. Filing with the
USPTO at the federal level can also be done, but it does cost more time
and money. You may want to postpone federal registration until a later
time to ensure that the name is right for your business. It will also allow
your company more time to gain traction prior to absorbing the extra
costs.

Obtain a Domain
Once you have determined that your name is available, you should
immediately register it with a domain service like GoDaddy. This will
serve as a placeholder for your website and prevent others from using
the same name.

Apply Online for an EIN

You will need to secure an Employer Identification Number (EIN) in order
to open a business bank account and transact business in general. You
can apply online at irs.gov and obtain one immediately.

Secure Required Business Licenses

You may need one, more than one, or none for the time being. Licenses
are usually required by state and local government. If you are working
outside of your home, you will at a minimum need to apply for a local
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business license with the city or town in which your business is located.
Depending on the type and location of your business, you might also be
required to register with the state for sales tax, unemployment, and other
certifications.

You can check for license requirements with your state’s Secretary of
State office, as well as with the Small Business Administration (SBA) at
sba.gov. The SBA offers small businesses a rich online library of resources
that is free. You can easily check their site for links to individual states’
licensing requirements.

Procure Insurance
The kind of insurance coverage you will need is determined largely by
the type of business you create. Workers’ comp is required once you
have your first employee. Property insurance is often a condition in
standard commercial leases if you are renting space. Once you
incorporate, you will want to consider E&O (Errors and Omissions) and
D&O (Directors and Officers) coverages, depending on the type of
business you are in. Liability insurance in general should be discussed
with your insurance agent. Group health insurance should also be open
to consideration as it could help to reduce the cost of your insurance
premiums.

Develop Website and Register Social Media

Profiles
If you’re on a budget, use a website builder like Squarespace or
Launchrock to immediately begin acquiring customers. At a minimum,
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the landing page verifies your credibility. One of the staples of a

legitimate website in today’s marketplace is social branding. This means
that your landing page should include links to the principal social media
sites including Facebook, Twitter, and LinkedIn. This will require that you
register your company’s profile with those providers, in addition to any
others that are relevant to your business.

Company Structure, Formation, and Corporate Basics

If you are ready to start approaching investors or customers, then you will
need to incorporate immediately in order to reduce your liability
exposure, minimize costs, and demonstrate your credibility.

When you incorporate, whether as a C-Corporation, a Limited Liability

Company (LLC), or any variation thereof, the new entity is treated legally
and financially as a separate person. This is often referred to as the
“corporate veil,” and it protects your personal assets from any liabilities
that the company incurs.

Additionally, incorporating will offer you tax benefits. The caveat here is
that you need to ensure that the type of entity you choose is appropriate
for your type of business and future needs. Tax planning is definitely one
of the more critical considerations when incorporating so it is strongly
recommended that you consult with a qualified business attorney or
accountant when making this decision.

For example, if you are a high tech startup with intellectual property and
are planning to raise financing in future funding rounds, a C-Corp might
be a better choice than an LLC. On the other hand, if you are an
environmental consulting firm with industry clients, but no need to raise
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funding or no intellectual property, an LLC with subchapter S selection

will minimize your tax burden and give you more flexibility.

Where Should You Incorporate?

Incorporating your company has never been easier. Whether it is

registering online directly with a state’s business division or opting for the
quick and easy access of do-it-yourself (DIY) incorporation documents on
DIY legal sites, the temptation for many startups is to use one of these
inexpensive options to minimize business costs.

There are, however, multiple risks of choosing a business entity that

winds up being inappropriate for your business. Deciding which entity
looks appealing without the guidance of an experienced business
attorney could expose you to higher liability and costs.

If you are planning on incorporating yourself, you need to carefully

choose where to incorporate. It is a common misconception that
Delaware is the best choice. For some companies, Delaware is the right
venue in which to incorporate, while for others incorporating in the
company’s home state is the right choice.

Why Delaware?

Tiny Delaware is home to big business, including 50 percent of all

publicly-traded companies in the United States, and nearly 65 percent of
all Fortune 500 companies. Banks find Delaware attractive because of its
high cap on the amount of interest they can charge borrowers.
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Companies that plan to seek venture capital (VC) financing know that VCs
tend to favor Delaware corporations. Even with states like Nevada and
Wyoming, and Florida beginning to flex sizable pro-corporation muscle,
Delaware remains the clear favorite.

There are two principal reasons why most tech startups incorporate in
Delaware: (1) they are incorporating as a C-Corp, and (2) they expect
high growth.

Before taking any steps towards incorporation, it is in your best interest to

get legal guidance. Many people incorrectly assume that Delaware is the
best state in which to incorporate when often there are better options.

Approximately one-half of all states have adopted the Model Business

Corporation Act (MPCA), making corporate law governing both public
and private uniform throughout much of the county. While Delaware
remains a notable exception, the trend is leaning towards more states
adopting the Act, leaving little variation between most states.

As a general rule, if you are a tech company that’s expecting rapid

growth, Delaware may be the best choice. In addition to their state law
being highly developed and favorable toward corporations, there tends
to be a fairly universal knowledge of Delaware corporate law among
lawyers across the country.

Delaware does offer C-Corps the greatest flexibility in terms of

structuring boards of directors, stock issuance and preference, and
voting rights. It also provides the broadest privacy protections. For
instance, it does not require director or officer names to be revealed on
formation documents.
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Other benefits of incorporating in Delaware include:

▪ Chancery Courts that specialize in business and corporate law

▪ No jury trials

▪ Management-friendly laws that allow directors to reserve substantial power

▪ No corporate tax on out-of-state Delaware corporations (although franchise

taxes are required)

▪ No inheritance tax on non-resident shareholders

▪ No tax on shares held by non-residents

▪ Only a majority of the outstanding stock is required for merger as approval

For these reasons, many investors prefer companies that have been
incorporated in Delaware as C-Corps. However, even if you are a high
tech startup with no reason or plans to go public, you should seek legal
advice from a home state attorney to explore your in-state options.

Why Not Delaware?

If you are a small, early stage startup that has no intention of seeking
venture capital or institutional financing, and you are not planning on an
Initial Public Offering (IPO), then incorporating in the company’s home
state is probably the best option.

If you incorporate in Delaware, but will be doing business in another

state, you will still need to register in the other state or states as a foreign
business entity. In addition, you will be required to file periodic reports in
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Delaware, as well as those states where you do business. Moreover,

Delaware requires that you regularly submit franchise taxes, even if you
are paying those taxes to the state(s) in which you are already doing
business.

Some observers have noted that another advantage to filing in Delaware

is that it takes very little time to complete the incorporation. However,
many (if not most) other states enable you to incorporate online with the
State Secretary of State’s Office in just a few minutes - and often for a
lower fee than Delaware.

Many companies do not require C-Corp status; in fact, incorporating as a

C-Corp for some companies could be detrimental to their overall
financial interests. Filing as an LLC with subchapter S selection or some
other type of entity that’s not a C-Corp - especially when there’s no
expectation of going public - is often best done in the state where the
company is conducting business.

Unique Industries

On a more delicate note, there are some types of companies that require
you to file your incorporation in your home state. One of the fastest
growing industries is the cannabis industry. For example, as of December
2015, 23 states and the District of Columbia currently have laws legalizing
marijuana in one form or another.

Colorado, Washington, Oregon, Alaska, and the District of Columbia all

legalized both recreational and medical marijuana. A number of other
states have either decriminalized marijuana or are allowing possession of
derivative products. For example, Georgia Governor Nathan Deal
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recently signed a law legalizing the possession of up to 20 ounces of

cannabis oil. This is likely due to the influence of thought leaders such as
Dr. Sanjay Gupta whose conversion from staunchly anti-marijuana to
vehemently pro-medical wields tremendous influence.

With another eight states expecting to legalize, to one extent or another,

all cannabis within the next couple of election cycles, everyone from
lighting manufacturers to irrigation companies to Wall Street venture
capitalists are trying to figure out the best route to incorporating these
new industry entities.

For some, incorporating will be limited to only those states in which they
are qualified to do or own a cannabis-related business; for others, equity
ownership might be impossible, but other structuring mechanisms are
available.

Generally, where you are incorporated is not going to affect the decisions
of most people, with the exception of perhaps investment bankers and
investors who are considering a fast growth C-Corp that is planning on a
future IPO, high tech or otherwise. Once again, consulting a
knowledgeable business attorney is going to be one of your best
investments.

Determining the Right Type of Entity

Selecting the right business structure for your company is one of the
most important choices you will make. It will impact almost the entire
universe of your business including your regulatory compliance,
employment obligations, tax and legal liabilities, and your ability to
attract investors.
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There are three principal types of corporations: C-Corporation, S-

Corporation, and Limited Liability Company (LLC). Knowing your
business needs and goals will dictate which structure will best serve your
financial interests and accommodate your growth.

The most important criteria you need to evaluate when selecting your
corporate structure are:
▪ Tax Liability: What opportunities do you need to promote your company’s
growth, while minimizing your tax burden?

▪ Formation Costs: What are the costs of incorporating in more than one state,
including maintaining a registered agent?

▪ Compliance Costs: What are the costs associated with administrative

compliance including filing annual reports, annual fees, and related taxes
(e.g., Delaware’s franchise taxes)?

C-Corporations are generally most popular with companies that are

planning to participate in equity or debt financing, raise funding through
multiple financing rounds, and aim to go public. If you are considering
venture capital, then a C-Corporation is going to be your choice since
venture capitalists are unable to invest in S-Corporations and generally
refuse to invest in LLCs.

S-Corporations find favor among those companies that will not be

seeking equity or debt financing through venture capital funds, do not
plan to go public, and do not foresee having more than 100 members.
The chief advantage of an S-Corp is that it provides tax benefits on
distributions. Distributions are excess profits, which are the sums
remaining after salary and payroll expenses (e.g., FICA) are deducted. At
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this point, the remaining profits are characterized as dividends and can
be distributed to the owners at a lower tax rate than ordinary income.

LLCs are most attractive to companies with objectives similar to S-Corp,

except that they have more flexibility. For instance, like an S-Corp they are
pass-through entities, so the owners do not get hit with double taxation
since income from the entity is paid only by individual members, not the
entity. Unlike S-Corps, an LLC can have more than 100 members, can be
owned by or own another entity, can have more than one class of stock,
and can be owned by non-residents. They are also less expensive than S-
Corps to form and maintain, since S-Corps require more administrative
attention, especially with respect to meticulously complying with IRS
regulations that strictly govern S-Corp oversight.
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Here is a convenient snapshot of some of the critical differences

between each type of entity:

Features C-Corporation LLC S-Corporation

Limited liability for Yes Yes Yes
owners
Yes Yes Limited to 100
Unlimited number of
shareholders/members Yes No No

Income of entity taxed No Yes Yes

separately from owners
Yes Yes No
/ shareholders
Yes Yes No
Income of entity not
taxed - passes through Yes Yes No
to individual owners /
shareholders No Yes Yes

Foreign ownership is
allowed

Entity can be owned by

or own other entities

More than one class of

stock / ownership
interest is permissible

Shareholders/members
can deduct business
losses on individual tax
returns
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These guidelines can arm you with the knowledge you need to make the
right decision when deciding on which corporate structure will best fit
your company. However, engaging an experienced corporate attorney
will assure you of that decision, or possibly even save you from a costly
mistake. Using this information as a basis for selection after discussing
your specific business needs with a lawyer is always recommended since
the circumstances of each company are as unique as fingerprints.

2. How Startups Compensate Employees

In order to adequately assess how best to compensate your employees,
you will need to gauge your appetite for risk and understand your
business needs. A realistic appraisal of these essential business
components will govern your staffing strategies.

For example, a consulting startup is going to have fundamentally

different staffing needs as compared to a tech startup. How you structure
compensation will depend largely on these considerations.

A small consulting firm, for instance, may simply need an administrator to

assist with general housekeeping, such as organizing files, scheduling
appointments, and interacting to a limited extent with clients. Similarly, a
marketing start-up might need an entry level graphic designer.
Employees in these types of positions will typically expect a regular
paycheck.

On the other hand, a high tech startup will usually have a need for more
sophisticated staff. Inventors, software experts, biotech professionals, and
engineers might be the only personnel who can contribute to any
meaningful growth of the company, let alone business sustainability.
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When it comes to deciding how to compensate your employees, there

are options that can give you the flexibility you need to meet the needs of
both the company and valuable staff.

Wages

Wage and hour compliance is governed by the Fair Labor Standards Act
(FLSA). For FLSA purposes, employees are generally classified as exempt
or nonexempt, depending on their salary and the type of work they do.

Exempt employees typically fall under one of the specified FLSA

categories. The most common are white-collar professionals, and they are
exempt from overtime requirements. This option is appealing to
employers since employers are not required to pay overtime or keep
track of their time. However, since it is an exception, the burden of
proving the legitimacy of this classification is on the employer.

One more thing you will want to keep in mind is that exempt employees
who are paid salaries or commissions are entitled to receive earnings that
must equal $7.25 an hour, or higher where the state law provides for a
greater rate. For instance, an employer is prohibited from paying an
employee a salary of $250 per week since the minimum wage
requirement would place a salary based on a 40-hour week at $290.

Nonexempt employees are those who are paid by the hour. Because they
are nonexempt, employers are legally required to pay them not only the
minimum wage, but also overtime. The federal minimum wage is $7.25.
However, 25 states have minimum wage rates that are higher than the
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federal minimum wage. When state minimum wages are greater than the
federal rate, then the FLSA obligates the employer to pay nonexempt
employees the higher of the two rates. Conversely, some states have
minimum wage rates below the federal standard. In this scenario,
employers must pay employees the federal rate of $7.25 per hour.
Additionally, the FLSA requires employers to pay nonexempt employees
one and a half times the employee’s hourly wage for overtime. Overtime
is any amount above 40 hours per week.

There are numerous other FLSA and state law wage and employment
requirements. For instance, the FLSA forces employers to provide
employees with breaks. Furthermore, while an employer might wish to
offer comp time (time off) to an employee in lieu of paying overtime, this
is prohibited with respect to nonexempt employees.

While the FLSA will remain uniform, state law will vary. Consulting a
knowledgeable attorney in this area is highly recommended.

Equity Grants

Founders of early startups sometimes offer key employees who can help
grow their business equity in lieu of or as a supplement to wages. This is
a popular choice of compensation for bootstrapped tech startups.

This choice tends to take the form of stock options, which are used to
incentivize employees who can benefit from the increasing value of the
stock’s price. The value is theoretical at the outset since a young company
usually does not have a valuation: there are no customers, purchase
orders, or assets. For companies that are planning on going public and
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have a promising future, this can be a very appealing option to an

employee.

The typical equity grant for early hires is about 1-2 percent of the
company’s outstanding shares. Outstanding shares are the number of
shares that a company is legally permitted to issue pursuant to its
incorporation documents; issued shares are the actual number of shares
that the company has issued.

Stock options make the most economical sense for more sophisticated
startups with a relatively developed staff (senior management, rank-and-
file, etc.). Since creating an options program is time intensive and
requires highly specialized legal expertise, they are quite costly to
implement. Therefore, creating a stock options program for just one
employee does not usually justify the cost, but if you are planning to
develop a highly skilled staff, then offering options could be the right
choice.

Caveat: Compensating employees only with stock or stock options is

generally not considered wages for purposes of minimum wage
calculation. Accordingly, this type of arrangement can easily violate
minimum wage laws. While there might be ways to structure this type of
compensation package, they are very narrowly construed and require
robust legal skill. If you are thinking about this option as compensation,
engaging an experienced attorney is essential in order to avoid fines or
legal action, or both, that could impair your company’s brand and value.

Cash and Equity

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When stock is used as a component of compensation, it is vital for the

startup to accurately value shares. Failure to do so can result in sharp
penalties, as well as damage to the company’s reputation and value. Also,
it is crucial to understand that the company will still be legally required to
submit payroll taxes based on sweat equity.

Similarly, correctly characterizing your employees as exempt or

nonexempt is crucial to ensuring legal compliance. As noted earlier,
mischaracterizing an employee as exempt can result in steep
consequences. In addition to interest, fines and penalties, a company will
also be required to account for and pay any overtime to employees who
were incorrectly characterized as exempt.

In some instances, the company’s executive officers can be subject to

criminal penalties, including imprisonment. Therefore, even if a startup
believes that an employee is exempt, it is prudent to still maintain good
records reflecting the employee’s time. There is an enormous variety of
inexpensive employee time tracking and management software that is
easily available. This is an essential compliance tool, so make sure you
integrate it into your management from the outset.

Using equity compensation can be useful, but also costly since it

demands professional administration, usually by an accountant or an
attorney. If stock is given in lieu of wages or sold for less than its fair
market value, the employee can incur unintended tax consequences.

Federal and state securities, tax, and labor laws - among others - will
govern stock option plans, so it is paramount to a company to ensure full
and accurate compliance. Often even the most diligent startups learn at
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some point that their administration of a stock option program was

flawed, exposing them to fines, penalties and restitution.

Another potential negative consequence of an incorrectly administered

stock option plan is that it can derail a potential acquisition. It is not
unusual for non-compliant stock option programs to be discovered by
VCs during a due diligence examination in connection with a financing
round.

All of these more common pitfalls can be avoided be engaging legal

counsel or an accountant with expertise in establishing a compliant stock
option program.

Issuing Stock Certificates

There is a lot of confusion about the necessity of issuing physical stock

certificates. The reason for paper stock certificates is to ensure accurate,
indisputable evidence of shareholder ownership. While most companies
still issue traditional paper stock certificates, the truth is that they are not
necessary.

In fact, public traded companies have been using the Direct Registration
System (DRS), ditching physical certificates several decades ago. DRS
allows investors to elect having their securities registered directly on an
issuer’s books. At the heart of the system is ensuring shareholder access
to their securities information.

Privately held companies can also use DRS and issue e-certificates.
However, before doing so, it’s advisable to check the laws of the state of
incorporation since state corporate law varies. For example, California has
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very specific notice requirements; and while Delaware enables

companies to issue e-certificates, it is not requirement.

Startups wanting to issue e-certificates need to incorporate relevant

provisions into their operating agreement or bylaws, and ensure general
compliance with state corporate law. If your company has already
incorporated, but didn’t include provisions to address the issuance of e-
certificates, then you need a board resolution to issue uncertificated
shares. Additionally, you’ll need to amend your bylaws to reflect the
change.

In smaller companies, corporate formalities might be easily overlooked,

so it is vital to your compliance to enlist competent legal counsel to help
you navigate through the requirements. Also, engaging an attorney can
save you money in the long term since there can be tax and other
regulatory implications - whether you’re going paperless or relying on
physical certificates.

DRS can certainly save a lot of time and money, but you really should
consult a lawyer to help you evaluate what makes the most sense for your
business model. You can also take a look at the Security and Exchange
Commission’s (SEC) information sheet available at www.sec.gov that
describes advantages and disadvantages of each type of registration
from the investor’s perspective.

3. Who Makes the Decisions for Your Company?

Startups that start out small will usually have an informal, more flexible
management style. Being inclusive with a small group is logistically easier
since for one thing, you can fit everyone in the same room. Decision-
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making can accommodate each person’s input, building important

camaraderie.

However, as small companies experience increased growth, it can

become challenging to include everyone’s opinion and feedback. On a
practical level, it will usually be inefficient since it will take more time and
effort to coordinate scheduling; meetings will take longer; and formal
rules of order can be counterproductive.

At the same time, a new company is - by design or by default - creating a

corporate culture. Its core values, behavior, and beliefs will determine
how a company engages with its employees and handles external
transactions with vendors, colleagues, strategic partners and others.

Aside from the cultural aspects of decision-making, a company’s legal

formalities will dictate who ultimately has responsibility for the company’s
overall management.

If you are a small startup incorporated as an LLC or S-Corp, then the

founders are the shareholders. They have the responsibility to ensure a
company’s legal and regulatory compliance.

A small C-Corp could have one person fill the role as the company’s sole
shareholder, director, officer, and employee. A larger C-Corp will have
multiple shareholders who own the company and elect a board of
directors (BOD). The BOD is charged with making business decisions and
selecting corporate officers such as the CEO/president, secretary, and
treasurer/CFO. They also issue stock and set the price per share.

