Raising Capital: The Friends and Family Round

An idea is hatched a team is formed and the startup or small business launches a plan to bring its unique value offering to its consumer base. To get there takes not only talent, dedication, and a bit of luck, but it also takes capital.

Timing is immensely important for any business, and each hour that ticks by is an hour a competitor can get ahead. Therefore, it is imperative the team is able to focus entirely on the venture, rather than squeezing in time before or after another job. To do so, however, founders and their team typically must make at least some money, even if it’s below what they could command on the open market. Unless the founders are already wealthy, this requires an infusion of outside capital.

Without prior successful exits, and without landing the startup in a prestigious incubator, most new business ventures do not have investors beating down their door to invest right away. Therefore, often founders look to their friends and family to help with initial financing so they can build the company to a level that will attract outside investors.

Even if a founder is “just” raising investment money from friends and family, there are still a number of legal matters that must be considered and followed to ensure that the company is protected and compliant:

(1) Investor Status

To sell a security (equity in the company) pursuant to a private placement, a company must take reasonable steps to ensure that the investors are “suitable” according to SEC standards, and their status allows the company to meet a specific exemption from public registration. Do not be fooled – a convertible note, SAFE, KISS, or other convertible instrument is considered a “security” by federal and state standards.

Investor participation in a private placement is usually limited to people that are  considered “accredited investors,” but can extend out to those who are “sophisticated and wealthy” by the SEC or people with a close personal connection to a founder under California Corporations Code 25102(f).

In short, startups should use an investor suitability form and the advice of an experienced attorney who can help the founders vet each prospective investor. With these tools, the company can ensure that it does not take money from an investor who cannot afford to lose it, and inadvertently violate federal and state private placement rules.

(2) The Pitch

Far too often we notice the focus at the outset of a friends and family round is on the instrument the startup plans to use (such as a convertible note), which typically is putting the cart before the horse. Before things like interest rates, valuations, and discounts are discussed, the investor needs to be excited about investing and convinced that they want to spend their money on the company.

To effectively draw in investors and convince them of the viability of the company, create an engaging pitch deck (often in PowerPoint or a PDF, or a paper version depending on the audience), which outlines the business plan, including: (i) the problem being addressed, (ii) the company’s mission statement and proposed solution to the problem, (iii) competitive analysis, (iv) the business model, (v) the founding team, (vi) amount the startup is looking to raise, and (vii) pro forma financials. A good pitch deck will help sell a prospective investor on why the risk could result in a nice downstream payday.


(3) SAFE Versus a Convertible Note

As an early stage startup without a proven track record, the company must balance an attractive offer versus an offer that is startup friendly. The Y Combinator SAFE has definitely come into vogue as of late. However, it’s a much more startup-friendly instrument than its cousin, the convertible note, and as a result, for many sophisticated investors it will be a non-starter unless the startup is very “hot,” such as already being accepted into Y Combinator. Thus, a convertible note is often a wise starting point.

Unlike a SAFE, a convertible note has a maturity date and allows the investor to earn interest on their investment until the note converts into equity during a fixed price round (such as a Series A). Promising a maturity date and paying minimal interest can be small concessions for a startup and potentially speed up the seed round. Otherwise, the longer it takes to close on the seed capital, the less likely the startup will find a chance to spread its wings. While a startup needs to be strategic and not give away too much, in some cases immediate advantages can be seen to make the investment opportunity attractive to a prospective investor.


(4) Cost Versus Amount Raised

Cash is a scarce resource when a startup is formed, and that means founders must be extra cautious about how each dollar is spent. Therefore, when raising outside capital care must be given to factors such as (i) the likelihood of a lengthy negotiation process against a fast close, (ii) advisor fees, including legal, marketing, and accounting, and (iii) the total founder time commitment to closing investors versus focusing on what they are good at – developing their product or service offering. Using experienced professionals to guide the process, make introductions, and influence strategy can go a long way towards lowering the overall costs and time, even if it can seem daunting to shell out the cash to hire experienced help before the investment money is received.

When raising capital there are a myriad of considerations that extend beyond those provided above. Wise founders surround themselves with an experienced attorney, CPA, and a board of advisors. We recommend founders consider the topics above, but this list is not exhaustive, and so we strongly encourage any founder to enlist the assistance of the necessary professionals to help make informed decisions.

