• Venture capital term sheets often contain terms which are not most advantageous for startups and their founders.

• Common pitfalls include "no-shop" clauses, mandatory board seats, option pool shuffles, and "double-dip" participation.

• Startups and their founders are encouraged to seek the advice of competent legal counsel on how to best negotiate these and other points in venture capital term sheets.

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While VC firms can seem like friendlier negotiating partners than, say, private equity funds, it’s nevertheless imperative to bear in mind that these are professional investors, and that the purpose of venture capital term sheets is to get the best deal possible for the firm (and not necessarily you). The thing about common pitfalls in term sheets, though, is that they’re not always obvious, and it’s recommended that concerned parties engage competent legal counsel to assist on these issues. Nevertheless, knowledge and experience are invaluable in this context, and this Insight is designed to help shed light on some frequently seen issues for founders and startups in something of a “what to look out for in venture capital term sheets.”

1. Shop Where You Want

The single biggest red flag in any venture capital term sheet is a “no shop” (or “no-shop”) clause. A no-shop is another way of describing an exclusivity covenant, basically stating that the startup cannot seek out or connect with other potential investors for a set period of time. The point of a no-shop is to provide the parties with a window of time in which to finalize their agreement. What this really means is that it provides protection to a venture capital firm or other investor from having their investment “scooped” by a competitor. It’s a power play, made by a player who thinks the company they’re negotiating with needs their investment more than they need to make it. In some cases, that is the dynamic. But in many cases, particularly those in “hot” deal markets, competition is a startup’s best friend, and a long no-shop period could allow the “heat” of the market to dissipate while the startup’s options are still under restriction. In our view, a no-shop is an immediate red flag, and startups or other companies presented with one should consult competent legal counsel in order to formulate a strategy in response.

2. Seats Not For Sale

Venture capital term sheets very often contain a requirement that the investor gets a board seat. Board seat requirements have become so common that they’re almost a templated term in various VCs’ model term sheets. (That was a joke, but…was it?) But realistically, startups and other companies shouldn’t be of the mindset that their first, second, or other early stage investment round should require giving away one or more board seats. Investors will argue that a board seat is necessary in order to secure their investment. However, at a minority position on the board, does it actually accomplish anything, beyond perhaps setting the stage for other eventual board seats forming a bloc of investor-directors who can wrest control away from the founders? True concerns of investors around investment protection can often be resolved in the Stockholders’ Agreement, particularly if the investor is purchasing a class of equity other than common (e.g., a series of preferred). 

3.  The Option Pool Shuffle

As much as we’d like to, we can’t claim credit for inventing the term “Option Pool Shuffle,” as typically seen on venture capital term sheets. The term was invented, as far as we know, by the co-founders of AngelList on their blog, Venture Hacks, though the first use of the clause is probably way further back in corporate law history than that. The term refers to a bit of a valuation trick that’s become something of a standard when negotiating with prospective investors over startup valuation. So, what it is, and how does it work? So, part of what a venture investment will be used for, in many cases, will be increasing the company’s headcount. These new hires will very likely require equity in addition to salary and bonus compensation, and so it follows that the company will need to create a new or expand an existing option pool. The “option pool shuffle” applies these options as issued and outstanding (and thus counts them as part of the company’s fully diluted capitalization) on a pre-money basis! So, it’s not: pre-money valuation + new cash = post-money valuation; instead, it’s pre-money valuation + new cash + new options = post-money valuation, effectively applying a discount to the pre-money valuation. And how’s this all justified? The new hiring.

In most cases, new hiring is going to be a part of financing-fueled expansion, so a response of “we’re not going to hire” doesn’t typically work (though, in a post-AI world, maybe it can?). What startups and their founders can do is push back to make the new options pool more realistic (i.e., reduced), by putting realistic goals and hard numbers towards the question of “how big does the new option pool need to be?” Not surprisingly, this typically results in lower figures than what was initially counted in the investor’s calculation, and it’s through negotiation on this basis that this “discount” for the investor can often be pared back. A wholly separate tack to take is to reject the premise of including the new option pool on a pre-money basis, as its inclusion on a post-money basis would have the effect of diluting both the existing stockholders and the new investors proportionally. The important things to note here are: a) to be aware of this pitfall; and b) to engage a competent legal advisor to assist with understanding market trends and feeling out the correct amount of pushback in the context of a venture capital term sheet and subsequent financing deal.

4. Double Dippers

Investors and financing providers typically invest for preferred, not common shares. These preferred shares are so-called because they typically come with a liquidation preference. Simply put, a liquidation preference is the right, in a liquidation scenario, to receive a payout up to a certain amount (typically 1x or another multiple of their initial investment) prior to the common stockholders receiving a payout. In the event of multiple classes of preferred shares, the liquidation preferences of each class will likely be pre-determined as to preferences vis-a-vis each other in a Stockholders’ Agreement or similar document. “Double dip” participation (also known as “participating preferred”) means that a preferred stockholder has a liquidation preference, and then takes a portion of (or, “participates” in) the distribution of the net proceeds left for other stockholders. For example, if a company with only 2 classes of stock (common and preferred) has a preferred stockholder who’s invested $1 million on a 2x liquidation preference and 10% participation (i.e., the “double dip”), if the company were to sell for $3 million in proceeds, the preferred investor gets $2 million back (the liquidation preference) plus another $100k (10% of the remaining $1 million in net proceeds).

It’s vital for founders and their counsel to set limits around double dip participation, such as caps on total return for preferred stockholders. While it’s important for investors to be compensated for their investment (why else would they invest?), it’s important to ensure that the returns match the risk, and furthermore, that the deal is in line with prevailing market terms. Professional advisors, such as startup lawyers, typically have broader vision into current market trends, and founders and startups are encouraged to seek competent legal counsel to advise on how to approach double dip participation and other items pertaining to distributions of proceeds which may exist in venture capital term sheets.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Compensation-oriented stock options typically come in two varietyes: ISOs and NQSOs.

• Incentive Stock Options, or "ISOs," tend to provide more favorable tax treatment and other benefits, but come with significant restrictive conditions.

• Non-Qualified Stock Options, or "NQSOs," are available for issue to consultants, advisors, board members, and other non-employee personnel, but are subject to less advantageous tax rules than ISOs.