In a large C-Corp, it is the shareholders who must approve the company’s

articles of incorporation, bylaws, and mergers and acquisitions.
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4. Creating an Option Pool and Why You Need It

An option pool is a certain amount of stock that a company reserves for
future issuance to advisors, consultants, directors, and employees. It is a
very specific legal creature that requires great skill in drafting and
executing since it is governed by the 1933 Securities Act.

Many startups - particularly in the tech industry - offer key hires options as
part of their compensation package. Not only do options help
bootstrapped startups fill in the compensation gaps where cash is in
short supply; as importantly, they tend to align the interests of the
employee and company by instilling in the employee a sense of
ownership in and commitment to the overall success of the business.

Allocating approximately 10-15 percent of your authorized shares to an

option pool is the norm. This means ensuring that at the time you
incorporate, you have authorized an adequate supply of authorized
shares. Startups can feel anxious or shy about issuing millions of
authorized, but it is crucial that a company optimizes its flexibility to
accommodate for future growth. Reserving an ample supply for future
investors and employees requires long-range planning.

If you are planning on multiple financing rounds and significant staff

expansion, then you want to do a couple of things: (1) authorize enough
shares when you incorporate, even if the number seems ridiculously
high; (2) make sure to specify the lowest par value per share no matter
how unrealistic it may seem; and (3) be judicious in the number of shares
you distribute among early founders and to employees.
Hacking Startup Law

5. Issuing Equity to Founders and Early Team

Members
Recent years have seen the rising popularity of restricted stock units
(RSUs) offered as an alternative to more traditional stock options.

Stock options essentially give you the right to buy shares at a certain
price (the strike price) after a vesting period - typically, after your one-
year anniversary date, with 25 percent transferred to you each year over a
four-year period. The key here is that you must purchase the options. Your
hope is that by the time you’re eligible to buy the options, the stock has
appreciated.

However, stock value could have eroded making it worthless. That is

where RSUs come in.

Restricted Stock Units

RSUs are a relatively new financial creature. Similar to options, there’s a

vesting period where the employee must satisfy certain conditions before
the stock or its value is transferred (typically, there is a period of time and
other conditions - e.g., work performance). Unlike stock options, there is
no purchase involved. Instead, a certain number of units are allocated - or
granted - to the employee, but there is no value or funding until after the
employee has satisfied the vesting requirements.

After vesting, RSUs are transferrable if the employee accepts the grant.
Therefore, these instruments always have a value, in contrast to options
that can decline in value by the time of vesting. The value of your RSUs is
the closing market value of the stock price on the vesting date. That is
also the point at which your tax liability is triggered, requiring you to pay
withholding and income tax on the amount received.
Hacking Startup Law

Anyone receiving RSUs will most likely be required to file an 83(b)

Election Form. The election must be filed with the IRS within 30 days of
receiving or purchasing the RSUs. It effectively notifies the IRS that the
RSU recipient is choosing to be taxed on their equity on the date the
grant was made rather than on the vesting date. If an 83(b) Election Form
is not filed, then the IRS will tax the recipient at the time the RSUs vest.

What is most important to understand here is that no matter which

election is made, both options result in tax at the ordinary income tax
rate. Also, the recipient will pay a long-term capital gains tax when the
shares are sold. This means that making the proper 83(b) Election is
crucial to a sound long-term financial strategy.

One more note: unlike some other IRS provisions, the 83(b) Election is
strictly enforced. There are no exceptions and no relief is available for late
filings. A copy of the Election Form must also be filed with the company.

Stock Options

Stock options give an employee the right to buy a certain number of

shares at a certain price (the strike price) at a certain time after they have
earned the right to exercise (buy) your options. The employees earn the
right to exercise their options (buy the company’s stock at the strike price)
after the vesting period, which is typically four years, with a one-year cliff.
This means that if the employees leave the company before the end of
the first year, they get nothing; if they continue to be employed with the
company after the first year, they get 25 percent after their first year
anniversary and 25 percent each year until they are fully vested after four
years.
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Employees offered options are not obligated to purchase company

stock; they simply have the option to buy or not. If the stock is valued
above the strike price at the time of exercise, then the employee can buy
it, making a profit when it’s sold; conversely, stock valued below strike
price at the time of exercise will be worthless. For example, if an options
contract allows an employee to buy the stock at $10/share, and it is
selling at $15/share on the day they can exercise their options (after the
vesting period), they can buy it for $10/share, sell it for $15/share, and
realize a $5/share gain on which they will pay taxes only when they sell.
On the other hand, if the stock is valued at $9/share at the time they can
exercise their options, then they are looking at worthless stock and are
not obligated to buy.

Also, there are different types of stock options with varying tax
consequences - e.g., incentive stock options (ISOs) and nonqualified
options. Seeking professional guidance is always recommended.

One more important note about the strike price of options: the strike
must be set at fair market value of the company at the time of the grant.
Under IRS Rule 409A, options are legally considered deferred
compensation. This subjects the options holder to tax consequences if
certain rules are not closely adhered to.

Rule 409A legally obligates a company’s Board of Directors to set option

strike prices at fair market value: if the strike is too low, then the IRS will
treat the options as income and collect taxes as soon as they are issued.
This, in turn, triggers the company’s legal withholding duties - all of which
can be avoided simply by proving the fair market value of the strike price.

Enter the 409A valuation firm providing privately held companies with
third party valuation verification. While this mechanism can greatly
Hacking Startup Law

benefit options holders, it does add significant expense to a company’s

operating budget, which is one powerful reason why the popularity of
RSUs has accelerated in recent years.

Vesting

When you start a company with another co-founder or offer an employee

options or RSUs, you want to ensure that they have a long term interest in
helping the company succeed. If you give them options or RSUs without
a vesting period, you run the risk of them exiting too early, leaving you
without the value of their commitment, while they walk away with a
potentially valuable piece of the company.

Vesting is a mechanism that deters an employee with options or RSUs

from leaving a company too early; in order to receive the full value of
their shares, the employee must remain with the company for a minimum
period of time.

A common feature of vesting schedules is the vesting cliffs. Essentially, a

vesting cliff is like a trial partnership. If an employee is granted a certain
percentage of equity, it is stipulated that if they quit or get terminated at
any time during the cliff period, then the employee is prevented from
collecting any equity.

The typical vesting period is four years with a one-year cliff. That means
that each year, the employee would earn 25 percent of their interest;
after four years, they would be fully vested at 100 percent. However, to
avoid them from realizing gains too early, there is a one-year cliff period:
If the employee exits the company before one year, they lose 100 percent
of their equity. If they exit after one year, but before two years, they can
Hacking Startup Law

collect 25 percent of their equity; 50 percent after two years; 75 percent

after three years; and finally 100 percent at the end of four years when
they become fully vested.

Occasionally, a company will want to speed up vesting to accommodate

certain investors. Acceleration clauses are usually relevant to advisors
who have successfully led a company to where it can be sold or go to IPO
while the advisor is still sitting on the cliff. Since their contribution led to
your success, it’s only fair to compensate them accordingly. Therefore,
accelerating vesting and removing the cliff are commonly found in
advisor stock option agreements and RSUs.

Chapter One Checklist

✓ Complete a business plan.

✓ Obtain EIN - This is the entity’s tax ID number.

✓ Complete bylaws if a C-Corp or execute operating agreement if an LLC or S-

Corp. Open checking and credit accounts.

✓ Procure relevant insurance - Property and general liability insurance, D&O

(Directors and Officers) coverage and E&O (Errors and Omissions) insurance.

✓ Issue stock - can be issued with physical certificates or registered online,

which is the more common option.

✓ Ensure stock options comply with all legal and regulatory requirements - must
be in full compliance with a properly qualified plan after valuation under
Section 409A of the IRS Code.

✓ File 83(b) Election Form within 30 days of the grant.

✓ Secure a domain name and establish a website.

✓ Ensure compliance with state and local law - e.g., unemployment insurance,
business licenses, registration as a foreign entity.
Hacking Startup Law

✓ Keep legal compliance on the radar.

Chapter 2: Creating and

Protecting Intellectual
Property.
Intellectual Property rights can be crucial to the value of a new company,
especially high tech companies. There are two IP-related concerns for
startups: (1) employment related issues, and (2) creating and protecting
IP rights (IPR). Since the employment related concerns were addressed in
Chapter 1 and will be addressed in further depth in Chapter 4, we will
limit our review here to how to create and protect a company’s IPR.

How to Own Your Intellectual Property

Intellectual property (IP) includes patents, trademarks, copyrights, trade
secrets, and customer lists, and is considered an asset. Patents and IP in
Hacking Startup Law

general can and often do attract investors. They can also serve to deter
others with similar ideas.

IP disputes can and often do arise in employment related matters. While

no agreement is ever 100 percent airtight, IP disputes can be mitigated
with careful, advanced planning.

A business needs to ensure that all IP created by employees in the scope

of employment is owned by the company. An employee who authors or
invents a work that successfully generates income for their company can
often feel that they own the work, or are entitled to a portion of the
proceeds. A company with the right employee agreements and clear
policies about employee-generated IP will go far in minimizing the risk of
litigation and maximizing profit by having 100 percent ownership of the
IP rights associated with any protected work.

Since a business does not automatically own the rights to employee-

generated IP, it is critical to obtain from all employees - even those who
do not participate in creating the IP - all of the necessary agreements that
will protect the company’s exclusive ownership of the property.

Different types of agreements cover different types of property. A

confidentiality agreement and noncompete agreement are two more
general contracts that obligate all employees to not share their
knowledge of the IP and trade secrets with anyone outside the company,
particularly competitors.

For works of authorship, copyright assignments and work-for-hire

agreements are advisable. A work-for-hire agreement will be more
favorable to an employer because it is not subject to future termination,
as is a copyright assignment. For patents, an IP assignment will generally
be the best option. Executing an invention assignment agreement with
Hacking Startup Law

the employee-inventor will allow a company to file for patent protection

with the U.S. Patent and Trademark Office (USPTO) as the owner of the
patent.

For bootstrapped tech startups, there are more cost effective alternatives
that can provide relatively robust intellectual property (IP) protection.
General business strategies include confidentiality agreements,
noncompete agreements, employee handbooks, and company policies.
All employees, board members and advisors should be required to sign
agreements obligating them to assign all business-related IP to the
company, as well as to maintain confidentiality about all trade secrets,
confidential processes, customer lists, and of course traditional IP works.

You will also want to extend IP protection through agreements with non-
employees, including vendors, outsourced designers and engineers, and
testing facilities.

Patents

The patent strategy for a startup is going to be fundamentally different

than it is for an established company. For one thing, an established
company has the resources to evaluate its markets and customers.
Moreover, it has existing distribution channels that startups lack. These
are critical ingredients to assessing whether a new business should invest
the enormous sums of money patent registration - and enforcement -
requires.

Contrary to some conventional wisdom that holds there’s deterrence

value in patent registration, the reality is that large companies can - and
Hacking Startup Law

do - often prevail in this type of litigation. Its value as a sword or shield is,
therefore, debatable.

With all of that said, patents can offer a tech startup many benefits. It can
attract investors and deter competitors.

In order to address the high costs, mounting litigation and general

burdens associated with patent registration, Senators Patrick Leahy and
Lamar Smith introduced a reform bill that was ultimately passed and
signed into law in September 2012. The America Invents Act (AIA) is the
single most important change to U.S. Patent law in 60 years.

The AIA is likely most relevant to high tech startups with potentially
lucrative patents. Significantly, the law changed U.S. patent rights from
first-to-invent to first-to-file for applications filed on or after March 16,
2013. The new law also expanded the definition of “prior art,” which is
immensely useful for first-to-file patent applicants.

This law can be a game-changer for tech startups. Whether a company’s

IP assets are assets that should be protected with patent registration or
with other strategies can best be determined with the assistance of an
experienced IP attorney. Because IP creation and protection is extremely
technical work, demanding the highest degree of precision over a long
period of time (usually, several years), engaging legal counsel is highly
advised.

Software

On average, software patents will cost somewhere around $8,000, which

includes attorneys’ fees and filing fees. I’ve seen them at low $3,000, and
as high as $16,000.
Hacking Startup Law

Intellectual property (IP) lawyers are among the highest paid attorneys.
You can minimize high rate billable hours by doing as much research as
possible on your own to verify the eligibility of your patent, and
assembling all relevant documentation and material to reduce a lawyer’s
billable hours down the road.

Alternatively, you can spend roughly $2000 to file a provisional patent,

which works like a starting date placeholder. Provisional patents are
popular with software companies who are trying to buy time in order to
evaluate the proprietary value of their software innovation before
committing bundles of money and time to a full-scale patent filing.

As for time, software patent registrations are taking, again, on average,

about two and a half to three years. Sometimes it takes less time,
sometimes more - there is no magic number.

The U.S. Patent and Trademark Office (USPTO) offers a dashboard that
unpacks all kinds of patent information (their link is: http://
www.uspto.gov/dashboards/patents/main.dashxml). The gauges are
pretty current and can help you get an idea of their unexamined
application backlog, as well as how long it’s taking them to make final
determinations on those applications.
Hacking Startup Law

Trademarks

Trademarks are also known as service marks. They can be your trade
name (the name under which your company does business), but they also
include logos, symbols, and slogans.

Trademarks represent a company’s brand - its reputation - and therefore

is a valuable asset that can and should be protected. Trademark
protection demands more than registration: it is vital for a company to
proactively assert quality control over its mark.

Quality control is context-specific: it depends on a myriad of factors

including the nature of the services or products that use the mark.
Without exercising quality control, a licensed marked is considered
abandoned property.

A company that strictly enforces usage guidelines will enhance its

ownership of the mark. For example, color, format, font, size, style and
placement are all deemed appropriate quality controls.

Trademarks should be registered on both the federal and state levels.

You can register for federal trademark protection online with the U.S.
Patent and Trademark Office. Many states will also allow you to file for
trademark protection online. For those states that have not yet adopted
online services, you will need to contact the business division of the
Secretary of State’s office and request an application for trademark
registration.

If you think trademarks are insignificant or a bit on the frivolous side,

think Apple, Coca Cola, Delta Air Lines, and Starbucks. This slim list
represents the power of trademark - and brand.
Hacking Startup Law

Copyrights

Copyrights are often overlooked by companies as a valuable business

asset. In addition to books, there is a considerable wide array of other
works that are appropriate for copyright protection. These include:
computer programs, websites, newsletters, databases, directories,
technical and architectural drawings, manuals, technical works, training
films, digital works, movies, and musical recordings.

Ownership of a copyright is automatic: it emerges as soon as the work is

created. Claiming the copyright and marking the work with the copyright
symbol © - even if handwritten - will further establish ownership.

With that said, it is strongly recommended that you register your

copyright with the U.S. Copyright Office. The cost is minimal and
registration will help ensure your rights in the event that the work is
misappropriated.

Like patents and trademarks, copyrights can also be used as collateral for
securing a loan or as an additional asset for purposes of valuation in an
acquisition.

Summary
For bootstrapped tech startups, there are alternative/more cost effective
routes that can provide relatively robust IP protection. Business strategies
that incorporate employee agreements (e.g., noncompete and
nondisclosure agreements), policies, procedures, and regular training will
all help to reduce the misappropriation of a company’s IP. A startup can
also extend the reach of its IP protection through agreements with non-
Hacking Startup Law

employees including vendors, outsourced designers and engineers, and

testing facilities.

Chapter Two Checklist

✓ Register domain name.

✓ Register trade names, brand and product names, service marks, trademarks
and logos.

✓ Use copyright notices where appropriate.

✓ File patents.

✓ Ensure confidentiality - have all of your employees, investors, officers,

directors and vendors sign confidentiality agreements.
Hacking Startup Law

Chapter 3: Raising Money.

Financing a startup - whether bootstrapped or cash-endowed - is always
a challenge for early-stage companies. Sometimes a founder will rely on
their own funds (thus, bootstrapped), but more often founders will
consider future rounds of financing. This is especially true for high tech or
larger companies.

Growing Pains
Founders usually have strong emotions about sharing ownership with
outside investors. On the one hand, they ordinarily require capital; on the
other hand, they are apprehensive about surrendering control.

When a company agrees to accept funding, it will often receive much

needed capital injections that can significantly grow a company’s value
and market share. The tradeoff is dilution. Dilution occurs when equity
(the percentage of a company’s ownership) is exchanged for cash
infusions and the opportunity to become a more prosperous company.

So how much of your company should you give to an investor?

The numerous variables in play for each entity create circumstances as

unique as fingerprints. So, there is no-one-size-fits-all answer. Perhaps it
would be useful to imagine the metaphorical pie, and to think about how
you define “investor.” Placing your investors in different groups will also
help you to determine how to share your growing pie.

Hacking Startup Law

Investor Types
The usual cast of investors consists of family and friends, angel investors,
and venture capitalists (VCs).

▪ Family and friends (F&F) typically do not expect to own a percentage of your
company. Rather, their cash infusion tends to be a simple note: a loan plus
interest to be repaid by a certain date.

▪ Angel investors are high net worth individuals who provide a company with a
loan with the expectation that their loan will convert to equity ownership
(shares) at a later date when a company’s valuation can be determined.

▪ VCs are private investors who offer funding to promising new companies. Since
their investments are characterized as securities, they usually enter the
funding rounds at the Series A stage. They typically demand 50% ownership at
the Series A round, where the company’s first valuation is first ascertained.

The Big Pie Picture

When you start your company, you might own 100 percent of a small
entity with little to no assets (thus, no value). As you grow, you will own a
smaller percentage, but it will be part of a much larger pie. In other
words, 100 percent of nothing does not have much value, but 50 percent
of a $1 million pie starts to look like something. As you continue
enlarging the size of your pie with each new round of funding, your
equity stake will be reduced, but the value of your holdings should be
significantly higher. So, thinking about “value” as opposed to
“percentage” is probably a better way to think about this question.
Hacking Startup Law

Making the Rounds

While each company and its circumstances are unique, there are some
guidelines to consider regarding the usual percentage of shares that get
sliced off in Seed, Series A, and Series B rounds. Certainly, much depends
on the valuation and other variables, which we will for put aside for now.
(Valuation will be discussed in more depth below under convertible debt
notes.)

As you advance to the next funding round, you should realistically expect
further dilution. Founders start with 100 percent ownership. Seed rounds
- the earliest stage of funding, usually from family and angel investors -
typically dilute founders’ ownership by an average of 15%.

By the time you reach the Series A stage, you need to be prepared for
further dilution. Series A investors are usually funders who provide
venture capital for emerging companies. Since their funding typically
exceeds $2 million, their percentage of ownership can be as high as 50%.

If you get to the Series B round, expect a dramatically different mindset

from earlier funders. Whereas Series A and seed investors believe in your
vision and have bought into the prospects of your company, those in
Series B want to see that you’ve successfully progressed and satisfied
important milestones. They typically see about 33 percent ownership,
which will dilute all previous ownership percentages.
Hacking Startup Law

You also need to reserve a percentage for the option pool - usually, about
10 percent to 15 percent. Since a startup’s valuation is usually an
unknown, you need to make sure that you’re protected by the terms in
your note. While a valuation cap is one device, there are other moving
parts.

Recap:
▪ Seed rounds: (founders, F&F, employees and angel investors): expect anywhere
from 10 percent to 25 percent as a normal range, with a median 15 percent
dilution to be realistically expected.

▪ Series A round: 25 to 50 percent dilution is the typical range.

▪ Series B round: an estimated 33 percent is the norm.

Hacking Startup Law

Here’s a chart that could offer you some additional guidance:

Group Pre-Seed Post-Seed Post-Series A Post-Series B

Founders 100% 85% 30% 20%

S e e d 15% 10% 5%
Investors
Series A 50% 31 1/3%
Investors
Series B 31 1/3%
Investors

Option Pool 10% 12 1/3%

Total: 100% 100% 100% 100%

A Special Note About Advisors

Let’s say you start with a co-founder. You might carve the pie 50/50 at
first, but later decide you could use someone with experience to help you
make a larger pie. So you hire an advisor with knowledge, experience
and a network in your industry. The appropriate percentage of equity that
you should offer an advisor will depend on their depth and breadth of
experience. It will also depend on which round of financing your
company finds itself in.