Disclaimer: This post discusses general legal issues and developments, is intended to serve as informational only, and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Starting a Consulting Business

You’ve worked hard to specialize and sharpen your skills and now you’re ready to branch out and start your own business. There can be many benefits to starting your own consulting business including, but not limited to, control of your work-life balance, ability to earn more money, and power to decide how your brand will be marketed, and what values your business will stand for. However, as you embark on such an exciting journey, there are a couple of upfront issues you definitely need to consider.

Here are a few talking points you should address with your lawyer and CPA as you start to plot out next steps:

(1) Should I Form a Legal Entity?
When considering forming a legal entity there are three primary reasons we see clients benefit from doing so:

(a) Limited Liability Protection
By operating your business through a legal entity (by “through a legal entity” we mean that your clients will sign a contract with your legal entity rather than with you individually), you create a shield wherein which a client would sue your legal entity, and not you personally, if an issue arises. This protects your personal assets including your home, retirement savings, car and other assets.  Such a separation can make a huge difference if you have a slip up, and is a key reason many people form a legal entity.

Furthermore, this liability protection doesn’t stop with just clients. It also applies to your team of consultants and employees you might hire to assist with various projects. We recommend you read our post regarding labor and employment issues that come with hiring independent contractors (read more here), but the moral of the story is that like your clients, if a service provider you hire has an issue with your business he/she/it will be suing your legal entity, and not you personally.

(b) Tax Savings
While certainly not a hard and fast rule, some of our clients are able to save money on taxes by establishing a legal entity and then electing to have it taxed as an S-Corporation. One important thing to understand is that an S-Corporation is not a legal entity; it’s a tax election which means whether you form a Limited Liability Company (LLC) or a Corporation, both can elect to be taxed as an “S-Corp”.

As an owner of an entity taxed as an S-Corp, you can set yourself a reasonable salary, and then after you pay out your salary and other business expenses, you can take a profit distribution and the profit distribution will not include withholding for the standard self-employment taxes that a sole proprietor would pay on every dollar earned.  Depending on the amount of revenue earned you can see a potential tax benefit under the aforementioned S-Corp structure.

(c) Marketing
While alone it is not enough of a reason to start an entity, one additional perk our clients enjoy is the ability to create a more professional marketing persona under a legal entity. For example, if I am hiring “Blue Mountain Consulting”, it’s at least ambiguous as to whether or not I’m hiring a solo outfit or a team of fifty employees. Such a persona is more difficult to pull off if you remain a sole proprietor.

(d) Common Downsides to Forming an Entity
Many professionals and skilled service providers got to where they are because they are smart enough to stay in their lane, and when necessary, hire others to assist on matters they otherwise are not equipped to handle. Thus, forming an entity will come with legal and filing fees (roughly $1500-2500 if using our firm depending on your desired setup, and we’re happy to discuss in greater detail your specific situation). Additionally, by forming a legal entity you will now be an entity that owes a minimum franchise tax of $800 every calendar year to the state of California, and that franchise tax can go up from there depending on revenues earned. Finally, especially those consulting businesses that establish S-Corp taxation or have multiple owners, you will need to setup payroll and it is advisable to work with a  CPA to handle taxes, which come with additional business expenses.

(2) So I’ve Decided to Form an Entity, What Other Key Decisions Must I Make?
Certain professions are limited as to the type of legal entity they can form. By way of example, attorneys are only permitted to establish “professional corporations” or “limited liability partnerships”. Therefore, depending on the type of work you will perform you will need to analyze if there are any limitations as to the type of entity you can form.

Additionally, you are advised to speak with a CPA to see if they recommend a certain tax structure (including but not limited to a “disregarded entity”, “S-Corp” or the less frequent “C-Corp” structure) based on your forecasted business activities and revenue.

Furthermore, and it’s recommended you do so with the assistance of a lawyer, you need to pick and analyze the name you plan to use for marketing purposes to ensure you will not run into downstream issues with a competitor, or with governmental regulations from the respective governmental body that governs your business activities (by way of example, the State Bar of California places restrictions on certain names that can be used).

Finally, you cannot form a legal entity until you’ve first established where your business will be located and who will serve as your registered agent (you can read more about a registered agent here). Certain cities will not allow the use of mailbox (such as a UPS Box) and California will not allow you to list a PO Box as a corporate business address.