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Stock options are a staple in equity compensation, serving as a key incentive mechanism for companies to attract and retain talent. Essentially, stock options give employees the right to purchase company stock at a predetermined price at a future date. The choice between issuing incentive stock options (“ISOs”) and non-qualified stock options (“NQSOs”) carries significant legal and tax implications, which are crucial for both employers and employees to understand. On these matters, it is recommended that both companies issuing options and employees receiving options consult with competent legal counsel.

The Distinct Types of Stock Options

1. Incentive Stock Options (“ISOs”): ISOs qualify for special tax treatment under the United States Internal Revenue Code (the “Code”), making them a potentially tax-efficient option for employees. However, ISOs come with strict qualifying criteria (e.g., they can only be issued to employees).

2. Non-Qualified Stock Options (“NQSOs”): NQSOs are more straightforward but less tax-advantageous than ISOs. NQSOs can be granted to a broader array of service providers, not just employees, making them flexible but potentially leading to immediate taxable income upon exercise.

Tax Implications of ISOs and NQSOs

• ISOs: These provide a favorable tax deferral opportunity as no regular income tax is due at exercise. Taxes are only owed when the employee eventually sells the stock, potentially at long-term capital gains rates, which tend to be lower than regular income tax rates.

• NQSOs: When an employee exercises NQSOs, they are taxed on the difference between the stock’s fair market value (“FMV”) at the time of exercise and the exercise price as regular income. This tax occurs regardless of whether the employee sells the stock, creating a potential cash flow issue.

Choosing Between ISOs and NQSOs

Deciding whether to grant ISOs or NQSOs should involve the consideration of several factors:

• Eligibility and Limitations: ISOs are strictly available to employees and must be exercised within three months after the employee leaves the company, among other restrictions. They also have caps on how much can be exercised in a year and require that the stock be held for certain periods to receive tax benefits.

• Flexibility and Broad Applicability: NQSOs can be granted to a wider group of individuals, including consultants, advisors and board members, providing companies with greater flexibility in their compensation strategies.

Potential Pitfalls and Considerations

Despite their advantages, ISOs are not always the optimal choice due to their restrictive conditions. They must be held for more than two years after they are granted and more than one year after exercise to qualify for the aforementioned favorable tax treatment. Any ISOs not adhering to the governing set of rules will automatically be treated as NQSOs.

For startups and other early-stage companies, understanding these nuances is vital to effectively leveraging stock options as part of a comprehensive compensation strategy. Incorrectly handled options can lead to unintended financial and tax consequences for both the company and its employees.

If an ISO fails to meet its qualifying criteria, it defaults to NQSO status, altering the anticipated tax benefits. This might occur due to various reasons, including failure to meet the holding period requirements or if the options are cashed out during a company acquisition, which would be treated as ordinary income for tax purposes.

Conclusion

Stock options, whether ISOs or NQSOs, offer companies a versatile tool in designing competitive compensation packages. However, the complexity of their tax implications and the legal requirements involved necessitate careful planning and consultation with legal and tax professionals to ensure that the benefits align with the strategic goals of the company and the financial well-being of its employees.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Acceleration is the early vesting of securities otherwise subject to a vesting schedule.

• Single-trigger acceleration typically occurs upon the sale or acquisition of the company.

• Double-trigger acceleration typically occurs after the occurrence of the above trigger along with the termination without cause or resignation with cause of the subject employee.

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When navigating the complexities of equity compensation in startups and other early-stage companies, understanding the differences between single-trigger and double-trigger acceleration is crucial for founders, executives, and employees looking to gain a fulsome understanding of their equity positions within their company. These mechanisms are designed to specify how and when equity vests, typically regardless of vesting cliffs, and particularly in scenarios involving the sale or acquisition of the company.

Single-Trigger Acceleration

Under single-trigger acceleration, a single specified event—typically the sale or acquisition of the company—immediately accelerates the vesting schedule to which it applies. Accordingly, all or part of the equity that had previously been subject to vesting suddenly becomes fully vested. While single-trigger acceleration can be a boon to employees by providing immediate access to equity, it is not without drawbacks. Some view single-trigger acceleration as discouraging of long-term commitment to the company post-acquisition, as newly vested employees may elect to leave their employment upon having their equity become fully vested. Furthermore, potential acquirers may be discouraged by the additional costs imposed by the newly vested equity.

Double-Trigger Acceleration

Double-trigger acceleration is a bit more complex than single-trigger acceleration, requiring the occurrence of two separate events. Typically, these events are: a) the sale or acquisition of the company; and b) the subsequent or related termination of the employee’s employment with the company, usually either: a) by the company, without cause; or b) by the employee, with cause. (Note: the definition of “cause” is specific and is typically defined in various documents within the company’s governance framework. We may discuss this in a separate Insight.)

The double-trigger acceleration framework is overall more protective of the company’s interests, as it contains a mechanism to incentivize employee cooperation and continued service after a sale or acquisition of the company—a factor which makes the company a more valuable target. However, employees are not without protection, as typically dictated by the second trigger mechanism.

Choosing Between Single-Trigger and Double-Trigger Acceleration

The choice between these two types of acceleration should be guided by the specific needs of the company and its employees. Under the umbrella of company needs, however, the perspective of third parties is also often taken into account. In cases where the company and its management feel strongly about the need for future investment (e.g., venture capital), these stakeholders will generally contemplate how investors and other third parties will view a single-trigger vs. double-trigger acceleration framework. Typically, investors and similar parties will look more favorably upon companies with double-trigger acceleration, as having a mechanism to ensure key talent retention post-exit is generally seen as a valuable benefit. Companies and members of management are encouraged to seek the advice of competent legal counsel on these matters, typically as key perspectives vary from industry to industry and continue to evolve across the board.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Forming a Limited Liability Company (“LLC”) is a popular choice for many company founders, typically offering liability protection, pass-through taxation, and flexibility. However, choice of LLC jurisdiction (the state in which the LLC is formed) is important and should be considered in light of the various costs and benefits afforded by each relevant jurisdiction. For startups and many other companies, Delaware and New York are two common choices, each with its own unique advantages and considerations.