There are no hard and fast rules about assigning advisor equity, but there
are some guidelines that show an average range of 0.2 percent to 1
percent is the customary average.
Hacking Startup Law

Flexible Equity
Founders often assume that the best way to initially divide equity is to do
so equally or in fixed splits. What that means is that a percentage of
ownership is allocated among founders (or founders and employees)
without changing. So whether you divide the pie 50/50, in thirds or
however you allocate percentages, that share will remain the same
(except, of course, that they’ll be proportionately diluted at each funding
round).

Fixed equity is a pretty inflexible model and often leads to conflict and
sometimes even a company’s extinction. That’s why innovative equity
sharing models are becoming increasingly popular. The dynamic-split
model is one variation that enables company owners to be more flexible
in adjusting equity allocation according to the weighted contributions of
each owner.

Since many founders often lean toward equal and fixed splits, we are
going to break down these two model to show you how they work.

Equal Splits

This should be carefully considered since each founder/partner usually

offers a different value to a startup - some provide more cash, others
more experience or broader networks, while still others might contribute
inventory and equipment. Accordingly, each founder’s contribution
should probably be weighted differently to reflect as accurately as
possible the value of their contribution, which will usually result in
unequal percentages.
Hacking Startup Law

Fixed Splits

Next, equity splits tend to be fixed, meaning that the assigned

percentage of ownership remains firm. This, too, should be carefully
evaluated since founders’ contributions are typically more fluid, changing
over time. A founder who initially contributes substantial sweat equity
may later inject significant capital. Because cash is usually awarded a
higher weighted value, it would be more appropriate to adjust that
person’s equity share upwards to reflect their larger contribution.

Hacking Startup Law

Alternatives

In response to the minefield of challenges that fixed equity models have

presented to startups, new equity sharing arrangements have been
developed. The dynamic-split model is one alternative that’s finding
increasing popularity. This system allows founders more flexibility in
assessing equity percentages as contributions shift over time. Since it
allows for a fairer and accurate apportionment of founders’ contributions,
it reduces conflict among founders, which helps to ensure a startup’s
longevity.

The way it works essentially is that relative values are assigned to each
person’s contributions. For example, one founder might have greater
access to financial resources, while another founder has more product
knowledge and the ability to enhance the company’s intellectual
property. Each type of contribution would be given an hourly value to
reflect the premium value of the contribution.

For instance, capital injections might be assigned a factor of four times

the actual value, intellectual property might be equal to or greater than
cash contributions, equipment might be given a value at twice cash value,
and so on.

Vesting Requirements
You will also want to ensure that your advisors, employees and co-
founders do not unfairly benefit in the event of an early exit. Vesting and
cliff periods are critical to preventing this from occurring.

Vesting periods are usually four years, with rights accruing only after one
year. If someone who is assigned an equity share in your company
Hacking Startup Law

departs within the first year and your agreement doesn’t specify a vesting
cliff, they will reap the financial benefits without providing the promised
value to facilitate your company’s growth.

Therefore, all early equity owners should have a minimum vesting period,
requiring them to contribute to the organization’s growth for at least one
year before they can access the value of their ownership percentage. If
they leave before the end of the first year, they forfeit their ownership. If
they continue with the company beyond the initial year, they can start to
accrue a percentage of their ownership (for example, an additional 25
percent each year for four years, with full vesting after the vesting period
has been satisfied).

Protecting Your Equity Stake

It is strongly recommended that you engage an attorney to review all
your funding documents so that you understand what you actually own
and what you are sharing. While each round of investment presents a
new valuation, you’ll need to ensure that there are minimal - if any -
restrictions on your equity, such as vesting periods that give you less than
what you might think you own.

These simple guidelines are offered to you in order to give you some
idea of what the range of possibilities looks like to many startups. It’s not
recommended that you rely on any of these general parameters as a
substitute for sound legal advice. You are going to encounter questions
that are very specific to the unique circumstances of your company, and
therefore require competent legal advice. This includes everything from
vesting cliffs to intellectual property and other issues beyond the horizon.
Hacking Startup Law

Financing Mechanisms
The most important thing for you to do before anything else is to ensure
full disclosure and adequate understanding of any terms and conditions
with the proper documentation. This means having a business plan to
share with your family and friend investors, as well as adequate legal
protection - whether you’re using an investment vehicle or a simple
unsecured loan.

In order to best protect your company and interests, as well as personal

relationships, it’s highly recommended that you obtain legal guidance,
which can save you substantial money and hard feelings down the road.

The necessity to clarify the expectations of your F&F investors prior to

accepting funding cannot be overemphasized. Since F&F investors
usually do not demand sophisticated deal structures, you might be
expected only to repay the loan. Typically, smaller investments from
friends and family are unsecured loans (i.e., there’s no collateral to secure
the loan’s repayment).

On the other hand, some early stage investors might expect higher
returns, so considerable thought should be devoted to developing some
common key elements. Critical terms might include defining the equity
type (e.g., common stock), board seats (e.g., offering seats to leading
angels), price (ownership percentage), mechanisms for minimizing
dilution, and dissolution preference.

A sophisticated investment structure is going to look dramatically

different from a simple loan. Convertible debt notes would generally be
inappropriate for smaller investments. Instead, convertible equity could
Hacking Startup Law

be an appealing alternative to traditional convertible debt notes.

Convertible equity vehicles - such as Ressi instruments, Y Combinator’s
SAFE agreements, or KISS securities - also help simplify these
transactions, reduce legal costs and enhance the opportunity for the
company’s success.

Convertible Debt Notes

A convertible debt instrument is a loan from an early round private

investor (angels or VCs). VCs and angel investors are high net worth
individuals who offer startups private loans with the expectation that at
some point later down the road (e.g., 1-2 years), the debt changes into
equity ownership (stock) in the company.

They were pioneered to allow founders to get a quick loan from private
investors, in exchange for promising to repay those investors with equity
(stock) at a later time when equity could be determined - normally, after a
Series A funding round. In other words, company founders get fairly
quick, inexpensive (low interest) cash, which they repay with ownership
equity at maturity.

First, it’s important to understand that the general purpose of convertible

notes is to reward early investors for taking an extra risk, and to provide
some protection for them when valuation is ascertainable at a later time -
that later time normally being the Series A round.

Your share price at the Series A stage is determined by dividing the

valuation cap by the A valuation. This means that if you invested with a $2
million cap, and A investors set the price at $4 million, paying $1 per
share, you would divide $4 million by $2 million and arrive at $.50 per
Hacking Startup Law

share - effectively giving you twice as many shares as the A investors at

the same price. While a valuation cap can give you some protection by
setting the maximum price that the note will convert into equity, there are
other variables in play.

The discount rate is one factor that should not be overlooked. Like the
valuation cap, it determines how much you’ll receive for taking an early
risk. Average discount rates fall at around 20 percent. What this means for
you in that if your convertible note provides for a 20 percent discount,
and Series A investors land at a price of $1 per share, your equity
translates to $0.80 per share, giving you more shares for the same price.

You need to ensure that your note provides you with the option to use
either the valuation cap or the discount rate. These are fairly standard
terms since the idea is to allow the early investor to obtain the best price
for their early risk.

Typically, when you reach the A round, either the discount rate or the
valuation cap will provide you with a lower share price, which is the one
you want to opt for since it will give you more shares. The general rule of
thumb is to aim for a high valuation cap and low discount rate.

Finally, you need to consider other factors such as the note’s maturity
date and interest rate. Obtaining sound advice from a professional is the
best route to ensure you’re both protected and rewarded for taking on an
early risk.

Convertible Equity: SAFEs, Ressis and KISS

Simply because convertible notes are used by the majority of early-stage

investors does not mean that they actually “prefer” them to equity.
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The reason why convertible instruments have been overwhelmingly used

in lieu of obtaining a straight equity position is principally for two
reasons: (1) they expedite the early-stage funding round by reducing
legal expense and simplifying the overall process, and (2) they kick the
valuation can down the road to later funding rounds when the company’s
valuation can more accurately be determined.

For example, a convertible debt note can be written in just a few pages;
however, drafting a straight equity agreement is more time intensive and
therefore most costly. Drafting an equity agreement requires due
diligence, valuation assessment, SEC compliance, and negotiation.
Consequently, longer and more numerous documents are needed in
order to represent as thoroughly as possible all of the investors’ rights,
obligations, terms and conditions.

Put simply, it’s a more painstaking and expensive process at a time when
early investors don’t want unnecessary delays and companies don’t want
the disruptions; they’re anxious to pull the trigger to get operations
moving with minimal distractions.

However, there’s a hybrid option that’s been available for the past three
years. Convertible equity was unheard of until just a few short years ago.
After Adeo Ressi pioneered the new instrument in 2012, Y Combinator
caught on a year later in 2013, with 500 Startups following suit in 2014.

These descriptions basically sketch only the contours of these more

recent financing mechanisms. The crux is that they offer early investors
the opportunity to convert their loans to equity quickly and inexpensively
in the same way that convertible debt does, but without the maturity date
and interest accumulations - or the threat of near extinction.
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The largest challenge with traditional convertible notes is that if the

maturity date is reached without securing the next round of funding, the
note can be called for repayment. Without financing to repay the loans,
investors holding convertible debt notes can force a company into
bankruptcy.

Convertible equity solves this problem by eliminating interest and

maturity dates, while still providing for automatic equity conversion upon
successfully completing the Series A round of funding. Moreover, some
tax advantages could be available to convertible equity holders since it
appears that they’ll be characterized as qualified small business stock,
resulting in a lower capital gains tax.

SAFE, Ressi’s Convertible Equity and KISS agreements are fundamentally

the same types of instruments with just a few minor differences.

Identifying the need to reduce the potential financial stress that

convertible debt can inflict on startups at maturity, Ressi developed
convertible equity as an alternative financing mechanism that operates
similar to convertible debt notes, with two critical differences: (1) no
interest and (2) no maturity date.

Ressi’s innovation debuted just over three years ago, with Y Combinator’s
SAFE (Simple Agreement for Future Equity) following about one year
later. YC took its inspiration from Ressi and pretty much followed the
Ressi model, with some relatively inconsequential variations - e.g., Ressi
separates the note from the purchase agreement, whereas YC combines
them in a single document.

There are also some minor differences on round limitations, conversion

triggers and preemptive rights, but they both function with the same
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purpose: eliminate maturity dates and interest, sidestep debt, and ease
the process by reducing legal burdens.

Other than that, both instruments provide for equity conversion when
triggered by events such as financing or dissolution. Of course, the
agreement can be terminated if no triggering event occurs.

Although Mr. Ressi predicted in early 2014 that 60 percent of all early
startup financings would use convertible equity structuring by the end of
that year, estimates of mid-2015 placed it more at around 25 percent,
leaving them still relatively untested. Their rising popularity has, however,
hit a nerve for early stage investors, reflecting more long term
commitment.

The ultimate takeaway of Ressis, KISS and SAFEs is essentially that they
aim for long term stabilization by eliminating those features that make
convertible debt risky. Again, both securities remove interest and
maturity provisions characteristic of convertible debt notes in order to
reduce the risk of a run on investor calls that could trigger a domino
effect, ultimately leading to a total collapse.

Finally, each agreement - whether a SAFE, KISS or Ressi - can be

amended to include milestones that are tailored to the unique needs of
the company. The considerations that guide those amendments will
largely be the same as with convertible debt: minimizing legal fees,
adapting to the sophistication of the investors, deciding what is the
appropriate amount of time needed to raise financing, and how much
and what kind of financing is desirable.
Hacking Startup Law

Recent Developments: The Right to Pro-Rata

Participation in Seed and Series A Rounds
Among the most important rights that investors have is pro-rata
participation. This is especially true for investors in tech companies
because they give the investor the right to participate in future financing
rounds and to maintain their ownership percentage.

The Changing Pro-Rata Landscape

Up until several years ago, pro-rata rights were given to larger investors in
later rounds, less so to angel investors. However, it is now becoming
increasingly common to find angel investors demanding pro-rata
participation.

Why?

The reason is a purely economic one: there’s simply a whole lot more
angel investors with a whole lot more cash. The result is that tech startups
have access to far more capital than ever before. What you’re seeing now
is the mushrooming of larger tech startups with pretty beefy
capitalization. Combine that with unprecedented speed in their growth
and that means more companies that are giants by the time of an IPO.
Hacking Startup Law

Let’s look at a simple example:

Angel puts $500k into your company for a 10 percent ownership interest.
If the company raises $20 million on the next round, angel might not be
able to inject the $2 million that would be required to preserve their 10
percent ownership stake.

As you can see, even if this angel were given pro-rata rights, it doesn’t
mean they would be able to execute them, since in this example we’re
assuming that the investor doesn’t have the cash to keep their 10% stake.
You can see how easy it is for an angel to feel like they’re being pushed
out by the more weighty investors in the room.

What is happening now, however, is that there is a fairly abundant

number of extremely high net worth angels who are ready, willing and
able to put significantly higher sums into later financing rounds. Since
they have the means to participate in those later rounds, they want to
maintain their percentage of ownership, and pro-rata rights allow them to
do this.

Cutting the Seedlings

Investors are wealthier and more sophisticated than ever before. They
rely on their due diligence when making the decision to invest, so
signaling does not necessarily carry the weight it once did. Consequently,
the heat is being turned up in these later funding rounds as seed
investors are fighting more for their pro rata rights, while later investors
want to maximize their gains.

Some later stage investors take an all-or-nothing approach by

threatening to pull out of the deal if seed investors don’t surrender their
Hacking Startup Law

pro-rata rights. But this is not true for all later investors. Later stage
investors who are opting to find a more balanced way forward tend to
promote not just better deals, but also a stronger organization.

Ultimately, the later stage investor’s decision is philosophically-based.

The primary take-away here is that later stage investors don’t come in just
one color: there are many shades along a broad spectrum of advanced
investors.

Caveat: Engage in some due diligence as early as possible - and

certainly before a Letter of Intent and Term Sheet - to make sure this is an
investor you will be comfortable with.
Hacking Startup Law

Entrepreneurial Advantage: It’s a ‘Seller’s’ Market

Entrepreneurs have the opportunity to leverage the growing competition

between seed and later stage investors. Since VCs have growing
appetites to own as much stock as possible in a promising tech startup,
they are more willing to allow founders to take money off the table pre-
launch.

While many founders usually hold their shares until IPO or sale, some are
opting instead to cash out early. The reason gets back to the changing
landscape: more investors - seed and VCs - with extraordinary cash
reserves.

If a VC wants to have at least a 20 percent stake in your hot tech startup,

they are going to be willing to secure their position by paying founders
to take an early exit in exchange for a larger portion of the pie - and
potentially far greater gains down the road.

Some founders are incentivized by these lucrative early exit offers. Take
for instance two 30-something year old founders of Secret, a messaging
app, who made $6 million from selling some of their shares in an early
round of financing.

Like with most things, there are tradeoffs and moderation is the operative
word. Ideally, the interests of founders and investors should be aligned. If
a founder’s early liquidity feeds off the intensity of investor competition
and their exit payoff is too high, it could be damaging to both parties’
interests: Founders’ creativity and drive could become flat and VCs won’t
get the value of founder expertise to create a winning product.
Hacking Startup Law

Look for Win-Win Strategies

As a founder, one of the best things you can do is to understand who

your investors are and what drives them. While it’s common to find VCs
who disfavor an angel’s pro-rata rights, there are others who are finding
innovative ways to accommodate everyone’s interests.

For instance, some VCs adopt an approach that’s inclusive of angel and
micro-VCs. This type of strategy incorporates a guarantee of angels’ pro-
rata rights, subject to a clause that gives the majority of their class of
preferred shares the right to waive pro-rata participation in whole or in
part. If the majority votes to waive their rights, then everyone in the round
is required to waive their rights.

An additional clause provides that if the majority does exercise its pro-
rata rights, then they are required to offer the same deal to early investors
proportionate to the majority. For example, if a VC is 80 percent of a
round, but decides that it’s more sensible to take only 40 percent, then all
investors in the round must adjust their percentages proportionately. This
approach assures a more equitable accommodation of the rights of
angels and later stage investors.

Final Thoughts for Frothy Times

Anything can change on a dime, so founders - especially of tech startups

- are well-advised to consider how the competition between angels and
later investors over pro-rata rights can best work to their advantage.

Each company has its own unique set of circumstances. Your angels
might have pro-rata rights, but this doesn’t mean they can enforce them.
For example, if their investment is a relatively small one, even with pro-
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rata rights, they might not be able to participate because they don’t have
the means. If they do have the means, VCs might insist those rights be
surrendered or they (the VC) will walk. Or, the VC might find a way to
appease everybody’s interests.

This is no substitute for legal advice, so enlisting the assistance of an

experienced attorney to help guide you through this process is a solid
investment.

Best Practices
Best practices is something that is going to encompass much more than
just legal documents and financing. The following list offers some general
guidelines that will help you understand the larger picture, and therefore
steer you in the ‘right’ direction. Generally, the right direction is one
where you have more clarity, better focus, and an enhanced vision that
builds a more robust company.

1. Join Forces with Knowledgeable Investors

Founders need to be prepared to tackle complex questions, often

spontaneously. Having an experienced investor by your side can help a
founder respond more effectively to important decisions and inevitable
challenges. While you do not want your investor to necessarily be overly
involved in the minutia of daily operations, having access to a
knowledgeable investor can be a valuable resource for dealing with
strategic issues. Let them know you’d like to use them as a resource
moving forward.
Hacking Startup Law

2. Start with Good Communication

This includes providing your investor with a realistic assessment of all the
pertinent information. You want to build trust and a strong foundation, so
make sure that you are prompt in submitting important data and honest
with both the positives and negatives. Be proactive and diligent in your
communications.

3. Be Compliance Conscious

By not cutting corners and demonstrating a commitment to meeting

minimum compliance standards - possibly even reaching beyond
compliance - you’ll inspire confidence. Inform your investors that you’re
thinking along these lines. You’ll boost your trust quotient and appear
more professional.

4. Be Transparent

Make sure you divulge all strategic information, while not compromising
confidential information. Distinguishing between the two can be tricky
and require some legal guidance.

5. Think: Investor=Resource

Investors will often have a fairly well developed network. They can help
founders create value by introducing you to potential customers or future
investors. Don’t be shy about asking your investor for introductions to
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important stakeholders such as those who could be valuable strategic

partners, advisors, customers - and additional investors. Let them know
you’ll be relying on their expertise and connections.

6. Be Self-Disciplined

Be prudent about your expenditures: founders with a lot of accessible

capital at their fingertips can make some imprudent spending decisions
“in the best interest of business.” Those pricey dinners, memberships
(even professional ones), and marketing costs add up quickly, so look for
value and distinguish between ‘needs’ and ‘wants.’ Be cautious with your
time: time management is more crucial than you realize. You don’t need
to attend every event, accept every lunch invitation, or even look at every
invitation as an opportunity. Again, let your investor know that you’ll be
counting on them as a resource.

7. A Solid Term Sheet

Along with your letter of intent, the term sheet facilitates an

understanding between founders and investors as to what’s expected
regarding debt vs. equity considerations, BOD participation, liquidation
preference, future financing and valuation, and what the parties can
anticipate in the event that the company is acquired prior to a loan’s
maturity. While a term sheet is more than just a handshake, it is still not a
financing commitment. It - along with your negotiation - sets a tone, so
make it a positive one.
Hacking Startup Law

8. The Right Financing Structure

In order to sell equity, you need to know the company’s valuation. Since
figuring out a startup’s value is usually impossible (it’s just starting up, so
it typically doesn’t have any value in the beginning - no assets, revenue or
customers), determining equity would be arbitrary. It would also likely
impair a fairer assessment later, after the company does achieve positive
cash flow. Convertible debt notes were innovated to enable a startup
without a valuation to raise capital quickly and less expensively than
equity, and as a feasible alternative to obtaining an ordinary bank loan.