While not an exhaustive list, we’re hopeful you can use this outline to help kick off the conversation internally, and with their team of helpful professionals. We frequently assist clients who are transitioning to their own business, and we’d be happy to setup a time to talk about your specific situation in more detail.

Disclaimer: This post discusses general legal issues and developments, is intended to serve as informational only, and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Corporate Governance Basics for Delaware Corporations

As the founder of an emerging growth company you are likely an expert in what makes your company and idea valuable, but actually managing the corporate governance can at times feel like learning a new language. Obeying corporate governance formalities is important if you want to receive the benefit of the limited liability protection afforded by the corporate entity, and when your startup goes to raise a round of capital, such as a Series A round, your investors will want to kick the tires and ensure you’ve been following the rules.

With this as a backdrop, here are a few basics we encourage all founders to consider post incorporation of a Delaware Corporation. This list is not exhaustive and we encourage you to work with an experienced attorney to ensure proper compliance. Additionally, this discussion is limited to a DE Corporation (the most popular entity structure for an emerging growth startup), so if you’re operating a different entity you are encouraged to contact an attorney in your state to properly advise how state law impacts the list below.

Board Approval Required To:

• Amend the Certificate of Incorporation.

• Enter into fundamental corporate transactions (sale of company, merger, sale of substantially all assets of corporation, dissolution, etc.).

• Appoint officers, such as CEO, CFO, and Secretary.

• Issue securities that will affect the capitalization of the corporation (issuing shares, issuing stock options, etc.) – remember “securities” includes instruments such as convertible notes, SAFEs, and KISS Agreements.

• Enter into material agreements (agreements that have a disproportionate impact on your business, such as IP licenses, customer contracts, vendor contracts, etc.).

• Compensation arrangements with officers and high level executives (not all employees, who can be handled by the officers or executives hired by the Board).

Other “material” actions, which vary from company to company. For example, an expenditure of $10,000 may be material for an early-stage company, but immaterial for an established company with high revenues. Examples include, but are not limited to: (i) changing the business plan or course of business the company has historically taken; (ii) expanding the business to other states or counties; (iii) creating a subsidiary, (iv) a transaction between the Board and a Board member or officer (“Interest Party Transaction”); (v) distributions to shareholders; (vi) borrowing or lending money; (vii) adopting an annual budget; (viii) hiring or terminating members of senior management; and (ix) adopting employment benefit, profit-sharing, and equity incentive plans.

Day-to-day matters typically do not require Board approval, such as purchasing office supplies, making purchases covered by a budget previously approved by the Board, signing NDAs, and hiring non-senior level employees.

Shareholder Approval Required To (may be in addition to Board approval):

• Amend the Certificate of Incorporation.

• Enter into fundamental corporate transactions (e.g. sale or merger of company, dissolution).

• Elect Board of Directors.

• Establish stock option plans and any amendments to the same.

Permit interested director transactions (i.e. transactions in which a member of the board has a direct financial interest).

Shareholder votes may occur by written consent if the matter is approved by the holders of outstanding stock having not less than the minimum number of votes required if the vote was at an in-person meeting. Prompt notice of actions taking without a meeting by less than unanimous consent must be given to the shareholders who did not consent in writing.

At Archetype Legal we work to find convenient and efficient ways to assist and keep your corporation healthy as you focus on growing your business. If you have any questions please don’t hesitate to reach out to us at hello@archetypelegal.com.

Disclaimer: This post discusses general legal issues and developments, is intended to serve as informational only, and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Hiring Independent Contractors

In April of this year the Supreme Court of California issued a landmark decision related to the use of independent contractors. The decision, Dynamex Operations West, Inc. V. Superior Court of Los Angeles, gave the California Supreme Court a fresh opportunity to redefine the previously relied on “Borello test”, and the court laid out a three prong test that must be applied when using independent contractors.