Delaware

Delaware is known for its business-friendly legal environment, making it a magnet for the formation of LLCs and corporations alike. One of the primary benefits of choosing Delaware as LLC jurisdiction is its Court of Chancery, a court dedicated exclusively to business disputes and staffed by judges with deep experience in corporate law. This specialized court system often results in quicker resolutions to business disputes, with a well-established body of law providing more predictability in legal outcomes.

Additionally, Delaware offers a streamlined registration process and relatively low annual fees; at the time of this writing, the annual franchise tax is a flat rate of $300 for LLCs, irrespective of income level. However, a factor to take into consideration is the requirement of many states for companies formed in other states (so-called “foreign companies”) to register or otherwise qualify to do business in their state. Such registration and/or qualification is typically accompanied by a fee. As many companies incorporating in Delaware maintain their places of business in other states, the payment of such fees is quite common. 

New York

New York is a popular choice for startups and other companies to choose as LLC jurisdiction, perhaps most commonly in cases where such companies will maintain a principal place of business in New York. Being a major global commercial hub, New York offers its own set of advantages. Physically operating in New York can enhance credibility and prestige, given its status as a financial and cultural center, and companies in New York also benefit from the ability to access local markets and networks directly.

However, choosing New York as LLC jurisdiction can come with higher costs. There is a publication requirement, under which LLCs must advertise their formation in two newspapers for six consecutive weeks, which can cost upwards of $1,000, depending on the county. The annual filing fee is on a sliding scale based on gross income, and there may be additional costs associated with state tax rates and other regulatory requirements. However, for companies operating in New York, incorporating in New York avoids the requirement of registering for—and paying a fee for—foreign qualification.

Choosing An LLC Jurisdiction

Ultimately, whether Delaware, New York or any other state, the choice of LLC jurisdiction should consider the nature of the business, where it will primarily operate, and other factors (including factors not discussed in this Insight). Those interested in forming an LLC are encouraged to seek the advice of competent legal counsel when undertaking this important step in their business journey.

Chatterjee Legal is able to assist on the matters discussed in this Insight. Please reach out via e-mail to insights@chatterjeelegal.com and a member of our team will be in touch with you shortly.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Rule 504 is a form of Reg D private placement that can provide issuers with access to a wide range of investors.

• Rule 504 allows issuers to raise up to $10 million in any 12-month period.

• Offerings under the Rule must comply with state "blue sky" laws, which is often a reason for issuers to choose to offer under another exemption.

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For small businesses and startups looking to raise capital, navigating the complex landscape of securities law is a critical step. One important avenue is Rule 504 of Regulation D. Often referred to as the "Seed Capital Exemption," this rule allows smaller companies to engage in the limited offering and sale of their securities without the need to register these transactions under federal securities laws. What follows is a summary look at Rule 504, highlighting its provisions, opportunities, and compliance considerations.

Rule 504 permits eligible companies to raise up to $10 million in any 12-month period in a non-public offering. While many startups and other companies looking to fundraise are eligible, it is important to note that Exchange Act reporting companies, investment companies, companies without a specific business plan, and blank check companies are not eligible to offer securities under the Rule. 

One of the main attractions of this exemption is its relative flexibility compared to other exemptions under Regulation D. For instance, unlike Rule 506(b) or Rule 506(c), which have more stringent investor requirements, Rule 504 allows offerings to be sold to an unlimited number of investors, including non-accredited investors. But, similar to the Rule 506 exemptions, there are no individual investment limits pursuant to Rule 504 as well. Issuers of 504 offerings also do not have to conduct verification of investors, e.g., as to their "accredited" status.

What many prospective issuers view as the main drawback of conducting a 504 offering is that, unlike those under Rule 506, Rule 504 offerings are not exempt from compliance with state securities laws (also known as "blue sky" laws). For many issuers, this presents a challenge that ends up steering the offering towards Rule 506 or another exemption. Furthermore, there are additional hurdles (in the form of exception requirements to meet) to clear if the offering is to be marketed broadly (i.e., via advertising or general solicitation), versus Rule 506(c) which poses no such hurdles. 

Issuers using Rule 504 must also be mindful of anti-fraud provisions under federal securities laws, which require all information provided to investors to be free of false or misleading statements. Ensuring compliance with these provisions requires careful planning and thorough documentation, and prospective issuers are encouraged to seek the advice of competent legal counsel on these matters.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Regulation Crowdfunding (or "Reg CF") presents opportunities for issuers to access a broad base of investor capital without the complexity of pathways such as an IPO.

• Reg CF offerings can be particularly successful for endeavors of interest to a niche or particular community.

• Reg CF offerings are still securities offerings and are not the solicitation of donations.

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The SEC’s Regulation Crowdfunding (“Reg CF”) has opened up new avenues for startups and small companies to raise capital directly from the public without the complexity or scale of an IPO. This regulation, part of the Jumpstart Our Business Startups (JOBS) Act, passed in 2012, allows non-accredited investors to participate in early-stage funding opportunities. However, while Reg CF can be a valuable tool for raising funds, issuers must take steps to navigate its compliance requirements, and issuers are encouraged to consult with competent legal counsel in that regard.

The Essentials of Reg CF

Reg CF allows eligible companies to raise up to $5 million from individual investors over a 12-month period. In order to conduct a Reg CF offering, businesses must file their offering with the SEC, typically using Form C. Form C includes details about the issuing company, its financial condition, its use of the offering’s proceeds, and the terms of the offering, among other details.

One of the relatively unique aspects of Reg CF is that it requires offerings to be made through an SEC-registered intermediary, either a broker-dealer or a funding portal. These intermediaries are tasked with facilitating transactions, ensuring investors are educated about pertinent risks, and ensuring that issuers meet the relevant regulatory requirements.

Opportunities for Startups and Small Businesses

For startups and small businesses, Reg CF presents a unique opportunity to access capital more easily than via some traditional funding routes, such as IPOs. Crowdfunding issuances tap allow issuers to tap into a broader investor base, and are typically marketed through online / digital channels. Reg CF can be particularly successful for niche or community-focused endeavors which resonate strongly with specific groups of people, however, it is important to note that offerings via Reg CF are still the sale of securities, and not the solicitation of donations.