9. A Sensible Business Structure

Delaware isn’t always the best option for incorporating, whether as a C-

Corp or some other type of business entity. Also, it can be tempting to
incorporate yourself since many states now offer immediate, online
incorporation for less than $100. If you haven’t yet incorporated or are
changing structures, do not DIY this vital aspect of your business. Engage
a knowledgeable attorney to help you decide on where and how to
incorporate. Another important consideration is to avoid being top heavy
with too many co-founders.
Hacking Startup Law

10. Build a Strong Team

Hire key recruits who can offer your company not only product and
process expertise, but a different way of thinking. You aren’t committing
to adopting their views as much as incorporating their ability to push
your team’s thinking in new directions. What I’m aiming at here is
essentially incorporating design thinking into your corporate culture.
Design thinking is a problem-solving technique that’s fundamentally
dissimilar to traditional, linear approaches. Instead, you start with a goal
in mind rather than the notion of solving a particular problem. Traditional
analytical thinking limits creativity and the explosion of ideas that can
result from a nonjudgmental brainstorming session. Design thinking
allows for unlocking a solution or inviting a critical ‘but-for’ tweak that
takes the company or a product in a direction that couldn’t otherwise
occur if your team was constrained by self-imposed restraints. Educate
your investor about your team-building and problem solving approaches.
It can distinguish you from your competition.

Tying Together the Loose Ends

As is often the case, many of these practices do not have neat borders.
You will find that nurturing these practices prior to closing and continuing
to promote them as values after closing will serve you throughout the
company’s lifecycle.
Hacking Startup Law

Chapter Three Checklist:

✓ Establish appropriate vesting schedules upon incorporation.

✓ Ensure proper structure of your Board of Directors.

✓ Evaluate whether you need an advisory board.

✓ File 83(b) Elections with the IRS if needed.

✓ Develop your funding strategy.

✓ Determine your capitalization table.

✓ Decide on appropriate equity incentives.

✓ Determine pre-money valuation.

✓ Decide whether you will issue convertible debt notes or use convertible
equity instruments.
Hacking Startup Law

Chapter 4: Building a
Team.
From the moment you hire your first employee, you are entering an
entirely new area of legal compliance. Employment and labor law
includes a comprehensive set of legal requirements for employers that
includes wage and hour laws, workers’ compensation regulations, anti-
discrimination and harassment compliance, and workplace poster
provisions. These laws exist at both the state and federal levels, and
employers must comply with both sets of standards.

Recordkeeping, reporting, and notice obligations are the most important

tasks for employment law compliance. This chapter will provide you with
an overview of the essential federal requirements. Since compliance with
state law is also required, you will need to contact your state’s labor office
to obtain additional information. Consulting with a knowledgeable
employment attorney is the best route to ensure full compliance with
state and federal law.

The Employment Law Spectrum

The scope of employment law is considerable. It includes wages, safety,
citizenship, family and medical leave, whistle-blowing and many other
areas. It applies to all employees, with additional protections given to
those in certain groups. Protected classifications include race, religion,
disability, age, gender, marital status, national origin, ancestry, pregnancy,
sexual orientation, gender identification and a number of other classes.
Hacking Startup Law

Employment requires legal compliance in areas too numerous to discuss

in this limited space. Some of the more important areas to pay attention
include the following:

▪ Hiring, retention, termination, and references

▪ At-will employees and employee contracts

▪ Independent contractors

▪ Safety

▪ Privacy

▪ Discrimination and harassment

▪ Family and Medical Leave Act (FMLA)

▪ Citizenship

▪ Wage Laws and Compensation (including stock options)

Hiring, Retention, Termination, and References

Each year, thousands of claims are filed with the Equal Employment
Opportunity Commission (EEOC) alleging discrimination in connection
with hiring or firing decisions. The most important thing an employer can
do is to meticulously document each step in the hiring, retention or
termination process.

This means taking detailed notes about relevant matters such as their
professional demeanor, their job-related experience, and the ability to
communicate effectively. These notes can protect you in the event you
are later sued for some alleged discrimination. Developing protocols for
interviewing, retention, and termination that are employment law
compliant will minimize your exposure to unnecessary litigation.
Hacking Startup Law

Occasionally an employer will need to terminate an employee who is not

performing up to expectations or who creates a hostile work
environment. For example, an employee who continually demonstrates
bias against a coworker because of the coworker’s race, gender, religion,
or sexual preference should be terminated.

When references are requested from a terminated employee’s potential

future employer, responses should be provided only in writing to the
specific requests. It is advisable to obtain legal counsel to guide you in
drafting a reply.
Hacking Startup Law

Onboarding
Recruiting top talent is time consuming and costly. When you have finally
identified the candidate who offers the most promise to your business in
terms of skill, experience and overall good fit, the last thing you want to
do is lose them to a competitor.

Onboarding is a vehicle that - when used effectively - can transport your

new employee from a date prospect to a fully committed partner. In a
nutshell, it is basically corporate acculturation. Once upon a time it was
more commonly known as “orientation.”

But it is actually so much more: onboarding can be a company’s secret

weapon when implemented properly.

Employee retention is almost invariably rooted in successful integration.

When you invest time into thoughtfully blending new employees into the
admixture of your company’s culture, you are creating a stronger
corporate alloy.

For startups, onboarding can be perplexing since your culture is still

embryonic. At its core, however, bringing on a new employee is about
walking your talk and basic sensitivity. It means being authentic and
verifying representations you made during the interview process about
who you are and what you are about. If you told your recruit that ‘the
team’ hangs out together for trivia Thursday at the local eatery, then
follow through with an invitation.

When your new employee starts on his/her first day, go beyond setting
up their office space with the basic tools. Think about the extras: a
personal welcome note, an invitation to lunch, a new coffee mug and
Hacking Startup Law

some company swag, company tickets to an event - all these personal

touches reinforce that your recruit made the right decision.

Of course you will need to move beyond that first day with consistent
action. Creating a positive environment requires a regular effort. It can be
as simple as expressing gratitude with a thank you note, company t-shirts
for the employee’s kids, or simply getting a few minutes of face time to
check in and recognize contributions and accomplishments.

Managers should be available almost on demand for the first month or

so. Tools and resources needed for the job should be readily accessible.
Including new employees in meetings - no matter how informal - and
sharing important information with them is crucial to minimizing fractures.
Building a cohesive organization that pulls together in the same direction
not only builds trust and stimulates innovation, but also can serve as an
inoculation when headhunters try to lure away your valuable employees.
Hacking Startup Law

At-Will Employees
The majority of states recognize at-will employment. This means that
either the employer or employee is legally permitted to terminate
employment at any time. Furthermore, an employer is entitled to fire an
employee for any reason that does not violate any laws or regulations.

An employee who has a contract is an exception to the at-will rule. An

employee who has a contract can only be fired for “good cause.”

There are two types of contracts: actual and implied. An actual contract is
a written contract. The contract may specify the reasons for which an
employee can be terminated or it may simply state “only for good cause.”

Occasionally an employer will unintentionally create a contract that is

implied. This typically arises in connection with the following
circumstances:

▪ An employee handbook or manual that includes a statement about employees

becoming permanent after a certain probationary period

▪ A statement made by a supervisor during the hiring or evaluation process that

creates a promise or condition that the employee can be terminated only for
good cause

The meaning of “good cause” is determined by the jurisdiction’s laws and

the specific facts of the case. Generally, it means that employment can be
ended only because of business-related goals or needs.

Some examples of good cause include:

▪ Violating company policies

▪ Revealing confidential information or trade secrets

▪ Criminal activity

▪ Poor job performance

Hacking Startup Law

▪ Dishonesty

▪ Creating a hostile workplace or harassing coworkers

▪ Endangering health or safety

Finally, employers who are bound to a contract are obligated to observe

the duty of good faith and fair dealing. An employer’s breach of this duty
requires extreme behavior such as falsifying a record of poor
performance or terminating employment to avoid financial or legal
obligations such as eligibility for health insurance or stock options.

Offers of Employment
An offer of employment letter can create a contract or simply be a vehicle
for clearly communicating expectations. If you do not wish to enter into a
legally binding contract with a prospective employee, then that needs to
be unequivocally communicated in the offer of employment.

Engaging an employment law attorney can help you avoid inadvertently

creating a contractual relationship, while documenting the terms and
conditions of employment. At a minimum, there should be a clear
statement that the relationship will be deemed at-will, which allows either
the employer or employee to terminate employment for any reason that
is not illegal.

You will also want to avoid using any language that discusses “the future”
or “job security.” Salary should be expressed in weekly or monthly
increments, not in terms of an annual amount.

Specify that the employment is contingent upon compliance with state

and federal laws, as well as company policy. For example, documentation
that proves eligibility to work in the United States is a legal requirement.
Hacking Startup Law

For citizens it is likely completion of an I-9 form; for legal residents, it

would be the appropriate work visa. Additionally, drug screening and
background checks might also be required as a matter of law or
company policy. Executing a nondisclosure agreement would be an
example of policy.

Employment Agreements
An employment agreement is a legally binding contract between the
employer and employee, usually reserved for senior level managers and
executives. It could be in the form of an offer of employment letter, or a
more formal contract document. What is most important to understand is
that as with most contracts, there are advantages and disadvantages.

The advantages of a company using employment agreements include

attracting and retaining top talent for a relatively significant period of
time. On the other hand, if the employee becomes less productive
during the contract and actually winds up costing you money, you could
back yourself into a corner where the only options are to suffer the loss or
risk litigation as a result of termination.

Accordingly, it is vital to ensure that you have a well-crafted employment

agreement with reasonably limited contract terms. Two of the most
critical components are duration and cause for termination.

Duration should be limited to one to two years, or defined by the

completion of a specific project. Of course, circumstances could dictate a
longer term, for instance when hiring a CEO or CFO. No matter what the
term of employment is or how it is defined, responsibilities and
performance goals should be as specific as possible.
Hacking Startup Law

Grounds for termination should also be carefully drafted to allow the

employer adequate latitude to dismiss the employee if that becomes
necessary. Reasons to terminate can include business need (e.g., there is
no longer a need for the position and the costs of maintaining the
employee on contract will be financially detrimental to the business); or, it
can address the employee’s specific failure to satisfy the job requirements
or meet performance objectives. Breach of loyalty, confidentiality and
similar violations should also be grounds for termination.

Benefits should also be specified in detail. These include sick days;

personal days; life, health and disability insurance; stock options, vesting
and golden parachutes; retirement accounts; continuing education; and
any similar job perks.

Nondisclosure provisions should also be incorporated. These should

address all confidential and proprietary information without limitation.
Proprietary information includes intellectual property (patents,
trademarks, copyrights), trade secrets, drawings, billing methods, client
lists and virtually anything related to the core competencies of your
company and its competitive advantages. It is imperative to include a
clear statement that confidentiality and nondisclosure obligations survive
the employment relationship. This limitation serves to protect your
proprietary information and trade secrets even after an employee no
longer works for your company.

Similarly, a clause that limits the employee’s post-termination ability to

recruit employees from your company should also be incorporated. State
law varies on restricting a former worker’s ability to solicit vendors or
employees of a business, so you will want to obtain legal guidance from
an employment lawyer on the language and enforceability of this type of
provision.
Hacking Startup Law

Assignment clauses are crucial to ensure that the ownership of any work
(e.g., intellectual property) that is generated by the employee is assigned
to the business. For example, if the employee procures a trademark or
patent during the employment term, the employee must agree to
promptly assign all rights and ownership to the company.

Alternative dispute resolution should also be required. Arbitration or

binding mediation are particularly effective at reducing cost and
minimizing business disruption.

Since employment agreements do bring some risk to employers, you will

want to engage an employment law attorney to help you minimize
exposure to liability. Rather than viewing this as a cost, think of it as a
value added service that can protect your business from unnecessary
litigation.

Independent Contractors
Employers need to pay particular attention to independent contractors.
This is an especially thorny area that has resulted in confusion for many
employers.

The challenge results from the substantially higher costs associated with
maintaining traditional employees. An employer is required by law to pay
for unemployment, Medicare, and social security taxes for each
employee. On the other hand, independent contractors are not subject
to these payroll taxes, which can become quite costly for employers.

Many employers decide to hire an “independent contractor” to test their

abilities prior to hiring them as an employee. The mischaracterization -
whether intentional or unintentional - often results in some expensive
Hacking Startup Law

consequences including back wages and the application of payroll taxes

with interest and penalties. Criminal sanctions are also a possibility.

Distinguishing between an independent contractor and an employee can

be dicey even for the most well-intentioned employer. The following list
represents just a few guidelines issued by the U.S. Supreme Court that
are considered to be only some of the more weighty factors in
determining employee status:

▪ The degree of control an employer has over the work - the more control an
employer has over how a worker performs work will favor an “employee”
designation

▪ The extent to which the worker can or does provide similar services to other
businesses - working exclusively for one employer will lean in favor of
“employee” status

▪ The permanence of the relationship - established relationships will suggest an

“employee” designation

▪ Investment - the more tools (e.g., phones, computers, software) an employer

provides to a worker will tilt in favor of “employee” status

Navigating through the murky waters of accurate employee classification

can result in a shipwreck. Startups are, therefore, cautioned to work
closely with an attorney to ensure proper classification of a worker as
either an independent contractor or an employee.

Safety
Employers are required to provide a safe work environment - whether in
or outside the office. This requirement obligates employers to ensure that
employees are outfitted with safety equipment where needed, and that
they are well trained about how to properly use the equipment.
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The Occupational Safety and Health Act (OSHA) is the federal agency
charged with overseeing and enforcing workplace safety. Mandatory
standards for specific industries and activities must be observed. The use
of caustic or toxic substances in the workplace will trigger the employer’s
obligation to complete material safety data sheets (MSDS).

Since OSHA is known to make unannounced inspections at all types of

workplaces, it is vital that you know both OSHA and your state’s safety
requirements. Make sure that you create and enforce written safety
policies and that your employees are adequately trained.

Privacy
This area captures a wide range of activities including drug and alcohol
testing, Internet and email monitoring, searches, and security cameras.
Sometimes these actions are warranted by the nature of the business.

For instance, a small pharmaceutical research and development (R&D)

company may be developing a proprietary treatment for a specific
disease that could potentially displace competitors; or a high tech startup
could be creating a unique technology that promises to transform digital
mobility. Both of these types of businesses have proven to be vulnerable
to corporate espionage.

If you are a high tech startup or any other business where R&D or the
development of any new proprietary product or service is sensitive, you
will need to protect your company and its valuable assets. Security
cameras, monitoring, and searches are available options.
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There are also many businesses that do not have the option: they are
required by law to install surveillance equipment, monitor employees,
and possibly even conduct routine testing and searches.

As an employer, you can minimize your exposure to privacy violation

claims by taking a few simple steps: (1) inform potential employees
during the interviewing and hiring process; (2) remind current employees
in handbooks, training materials, and training sessions; and (3) post
privacy policy statements in conspicuous places where employees can
easily read them. Finally, work with a knowledgeable employment
attorney who can help you tailor your practices and policies to protect
your interests without unreasonably intruding on employee privacy.

Discrimination and Harassment

Special attention is required here. Federal anti-discrimination laws apply
to companies with 15 or more employees (20 for age discrimination).
However, state law varies considerably.

Since you are required to comply with both federal and state laws, you
will need to learn state requirements as soon as you have your first
employee. This is because some states’ discrimination and harassment
laws apply to all businesses regardless of size.

Multiple states also provide employees with additional discrimination

protections that are limited or even nonexistent at the federal level. It is
therefore crucial to learn what your state’s discrimination laws are since
state employee protections can often be greater than the federal
safeguards.
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Family and Medical Leave Act (FMLA)

This law entitles “eligible” employees of “covered” employers to take
unpaid leave for legally specified reasons without losing their job or
health insurance coverage.

For startups with fewer than 50 employees: good news - the law does not
apply to you. There are two main exceptions to this rule. If you are
deemed either a successor in interest or joint employer, you may be on
the hook for FMLA compliance. This is not typically the case, but you
should make certain by checking the requirements at both the federal
and state levels.

For companies that have hit the 50 employee mark: federal and state
compliance is mandatory. Unfortunately, this is another area where there
can be a considerable difference between federal and state laws. The
safest route for an employer to take here is to observe whichever one
provides the employee with greater rights.

This can actually be tricky for companies just approaching or surpassing

50 employees. What happens when you are bouncing around that 50
employee mark as companies often do - e.g., when new hires put you
above 50 but then you subsequently drop to 49 and just continue to
hover over that threshold?

The FMLA’s answer is that the law applies if you have had at least 50
employees during 20 or more calendar workweeks in either the current
or preceding year. It is important to note that the workweeks do not need
to be consecutive, so special care is required here.
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Like many other regulations, the FMLA is a skein of rules that requires an
employer’s strict attention. As your company approaches 50 employees,
you will want to obtain legal guidance to ensure your full compliance.

Citizenship
The Immigration Reform and Control Act (IRCA) prohibits employers of
any size from discriminating based on citizenship or immigration status in
connection with hiring, firing, or recruiting. Employers are therefore not
permitted to ask whether an applicant is a citizen prior to offering
employment.

At the same time, IRCA requires employers to verify an employee’s

identity and employment eligibility. Specifically, it requires that an I-9
form (Employment Eligibility Verification) be completed for each
employee. These should be requested only after an individual is hired to
preempt illegal discrimination claims. However, it is completely legal to
advise applicants of these requirements by including a statement on the
employment application that all persons hired will be required by federal
law to verify their employment eligibility.

IRCA also prohibits discrimination on the basis of national origin. This

additional qualification applies to even small employers with as few as
four employees.
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Wage Laws: The Fair Labor Standards Act (FLSA)

The FLSA establishes the legal requirements for minimum wages,
overtime pay, child labor, and recordkeeping. The standards apply to
both full and part-time employees.

Wage Requirements

The Act exempts certain employees from minimum wage and overtime
pay provisions, while it exempts others only from overtime requirements.
For example, professional, executive, and administrative workers are
exempt from both the overtime and minimum wage requirements, while
commissioned employees in service industries are generally exempt only
from overtime pay provisions.

Under the Act, employers must pay non-exempt employees a minimum

wage of $7.25 per hour. However, where state law provides for a
minimum wage above $7.25 per hour, the Act requires the employer to
pay the higher rate.

Employers are permitted to require an employee to work more than 40

hours a week, as long as non-exempt employees are paid one and one-
half times their regular hourly wage for all hours worked beyond 40
hours. Exempt employees are not covered by this standard.

Notice Requirements

FLSA employers are legally required to conspicuously place FLSA posters

where they can be conveniently read by employees. If you employ a
person with a disability, then the Employee Rights for Workers with
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Disabilities/Special Minimum Wage poster is also required to be

displayed in an easily accessible place.

Additional labor and employment posters may be required by both

federal and state law. Again, it is imperative to speak with a qualified
attorney about other postings you may need.
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Recordkeeping Requirements

FLSA employers are required to maintain specific records for each

exempt and nonexempt employee. While there is no required form,
records must contain certain information about the employee, wages,
hours, and other mandatory information including:

▪ The employee’s full name and social security or other identifying number

▪ Full address

▪ Date of birth

▪ Gender and occupation

▪ Time and day of week when employee’s workweek begins

▪ Hours worked each day and total workweek hours

▪ Basis on which wages are paid (hourly rate or weekly salary)

▪ Regular hourly pay rate

▪ Total weekly straight-time earnings

▪ Total weekly overtime earning

▪ All additions to or deductions from the wages

▪ Total wages paid each pay period

▪ Date of payment and pay period covered by the paycheck

To ensure full compliance with federal recordkeeping requirements,

employers need to review the regulations, which can be found at
www.dol.gov. Additionally, state laws and regulations will also need to be
consulted in order to guarantee compliance.

Record retention requirements include maintaining payroll records and

sales and purchase records for a minimum of three years. Wage
Hacking Startup Law

computation records are required to be kept for two years. This includes
wage rate tables, work and time schedules, time cards, and records of
deductions from or additions to wages.
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Reporting Requirements

There are no specific reporting requirements under the FLSA. The only
general obligation is to store the records either at the place of
employment or central records office; and further to make the records
open for inspection by designated government officials who may need
access to the records.