As has been the case for years, in California workers are presumed to be employees and the burden falls on the hiring party to properly ensure the service provider is appropriately classified. With the recent Dynamex ruling, in order to ensure proper classification takes place the hiring party must meet the “ABC test” adopted in April of 2018 by the California Supreme Court. Previously, under the Borello test the court held that the “right to control” was the most important factor among several factors when analyzing if a party should be classified as an independent contractor.  Under the new ABC test, the hiring party must show all three exist in order to withstand any scrutiny, and these are:

(A) The worker is free to control the direction of the work, both under contract and as a factual matter;

(B) that the worker is performing services outside of the hiring party’s normal course of business; and

(C) that the worker is customarily engaged in providing consulting services in the same nature as the work performed.

At this point, an example might be helpful. Archetype Legal PC fits the mold as an independent contractor for all of it’s clients. Our team is free to control the direction of the work, and the work is performed off site and using our own equipment. Our services (i.e. legal services) are outside of the scope of services are clients offer their own customer base, and our firm is customarily engaged in providing consulting legal services.

So why does all of this matter, you might be wondering. It’s important because if a worker is classified as an employee the employer is required to pay social security and payroll taxes, as well as workers compensation insurance and unemployment insurance and state employment taxes. Additionally, the employer must comply with a host of federal and state wave, hour and working conditions rules and regulations, which do not apply if the service provider is a contractor.

Therefore, by classifying someone as a contractor instead of an employee the employer has an opportunity in the short term to save money. However, the key wording there is the “short term” because even one misclassification issue can sink an otherwise growing small business or startup.

Although far from a silver bullet when it comes to a misclassification claim, here are a few things we encourage clients to consider including when drafting the consulting agreement assuming the hiring party has determined it can satisfy the ABC test above:

• Avoid using words like “control” to describe the hiring party’s role in the business relationship.

• Avoid requiring specific hours (such as 8AM-5PM) or requiring the contractor to provide the services from the company’s facility using the company’s tools and equipment.

• When possible, pay on a flat fee basis and not by the hour, day, week or month.

• Set a specific term which outlines the length of the contractual relationship and do not leave the contract open ended as if the service provider will remain with the company for months, or even years.

• Specifically declare the service provider’s status as a contractor and the service provider’s obligation to pay taxes, business license and insurance requirements

This post is meant to function as an overview of the new California Supreme Court ruling, and not all-encompassing labor and employment advice when it comes to hiring contractors. Each reader who is considering hiring a service provider is encouraged to speak to an attorney who can advise the reader on all of the facts and circumstances of your unique situation as well as assist with filling out a proper consulting agreement (as what should be considered goes beyond the bulleted list above).

Disclaimer: This post discusses general legal issues and developments and intended to serve as informational only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Is Your Business Prepared for the GDPR Compliance Deadline?

On May 25, 2018, a new European privacy regulation called The General Data Protection
Regulation (GDPR) will come into effect. The goal of the GDPR is to provide citizens of the EU
and EEA with greater control over their personal data and assurances that their information is
being securely protected. The GDPR will be implemented in all privacy laws across the entire EU
and European Economic Area (EEA) region. It will apply to all companies controlling, processing
or storing personal information about individuals in Europe.

So how does the GDPR impact your U.S.-based business? If you think the GDPR does not apply
to you, think again. The GDPR applies to any business that does one or both of the following:

·       Offers products or services to citizens of the EU.
·       Collects personal information from citizens of the EU.

If your business meets either of these criteria, it doesn’t matter where your business is located.
This means that a U.S.-based business that simply collects email addresses from EU citizens will
be required to comply with the GDPR.

The GDPR signifies a radical reform to the current data protection regime and is going to
dramatically change the game when it comes to privacy and data.  Your business may need to
make major and systematic changes to the ways in which you handle data in order to achieve
compliance. Under the GDPR, individuals have expanded rights, including:

1. The right to access (GDPR Art. 12, 15) – Individuals have the right to demand access to
their personal data and inquire how their data is used by the company after it has been
gathered.

2. The right to be forgotten (GDPR Art. 12, 17) – If an individual withdraws their consent
from a company to use their personal data, they have the right to have their data
permanently deleted.

3. The right to data portability (GDPR Art. 12, 20) – Individuals have a right to transfer
their data from one service provider to another.

4. The right to be informed (GDPR Art. 12, 13, 14) – Consumers must “opt in” for their
data to be gathered, and consent must be explicitly.

5. The right to correction (GDPR Art. 12, 16) – Individuals have the right to have their data
updated.

6. The right to restrict processing (GDPR Art. 12, 18) – Individuals can request that their
data is not used for processing.