Compliance Challenges

It is not accurate to think of Reg CF as “easy” or devoid of ongoing compliance obligations. For issuers, Reg CF requires adherence to certain regulatory requirements both at time of issuance and thereafter, including annual updating of financial statements, amendments to Form C for significant changes, and ensuring that promotional materials are not misleading and do not omit material information. Failure to comply can lead to penalties, including potential disqualification from future offerings.

Looking Ahead

While the JOBS Act has been in effect for over a decade, the adaptation of the securities marketplace to regulatory changes and new opportunities can take some time, and the ways in which Reg CF is practically applied continues to evolve. Issuers interested in pursuing a Reg CF offering should consult with competent counsel and take steps to become familiar with the requirements and use cases of Reg CF at present.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Venture capital fund regulation stems from a number of various US laws and regulations.

• There exist various exclusions and exemptions in venture capital fund regulation of which funds and fund managers should be aware.

• Funds and fund managers are encouraged to consult competent legal counsel to navigate the often murky waters of venture capital fund regulation.

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Venture capital fund regulation is based on a comprehensive set of federal securities laws and regulations and is primarily overseen in the US by the Securities and Exchange Commission (SEC). These laws and regulations inform the ways in which venture capital funds raise capital, establish fund structures, and market to potential investors, among various other facets of venture capital fund operation. Venture capital fund regulation varies in scope based on the fund’s organization, management, size, and investor profile, among other factors. While it is highly encouraged for fund managers to engage competent legal counsel to assist with venture capital fund regulation, it is nevertheless also crucial for managers to have a basic understanding of the regulatory landscape in which their funds operate, and that is the purpose of this Insight.

When examining venture capital fund regulation, there are three levels of regulation to consider: the fund itself, the fund manager, and the process by which the fund conducts its fundraising. It is also vital to note that there is much more to venture capital fund regulation than can be easily and simply distilled for the purposes of this Insight, and that this Insight serves as a summary only.

The Fund

The first and most important thing to understand about venture capital fund regulation is that venture capital funds are most typically “private funds,” which means they do not need to register with the SEC as an “investment company” pursuant to the Investment Company Act of 1940 (the “Company Act”). In order to qualify as a private fund, a fund must qualify under one of three exclusions from the registration requirement.

• The first exclusion, under §3(c)(1) of the Company Act, is for funds with less than 100 beneficial owners.

• The second, from the same section, allows for up to 250 beneficial owners but requires that the fund qualify as a “qualified venture capital fund” under the definitions contained in §3(c)(1)(C)(i) of the Company Act and §203(l)-1 of the Investment Advisers Act of 1940 (the “Advisers Act,” covered in more detail further below).

• The third, from §3(c)(7) of the Company Act, limits the fund to “qualified purchasers” only, as such term is defined under the Advisers Act and subsequent rulemaking. The qualified purchasers bar is higher than that for “accredited investor,” as used, for example, in Rule 506 under Regulation D. It is also vital to note that while the Company Act does not provide a limit to the number of beneficial owners under this exclusion, other registration requirements (for example, under the Securities Exchange Act of 1934 (the “Exchange Act”)) may apply at certain thresholds.

Drilling down further into the second exclusion, §3(c)(1)(C)(i) of the Company Act caps the size (i.e., aggregate capital contributions and uncalled capital commitments) of a “qualified” venture capital fund at $10 million, and the term “venture capital fund” is furthermore defined in rulemaking pursuant to the Advisers Act (specifically §203(l)-1) as a fund which represents itself as pursuing a venture capital strategy, has limited redemption rights, holds no more than 20% of assets in “non-qualifying investments,” and adheres to certain limits on the fund’s use of leverage. For these funds, a “qualifying investment” is typically a direct equity investment into a private company, though this term and related terms are further defined in §203(l)-1(c).

The Fund Manager

Prior to the passage of the Dodd-Frank Act (“Dodd-Frank” or the “DFA”) in 2010, many private fund managers (or “advisers”) were exempt from registration with the SEC. Post-DFA, private fund advisers are subject to the same registration requirements as Registered Investment Advisers (“RIAs”) unless such private fund advisers qualify as an Exempt Reporting Adviser (“ERA”).

Under §3(l) of the Advisers Act, an adviser may qualify as an ERA if it acts as an adviser solely to venture capital funds (as defined in §203(l)-1). This is a common route taken by venture capital fund advisers, though there are others, particularly in instances where an adviser advises both venture and non-venture funds. Qualifying as an ERA relieves the adviser of some fairly significant regulatory requirements associated with being an RIA, though ERAs may still subject to basic registration requirements and are still subject to regulation around anti-fraud, anti-money laundering (AML), and other areas.

The extent to which basic registration filings are required depends on factors such as the size of the fund and the location of its principal place of business, among others. Unlike RIAs, ERAs are not required to file a full Form ADV, but instead may be required to file a truncated version either with the SEC or the relevant state securities regulator or regulators.

The Fundraising Process

When it comes to fundraising, venture capital fund regulation is not dissimilar from the ways in which many startups’ capital raises are regulated, e.g., by the SEC’s Regulation D (“Reg D”), promulgated under the Securities Act of 1933 (the ’33 Act). Like many startups, venture capital funds often undertake Reg D private placements under Rule 506(b) or Rule 506(c). These placements are subject to several requirements, which we have discussed in further detail in a separate Insight. For example, these offerings are not open to the general public, have compliance requirements with respect to vetting the accredited status of investors, and require other forms of regulatory compliance on the part of issuers. Venture capital funds looking to raise capital are encouraged to consult with competent legal counsel to advise on these and other matters pertaining to private fund capital raises.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• It is vital for startup founders seeking to raise capital to understand the main differences between Rules 506(b) vs. 506(c).

• Rule 506(b) imposes greater restrictions on marketing but allows sales to non-accredited investors.

• Rule 506(c) allows for broader marketing of offerings but only allows for sales to accredited investors.

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Understanding the differences between Regulation D issuances under Rules 506(b) vs. 506(c) is vital for any startup and founder considering initial fundraising. While legislative efforts in the last decade have made it considerably less challenging for early-stage companies to raise capital, the process nevertheless remains complex, and companies are encouraged to engage competent legal counsel to assist on these matters. Nevertheless, what follows is a basic primer on some of the larger issues at stake in Rules 506(b) vs. 506(c).

