December 19, 2011

Many companies are now hiring unpaid #interns and such agreements need to be structured carefully to avoid employment taxes and claims on intellectual property

An unpaid internship program is subject to some very strict requirements that are difficult to meet.  There is a multi-factor test used to determine whether someone can be considered an “intern”.  The safest route is to hire students who earn academic credit through the internship program, and to get signed agreements confirming the relationship and parties’ understanding that mirrors the six factors.  However, academic credit is not a requirement (nor is it sufficient).  The main focus is whether the company derives any benefit from the intern’s activities.  This means that the internship should be primarily educational in nature and interns should not do menial work of other employees (make copies, file papers, conduct research, etc.).  You can think of the unpaid internship as more of a job-shadowing position with minimal work on general skills (as opposed to company-specific skills) that is closely supervised.  I know it sounds very unproductive and strange for such strict requirements, but that is the current state of the law on this issue.

We usually recommend that the company pay interns minimum wage to avoid any issues, but in the end, it is a business decision whether having unpaid interns is worth the risk.  That said, many companies probably have less than compliant programs since the risk of an intern suing the company for violation of wage and hour laws is generally low.  Some things the company can do to comply with the rules though is to structure the internship like an academic or vocational course, complete with a syllabus or learning schedule.  The duration of the internship should be fixed and correlate with the school’s calendar.  Interns should be supervised closely – moreso than a regular employee – and not doing work that would have been done by other employees.  It also helps to make clear that interns are not subject to the same handbook given to employees (which contains policies like you mentioned, PTO and benefits, that suggests an employment relationship) and if possible they should get a separate handbook with just relevant policies (trade secrets, discrimination, harassment).  You can see that what it boils down to is that you want to separate interns from regular employees to the extent possible and to structure the program more like an educational or vocational program than a work internship.

I've attached a form of internship agreement that companies may find helpful

 

 

 

 

Newco_intern_offer_letter.doc Download this file

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December 18, 2011

#409A Valuations can now be done inexpensively even before a #Series A and if you've closed a #convertible note financing

To avoid stiff tax penalties for granting options at below fair market value, you must have a third party valuation firm determine the fair market value of the options.  This applies at all times during the life at the company, even for first options granted before a Series A.   In addition, granting options without a 409A valuation could jeopardize the acquisition of your company since buyers will not be willing to take on this tax risk or will require larger escrows and indemnities from you as part of the acquisition agreement.

Most companies do not consider a 409A valuation until after their Series A financing.  These valuations have tended to cost $5,000 or more, so founders have not wanted to spend precious cash on 409A valuations before raising venture capital.  However, many companies are now raising up to $1M in convertible notes, hiring employees, creating option plans and wanting to grant options. As a result, we at Orrick have now secured agrements with 2 valuations firms that will complete these valuations for between $3-$4k for our pre Series A companies.  All your options granted prior to a Series A will now be covered under the IRS safe harbor.

If you are planning to grant options to employees hired with your convertible note capital, the benefit now outweighs the cost of obtaining one of these 409A valuation reports to cover your option grants. 

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December 13, 2011

#Foreign issuers going public in the US may no longer file for an #IPO confidentially with the #SEC

The SEC is no longer going to permit foreign issuers to file confidentially for their IPO in the US.   There is no change, however, in the other advantages of being a foreign issuer, including following local rules regarding disclosure (such as executive compensation) and local proxy rules.  Here's a link to the SEC release:  

http://www.sec.gov/divisions/corpfin/internatl/nonpublicsubmissions.htm

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December 11, 2011

What entrepreneurs need to know about Founders’ Stock

When entrepreneurs start a company, there are four things they need to know about their stock in the company:

• Vesting schedule
• Acceleration of Vesting
• Tax traps
• Potential for future liquidity through Founders Preferred Stock

VESTING SCHEDULE

The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not vesting until the employee has remained with the company for at least 12 months (i.e. a one year “cliff”). Vesting stops when an employee leaves the company.

Even Founders’ stock vests. This is to overcome the “free rider” problem. Imagine if you start a company with a co-founder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for much of the hard work. Founder vesting takes care of this issue.

Even if you’re the sole founder, investors will want to see your founder’s stock vest. Your ability and experience is one of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company’s development and funding process, want to make sure that you are committed to the company long term. If you leave, the VCs also want to know that there is sufficient equity to hire the person or people who will assume your responsibilities.

However, many times vesting of founders’ shares will follow a different schedule to that of typical startup employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history working with each other, and know and trust each other. In addition, most founders will start vesting of their shares from the date they actually started providing services to the company. This is possible even if you started working on the company prior to the issuance of founders’ stock or even prior to the date of incorporation of the company. As a result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.

This vesting is balanced by investors’ desire to keep the founders committed to the company over the long term. In Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the three or four years following the date of a Series A investment.