Penalties and Sanctions

The enforcement mechanisms available to the Department of Labor have

some sharp teeth, so meticulous compliance with FLSA standards is
essential. In some instances, officers, managers, supervisors, and
shareholders can be personally liable for FLSA violations. Penalties for
violations include payment of back wages, steep fines, and sometimes
imprisonment.

Using Stock, Stock Options and Restricted Stock Units as

Compensation

Using stock, stock options, or restricted stock units (RSUs) in lieu of or as

a supplement to compensation is a common practice among
bootstrapped startups. However, creating and administering a legally
compliant options or RSU program is expensive. Additionally, minimum
wage laws prohibit an employer from substituting stock and options for
pay where wages fall below the minimum standard.
Hacking Startup Law

Defining Equity, Stock and Shares

There is no financial or legal distinction between stock and shares. Stock
is a catchall term, used generally to refer to owning an unspecified
number of shares in a company.

Shares is more specific, referring to how a company’s stock is divided.

Owning stock in a corporation means you own a specific number of
shares.

Equity is also often used to describe ownership in a company. Equity can

mean stock or shares, although it is increasingly used to refer to stock
options or RSUs as well.

Stock options give you the right to buy a certain number of shares at a
certain price after a certain amount of time. They do not represent
ownership, however, unless your right to buy them has vested. Until then,
there’s no equity.

Equity is also used to refer to ownership outside the corporate business

structure. For instance, you might own equity in your house, which is
generally the difference between its value and what you owe. For non-
corporate businesses (e.g., partnerships), equity is determined by
subtracting liabilities from assets. For instance, if you and your business
partner are 50/50 owners, and your business assets are $300,000 and
your liabilities are $100,000, that leaves $200,000 of business equity, with
each partner’s equity valued at $100,000.

Stock is a type of equity that’s commonly referred to as an equity

investment. When you buy stock as an equity investment, you’re
expecting its value to increase and to derive income from its dividends or
the profit you make from its sale (capital gains).
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Since the terms are nearly synonymous, you might think of equity as the
umbrella term that means an ownership interest whether expressed as
stock or not. Shares are one expression of equity, but not the only kind
since you can own equity in a non-corporate business or investment
property.

Creating an Options Program

If you are planning to offer employees any of these options, you need to
work closely with legal counsel to avoid numerous pitfalls. For instance,
tax consequences could be unintentionally triggered resulting in a costly
impact to the recipient. Additionally, exercise prices for options must be
determined in accordance with the intricacies required by IRS Code
Section 409A. These programs further necessitate third-party valuations
and legally compliant administration.

For all these reasons - and more - stock options and RSUs make the most
economical sense only for more sophisticated startups with a developed
staff. This means having an organization with both managerial and non-
executive positions.

Stock Options vs. RSUs

Stock options essentially give you the right to buy shares at a certain
price (the strike price) after a vesting period - typically, after your one-
year anniversary date. The key here is that you must purchase the options.
The goal is for the stock to appreciate by the time the option can be
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exercised. If the value of the stock has eroded at the time of exercise,
then it becomes worthless.

This does not happen with RSUs, a relatively new financial creature.
Similar to options, there is a vesting period where the employee must
satisfy certain conditions before the stock or its value is transferred
(typically, there’s a period of time and other conditions - e.g., work
performance). Unlike stock options, no purchase is required. Instead, a
certain number of units are allocated - or granted - to the employee, but
there’s no value or funding until after the employee has satisfied the
vesting requirements.

After vesting, RSUs are transferrable if the employee accepts the grant.
Therefore, these instruments always have a value, in contrast to options
that can decline in value by the time of vesting. The value of RSUs is the
closing market value of the stock price on the vesting date. That is also
the point at which tax liability is triggered, requiring the payment of
withholding and income tax on the amount received.

Using Stock, Options and RSUs as Compensation

The most important thing to know here is that stock, options, and RSUs
are not considered compensation when determining minimum wage and
FLSA compliance. As mentioned, the federal minimum wage is $7.25 per
hour and higher in many cities and states.

If you are using stock or options in lieu of or as a supplement to

compensation, there is a considerable risk that you are violating state and
federal minimum wage laws. Since wage and hour litigation is
Hacking Startup Law

skyrocketing, it is crucial that you properly classify and compensate your

employees.

Using stock, options, and RSUs is permissible as long as you are

complying with federal, state, and local minimum wage laws. Obtaining
sound legal guidance will help you avoid the inadvertent violation of
minimum wage requirements that could capsize your business.

Protecting Confidential Information and Trade

Secrets
Protecting your confidential and proprietary information and intellectual
property (IP) is paramount for many startups, particularly in the high tech
field. These valuable assets not only endow a business with competitive
advantages, but also are considered property that can used as collateral
for securing financing.

Noncompetes, nondisclosures, and confidentiality agreements are some

of the most common tools employers use to protect their IP and
proprietary information. However, some of these restrictive covenants
have fallen out of legal favor in recent years.

For instance, noncompetes are increasingly invalidated by courts, usually

on the grounds that their geographic scope and length of time are
unreasonable. In some states - for example, California - noncompetes are
legally invalid. Moreover, including a noncompete provision in a contract
or other agreement could expose an employer to tort liability. Because of
their general unenforceability, many employers are using alternative
vehicles to address concerns about protecting confidential information.
Hacking Startup Law

Nondisclosure and confidentiality agreements can provide robust legally

protection of a company’s trade secrets and IP. These contracts are
actually the same type of agreement with different names. Other names
that are used include Secrecy Agreement and Proprietary Information
Agreement (PIA).

The most important feature of a reliable nondisclosure agreement (NDA)

is describing what information is confidential. This can encompass patent
applications and trademark registrations (both filed and not filed),
financial information, directories, methodologies, vendor and customer
lists, and business strategies.

NDA provisions must be narrowly tailored to serve the legitimate

interests of a business. Overreaching can result in the agreement being
invalidated, so skilled drafting is absolutely essential to ensuring a legally
enforceable contract. State law varies widely on the mechanics and
validity of NDAs. Using qualified legal counsel to help you draft your NDA
is strongly advised.
Hacking Startup Law

Chapter 4 Checklist:
✓ Complete employment eligibility verification (e.g., I-9 form, visa verification)
within three days of start date.

✓ Complete payroll state and federal forms.

✓ Ensure that nondisclosure, confidentiality and assignment contracts are

executed.

✓ Have employee sign a receipt that they received, read and understood the
employment handbook.

✓ Establish email and activate voicemail accounts.

✓ Prepare employee’s office space and make sure all applications have been
properly installed.

✓ Inform all staff of employee’s arrival and provide introductions.

✓ Issue business cards, parking permits, badges/ID cards, security and access
codes.

✓ Complete insurance and retirement account documents.

✓ Post all required employment notices in conspicuous locations.

✓ Draft policies and procedures.

✓ Train all employees in anti-discrimination, anti-harassment and all workplace

policies and procedures.

✓ Install recordkeeping system.

Hacking Startup Law

✓ Create and monitor reporting requirements tracking system.

✓ Implement regular training schedules for technology, policies and procedures,

and safety.
Hacking Startup Law

Chapter 5: How a Strong Board of

Directors and Advisors Can Help
You Grow.
Corporate governance is not typically the first thing entrepreneurs think
about when they are starting a new business. The words alone sound
heavy and nebulous. Even after understanding that the term means how
a company is directed and controlled by its practices and procedures, it
can still sound like nothing more than a lot of unnecessary window
dressing to a new startup that has more important things to do.

Startup founders often find themselves needing to attend to the nuts and
bolts of building a new company. It is easy, therefore, to brush off the
need for creating a board of directors, which can seem too formal and a
bit extravagant for a small startup.

But when founders are too busy trying to cut their way through the trees,
they can often miss sight of the forest. An effective board of directors
offers startups the ability to view the larger picture. Tapping into the
knowledge, skills, and experience of others can result in huge gains for a
new company.

What Does a Board Do?

There are basically two types of boards: (1) Board of Directors (BOD), and
(2) Advisory Board. The essential difference between the two types of
Hacking Startup Law

boards is that management is obligated to execute a BOD’s directives,

while an advisory board offers general guidance.

Specifically, a BOD is generally responsible for directing a company’s

general strategy and policies. Directors have explicit legal and financial
duties and are charged with holding officers accountable for the proper
management of a business by providing corporate governance, setting
goals, and measuring performance. An advisory board consists of
individuals who provide business advice and guidance. They offer
management valuable feedback and support as mentors or informal
consultants.
Hacking Startup Law

Why You Need a Board

Sometimes a BOD is established because investors make it a
requirement of funding. But why create a board if it is optional?

One very practical reason is that if you plan on seeking financing through
multiple funding rounds, then having a BOD can attract quality investors.
An effective BOD will have members with specialized expertise that will
keep steering you in the right direction, enhancing the company’s overall
profitability. If a public offering or the acquisition of your business is part
of your exit strategy, then a functional BOD can help you get there faster
with their expertise.

An effective board - whether a BOD or advisory - essentially eliminates

the need to reinvent the wheel. With the right people, a board can
provide a new company with important guidance from which a new
company can benefit. An ideal board will have members with experience
relevant to the company’s business. In addition to steering a business
away from avoidable mistakes, board members can also help make an
emerging business more efficient and profitable by providing a new
company with access to expanded professional networks connecting to
potential customers, suppliers, and investors.

Effective board members have two key characteristics: (1) they have a
genuine interest in your company, and (2) they have valuable knowledge
and experience. Simply put, they are committed to seeing your company
succeed and are willing to use their resources to promote its prosperity.
Hacking Startup Law

Who Should Be a Board Member?

The first step in creating a board is to carefully select criteria that will best
serve your company’s needs. The expectations and requirements of a
board member will vary depending on the type of business; however, all
boards require assembling a board with individuals who are willing to
commit their time and energy to developing your business.

Hacking Startup Law

The core criteria for considering a board member consists of the

following:
▪ Balance: In addition to founders and investors, a well-anchored board
ordinarily has independent directors who can protect shareholder interests
without a conflict of interest.

▪ Experience: Ideal directors should have both a fundamental understanding of

business and a skillset that complements management.

▪ Diversity: Directors should have diverse skills, expertise, and demographics.

What Size is Best?

A small startup should have a minimum of three members. Too few can
be as ineffective as too many. Most small companies that create a BOD
begin with three or five members. The goal here it to keep the number
uneven to avoid tie votes.

How Does a Board Work?

Assembling a robust board can offer a new company some significant
advantages. Creating the foundation for a functional board is the first
step.

The early days of a young board are usually devoted to drafting

corporate bylaws. These are the policies and procedures that govern a
company’s daily activities. It defines the responsibilities of managers, how
the business will operate, what the voting requirements are, when and
where shareholder meetings are held, and an array of other rules that
generally address the obligations of officers, directors, and shareholders.
Hacking Startup Law

As part of their responsibility for charting strategy, a board will develop

the company’s value proposition and market opportunities. As a
company grows, there will be a need to create committees. These
typically include compliance and governance, finance and audit, and
compensation.

A functional board will schedule regular meetings usually every other

month. Most board meetings run from three to four hours. Within a week
prior to the meeting, members should receive a board package. This
includes a detailed agenda in addition to documents relevant to the
agenda. Actions are recorded by the corporate Secretary and inserted
into the board minutes.

How Are Board Members Compensated?

With cash in short supply, bootstrapped startups are usually not in the
position to offer cash compensation to directors. (Expenses, however, are
normally reimbursed.) Instead, a young company often offers directors
equity in lieu of compensation.

The customary range is between 0.5 to two percent of outstanding shares

vested over a period of between two to four years. Lead directors can
receive as much as 10 percent more than other members. Founders and
investors who sit on the board should not be compensated with limited
exceptions.

If a company reaches the Series B round of financing, directors should be

compensated with cash retainers and offered new equity incentives.
Hacking Startup Law

Advisors
In contrast to a director, who owes fiduciary duties to the company, an
advisor does not vote on corporate matters and is typically engaged by a
founder for their domain expertise. However, evaluating an advisor’s style
is just as important as gauging expertise.

An advisor is like a coach: some styles are tough and confrontational

while others are more easy-going and encouraging. These stylistic
differences fall along a wide spectrum of approaches. Selecting an
advisor who can compensate for your deficits is one criteria that can be
helpful when choosing a compatible advisor.

After you have determined what skills and approaches you are seeking
from an advisor, you will need to identify candidates and start the
interviewing process. Make it a point during the interview to present
them with an actual or hypothetical dilemma relevant to your business.
Ask them about their experience in helping other founders with the same
or similar concerns. Listen carefully to how they describe their
experience; if they focus more on how they helped a founder resolve a
challenge rather than on themselves, that is a good indicator that they
will have your back.

Finally, be vigilant about candidates who are too keen to give you
answers. Advisors should guide a founder, not replace them. You know
what is best for your company and a reliable advisor knows this as well.
Accordingly, a good advisor will listen more than speak, ask many
questions, and help you define your challenges so you can focus on
finding the solution that is right for your business.
Hacking Startup Law

Test Drive First

When you have identified a promising candidate, ask for several names
of other individuals they have advised. Make sure to follow-up with these
references to learn more about the candidate’s style and
accomplishments. If the responses are positive, ask your potential advisor
to help you with a current challenge. If the experience proves valuable,
then you are ready to begin a more formal engagement and discuss
compensation.

Compensating Advisors
There are several schools of thought on advisor compensation. Some
entrepreneurs firmly believe that it is best to begin by asking an advisor
to invest in your company. Since most advisors are not inclined to agree
to this arrangement, the more common alternative is to offer advisory
shares.

Advisory shares are not a legal animal. When you hear the term “advisory
shares,” it typically refers to common stock options that are issued to a
startup’s advisors.

Startups usually offer an advisor who has been with the company from
the beginning anywhere from 0.2 percent to two percent depending on
several variables, notably the magnitude of their value and which round
of funding you are in. Vesting is usually monthly from one to two years.

Advisory share options normally do not contain a cliff, so vesting begins

immediately. For this reason, and further, to ensure that your advisor
Hacking Startup Law

delivers the promised value to your company, founders need to be

cautious about compensating advisors with equity.

When assessing how much equity to allocate to an advisor there are a

couple of key considerations. First, evaluate the advisor’s experience. It
can be helpful to consider whether they have first, second or third tier
experience. Think about it this way: a first tier advisor has an established
track record of successfully launching startups; a second tier advisor has
a decent amount of experience in the advisory role, but they’re still
building their portfolio; a third tier advisor is one who is fairly new to your
industry or the role.

Next, think about which stage you’re in: Pre-launch, Seed, Series A or
Series B. When you are considering your advisor’s equity allocation, the
length of time combined with results should yield a higher percentage.
On the other hand, an advisor who enters in a later funding round
perhaps provided advice on a more sophisticated level that significantly
moved the company forward. Their value should be rewarded with stock
options toward the higher end of the advisor compensation spectrum.

There is no one-size-fits-all formula. Since each company is different, you

will need to weigh the circumstances and results that are unique to your
situation. Engaging a knowledgeable business attorney to guide you
through these decisions can save you costly mistakes and maximize the
value of these transactions.
Hacking Startup Law

Chapter Five Checklist

✓ Draft bylaws.

✓ Set term limits for directors.

✓ Establish performance standards and removal criteria for directors.

✓ Create clear policies regarding director conflicts of interest.

✓ Develop and implement training programs for board members.

✓ Ensure that your board’s composition and organization complies with your
bylaws.

✓ Schedule regular meetings.

✓ Schedule annual meetings.

✓ Prepare and distribute meeting agendas at least one week prior to meetings.

✓ Record minutes.

✓ Create compensation package.

✓ Establish committees as needed (e.g., financial, audit, compliance,

nominating).

✓ Require directors to serve on at least one committee.

✓ Incorporate meeting procedures (e.g., Democratic Rules of Order, Martha’s

Rules of Order).

✓ Require board to develop a plan for raising and managing funds.

✓ Advise board of its legal obligations.

✓ Purchase D&O Insurance.

Hacking Startup Law

Chapter 6: Citizenship
and Residency.
According to the Small Business Administration (SBA), immigrants have
higher rates of business formation and ownership than U.S.-born citizens.
Moreover, these businesses tend to launch with greater startup capital as
compared to non-immigrant businesses.

Specifically, the Kauffman Foundation, a leading startup and

entrepreneurship research organization, has found that immigrants are
more than twice as likely to start a new business than native-born
Americans. As the number of foreign-born entrepreneurs continues its
steady climb, it is unsurprising that recent immigration reform in the U.S.
has been compelled to address this crucial issue.

With approximately 25 percent of technology and engineering startups

founded by at least one immigrant founder, and nearly 45 percent of
Silicon Valley startups launched with at least one immigrant founder,
foreign-born entrepreneurs are a crucial asset to U.S. economic vitality.
Despite efforts to streamline the visa process for foreign entrepreneurs,
the path to obtaining a U.S. visa to start or participate in a business
remains a labyrinth of arcane rules.

This section is designed to provide quick access to the various visa

options that are available to foreign entrepreneurs seeking to establish or
join a business inside the U.S. It is not exhaustive, so discussing
alternative options with a qualified immigration attorney is always
recommended. It will, however, outline some of the more common routes
Hacking Startup Law

foreign entrepreneurs pursue when seeking a U.S. visa to start or

participate in a domestic business.

Non-immigrant Visas
B-1 Business Visitor

This short-term visa is valid for only three to six months, and may be
extended only once for an additional six months. It is not a work visa. It is
intended for individuals who are visiting the U.S. to attend business
meetings, network, obtain funding, secure office space, and negotiate
contracts or other business.

E-2 Treaty Investor

This non-immigrant visa allows a non-U.S. citizen who controls a

substantial investment to work inside the country. The U.S. Citizenship
and Immigration Services (USCIS) requires an E-2 visa applicant to submit
extensive documentation to prove their investment.

To be eligible for an E-2 Investor visa, the applicant must be from a treaty
investor country that has reciprocity with the U.S. A minimum investment
of $100,000 is initially required. Startups are required to demonstrate an
investment that will support starting and operating the business, so the
USCIS uses a sliding scale appropriate to the business and its needs to
determine the sufficiency of capitalization.

An E-2 visa is usually renewed every two years and there is no limit on the
number of times it can be renewed, and there are no restrictions on
leaving or re-entering the country.
Hacking Startup Law

L-1 Intracompany Transferee Visa

This non-immigrant visa is generally available to executives and

managers of a company with offices in the applicant’s country and in the
U.S. It requires the employee to have worked in the foreign office for at
least one year within three years prior to application. The L-1 visa is also
used to open a new U.S. office. A related, but different, visa is the L-1B
which is designed to accommodate individuals who are not managers or
executives, but who have specialized knowledge.

H-1B Specialty Occupation Visa

Also a non-immigrant visa, the H-1B is generally available to a company’s

employees. The USCIS requires compliance with a lengthy list of
qualifications including USCIS-issues labor certifications. The number of
these visas is also limited.

Essentially, this visa allows U.S. employers to temporarily hire foreign

workers in specialty occupations. A "specialty occupation" is defined as
one that requires theoretical and practical application of highly
specialized knowledge in a field such as biotechnology, chemistry,
architecture, engineering, mathematics, physical sciences, social
sciences, medicine and health, education, law, accounting, business
specialties, theology, and the arts. It further requires a minimum
educational level of a bachelor's degree or its equivalent. Similarly, if a
license is required to practice in the worker’s particular field (e.g.,
professional engineer) then the worker must also obtain the required
state license.
Hacking Startup Law

An H-1B work-authorization is limited to employment with the sponsoring

employer. If an H-1B foreign worker is dismissed or quits their position
with the sponsoring employer, the employee is required to apply for
alternative non-immigrant status, secure employment with another
employer, or leave the U.S. If the worker finds employment with a
different employer, then the new application must be granted and their
visa status modified to reflect the reclassification.