By default, per the Securities Act of 1933 (the “33 Act”), a securities offering must be registered with the US Securities and Exchange Commission (SEC) unless it fits into one of several exemptions. The SEC’s Regulation D (“Reg D”) provides exemptions for securities offered via a “private placement.” A private placement can best be understood as an offering to a select group of investors, rather than a public offering on the open market (sort of, as we’ll explain later). The important questions to consider here are the who and the how, e.g. who is being offered securities and how are they being offered said securities. Also, it’s important to note that there are other pathways for offerings under Reg D, but we’re focusing on 506(b) vs. 506(c) here as these are, in our experience, the exemptions most commonly used by startups and similar companies.

Before we get into the distinctions between Rules 506(b) and 506(c), let’s cover their similarities:

• Unlimited funds: There’s no dollar limit on how much an issuer can raise via either 506(b) or 506(c).

• Public and private issuers: Issuers can be public (i.e., SEC-registered) or private, and US or foreign-domiciled. 

• Restrictions on resale: Securities sold via either Rule 506(b) or 506(c) must bear restrictions on resale.

• “Bad Actors” disqualified: Offerings cannot be made if a “Bad Actor” is involved on the issuing side, and issuers must take “reasonable care” (e.g., a questionnaire) to exclude Bad Actors (defined in Rule 506(d)).

• Intermediaries: Issuers under Rules 506(b) or 506(c) are not required to use an intermediary, however, any intermediary involved in the issuance must be a duly registered broker-dealer or exempt from broker-dealer registration (e.g., certain private funds).

Now, onto the core of Rule 506(b) vs. 506(c)…

The main point of distinction between Rules 506(b) vs. 506(c) is how the offering can be marketed. For 506(b), issuers are limited to direct marketing only to known investors–that is to say, those with whom issuers have a “substantial pre-existing relationship”–and no general solicitation is permitted. For 506(c), there is no limitation on how issuers may solicit investment. 506(c) doesn’t give issuers true public offering power, however, because of the next set of distinctions between Rules 506(b) vs. 506(c): investor financial profiles.

Rule 501 of Reg D defines what’s known as an “accredited investor,” and while the full definition is rather extensive, for simplicity’s sake, we can understand it as: a sophisticated / experienced investor; and/or b) a wealthy investor. The “why” of defining accredited investors–like much of securities regulation–has to do with investor protection (i.e., protecting vulnerable potential investors from scam investment opportunities skating by under the SEC’s radar), and both Rules 506(b) and 506(c) have restrictions on who can purchase securities pertinent to accredited investor status. 

For offerings under Rule 506(b) (which are more restricted in terms of marketing), non-accredited investors may participate, though no more than 35 may do so. In Rule 506(c) offerings (those which can be much more widely marketed), however, no non-accredited investors may participate at all. Furthermore, in a 506(c) offering, the issuer must take significantly greater steps to verify the "accredited" status of its accredited investors, whereas under 506(b), a simple self-certification questionnaire filled out by the putative accredited investor tends to suffice. 

So, how does this all break down? For companies looking to do a more “friends and family” style of financing round, a 506(b) offering allows sales to some investors who might want to “get in early” but don’t qualify as accredited investors. On the other hand, for companies looking to raise an aggressively-sized round from various top VC firms, but with an issuing team that may not be the best networked, a 506(c) offering allows a much wider, more omnichannel outreach, but with the above-mentioned limitations on who can ultimately be an investor, and moreover, greater cost and risk with respect to verifying the accredited status of investors. There are, of course, other smaller distinctions between Rules 506(b) and 506(c), and startups and other companies interested in conducing a Rule 506 issuance are strongly encouraged to engage competent legal counsel to advise on the matter.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Issuing stock is a vital but complex process in the startup growth cycle.

• Startups frequently issue stock using a private placement under Regulation D.

• Startups and other companies are strongly encouraged to consult legal counsel when issuing stock.

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For many startup companies, issuing stock is a pivotal process in raising capital to fuel growth, expand operations, and innovate in their respective markets. Understanding the legal and procedural framework of issuing stock is essential for entrepreneurs aiming to navigate the complexities of corporate finance and growth effectively.

Definition of Stock Issuance

Issuing stock is the process by which a startup or other company allocates shares of its equity to investors or other stakeholders in exchange for capital. These shares represent partial ownership in the company and can come in various forms, including common and preferred stock.

Legal Considerations

Before issuing stock, a prospective issuers (e.g., a startup) must take steps to comply with both federal and state securities laws. At the federal level, the Securities Act of 1933 mandates that all securities offered to the public must be registered with the Securities and Exchange Commission (SEC) unless an exemption applies. Startups and other new companies often use private placements under Regulation D for issuing stock. “Reg D,” as the regulation is often referred to, allows companies to raise capital from specific types of investors without requiring the extensive process of registration, subject to certain requirements being met with respect to how the offering and issuance are conducted. (We’ll dive deeper into the ins and outs of Reg D private placements in a separate Insight.) On top of the federal regulation, each state may have its own set of securities laws, often referred to as “blue sky” laws, which regulate the offering and sale of securities to investors in that state. Understanding which blue sky laws–and, equally importantly, which exemptions–may apply to a given issuance is critical, and startups and other issuing companies are strongly encouraged to engage competent legal counsel when issuing stock. 

The Process of Issuing Stock

1. Planning & Engagement: The first step of any major business project is–or at least it should be–coming up with a plan. This means gathering stakeholders, discussing the need for the action (e.g., issuing stock / selling equity), and identifying and engaging appropriate advisors, such as attorneys, investment bankers, etc.

2. Corporate Authorization: Next, the issuer’s board of directors must approve the issuance of stock, including the number of shares to be issued and the price per share. This decision is often documented in a specific board resolution drafted by counsel. 

3. Preparing an Offering Memorandum: For startups and other early stage companies raising capital via issuing stock, sales to private investors are overwhelmingly likely. For these issuances, the company or its financial advisers typically prepares a detailed offering memorandum or private placement memorandum (PPM). The PPM outlines the terms of the offering, the associated risks, the company’s business model, and its financials, thereby serving as a critical disclosure tool to inform potential investors of the nature of the prospective investment.