7. The right to object (GDPR Art. 12, 21) – this includes the right of individuals to stop the
processing of their data for direct marketing. There are no exemptions to this rule, and
any processing must stop as soon as the request is received. In addition, this right must
be made clear to individuals at the very start of any communication.

8. The right to not be subject to automated decision making (GDPR Art. 12, 22) –
Individuals have the right to demand human intervention, rather than having important
decisions made solely by algorithm.

Penalties for non-compliance are astronomic: €20 million or 4% of annual revenue, whichever is
greater. Do you have questions or concerns about GDPR compliance? Reach out to us at
hello@archetypelegal.com to learn more about what your business needs to do to comply.

Disclaimer: This post discusses general legal issues and developments and intended to serve as informational only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

Drafting An Equity Incentive Plan

To keep on talent, it’s frequently imperative that a startup and small business offer
significant equity packages to offset below market salaries.

When designing an equity incentive plan for your company, consider the following: (i)
which individuals you would like to reward, (ii) the specific types of awards that provide
the most fitting incentives for those who participate in the plan (e.g. stock options, stock
appreciation rights, phantom stock), and whether or not the plan meshes well with the
existing compensation program.

Once a general outline of equity awards has been established, the startup must consider
how much of the cap table will be comprised of the equity incentive plan. Because an
equity plan will likely be used for several years, the startup should estimate the number of
shares that will be needed to cover future grants for the coming years. Private companies
typically have only a handful of controlling shareholders and therefore can obtain the
necessary shareholder approval to amend the plan to increase the share reserve at any
time. Nevertheless, it’s typically advisable to reserve enough shares for three year's worth
of grants for administrative convenience.

After you are finished with figuring out the plan’s share reserve, you must determine the
actual individuals who are eligible. This generally includes employees, consultants, non-
employee directors and advisors. This may seem like an obvious step, but an important
one nonetheless to think about ahead of time.

Have your plan eligibility sorted out? Great. Now it is imperative that you determine how
(and by whom) the plan will be administered. In other words, will the board of directors,
the compensation committee, or another committee entirely be in charge of governing the
plan? And out of those options, what would be the scope of the administrator’s authority,
and whether they would be secured against expenses incurred related to any action they
become involved in? For most startups the easiest path forward is to have the startup’s
board of directors act as the administrator as the company’s framework is not built to
include numerous committees.

Vesting is also an important detail to address as you begin to put the equity incentive plan
together, including how much freedom the administrator will have to determine vesting
when grants are made. A few options are: a general provision that contemplates vesting,
but provides flexibility to set vesting schedules in award agreements, a minimum vesting
schedule, or a provision that either establishes the circumstances under which vesting will
accelerate, or gives the administrator this power.

Now you should figure out the acceptable ways that participants in the plan can pay the
exercise price (the price per share at which the owner of a traded option is entitled to buy
or sell the underlying security) for stock options. This could include providing a cash
payment, delivering previously owned shared to the company, or net exercise (the cost of
the exercise is paid with a portion of the shares being exercised).

Next, is it important to consider some smaller, but equally important details, such as the
circumstances under which awards may be transferred, whether or not to include a
“clawback” provision (money that has already been paid must be paid back under certain
conditions), and if you should include a forfeiture provision that causes a participant to
forfeit equity rewards if he/she is terminated or engages in inappropriate activity.
 
We’re on the home stretch! Finally, think about whether awards should be subject to
things such as confidentiality provisions or solicitation restrictions. After you are done
with this, you’ll have a solid framework for an equity incentive plan.
Certainly fair from an all encompassing discussion, and a well crafted equity incentive
plan for a private company can involve a host of other issues that should be addressed
with counsel. Have questions or comments? We’d love to hear from you.
You can reach us at (415)949-0795 or hello@archetypelegal.com.

Disclaimer: This post discusses general legal issues and developments and intended to
serve as informational only and may not reflect the most current law in your jurisdiction.
These informational materials are not intended, and should not be taken, as legal advice
on any particular set of facts or circumstances. No reader should act or refrain from
acting on the basis of any information presented herein without seeking the advice of
counsel in the relevant jurisdiction.  Archetype Legal PC expressly disclaims all liability
in respect of any actions taken or not taken based on any contents of this article