O-1 Extraordinary Ability and Achievement Visa

This non-immigrant option is available to individuals with exceptional

abilities in the sciences, arts, education, business, or athletics. The chief
classifications are:

▪ O-1A: Individuals with extraordinary ability in the sciences, education,

business, or athletics (excluding the arts, motion pictures or television
industry)

▪ O-1B: Individuals with an extraordinary ability in the arts or extraordinary

achievement in motion picture or television industry

▪ O-2: Individuals who will accompany an O-1 artist or athlete to assist in a

specific event or performance

▪ O-3: Individuals who are the spouse or children of O-1’s and O-2’s

J-1 Exchange Visitor

This non-immigrant visa is widely used by students and professors who

are accepted to participate in approved study and work-based visitor
programs.
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F-1 / Optional Practical Training (OPT)

An F-1 student is eligible for a work authorization after completing their

first full academic year. An F-1 student who qualifies for a science,
technology, engineering, or mathematics (STEM) degree is eligible for a
17-month extension after completing graduate studies.

A student in their first academic year might be able to start a company if

it is not located off-campus. Once the first academic is completed, the
student may be eligible to both start and work at an off-campus company
subject to specific restrictions and conditions.

There are three different types of off-campus employment F-1

students are eligible for:
1. Curricular Practical Training (CPT)

2. Optional Practical Training (OPT) (pre- or post-completion)

3. Science, Technology, Engineering and Mathematics (STEM) Optional Practical

Training Extension (OPT)

Any off-campus employment after the first academic year must be related
to the area of study and be authorized by the designated school official
and by the U.S. Citizenship and Immigration Services (USCIS) prior to
starting any work.

In the most general of terms, F1 students are prohibited from ‘engaging

in business.’ At the same time, students on F1 visa are not expressly
forbidden from ‘establishing’ their own business since they are allowed to
engage in ‘preliminary business planning.’
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Immigrant Visas
EB-1 Extraordinary Ability Visa

An EB-1 visa is used to obtain employment-based permanent residency.

It is generally intended for “priority workers” who are identified as foreign
workers with “extraordinary abilities.” This classification usually consists of
senior executives and managers who are transferred to the U.S. and
those who qualify as “outstanding professors or researchers.”

EB-2 Advanced Degree Professional and Exceptional Ability

Immigrant Visas

These visas generally require proof of a job offer from an employer and a
DOL labor certification. EB-2 visas occasionally are granted to individuals
who are seeking to waive the DOL labor certification. Specifically,
subsection (C) does not require an applicant to have an employer. An
advanced degree (masters and higher) or an exceptional ability in your
field are required in addition to showing that the defined exceptional
ability is in the national interest of the U.S.
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EB-5 Immigrant Investor Visa

This visa requires at least a $1 million dollar investment ($950,000 dollars

if the business or investment is located in a rural area). This program
allows entrepreneurs, their spouses, and unmarried children under the
age of 21 to apply for a green card (i.e., permanent residence) if they
meet the following requirements:

▪ Make the necessary investment in a commercial enterprise within the U.S.; and

▪ Plan to create or preserve ten permanent full-time jobs for qualified U.S.
workers.

Employer Compliance
In addition to obtaining visas from the USCIS, the Department of Labor
(DOL) has very specific requirements that employers must comply with
when hiring foreign workers. The following two sections are the most
relevant to U.S. startups, particularly those in the high tech industry.

1. Immigration and Nationality Act (INA): Foreign Workers

Immigrating to the U.S. for Permanent Employment

The applicable provision - Section 212(a)(5)(A) - of INA applies to

employers who will be hiring foreign workers immigrating to the U.S. for
permanent employment.

The first requirement an employer must satisfy is to obtain a permanent

labor certification from the Department of Labor. This document certifies
to the U.S. Citizenship and Immigration Services (USCIS) two things: (1)
that no U.S. workers are able, willing, available, or qualified to accept the
Hacking Startup Law

job, and (2) that the alien’s employment will not adversely impact the
wages or working conditions of similarly situated resident workers.

There is a fairly elaborate set of prerequisites that must be satisfied prior

to applying for the certification. These include providing proof of
adequate recruitment to locate U.S. workers, as well as a prevailing wage
determination.

Because this process involves a labyrinth of complicated rules and

regulations, it is advisable to seek an immigration attorney who will help
guide you through the required steps.
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Notice Requirements

There are no poster requirements. There are, however, certain

requirements that notice be provided to bargaining representatives or
employees at the place of employment if there is no bargaining
representative.

Recordkeeping Requirements

All relevant documents must be retained for five years from the date of
filing the Application for Permanent Employment Certification.

Reporting Requirements

None.

Penalties and Sanctions

Potential fraud or misrepresentation discovered prior to a final

determination on the issuance of a labor certification will result in a
referral to the Department of Homeland Security (DHS). Additional
penalties can include being barred from filing future applications for up
to three years, invalidating an issued certification, and referrals to other
relevant governmental entities for further investigation.

2. Immigration and Nationality Act (INA): Temporary

Nonagricultural Workers
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Employers seeking to hire temporary nonagricultural workers for

temporary jobs in the U.S. in the absence of qualified resident workers
are subject to H-2B regulations. Eligibility is determined after consultation
between DHS, DOL, and all other relevant government agencies. The
number of visas issued under the H-2B program during any fiscal year is
capped at 66,000 and generally cannot be issued for longer than a nine-
month period.

The procedure for obtaining an H-2B visa is similar to that for immigrating
workers: employers must obtain a labor certification from DOL
representing that there are U.S. workers available to perform the work
and the employment will not have a detrimental impact on the wages or
working conditions of similarly situated employees.

The process for securing an H-2B visa involves an intricate maze of legal
rules and regulations demanding scrupulous attention to each step. If
you are considering hiring a foreign worker temporarily, then the best
route is to seek legal guidance from an immigration attorney.

Notice Requirements

Posters advising H-2B workers of their rights and protections must be

placed in an obvious location

Final Thoughts
Whether you are an employer seeking to engage a foreign worker, or a
non-U.S. citizen whose objective is to work or start a business in the U.S.,
this list of options can give you a better understanding of some of the
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available paths to living and working inside the country. Engaging a

qualified U.S. immigration attorney will help you navigate through the
rules and process and can ensure a successful experience.
Hacking Startup Law

Chapter Six Checklist

✓ Create and implement immigrant/nonresident compliance policies, including
procedures or identifying and managing non-U.S. citizen workers.

✓ Determine which visas foreign employees qualify for.

✓ Incorporate hiring practices that review and monitor hiring decisions in timely
consideration of H-1B caps, the limitation of H-1B alternatives, and OPT
expirations.

✓ Develop and maintain LCA audit procedures and files.

✓ Confirm employment eligibility with E-Verify, a voluntary program provided by

USCIS to employers that electronically verifies employment status for new
hires.

✓ Prepare for L-1A site visits by creating procedures for staff - e.g., confirming
the identity of regulators and designating select managers to respond to L-1
site visits.

✓ Prepare for H-1B site visits by ensuring compliance is current and designating
specific managers for H-1B regulator visits.

✓ Ensure that you have copies of all required documents and supporting
instruments, and that they are up to date.
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Chapter 7: The Exit.

Every startup needs an exit strategy. There are investor-oriented exit
strategies, such as acquisitions and public offerings; and there are
dissolutions, such as where a company simply concludes its business or
where a founder cashes out their equity to a new shareholder or to the
company.

If you expect to have investors, they will require an investor-oriented exit

strategy since their infusion of capital is all about the return on their
investment.

When investors put a certain amount of money into your company, they
want to be reasonably certain that they can pull even more money out at
the exit - whether it is a public offering (IPO) or acquisition. Accordingly,
addressing exit strategy is a key element of your pitch to investors. They
will want to hear data and exit strategies about comparable companies in
comparable markets to assess the viability of your plan.

Specifically, investors want to know that you are aiming for a particular
multiple of revenues. There are many resources that can help you figure
out a realistic range of multiple for your business model. Many of these
resources specialize in business valuation and offer their reports and
services within narrow industries.

Typically what you are looking for here is a certain number multiplied by
revenues. So, for example, if you are an engineering firm, you are likely
looking at an acquisition rather than an IPO where the average multiple is
5X revenues. That means if your company is earning $10 million in
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revenues annually, then a reasonable sale price would fall around $50
million based on the sale of similarly situated engineering firms. This tells
investors that when you reach acquisition, they can receive a return on
their investment of five times that they invested.

The upshot is simple: if you want investors, you need to provide them
with a compelling exit strategy. No exit strategy means no return for an
investor. And while there are many financially stable companies that are
still in growth mode, that alone does not mean that an acquisition or IPO
is part of the plan. In fact, for some of these companies, their business
model deters either exit option.

If, however, you are seeking an exit, there are certain steps you will need
to get acquainted with to ensure that your company is properly prepared
when the time arrives. While it is always advisable to adhere to best
practices, it is an absolute necessity when considering an exit or
dissolution. So let’s talk about what each option requires and how you
can position your company to optimize returns for both investors and
founders.

Mergers and Acquisitions

A merger is technically a combination of two companies that extinguishes
both entities resulting in a new company. An acquisition occurs when one
company purchases another entity. Sometimes the acquired entity is
blended into the acquiring company, while other times it becomes a
subsidiary or affiliate.

When a startup is acquired by a larger company, investors should receive

a return on their investment - meaning that the company was acquired at
a profit to founders and investors. Cash or stock, or both, is used for
compensation.
Hacking Startup Law

Investors typically receive capital at the conclusion of an acquisition. Key

founders, managers, and employees, on the other hand, usually receive
stock and are required to continue their employment with the buyer for a
certain period of time. This allows the purchaser to obtain from pivotal
employees of the target company the benefit of critical operational
know-how and other valuable expertise. It also provides time for the
sellers’ stock to vest, thereby aligning the interests of the new and old
companies.

Walking Toward Acquisition

When is the right time to consider selling your company and what steps
do you take to move in that direction? This section highlights the
prominent stages and mechanics of positioning your company for
acquisition.

Timing

The best time to sell your company is when you are financially and
organizationally strong. A business that is stagnant or struggling is not
going to be a very attractive target to a buyer, so the time to think about
selling is when business is growing and finances are healthy.

For some businesses, this kind of thinking can be challenging. After all,
why would you want to lose both control of your company as well as the
opportunity to earn even higher profits? The answer comes down to
asking yourself what you want.

For some entrepreneurs, building a company is all about enhancing job

stability, increasing predictability, and possessing control. These business
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models are often created on the foundation of a revenue and tax

structure designed to maximize owner income; preparing the company
for acquisition is not the goal. These are typically LLCs who sometimes
resist lucrative offers from courting buyers; they simply do not want to
surrender control of their company or reduce their salary in exchange for
a potentially more profitable opportunity.

For other companies - whether LLCs or C-Corps - acquisition is the goal.

In contrast, they seek to incorporate best practices, elevate compliance to
a top priority, and create a business model that is inviting to investors and
future purchasers.

Valuation

Acquisition is a time-intensive, highly distracting process. When you are

certain that you want to sell your business, you will need to understand
value. A company’s value is often determined by its financial or strategic
value, and sometimes both.

For most startups, particularly in a high tech industry, an entity’s value is

more strategic. The buyer’s interest is typically based on filling a
complementary need, or it is a preemptive move designed to prevent
your acquisition from the purchaser’s competition. However, even when a
buyer’s motive is more strategically based, they will still want to see
positive cash flow and sound operations.

Determining Genuine Offers

When a buyer is genuinely interested in purchasing your company, they

are usually organized and persistent. Typically, you will see a term sheet
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demanding a relatively short deadline for response (not more than

several business days).

The two chief issues to address are retention and valuation. If you know
that your company has an estimated value of $20 million, a $15 million
offer will immediately tell you that you need go no further.

Next Steps

If you receive a realistic offer, you will need to fully share crucial financial
and information with your potential buyer. This requires having them
execute a nondisclosure agreement to prevent information vital to your
company and business model from being indiscriminately shared.

Once you have protected your confidential information, you are ready to
negotiate term sheets. Engaging an experienced business attorney will
greatly enhance your ability to fortify your business and legal interests.
Resist any efforts to pressure your company to capitulate to pressure.
Your goal is to maintain your leverage and assert your bargaining power
whenever needed to achieve the best possible outcome.

Since term sheets invariably contain contingency clauses, acquisition is

not finalized unless and until all of the terms and conditions have been
satisfied. The central term of whether a deal closes typically pivots on the
completion of the due diligence investigation.

Due Diligence

Conducting adequate due diligence is imperative to the future success -

and longevity - of an acquiring company. Therefore, potential buyers
Hacking Startup Law

need to take their time to be as thorough as possible in ensuring a

sweeping and competent investigation.

Numerous books of extreme length have been written about how to

conduct a proper due diligence inspection. To minimize risk exposure, a
comprehensive examination is required. Here, again, it is strongly
recommended to enlist the aid of qualified legal counsel. Here are some
of the more prominent considerations to acquaint you with the process.

Purpose

The central purpose of an acquisition due diligence examination is

valuation and risk assessment. The three primary areas that are assessed
for risk and valuation are legal, financial and operational.

Risks of Inadequate Due Diligence

Acquiring companies often find out too late that their investigation left a
lot of rocks unturned. The results of a weak investigation generally fall
into the following categories: (1) unanticipated costly integration, and (2)
inheriting considerable legal liabilities that were not uncovered. The
result is paying too much for the target, which does not quite have the
value initially believed to have possessed.

Components of Adequate Due Diligence

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The two primary components of a sound due diligence investigation are:

(1) document review and (2) field work.

The buyer will want to ensure that it has retrieved all the documents it
needs in order to accurately assess your value. Boxes of seemingly
endless files will be requested, causing disruption to your business. This,
however, is necessary to enable a sufficient assessment of the real value
and risk exposure of your business. If you have been diligent with your
legal compliance and well organized, then accessing the records should
be easy, minimizing disruption.

Field Work

Be prepared for an investigation of the backgrounds of key founders,

executives, and employees. A thorough examination often begins with
probing the backgrounds and reputations of key management, as well as
the acquirer’s general reputation in the industry with vendors, creditors
and customers, and among staff.

Document Review and Analysis

This entails your buyer making certain that it has all the documents it
needs for a thorough assessment of risk and valuation; and further, that
the files are scrutinized for errors, omissions, and any other impairments.
A meticulous examination of the records should also generate many
questions that they will follow up on both in writing and as part of the
interviewing process.
Hacking Startup Law

Key Constituents of a Strong Due Diligence Team

A robust list of questions is an integral part of an investigation, as is

requesting a comprehensive list of documents. Your buyer’s legal team
will be prepared with a substantial list of items and questions that
includes detailed sub-examinations of the following individuals:

▪ Business and industry professionals

▪ Marketing professionals

▪ Human resources

▪ Finance & accounting

▪ Compliance/Risk Management/Insurance

▪ Tax professionals

▪ Legal

The following graph from the Harvard Business Review is an excellent

depiction of how to incorporate best practices into your due diligence
process:
Hacking Startup Law

Sample List

The following is a sample of the types of documents you will be asked for
in connection with a due diligence investigation:

▪ Organizational records (e.g., incorporation documents, structural/governance

documents, jurisdictional qualifications/standing & status)

▪ Financial (e.g., liens/encumbrances, loans, notes, investments/holdings, real

estate records such as deeds, leases, zoning variances/compliance, etc.
Hacking Startup Law

▪ Regulatory compliance records (everything including anti-money laundering,

foreign account tax compliance, privacy, supply chain, labor, OSHA, SEC, anti-
corruption and bribery-notably the FCPA (Foreign Corrupt Practices Act))

▪ Employment records (e.g., EEO and health & safety compliance, benefits,
subcontractor agreements, confidentiality agreements, non competes, I-9
compliance)

▪ Insurance policies (e.g., D&O, E&O policies)

▪ Legal (including past, existing and potential litigation - both by and against the
company)

▪ Business (e.g., marketing strategies and procedures, customer lists, sales &
distribution, purchase & sales orders, product & vendor contracts, production
processes, R&D, operational controls/best practices, market position & SWOT
assessment (strengths/weaknesses/opportunities/threats) as part of the market
analysis)

▪ Intellectual property (e.g., licenses, copyrights, registrations, filings - past,

pending or contemplated)

▪ Management (e.g., compensation packages, employment contracts, benefits,

management/shareholder agreements, stock options)

Final Thoughts

Due diligence can be disruptive to both the buyer and target company. It
is certainly time consuming, often costly, and always a monumental
inconvenience. However, with compatible synergies, the result can be
well worth the investment of financial and other resources.
Hacking Startup Law

Initial Public Offering (IPO)

Some startups aim to position their companies for public offering. The
idea here is that the startup becomes prosperous enough to enable it to
register for selling stock to the public over a public market such as the
NYSE or NASDAQ.

IPOs are typically directed by a company’s Chief Financial Officer (CFO)

at least three years ahead of the target date. Here are the pillars you need
to build and perfect to adequately prepare your company for the big
day:

Develop Flawless Financial Controls

Financial processes need to be error-free. Ensure accountability with

monthly balance sheets and income and cash flow statements presented
at board and management meetings. Identify strengths and weaknesses
in your processes and reporting. Avoid reinventing the wheel by tapping
into the expertise of your board members and using recent IPO financial
statements to gauge the progress of your financial reporting
mechanisms.

Develop the Right Board

As mentioned in Chapter 5, your board of directors should include

members with the quality of experience that will serve your company’s
interests. If you have been planning for a public offering, then having
directors with public company experience should be paramount. Also as
previously mentioned, you will need individuals with a robust
Hacking Startup Law

background in audit and compensation who can serve on that committee

as the company expands. These are also the same individuals who will be
motivated to ensure that executive compensation is reasonable and
financial processes perfected.

Develop a Top Notch Senior Executive Team

Two of the most crucial members of your senior management are your
chief financial officer (CFO) and general counsel. Your CFO will ideally be
selected with IPO experience as a prerequisite. Your general counsel is
vital to buttoning up your regulatory and legal compliance. These two
positions are load-bearing walls supporting the rest of the team. You will
also need strong leadership in human resources, marketing, operations,
and product development.

Bankers and Lawyers and Accountants (oh my)

If you want to go public, this is the trinity you will need to shepherd you
through the process. Financial reporting is uncompromisingly stringent,
legal and regulatory compliance rigorous, and tax and valuation matters
exacting. For example, Financial accounting Standard (FAS) 109
(specifically, Interpretation 48), demands that a business discloses
income tax risks. Preparing for Form S-1 submission to the SEC holds a
company accountable for tax structuring, particularly when considering
an expansion. At the same time, Sarbanes-Oxley requires financial, legal,
and senior management to engage in active risk assessment and
compels public disclosure of exposure to specified risks.

SEC Review
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Once all of the documents have been submitted to the SEC for review
(notably, the Form S-1), the company should proactively engage in
developing investor relations. This should include highlighting best
practices (including any movements beyond compliance, which are
usually advisable); presenting market analysis (including projected
revenue and expected net income); and market position (including filling
an unmet market demand or other deficit). During this time, you will want
be vigilant to maintaining your website and an appropriate level of social
media engagement, focusing on transparency, authenticity, and
accountability.

Dissolution

An alternative to the investor-oriented exit strategy is one where the

company’s owners decide it is time to wind up business and dissolve the
company. This is usually a voluntary event, as opposed to bankruptcy, for
instance.

Winding up business is a legal term that means the business is ceasing all
of its operations; only those activities that are necessary to settling claims,
paying creditors, collecting balances, and related matters, are continued
until the final dissolution.