4. Securing State and Federal Compliance: For registration-exempt offerings such as Reg D private placements, the appropriate forms–such as “Form D”–must be filed with the US Securities and Exchange Commission (SEC) and applicable corresponding state authorities, as necessary. These forms notify regulators of the exempt offering and provide essential details about the company and the offering.

5. Finding Investors: The company can then proceed to secure investors, which might involve pitching to venture capital firms, angel investors, or participating in funding rounds managed by investment banks or brokers.

6. Issuance and Shareholder Agreements: Upon agreeing to terms with investors, transactions occur. The issuer takes in capital and shares are formally issued. This process involves updating the company’s share registry / capitalization table, and issuing stock certificates (or electronic stock certificates) to the new stockholders, if applicable. Stockholders’ agreements may also executed.

Conclusion

Issuing stock is a core mechanism for startups and other companies to secure the necessary capital for development and expansion. Despite the relative brevity of this summary article, however, the process is often complex, arduous and involved. Prospective issuers are strongly encouraged to consult with competent legal counsel and other professionals when issuing stock.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Electronic stock certificates provide a pathway to avoid issuing uncertificated shares without the need to use paper stock certificates.

• Electronic stock certificates provide companies with a way to simplify governance operations and minimize environmental impact in a single initiative.

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As companies move towards a new digital future, electronic stock certificates present yet another opportunity to ditch the hassle and negative environmental impact of using paper. At its core, a stock certificate is a document that evidences ownership rights to shares of stock in a corporation. Historically, companies have had two options with respect to certificating stock ownership: 1) issue certificated shares with paper certificates; or 2) forgo stock certificates altogether and issue uncertificated shares for which transactions and ownership are logged on a register. In the 21st century, however, we have a third option at our disposal: electronic stock certificates. These are just about as simple as they sound: like paper certificates, but in PDF (or some other digital) format. There are, however, some considerations that startups and other companies considering issuing electronic stock certificates should take into account.

First, companies should review their certificate of incorporation, bylaws, stockholders’ agreements, and any other relevant corporate governance documents which may have been adopted to ensure that electronic stock certificates are permissible and that paper certificates are not required. In many circumstances, an attorney can modify these documents in order to accommodate electronic certification. Furthermore, the decision to go electronic may require the consent of the company’s board of directors and/or its stockholders. In this instance as well, an attorney can be of assistance in drafting the appropriate documents for presentation and ratification.

So, what does an electronic stock certificate contain? Much like a paper stock certificate, an electronic stock certificate will include the name of the stockholder, the name of the corporation, the number of shares represented by the certificate, any applicable restrictions on transfer or other legends, voting trust arrangements, and a summary of powers, preferences, rights and restrictions.

For companies transitioning from paper to electronic stock certificates, all stockholders should be notified and offered the opportunity to exchange previously issued paper certificates for electronic ones. Companies, particularly startups, should bear in mind that this exchange process can be lengthy, expensive, and a distraction from day-to-day business operations. There are various electronic services which may be able to make this process simpler and easier for companies to undertake. Avoiding the problem altogether, new startups and other companies should discuss the use of electronic stock certificates with their counsel at time of entity formation / drafting of core corporate governance documents, particularly if they are interested in simplicity of process and corporate sustainability initiatives such as going paperless.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• The Defend Trade Secrets Act of 2016 (DTSA) represents a pivotal development in the protection of trade secrets.

• The DTSA contains provisions for federal jurisdiction, ex parte civil seizure, and robust damages.

• Companies should consider updating their form documents (e.g., NDAs) to provide notice of immunity under the DTSA for certain disclosures.

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For startups and other innovative businesses, protecting intellectual property–particularly trade secrets–is paramount. In 2016, Congress enacted the Defend Trade Secrets Act (DTSA), which changed the landscape of IP protection in the United States as we know it. The DTSA provides federal jurisdiction for the theft of trade secrets, aligning with existing federal intellectual property laws while also offering uniformity in trade secrets litigation, which had previously been governed by varying state laws. Companies also have certain compliance obligations with respect to the DTSA, as detailed further below.

The DTSA can be viewed as something of an extension of the Economic Espionage Act of 1996 (EEA), allowing an owner of a trade secret to sue in federal court for misappropriation. Trade secrets are broadly defined under the DTSA as all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, or codes—whether tangible or intangible. To qualify as a trade secret, the information must derive independent economic value from not being generally known or readily ascertainable through proper means by another person who can obtain economic value from its disclosure or use.

A notable provision of the DTSA is the introduction of a mechanism for civil seizure. This enables a court to order law enforcement officials to seize stolen trade secret materials without notifying the accused party beforehand if the court believes that the accused party would destroy evidence if they were forewarned. However, this provision is intended to be used in exceptional circumstances only, where an immediate and irreparable injury would occur. The threshold for initiating a seizure under the DTSA is high, and the act includes measures to protect defendants from abuses, such as security requirements and damages for wrongful or excessive seizures.

Furthermore, the DTSA explicitly allows for injunctions and damages. An injunction may prevent the dissemination of a trade secret, and the damages awarded can include actual losses caused by the misappropriation and any unjust enrichment not covered by the calculated losses. Additionally, if the trade secret was willfully and maliciously misappropriated, the court may award exemplary damages, which could be up to twice the amount of the actual damages.

The DTSA also contains a whistleblower immunity provision. This provision protects individuals from criminal or civil liability under any federal or state trade secret law if the individual discloses a trade secret in confidence to a government official or an attorney, solely for the purpose of reporting or investigating a suspected legal violation, or in a complaint or other document filed under seal in a lawsuit. It is vital that businesses like startups and other innovative companies update their form documents, such as their Non-Disclosure Agreements (NDAs), to provide notice to counterparties of this immunity under the DTSA.

Since its enactment, the DTSA has radically shifted the options businesses have to protect their trade secrets. It provides businesses with a federal avenue to pursue claims of trade secret theft, which can often involve complex jurisdictional issues when multiple states or international boundaries are involved. Moreover, the DTSA’s alignment with existing federal intellectual property protections reinforces the US’s commitment to safeguarding intellectual property rights.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

• Stockholders' Agreements are a vital part of robust corporate governance.