ACCELERATION OF VESTING

Founders often worry about what happens to the vesting of their stock in two key circumstances:

1. They are fired “without cause” (i.e. they didn’t do anything to deserve it)
2. The company gets bought.

There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if they both occur (double trigger acceleration).

“Single Trigger” Acceleration is rare. VC’s do not like single trigger acceleration provisions in founders’ stock that are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s services are terminated then the founders’ stock should not continue to vest. This is the “free rider” problem again.

In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the company’s headquarters are moved). However, under most agreements, there is no acceleration if the founder voluntarily quits or is terminated for “cause”. A 6-12 month acceleration is also usual in the event of the death or disability of a founder.

VC’s similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the company to a buyer. Acquirors typically want to retain the founders, and if the founders are already fully vested, it will be harder for them to do that. If founders and VC’s agree upon single trigger acceleration in these cases, it is usually 25-50% of the unvested shares.

“Double Trigger” Acceleration is more common. While single trigger acceleration is often contentious, most VC’s will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the enterprise from the acquiring company’s perspective. It is arguably in the acquiring company’s control to retain the founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event of involuntary termination by the acquiring company. In Orrick’s experience, it is typical to see double trigger acceleration covering 50-100% of the unvested shares.

TAX TRAPS

If things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests, and before you have the cash to pay those taxes.
There is a way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your Founder’s shares and paying your tax early on those shares. One of the most common mistakes I’ve encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company.

Fortunately, over the years, I’ve developed a number of work-arounds (depending on the circumstances) and we can many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed. Nevertheless, this is one of the first things that your lawyer should check for you.

Of course, you’ll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I’m sure you’ll be able and happy to pay!

POTENTIAL FOR FUTURE LIQUIDITY THROUGH FOUNDERS PREFERRED STOCK

Founders’ stock is almost always common stock because VC’s purchase preferred stock with rights and preferences superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new security for founders which we call “Founders’ Preferred” which enables founders to hold some of their shares in the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale.

The “Founders’ Preferred” is a special class of stock that founders can convert into any series of preferred stock sold by the company to VC’s in a future round of financing. The founders would only choose to convert these shares when they plan to sell those shares to VC’s or other investors in that round of financing. This special class of stock is convertible into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock is identical to common stock.

The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price.

Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as opposed to common stock.

Founders’ Preferred can usually only be implemented at the time of the first issuance of shares to founders. Therefore, it is important to address the advantages and disadvantages of issuing Founders’ Preferred at the time of company formation. I normally recommend for founders who want to implement “Founders’ Preferred” that such shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance of  Founders’ Preferred remains a new development in company formation structures. Therefore, it’s important to consult legal counsel before putting this special class of stock into effect.  In addition, for tax reasons, Founders' Preferred needs to be fully vested.

CONCLUSIONS

As discussed above, there are a number of issues to address when issuing founders’ stock. In addition to business terms associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate important legal and tax considerations. My advice to founders is to make sure to “get it right” the first time. Although here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it is important that founders get the right business and legal advice, and not just use pre-packaged forms.

This advice should begin at the time of company formation. A little bit of advice can go a long way!

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December 2, 2011

Founders Preferred Stock Documents

I am pleased to make available our official form of Founders Preferred Stock in WORD format for entrepreneurs created by us at Orrick.  The first form can be used to create Founders Preferred Stock at the time of incorporation.  The second form implements Founders Preferred Stock after a company has already incorporated.  You should consult legal counsel prior to using these forms.  

As I've previously discussed, Founders Preferred enables founders to sell a portion of their founders' stock in a future round of Preferred financing and to do so as exactly the same series of Preferred Stock sold in such future round.  As a result, investors in that future round can buy Preferred Stock directly from the founder.  Existing investors benefit because the transfer of shares from Founders to future investors does not dilute their ownership.  Investors also benefit when Founders can take some risk off the table and therefore continue to build the company over a longer period of time.  Founders benefit because it provides them with a path to some earlier liquidity.  The company benefits because the sale of Preferred Stock by the founder does not jeopardize the company's ability to maintain a lower price on its Common Stock for employee options.  And, Future investors benefit because they can purchase the latest series of Preferred Stock authorized and issued by the company.

In my experience, Founders Preferred usually comprises about 20% of the total shares of the company held by the founders.  The remaining 80% is Common Stock.  Please remember that Founders Preferred must be fully vested on grant for tax purposes. The Common Stock held by the Founders however may be subject to vesting (the most common vesting schedule is 4 year monthly vesting either with or without a one year cliff).

FOUNDERS PREFERRED AT TIME OF INCORPORATION:

Orrick_Founders_Preferred_DE_Certificate_of_Incorporation.doc Download this file
FOUNDERS PREFERRED AFTER INCORPORATION

Orrick_Founders_Preferred_DE_Amended_Restated_Certificate_of_Incorporation.doc Download this file

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