For an LLC or S-Corp, the state’s Secretary of State office will require
some documentation accounting for the financial status of the company
prior to it issuing formal certificate of dissolution. Some states allow this
to be filed online, while others require a hard copy submission.
Hacking Startup Law

Some of the financial accounting will include satisfying the following

IRS requirements:
▪ Filing final federal tax deposits

▪ Filing final quarterly or annual employment taxes

▪ Issuing final wage and withholding information to employees

▪ Reporting W-2 information

▪ Reporting capital gains and losses

▪ Reporting shareholder shares (e.g., K-1s)

▪ Filing final employee benefit/pension plan

▪ Reporting 1099 information

▪ Reporting subcontractor financial information

▪ Reporting dissolution / liquidation

▪ Requesting S-Corp election to terminate

▪ Reporting business asset sales

▪ Reporting sale or exchange of property used in the business

Finally, the company will file a certificate of dissolution with the Secretary
of State in the state in which they have located and all states in which they
are conducting business. A filing fee is invariably required to be
submitted along with the certificate. Upon dissolution, the company
ceases to exist.
Hacking Startup Law

Chapter Seven Checklist

✓ Obtain third-party valuation.

✓ Earn internal buy-in to facilitate the process - whether it is acquisition, IPO or

dissolution.

✓ Draft nondisclosure agreements.

✓ Assemble your due diligence team.

✓ Ensure that all your documents are current and complete.

✓ Review and perfect your financial processes to ensure they are free of errors.

✓ Confirm that your P & L and balance sheets are up to date and accurate.

✓ Prepare and assemble all documentation required for SEC submission.

✓ Organize accounts, loans, liens, tax records and stock options.

✓ Review ownership of all intellectual property, account for applications in

progress and ensure they are included in the company’s valuation.

✓ Assess any potential exposure to liability, including employee grievances.

Hacking Startup Law

The Startup Dictionary.

Numbers
10K: See “Form 10k.”

10Q: See “Form 10Q.”

‘33 Act: See “Securities Act of 1933.”

404 Audit: The audit required by Section 404 of the Sarbanes-Oxley Act
of a public company’s internal control over financial reporting. (See, also,
“Internal control reports.”)

83(b): See “Section 83(b) Election.”

A
Accelerated depreciation: An accounting method allocating higher
amounts of depreciation in earlier years and lower amounts in later years
of a fixed asset.

Accelerated filer: Defined in Rule 12b-2 under the Exchange Act as a

company that meets all of the following conditions at the end of its fiscal
year:
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▪ The public float of its common equity exceeds $75 million, but is not more than
$700 million on the last business day of its most recently completed second
fiscal quarter;

▪ The company is required by Section 13(a) or 15(d) of the Exchange Act to file
reports for at least 12 calendar months;

▪ The company has filed at least one annual report pursuant to Section 13(a) or
15(d) of the Exchange Act; and

▪ The reporting requirements available to smaller companies is not available to

the company.

A “large accelerated filer” is subject to the same requirements, except

that its public float of common equity must be greater than $700 million
on the last business day of its most recently completed second fiscal
quarter.

A company that does not meet the definition to qualify as either is

deemed a non-accelerated flier.”

Acceleration clause: Either (1) a stock option agreement or a restricted

stock agreement clause that accelerates vesting - in whole or in part - of a
stock option or restricted stock upon the occurrence of a certain event; or
(2) a provision in a loan, note or debt instrument that accelerates the
maturity date upon a borrower’s default.

Accredited investor: Specific to the qualified private placement of

securities that are made pursuant to Regulation D of the Securities Act,
exempting issuers from registration requirements.

Rule 501(a) of Regulation D defines an “accredited investor” as an entity

or natural person who meets certain net worth tests or other specified
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quantitative criteria - e.g., (1) directors, executive officers and general

partners of the issuer (issuer “insiders”); (2) individuals whose net worth
or joint net worth with their spouse exceeds $1 million (excluding the
value of their primary residence); and (3) individuals whose income was
in excess of $200,000 in each of the two most recent years or whose joint
income with their spouse was in excess of $300,000 in each of those
years and who have a reasonable expectation of reaching the same
income level in the current year.

Accrual basis accounting: Commonly used accounting method where

income is reported when earned and expenses are reported when
incurred, whether or not cash has been received or paid. Contrast with
“Cash basis accounting.”

Accruing dividend: Ensures a minimal rate of return for the preferred

stock investors usually in connection with a private company, where there
is a redemption of a class or series of preferred stock, or in the case of an
issuer’s liquidation. The result is that preferred stock receives
compensation for shares as if the company had declared annual cash
dividends on their stock.

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Adjusted basis: The basis in an asset less depreciation or amortization.

See “Basis.”

Affiliate: Rule 144 and Rule 405 of the Securities Act defines an affiliate
as an individual who controls, is controlled by, or is under common
control with another person. The control can be direct or indirect. Rule
144 generally includes executive officers, directors and 10% stockholders
in addition to relatives (e.g., spouses) and specified companies, trusts
and other entities that meet the definition. Occasionally, a 5% or greater
ownership is deemed an affiliate. See, also, “Rule 144,” “Insider” and
“Reporting person.”

Aftermarket: The trading activity of a security in the market after its

public offering.

Allocation: The number of securities that an investor is permitted to

purchase.

Amortize: To write off a regular portion of an asset’s cost as an expense

over a fixed period of time.

Angel: An early funding round investor in a startup. Angel investors can

be family, friends or other usually high net worth individuals who seek a
return on their investment in exchange for providing funding to an
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emerging company. In recent years, an increasing number of angels -

particularly in high tech startups - are Venture Capitalists (VCs).

Annual meeting: A meeting of company stockholders that occurs once a

year, where Directors are elected and the stockholders asked to consider
any significant corporate changes. The company’s bylaws specify the
governing rules for holding the meeting. SEC regulations require public
companies to distribute proxies and an annual report to stockholders.

Annual report to stockholders: A report distributed to stockholders once

a year at the annual meeting that analyzes the company’s financial
condition, and includes a detailed includes a description of the
company’s operations, financial statements and MD&A. SEC Rule
14a-3(b) dictates the legally required content of the report.

Anti-dilution adjustment: A formula that adjusts the price of a

convertible security (such as convertible debt note) when it changes into
another form of equity. The general purpose of the provision is to protect
the holder of security against price dilution. In a “weighted average”
formula adjusts the conversion rate using different variables including the
number of shares involved with the dilutive issuance and the price of the
dilutive issuance. The “ratchet” method reduces the conversion price to
the price paid for the dilutive issuance, no matter how many shares were
part of the dilutive issuance.
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Anti-takeover provisions: Provisions incorporated into a company’s

bylaws and related formation documents created to discourage
takeovers.

Appraisal: A right created by state law that gives minority shareholders

the right to have the fair market value of their stock valued by a court and
to receive that value in the event of a merger.

Articles of Organization / Articles of Incorporation: Essentially, a

company’s birth certificate. They create the legal entity and are usually
filed with a state’s Secretary of State office. The core elements include the
name, purpose and duration of the corporation, the name and address of
the registered agent, the address of its registered office, and in the case
of public companies, the number of shares the corporation is authorized
to issue and the rights of each class or series of stock.

Audit: An examination by an independent public accountant of a

company’s financials in compliance with GAAS, SEC or PCAOB standards.

Audit committee: A committee created by a company’s board of

directors that has responsibility for (1) hiring independent counsel; (2)
approving audit and tax services; (3) engaging and supervising
independent auditors; and (4) creating procedures for processing
complaints about the company’s accounting methods. All publicly traded
companies are required to have an audit committee whose members
satisfy certain minimum standards prescribed by law.
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Audit opinion / Audit report: An opinion given by an independent

certified public accountant at the end of an audited financial statement
where the auditor represents that they have examined the client’s
financial statements for the year in accordance with GAAS or the PCAOB.
The heart of the opinion is the auditor’s opinion whether the company’s
financial statements fairly represented its financial position, operations
and any changes in financial position for the audited period.

Authorized shares: The maximum number of shares a company is

allowed to issue as specified in its formation documents, which can be
increased by amending its charter.

B
Backdating of stock options: The date prior to the grant date, which the
board of directors approves to reflect a fair market value per share that
was lower than it was on the approval date — the result being a lower
exercise price. This practice is not encouraged since it subjects a
company to potential charges of civil and criminal misrepresentation and
securities fraud. Adverse tax consequences under Section 409A and
disqualification of stock options are other potential ramifications.

Balance sheet: A snapshot of a company’s assets that reflects its financial

standing at the end of an accounting period, generally expressed as
assets equal liabilities plus stockholders’ equity.
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Balloon note: A promissory note that requires little or no principal

payments until the final payment.

Basis: A method for determining capital gains and capital losses for tax
purposes based on the total investment in an asset, including purchase
price, commissions and other expenses.

Bear market: Low or declining prices in the securities market over a

sustained period of time.

Beneficial owner / Beneficial holder: The person who actually receives

the financial benefit of a security, commodity or asset.

Blackout period: A period of time during which directors, executive

officers, certain employees and certain other persons and related entities
are prohibited from selling or buying a company’s securities. The normal
blackout period is from two weeks before the end of each fiscal quarter
and to the second full day of trading after the quarterly earnings report is
made public. Blackouts also are imposed in connection with important
corporate changes, such as mergers and acquisitions.

Block trade: A purchase or sale of a large number of securities (at least

10,000 shares in the case of stock) as a single transaction that is
negotiated as opposed to traded.
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Board of Directors (BOD): The governing body of a company that is

elected by stockholders. The BOD is responsible for supervising
management and has fiduciary duties that it owes to the company's
stockholders. It is charged with appointing senior management,
assigning committee members, issuing shares, declaring dividends and
shaping company policy. The typical BOD includes both senior corporate
managers (e.g., the CEO) and external directors. Meetings are regular,
usually monthly or every other month.

Bond: A corporate or governmental issued debt security that promises to

pay holders a specific amount of interest for a certain period of time, in
addition to repayment of the principal at maturity.

Book entry: The electronic registration and maintenance of securities in

place of a physical certificate.

Book value: A company’s net worth which is calculated on the basis of its
total assets minus liabilities. It is possible for book value to be more or
less than its market value.

Bridge loan / Bridge financing: A loan that offers short term financing
until long term financing is obtained.

Broker: A person who makes securities transactions for others.

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Bull market: Rising prices of securities, assets or commodities in the

market over a sustained period of time.

Burn rate: How rapidly a company spends money to finance its

operations.

Business Judgment Rule: The legal obligation imposed on a company’s

BOD to execute its duties of good faith, loyalty and care on behalf of
stockholders.

Buyback: When a company repurchases its issued stocks or bonds.

Bylaws: A company’s detailed, formal rules that governs corporate affairs,

including the rights and responsibilities of officers, directors and
stockholders. They also set the guidelines for BOD and stockholder
meetings.

C
Call option: A buyer’s right - but not obligation - to purchase a specific
quantity of commodities or securities at a certain price (the strike price) at
a certain time.
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Capital asset: A durable asset intended to held over a prolonged period

of time, which is used to generate profit over the long term. It includes
tangibles and intangibles, movable and nonmovable goods, such as real
property, equipment; patents, goodwill, trademarks, and certain
investments.

Capital gain: A profit from the sale or exchange of an investment or

property.

Capitalization: The sum of a company’s long term debt and retained

earnings.

Capitalize: An accounting method that allows companies to spread out

the cost of new assets by deducting them as expenses over the long term
(more than one year) without negatively impacting revenues.

Cap table: A table that breaks out founder and investor percentages of
ownership, dilution of equity, and value of equity in each funding round.

Cash basis accounting: An accounting method that records revenues at

the time cash is paid or reflects expenses when they are paid in cash.

Cash Flow Statement (CFS): A legally required component of a

company’s financial reports that records all cash and cash equivalents
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entering and leaving the business. It identifies the sources of a company’s

revenues, how it is spending, and how it is operating.

“C” Corporation: A corporate entity that is taxed separately from its

owners (shareholders), in contrast to S-Corps and LLCs.

Certificate of Good Standing: A certificate issued by the state in which a

company incorporated that reflects its current compliance with state law,
including tax payments and annual report filings.
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Certificate of Incorporation: Also called Articles of Incorporation of

Charter, it is the document that reflects the formal establishment of the
organization. Key elements include the name and purpose of the
corporation, the address of its registered office, that name and address of
the registered agent, and if a C-Corp, the number of authorized shares.

Closely Held Corporation: Is a corporation that is not a personal service

corporation and where more than 50% of its outstanding stock is owned
by no more than five people at any time during the last half of the tax
year.

Collateral: Specific property a borrower pledges to secure repayment of

a loan.

Common stock: A security that represents ownership in a corporation and

entitles holders to elect directors and vote of significant corporate
changes or policy. In liquidation, common stockholders have the lowest
priority of right to corporate assets, and may be paid only after preferred
shareholders, bondholders, and other debtors have been paid in full.

Compensation committee: A committee formed by the board of

directors that responsible for compensation decisions. Compensation
committees are usually required by market exchanges (e.g., NYSE,
NASDAQ), with the obligation that it consist only of independent
directors. Furthermore, the committee is required to have a written
charter and mandatory duties, specifically relating to the supervision of
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compensation advisors. as required by Exchange Act Rule 10C-1.

NASDAQ requires that the compensation committee have at least two
members.

Convertible debt: A debt obligation of a corporation that changes into

stock upon the next funding round or becomes due as the result of
maturity or other defined event.

Corporate governance: The system of practices, procedures, and rules

that controls and directs a company. It is the institutional framework that
is designed to ensure corporate accountability, transparency, and fairness
with all of its stakeholders - internal and external.

Corporate record book: The combined records of a company’s

organization, formation, and compliance with tax and corporate law
including annual reports, minutes from BOD and shareholder meetings,
and all corporate resolutions.

Crowdfunding: Business fundraising using primarily online portals such

as Kickstarter that qualifies as exempt from an array of securities
regulations.

Cumulative voting: A method of voting that benefits minority

shareholders when electing directors to the board by allowing
shareholders to cast all of their votes for a single board candidate when
there are multiple board openings. For example, if there are five
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openings available on the board, a shareholder with 100 shares would

have 500 votes. They could choose to cast 100 votes per nominee or cast
all 500 votes for one candidate.

D
Dealer: In contrast to a broker, a dealer is a person or firm that buys or
sells securities for their own account - i.e., a principal.

Debenture: Similar to bonds, this type of debt instrument is issued by

governments and corporations to obtain capital, but is backed by the
reputation and known creditworthiness of the issuer rather than by assets
or collateral.

Debt financing: Selling bills, notes or bonds to individuals or institutional

investors to raise funds for capital expenditures and working capital.

Deferred compensation: Employee compensation to be paid at a later

date. Generally, taxes are deferred on this income until it is actually paid
out. Example include stock options, retirement plans and pension plans.

Depreciation: Either (1) a tax or accounting method that allocates the

cost of a tangible asset over its useful life; or (2) an actual decrease in an
asset's value as the result of unfavorable market conditions.
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Derivative securities: A type of security where its price depends on or

derives from an underlying asset, such as commodities, currencies,
interest rates, stocks, bonds and market indexes.

Dilution: The reduction of ownership percentage that is caused by the

issuance of new stock or when stock options holders exercise their
options. As the number of shares outstanding increases, each existing
stockholder owns a smaller - or diluted - percentage of the company.

Disregarded entity: An entity that is disregarded for U.S. federal income

taxes, but is recognized by state law as a separate legal entity (e.g., a
single member LLC).

Dissenters’ rights: State corporate law that gives a corporation’s

shareholders the right to receive a cash payment for the fair value of their
shares in an acquisition or merger they did not consent to.

Distribution: Either (1) Income and capital gains mutual funds make
periodically to their investors in a calendar year; (2) Cash or stock
payments a company makes to its shareholders; (3) Higher volume
trading than the previous day without price appreciation; or (4) Assets
removed from a retirement account and paid to the account owner of
beneficiary.
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Dividend: A distribution of part of a company's earnings to a class of

shareholders made in cash or as shares of stock or other property.
Dividends are declared by a company’s Board of Directors.

Dow Jones Industrial Average (DJIA): The price-weighted average of 30

significant stocks traded on Nasdaq and the New York Stock Exchange.

Down round: A later round of financing where investors buy stock from a
company at a lower valuation than the valuation created by earlier
investors.

Drag along rights: A right majority shareholders have to compel minority

shareholders to participate in the company’s sale, giving minority
shareholders the same price, terms, and conditions as any other seller.

Due diligence: A comprehensive investigation of a potential transaction

prior to entering into or completing an agreement.

Duty of care: One of the two primary fiduciary duties directors owe to a
company, requiring them to make business decisions that are in the
organization’s best interests only after taking all information carefully into
consideration.

Duty of loyalty: One of the two primary fiduciary duties directors owe to
a company, requiring them to all times act in the company’s best interests
Hacking Startup Law

by avoiding potential conflicts of interest and not usurping corporate

opportunity for personal gain.

E
Earnings: Usually the quarterly post-tax net income of a company.

Earnings per share: A portion of a company's profit allocated to each

outstanding share of common stock.

EBIT: Earnings Before Interest & Tax, this is an indicator of a company's

profitability that is calculated as revenue minus expenses, excluding tax
and interest.

EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization,

this is an indicator of a company's financial performance calculated as
Revenue - Expenses (excluding tax, interest, depreciation and
amortization).

Employee Stock Ownership Plan (ESOP): A qualified (i.e., under the tax
code), defined employee contribution, designed to invest primarily in the
stock of the sponsoring employer.

Escrow agreement: Legal documents that set out the terms and
conditions between parties involved in an escrow, essentially arranging
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for one party to deposit an asset (e.g., money) with a third person (called
an escrow agent), who delivers the asset to another party if and when the
specified conditions of the contract have been met.

Exchange: A marketplace in which securities, commodities, derivatives

and other financial instruments are traded.

Exchange Act: Federal legislation enacted after the 1929 market crash to:
(1) ensure certain heightened levels of transparency in financial
statements to enable investors to make informed decisions about
investments, and (2) penalize misrepresentation and fraud in the
securities markets.

“Exercise” a stock option: To purchase the securities underlying an

option.

Exercise price: Also referred to as the strike price, it is the price at which
a security can be bought (“call option) or sold (“put option).

Expense: (1) The economic costs a business incurs by its operations to

earn revenue that are usually tax-deductible (i.e., they reduce taxable
income).
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F
Fair Value Accounting: The estimated value of all assets and liabilities of
an acquired company that is used to consolidate the financial statements
of both the acquiring and acquired companies. Final prospectus

Financial Accounting Standards Board (FASB): The seven-member board

of accounting professionals that establishes standards of financial
accounting and reporting in the United States, known as the generally
accepted accounting principles (GAAP), which governs the preparation
of corporate financial reports.

Fixed asset: A l tangible piece of property that a company owns and uses
in generating income and is not expected to be consumed or converted
into cash in less than a year's time.

Float: Money in the banking system that is briefly counted twice due to
delays in processing checks (e.g., when a check is showing in both the
payor and recipient banks). Also used to mean the total number of shares
available for trading.

Form 10-K: The comprehensive summary of a company's performance

that must be submitted annually to the SEC, usually containing more
detail than the annual report.
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Form 10-Q: The comprehensive report of a public company's

performance that must be submitted quarterly to the SEC, requiring
disclosure of relevant financial information.

Form 12b-25: An SEC filing, also referred to as the Notification of Late

Filing, which is used when a company anticipates that other key filings
will not be completed by their deadlines.

Form 8-K: A report of unscheduled material events or corporate changes

that could be important to the shareholders or the SEC.

Form S-1: The initial registration for new securities required by the SEC
that is also commonly referred to as the Registration Statement Under the
Securities Exchange Act of 1933.

Form S-3: A simplified security SEC registration available to companies

that have met prior reporting requirements (e.g., companies that have
met all reporting requirements listed under sections 12 or 15(d) of the
SEA of 1934).

Form S-4: A form that required for submission to SEC when two
companies are involved in a merger or acquisition.
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Form S-8: An SEC filing used by publically traded companies to register

securities that will be offered to its employees through benefit or
incentive plans.

Franchise tax: A state tax on businesses that are incorporated or

operating within that state.

Freeriding: An illegal practice of buying and selling stock before paying

for it; an illegal practice where part of a new securities issue is withheld
and later sold at a higher price by a regulated underwriter.

G
Generally Accepted Accounting Principles (GAAP): The accounting
principles, standards and procedures that companies use to draft their
financial statements.

Generally Accepted Auditing Standards (GAAS): A set of guidelines used

by auditors auditing a company’s finances that ensures, ensuring the
accuracy, consistency and verifiability of auditors' actions and reports.