• Startups should consider adopting a Stockholders' Agreement prior to seeking investment.

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A Stockholders’ Agreement, also known as a Shareholders’ Agreement, is a legally binding contract among the stockholders of a company. Primarily concerned with governing the relationship between the company’s stockholders, the agreement also governs the way in which the company is managed, sets terms and conditions on ownership of company stock, and protects the interests of individual stockholders. The overall purpose of a Stockholders’ Agreement, like most agreements, is to minimize disputes between its signatories, in this case by setting forth rules for fair treatment of stockholders and proper management of the company. For example, these agreements frequently contain provisions on the purchase and sale of stock, protocols for conducting key business and making decisions affecting the rights of stockholders, mandatory actions to be taken in the event of a stockholder’s death, incapacity, or exit from service to the company (typically in the case of an employee or executive), and other similar provisions.

Key Provisions

1. Buy-Sell Provisions: One of the most critical elements of any Stockholders’ Agreement is the inclusion of buy-sell provisions, or “buyout” provisions. Often referred to colloquially as a “business pre-nup,” these clauses dictate what happens to a stockholder’s stock if they wish to exit the company, die, or become incapacitated. Buy-sell provisions sometimes also include language governing scenarios in which a stockholder is forced out of the company, providing a clear method for calculating the value of shares and who may purchase them.

2. Control and Management: These provisions detail management of the company and how decisions will be made, including the appointment of directors to the company’s board, and the delegation of management responsibilities. Control provisions also discuss voting rights, often detailing the sorts of decisions requiring a supermajority of votes–or unanimous consent–instead of just a simple majority.

3. Pre-emptive Rights: Pre-emptive rights, also commonly referred to as “anti-dilution provisions,” allow existing shareholders the first opportunity to buy new shares of stock issued by the company, thus enabling them to maintain their proportionate ownership of the company and prevent dilution.

4. Drag-Along and Tag-Along Rights: Also commonly referred to as “drag/tag,” these rights deal with events surrounding the sale of the company and work in opposite ways. Tag-along rights protect minority stockholders in the event of a sale of the company. In the event that a majority stockholder sells their stake in the company, the minority holders have the right to join the transaction and sell their stock under the same terms as were received by the majority. Drag-along rights function in the opposite way, giving a selling majority stockholder the right to force minority stockholders to join in a sale of the company at the same terms, thus facilitating cleaner transaction.

5. Dispute Resolution: Stockholders’ Agreements often contain rules and procedures for resolving stockholder disputes, including through mandatory mediation and/or arbitration, among other means.

Benefits

Stockholders’ Agreements aren’t strictly necessary for any company. They are, however, highly advisable for any company with more than one stockholder (i.e., most startups and larger companies). The agreements provide a clear framework for governance and decisionmaking, giving stockholders much needed predictability, stability and direction as their companies’ organizational structures and cap tables grow increasingly complex. Furthermore, to investors, a well thought out Stockholders’ Agreement tends to make investment more attractive, as it demonstrates that the company is well-managed and that the risks of shareholder conflict are minimized.

Conclusion

A Stockholders’ Agreement is an essential tool for both large and small companies, and particularly startups. It ensures that stockholders are on the same page regarding how the business is run, how their rights are safeguarded, and how disputes and other issues will be handled. By clearly defining the roles, responsibilities, and rights of stockholders, a Stockholders’ Agreement can pre-empt conflict and pave a solid path forward for startups and other companies. Stockholders’ Agreements are often long and complex, however, and it is advisable for companies thinking about implementing a Stockholders’ Agreement to consult with competent legal counsel to draft and tailor an agreement according to their specific preferences and requirements.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• LLCs tend to offer more flexibility in management and taxation.

• Corporations offer more structure and typically provide easier share transferability.

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When starting a company, founders should become familiar with types of business entities before deciding if and how to incorporate. LLCs and corporations are typical forms of entity used by startups. Although both provide similar liability protection for owners, there are several key differences as highlighted below.

LLCs are limited liability companies. These companies offer more flexibility regarding management and taxation and require fewer record keeping requirements. Owners are called members and own a percentage of the business, which is sometimes called a membership interest. These members act like partners. They can be involved in managing LLCs (member-managed) or can appoint someone else (manager-managed). The operating agreement, an enforceable contract among members, can control a new company’s management structure. There are often restrictions on transferring membership interests in LLCs. The approval of other members can be required, while some states require that LLCs are dissolved if a member leaves. These companies do not have their own tax classification and founders can choose how they are taxed, whether it be as sole proprietorship, a partnership, an S corporation, or a C corporation. 

Corporations, on the other hand, offer greater structure and the ability to transfer shares easily. Owners of corporations are called shareholders and are issued shares to correspond with their percent of ownership. These shares are easy to transfer from one person to the other, giving corporations perpetual life. The management structure at these companies is more rigid, often compromised of a board of directors for broad oversight and various officers for managing the day-to-day. Corporations will hold annual shareholder meetings, issue annual reports, and have more reporting requirements to meet. They are taxed as either C corporations or S corporations.

Decisions regarding corporate form are incredibly important, and should be made in consultation with the appropriate legal and tax resources. A startup lawyer is typically a source of valuable information and advice on such matters.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• Benefit corporations are legal entities designed to produce both a public benefit and shareholder value.

• B Corporations are companies that have been certified by B Lab and demonstrate high social and environmental performance.

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Benefit corporations and certified B Corporations are sometimes confused with each other due to their similar names. The sections below break down their key characteristics and differences. 

Benefit corporations are a type of legal entity designed to produce a public benefit and drive shareholder value. Their framework creates a foundation conducive to long-term mission alignment through capital raises and leadership changes and allows for flexibility regarding sale and liquidity options. These benefit corporations have several obligations. They must commit to creating public benefit and value in addition to generating profit. They must consider their impact on society and the environment to create long term sustainable value. They must report to shareholders, and often the wider public, on social end environmental performances. There are different versions of benefit corporations adopted in thirty states. The Delaware Public Benefit Corporation is considered a gold standard, though.