General partner: Partnership owner/s with unlimited liability; also

commonly referred to as a Managing Partner, the person responsible for
daily business operations.
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Going Public/IPO (Initial Public Offering): Selling formerly privately held

shares to new, public investors for the first time.

Golden Parachute: Significant benefits, including cash bonuses, stock

options and severance pay, provided to a senior executive in the event of
a merger or acquisition where the executive is terminated; often used as
an antitakeover device to discourage unsolicited takeover attempts.

Goodwill: A type of intangible asset that consists of a company’s brand

value, reliable customer base, good employee and customer relations,
and proprietary technology (e.g., patents), and reflected in the assets
section of a company’s balance sheet.

Grant: An award (e.g., stock option) issued to key employees.

Gross profit: Equivalent to total sales, it is a company's total revenue

minus the cost of goods sold; the profit a company makes after
deducting the costs associated with making and selling its products or
the costs associated with providing its services.

H
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Hedge: An investment used to reduce the risk of adverse price

movements in an asset.
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I
Incentive Stock Option (ISO): A type of employee stock option that has
the specific tax advantage of paying at a capital gains rate rather than as
ordinary income tax when the option is exercised.

Income statement / P&L statement: A financial statement that measures

a company's financial performance over a specific time and provides a
summary of how the business generate revenues and incurs expenses by
its operating and non-operating activities.

Independent director: A member of the Board of Directors who is not

employed with the company.

Initial Public Offering (IPO): A private company’s first sale of stock to the
public.

Inside Director: A board member who is an employee, officer or other

stakeholder in the company.

Insider information: A nonpublic fact about the plans or condition of a

publicly traded company that could offer a financial advantage to
someone working closely with the company in the buying or selling of
that organization’s stock.
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Insider: A director, senior officer of a company, or any person or entity

that beneficially owns more than 10% of a company's voting shares.
Insiders must comply with strict disclosure requirements regarding the
sale or purchase of their company’s stock.

Insider trading: When someone with access to material, nonpublic

information about a company or its stock or security instruments uses that
information in the sale or purchase of the security.

Institutional investor: An individual or organization that is not a bank

and trades securities in large enough share quantities or dollar amounts
that they qualify for reduced commissions and preferential treatment,
such as being subject to fewer regulations than banks on the assumption
that they are more sophisticated.

Intangible asset: A nonphysical asset such as trademarks, patents, brand

value and goodwill.

Issued shares: The number of authorized shares sold to and held by a

company’s shareholders of a company, including insiders, institutional
investors and the general public.
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Issuer: A legal entity that develops, registers and sells securities to

finance its operations, and are legally required for the obligations of the
issue and for reporting financial conditions, material developments and
any other operational activities.

J
JOBS Act / The Jumpstart Our Business Startups Act: An act signed into
law on April 5, 2012 that removes many SEC regulations on small
businesses and reduces restrictions on capital raising for small
businesses, specifically allowing them to go public with less than $1
billion in annual gross revenue and to raise capital through crowdfunding
(public solicitation of investments in the company).

Joint venture: Where two or more parties agree to pool their resources
for accomplishing a specific business objective, and where each JV
participant is responsible for profits, losses and costs.

K
Ks and Qs: Generally, refers to three types of reports public companies
must file: (1) annual reports on Form 10-K, (2) quarterly reports on Form
10-Q, and (3) current reports on Form 8-K.

L
Letter of Intent (LOI): Similar to a term sheet, an LOI outlines the terms
of a deal and is essentially an “agreement to agree.”
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Leverage: Either (1) Using financial instruments or borrowed capital to

boost the potential return on investment (ROI); or (2) debt used to
finance a firm's assets.

Leveraged Buyout (LBO): Acquiring another company using significant

borrowed money to meet the cost of acquisition; also used to refer to
acquisitions where the assets of the acquired company are used as
collateral for the borrowed funds.

Limited partner: A partner with liability that is limited to the partner's

share of ownership and are generally not involved in the daily activities of
operating the business.

Liquidation: Typically occurs when a company becomes insolvent (i.e., is

unable to pay its obligations when they come due).

Liquidity: The extent to which a security or asset can be quickly bought

or sold in the market without affecting its price.

LLC (Limited Liability Company): A type of corporate structure that

offers its members the benefit of corporate protection from personal
liability for the company’s debts or other liabilities, while allowing
Hacking Startup Law

members to benefit from flow through taxation (i.e., individual members

are taxed personally, but the corporate entity is not taxed).
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M
Management fee: A charge made by an investment manager for
managing an investment fund to compensate a manager for their time
and expertise.

Market Capitalization (or Cap): The total market value of all of a

company's outstanding shares calculated by multiplying a company's
outstanding shares by the current market price of one share.

Market order: An order that an investor places through a broker to

immediately buy or sell a security at the best available current price with
no restrictions on the buy/sell price or time of execution.

Maturity date: The date on which the principal of a note, draft,

acceptance bond or other debt instrument is due to be repaid in full.

Mezzanine financing: A blend of debt and equity financing used to

finance a company’s expansion, which gives the lender the right to
convert the debt obligation to an equity or ownership interest in the
company if the loan is not paid back in full and by its maturity date.

Money market fund: A portfolio of investments consisting of short-term

(less than one year) securities that are high-quality, liquid monetary and
Hacking Startup Law

debt instruments intended to earn interest for shareholders while

sustaining a net asset value of $1 / share.
Hacking Startup Law

N
Net income: A company's total earnings / profit, that is calculated by
adjusting for interest, taxes, depreciation and other expenses against
revenues, and reflects a company’s profitability over a period of time.

Net proceeds: The amount a seller receives after costs and expenses are
deducted from gross proceeds after the sale of an asset.

Nonstatutory (or Nonqualified) stock option: A type of employee stock

option where ordinary income tax is paid on the difference between the
grant price and the strike price, rather than capital gains.

Notice of meeting: The legal notice to stockholders stating the time and
place of a stockholder annual meeting that is normally attached to the
front of a proxy statement.

O
Offer: An expression of interest by one party to buy from or sell to
another party an asset.

Option: (See “Stock Option.”)

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Optionee: The holder of a stock option.

Organizational meeting: The initial meeting of a company, auditors,

underwriters and attorneys preparing a company for public offering that
is usually convened to review the timetable for the proposed offering.

Outside director: A member of a company's board of directors who is

not an employee of the company and tend to be valued for their
tendency to provide unbiased opinions.

Oversubscribed: Where the demand for an IPO of securities exceeds the

total number of issued shares. If the shares are accurately priced, then
there should be no shortage or excess of shares. When demand exceeds
supply, it means the share price was set too low.

P
Participating preferred stock: A type of preferred stock giving the
holder the right to dividends equal to the specified rate of preferred
dividends plus an additional dividend based on a specified condition.

Par value: A bond bond’s face value or a stock’s as stated in its formation
documents. Par value is more important for bonds than it is for shares,
because of its maturity date. Shares typically have nominal or no par
value (e.g., 1 cent per share).
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Poison Pill (“Shareholder rights plan”): A defensive strategy

corporations use to discourage hostile takeovers, by creating features
that make its stock less of an attractive target.

“Pooling of Interests” accounting: A method of accounting that allows

two companies to combine their balance sheets during a merger or
acquisition.

Preemptive rights: A privilege possessed by certain shareholders that

gives them the right to purchase additional shares in the company prior
to the general public.

Preferred stock: A class of corporate ownership that offers its holders

higher priority over common stock on claims related to earnings and
assets (e.g., dividends must be paid prior to common shareholders).

Preliminary Prospectus: The initial draft registration statement filed with

the SEC prior to an IPO, to provide material information to prospective
shareholders about the company's business, management, ownership,
strategic initiatives and financial statements.

Premium: Either (1) the total cost of an option, or (2) the difference
between a security’s face amount at issue and the higher price that is
paid for a fixed-income security.
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Price to Earnings (P/E) ratio: The Price-to-Earnings Ratio or P/E ratio is a

ratio used to value a company, which measures current share price
relative to its per-share earnings.

Pricing term sheet: An outline of the pricing terms related to an offering

(e.g., listing the principal amount, benchmark treasury rate, yield to
maturity, interest payment dates, maturity date and relevant material
terms).

Private equity: Equity capital not on a public exchange, that consists of

investors and funds who make investments directly to private companies.

Private placement: The sale of securities to a small number of select

investors as a way of raising capital (e.g., to mutual funds).

Pro forma financial statements: Hypothetical financial statements to

show the effects of an acquisition, public offering or other occurrence.

Projections: Verbal or written prospective statements that a company

makes regarding its financial performance.
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Prospectus: A formal legal document required by and filed with the SEC
that contains details about a security offering that is for public sale to the
public.

Proxy: A legally authorized agent charged with acting on behalf of

another party (e.g., voting on behalf of a shareholder at an annual
meeting).

Public company: A company that has issued securities through an IPO is

traded on at least one stock exchange or OTC market.

Public offering price: The price of new issues when offered to the public
by an underwriter.

Put option: The right of an investor or entity to demand that a

corporation or other investor repurchase a specified number of shares at
a fixed price at or during a specified time.

Q
Qualified Institutional Buyer (QIB): A corporate entity that qualifies as an
"accredited investor,” which is defined in SEC Rule 501 of Regulation D as
one that owns and invests, on a discretionary basis, at least $100 million
in securities; and, if a broker-dealer, at least $10 million.
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Qualified stock option: See “Incentive Stock Option - ISO.”

A type of security that receives more favorable tax treatment than a

nonqualified stock option, but also requires the holder to incur greater
risk by holding onto the instrument for a longer period of time to receive
favorable tax treatment.

Quorum: The minimum acceptable level of individuals with a vested

interest in a company needed to make the proceedings of a meeting
valid under the corporate charter.
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R
Raider: An individual or entity that attempts to gain a controlling interest
in a company with undervalued assets to make a significant profit in a
short timeframe by selling its assets, rather than rehabilitate its operations
around and restore value over the long term.

Ratchet: An anti-dilution mechanism that protects a series of preferred

stock by automatically adjusting the conversion price to a lower price in
the event that the preferred series was issued at a higher amount (e.g., if
the conversion price of Series A Preferred Stock is $1.00 - equal to the
initial purchase price per share - and XYZ sells its Series B stock for $0.25
per share, then the Series A conversion price would be adjusted from
$1.00 to $0.25).

Recapitalization: Restructuring a company's debt and equity usually to

increase the stability of its capital structure, usually by exchanging one
form of financing for another (e.g., removing preferred shares and
replacing them with bonds).

Receivables: An asset designation applicable to all debts, unsettled

transactions or other monetary obligations owed to a company by its
customers or debtors, including all debts - even if not yet due - owed to
the company.
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Record date: The deadline a company establishes to determine which

shareholders eligible to receive a dividend or distribution.

Redemption: The return of an investor's principal as a fixed income

security (e.g., bonds) or the unit sales of a mutual fund, that is either at a
premium or at par price.

Registered securities: Either (1) Securities whose ownership is registered

with the issuing company; or (2) securities unavailable for sale because of
restrictions imposed at the time of issue.

Regulation D: An SEC regulation governing exemptions for private

placement, that allow smaller companies to raise capital through debt
securities or sale of equity without first having to register their securities
with the SEC.

Repricing: The exchange of stock options whose exercise price is below

current fair market value for options whose exercise price is above fair
market value, allowing an investor to exchange worthless options for
options that have value.

Restricted stock: Unregistered, nontransferable shares of ownership in a

corporation issued to corporate affiliates such as executives and
directors, subject to compliance with specific SEC trading regulation, and
which become unrestricted (i.e., available for sale) after they have vested.
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Restricted stock units (RSUs): A type of deferred compensation where

stock is paid out at some future date (i.e., after it has vested), assuming
the employee remains with the company, entitling the recipient to the full
value of the RSUs - meaning they will always have value, in contrast to
options whose value can erode rendering them valueless.

Retained earnings: The percentage of net earnings not paid out as

dividends, that are retained by the company to be reinvested in its core
business.

Retention / Allotment: The number of shares during an IPO granted to

each participating underwriting for sale.

Revenue / Gross Income: The amount of money a company receives

during a specific period, including discounts and deductions for returned
merchandise, calculated by multiplying the price at which goods or
services are sold by the number of units or amount sold.

Rounds: Stages of financing of a corporation. The first round of financing

is the initial raising of outside capital, with later rounds usually attracting
institutional investors.

Royalty: Money paid to use intangible property (e.g., copyrighted

materials).
Hacking Startup Law

S
Safe harbor: Either (1) a legal provision used to reduce liability as long as
there is a demonstration of good faith; or (2) an accounting method that
avoids adverse legal or tax consequences by providing a legal, simpler
method for determining taxes.

Sarbanes-Oxley Act of 2002: Federal legislation passed to protect

investors from fraudulent corporate accounting activities, it requires strict
financial disclosures from corporations designed to prevent accounting
fraud that were associated with the Enron, WorldCom and Tyco scandals,
which debilitated investor confidence.

“S” Corporation: A type of corporation that satisfies IRS requirements

allowing it to be taxed under Subchapter S of the Internal Revenue Code,
and which permits a company with fewer than 100 shareholders to be
taxed as a partnership, meaning that any profits earned are not taxed at
the corporate level, but pass through to the individual shareholders.

Secondary offering: When new stock is issued for public sale that has
already gone through an IPO, usually with the aim of refinancing or
raising capital for expansion.

Section 409A: A tax code provision relating to deferred compensation

arrangements, including stock options, severance arrangements and
Hacking Startup Law

bonus plans. If the compensation arrangement fails to comply with

Section 409A, the employee will be subject to severe tax consequences.

Section 83(b) election: A tax filing that allows a holder of security, which
was received as compensation and is subject to forfeiture (i.e., unvested
stock) to pay taxes upon the receipt of the restricted stock rather than on
the date the stock vests to avoid paying tax at the higher ordinary income
rate, and to be eligible to pay tax at the lower capital gains rate.

Securities Act of 1933: Federal legislation passed after the 1929 market
crash to: (1) expand transparency of a company’s financial statements to
enable investors to make informed decisions about investments, and (2)
establish laws against misrepresentation and fraud in securities markets.

Securities and Exchange Commission (SEC): A government commission

established to regulate securities markets and protect investors, and to
specifically oversee corporate takeovers. Its five commissioners are
appointed by the President with approval from the Senate.

Securities Exchange Act of 1934: federal legislation passed to provide

supervise securities transactions on the secondary market, and to
regulate brokers-dealers and exchanges to protect the investing public.

Seed capital: Capital used by a startup in its initial operations, which is

often obtained from family and friends, angel investors and sometimes
the entrepreneurial founders themselves.
Hacking Startup Law

Shares authorized but unissued: The number of shares a corporation is

authorized by its charter to issue, but which have not yet been issued to
stockholders.

Shares issued and outstanding / Outstanding shares: Shares issued to

and currently held by stockholders.

Shares reserved for issuance: Authorized but unissued shares a

corporation’s board sets aside to be issued upon the conversion of
outstanding convertible securities (e.g., stock options).

Shell Corporation: A corporation without assets or operations that may or

may not be illegal, and is often properly used for tax avoidance as
opposed to tax evasion.

Short sale: Where an investor sells borrowed securities, expecting prices

to decline, and is required to return an equal number of shares at some
future date.

The payoff to selling short is the opposite of a long position. A short seller
will make money if the stock goes down in price, while a long position
makes money when the stock goes up. The profit that the investor
receives is equal to the value of the sold borrowed shares less the cost of
repurchasing the borrowed shares.
Hacking Startup Law

Short term debt: An account reflected on a company’s balance sheet as

a current liability, consisting of debt that is due within one year.

Staggered board: A staggered board is a board of directors whose

members are grouped into different categories representing a certain
percentage of the total number of board positions, and whose elections
occur at different times.

Startup: A company that is in its earliest stages of formation and

operations, often bootstrapped (i.e., funded by their founders), as they
endeavor to create a product or service designed to fill a market need or
demand.

Stock: Equity ownership in a company.

Stock certificate: The physical piece of paper representing ownership in

a company, which reflects the number of shares owned, the date, an
identification number, a corporate seal and signatures, and typically have
intricate designs similar to currency to discourage counterfeiting.

Stock exchange: A formally organized marketplace where securities are

traded by members of the exchange, acting as agents (brokers) and as
Hacking Startup Law

principals (dealers or traders), and which requires registration under the

Section 6 of the Exchange Act.

Stockholder: A person or entity that owns shares in a corporation,

whether as common stock or preferred stock.

Stockholders’ equity: The segment of a company’s balance sheet that

shows the capital it received from investors in exchange for stock,
donated capital and retained earnings, and is calculated either as (1) total
assets minus total liabilities; or (2) share capital plus retained earnings
minus treasury shares.

Stockholders’ voting agreement: An agreement between a company’s

founders and investors used in a venture capital financing to give
investors the right to elect a certain number of directors.

Stock ledger: The list of a corporation’s stockholders that records the

total number of shares, the stock certificate number, and the date on
which the stock was issued.

Stock option: An assignment of a certain number of shares giving an

individual - usually an employee - the right, but not the obligation buy
stock at a certain price (the strike price) at a certain time.
Hacking Startup Law

Stock split: A corporate decision to divide a company’s existing shares

into multiple shares, and where the total dollar value of the shares
remains the equal to their pre-split amounts.

Strike Price: The price at which a stock option or warrant can be

purchased.

Syndicate: A professional financial services group formed temporarily to

handle a large transaction by pooling their resources and sharing risks,
which would otherwise be difficult to achieve without the benefit of a
larger group.
Hacking Startup Law

T
Tag-Along Agreement (or Co-Sale Agreement): A contractual agreement
between management stockholders and investors usually in connection
with venture capital financing where the management stockholders
agree not to sell any of their stock in the company without first giving the
investors the right to participate in the sale, on the basis of their pro rata
share of ownership.

Tender offer: An offer to purchase some or all of the shares in a

corporation. The price is usually offered at a premium relative to the
market price.

Term sheet: A non-binding agreement outlining the basic terms and

conditions for an investment that essentially serves as a foundation
document for more detailed legal documents.

Trade date: The day, month and year that an order to buy, sell or transfer
a security is executed in a market.

Transfer agent: A financial institution that a corporation designates to

maintain investors’ records, transactions and account balances; to handle
investor correspondence; and to cancel or issue security or stock
certificates.
Hacking Startup Law

U
Unaudited statement: A statement that an auditor prepares or assists in
preparing but does not examine in accordance with GAAS.

Underlying security: The security from which a derivative gets its

value.Underwriter: A company that administers the public issuance and
distribution of securities from a corporation and determines the offering
price of the securities, buys them from the issuer and sells them to
investors through a distribution network.

Up Round: When a private company offers equity securities at a price per

share that is greater than the price per share of the company’s last
securities offering.

V
Venture Capital (or “VC”) Financing: Raising money for a company in its
early stages of growth by selling stock (usually preferred stock that
converts to common stock in the event of an IPO) to one or more venture
capital firms.

Venture Capital (or “VC”) Fund: An entity, usually a limited partnership

or limited liability company that invests in startup businesses with
potential for a high return on investment.
Hacking Startup Law

Vesting or Vested: A specified period of time over which an employee

granted stock incentives begins to accrue rights to stock options or other
employer contributions, and which are generally not subject to forfeiture.

Vesting Cliff: The period of time an employee must remain employed

with a company before their vesting rights are triggered, and where
failure to maintain employment with the employer for less than the cliff
period results in the total forfeiture of their rights to all options.

Vesting Period: The period of time that it takes before the option to buy
stock can be exercised in whole or in part provided that the holder
satisfies certain conditions, typically maintaining their employment with
the company.

W
Warrant: A type of security that gives the holder a right but not the
obligation to buy or sell the instrument at a specified price (the strike or
exercise price) by a certain date.

Working Capital: An indicator of a company’s liquidity, it is measured by

subtracting current liabilities from current assets.
Hacking Startup Law

Y
Yield: The income return on an investment, including the interest or
dividends received from a security.
Hacking Startup Law

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