B Lab, a non-profit, grants B Corporation Certifications to companies that meet their standards regarding social and environmental performance, transparency, and accountability. B Lab uses their B Impact Assessment, a public tool, to score companies. The information on the assessment is self-reported, with 10% randomly reviewed in person and on-site. Companies must score an 80/200 on the assessment to receive the certification. They are assessed on workers, community, environment, and customers. Once such standards are met, companies register with B lab and pay certification fees and annual fees. They then are able to use the distinctive B circle mark logo. 

To conclude, benefit corporations are a legal entity designed to consider the public good while generating shareholder value while B Corporation Certifications are given out to companies who meet various environmental, social, and governance standards.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• NDAs establish confidential relationships and allow for the sharing of information with reduced risk of wrongful disclosure.

• Businesses entering negotiations may sign NDAs.

• Employers can require employees to sign NDAs in order to protect confidential company information.

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Non-disclosure agreements, or NDAs, are cost-effective and generally short-form legal documents that establish confidentiality in business or other relationships. NDAs serve as an agreement that sensitive information will not be made available to others. The language in these documents can clarify specifically what must be kept a secret and outlines the potential consequences should there be a breach of contract.

NDAs are common for businesses entering negotiations with other businesses as they allow parties to share information without fear that it will end up in the hands of competitors or out in the public domain. Typically, parties are classified as “discloser” or “receiver” parties, and it is vital that each “receiver” party signs an NDA. When only one party will be disclosing confidential information, the other party may sign a “one-way” NDA which represents that it will be bound by the terms of the NDA. When both parties will be disclosing such information, the parties typically sign a “mutual” NDA which applies the obligations of the NDA to each party.

NDAs can also typically be found in employment documents for employees who come into contact with their employer’s confidential information. For many startups and other businesses, all employees sign NDAs.

When considering the use of an NDA, startups may wish to consult with a startup lawyer who can assist with drafting or review of NDAs.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• Non-compete agreements prevent employees from directly competing with their employer upon their termination or separation.

• Well crafted non-competes should be narrowly tailored and reasonable.

• Non-competes are unenforceable in some states and are often challenged in court.

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A non-compete agreement is a legal agreement or a clause in an employment document that specifies that an employee cannot compete with their employer after their employment is terminated. The agreement can also prohibit employees from revealing information to other parties during or after employment, though this may also be covered in a separate confidentiality agreement or clause.

These agreements should be narrowly tailored. There should be a specific a length of time that signees are barred from certain actions. This time limit, as well as the geographic limitation should be reasonable. Activities deemed “competition” should be clearly defined as well.

Non-compete agreements and clauses are more likely to be scrutinized by the courts than confidentiality agreements. Some states do not allow the enforcement of non-competes. For example, California, North Dakota, and the District of Columbia virtually ban them entirely, while some states (Illinois, Maine, Massachusetts, New Hampshire, Rhode Island, Washington) prohibit non-compete agreements for low-wage workers. This list can change from time to time, so it is important to consult with an attorney when drafting these provisions and regularly thereafter in order to ensure that your documents reflect the current state of the law in your respective jurisdiction(s).

President Biden’s Executive Order of 9 July 2021, the Promoting Competition in the American Economy Order, encouraged the Federal Trade Commission (FTC) to curtail the use of non-compete agreements and clauses that impact a worker’s mobility unfairly. Although there has not yet been (at the time of this writing) official federal action on these agreements, such action looms in the distance. Going forward, it would be wise for employers to pay close attention to their non-compete agreements to ensure compliance with this evolving area of law.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• Equity splits among founders determine the relative ownership of a startup at its outset.

• Salary replacement, IP contribution, qualifications, time of joining, and funding contribution should be considered when deciding equity splits.

• Equity splits should typically be set up with an accompanying vesting schedule.

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Equity is a non-cash compensation option that translates to partial ownership in a company. It is often given to founders and other financial supporters. There are several things to consider when deciding whom to grant equity to, and how much to grant them. These considerations are discussed below.

Equity can act as a salary replacement. Oftentimes, people who found startups or join them during very early stages work for a low salary–or no salary at all–in exchange for a stake in the company. The extent of a co-founder’s contributions should also be considered. Some may have greater skills, dedicate more time to projects, or carry out more integral work which may correspond with greater equity.

Additionally, those who join during the earliest stages of a company often receive larger pieces of equity. Founders who provide seed capital also typically receive equity with respect to both their work and their capital contributions separately. Past contributions and qualifications should also be considered. One can look at a founder’s network and prior professional experience, their development of important IP, their past presentations to investors, etc.

Once the amount of equity is determined, a vesting schedule should be established. Vesting is important for a number of reasons. First, it gives the company and its cap table a certain amount of security should a founder exit during the vesting period. Second, it demonstrates to venture capitalists and other potential investors that a company’s founders have a mature understanding of equity splits and conditions, and likely other startup fundamentals as well.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• Acquisition is a goal for many startups.

• Startups should prepare for acquisition long before seeking to close a transaction.

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At the end stage of a startup’s lifecycle, equity owners may seek an exit from their positions. For some companies, an IPO may provide a viable option. For others, acquisition presents a preferable alternative.

Prior to going to market for a transaction, however, there are several focus areas in which crucial effort yields a better startup acquisition. Attractive companies tend to have strong visions, superior products, strong talent, proprietary work product, and demonstrated profitability. 

The first key step in positioning for a startup acquisition is to ensure that all company books and records are in good order. This means anything from board resolutions and minutes, to HR documents, key contracts, and beyond.

Second, if the company has any protectable intellectual property (patents, trademarks, or other IP), having registrations or other forms of strong protection (e.g., trade secrets with strict data confidentiality protocols in place) can go a long way to demonstrating to a potential acquirer that the business is being run with a focus on value and would make a good startup acquisition.

Third, and perhaps most importantly, is a focus on demonstrating either a) profitability; or b) a clear path to profitability. This is very business-specific, and depending on the demand for startup acquisitions in the particular business’s market, actual profitability may not be a requirement in order to get a deal done.

When considering the startup acquisition route, companies should consult with a startup attorney in order to understand the process and how best position themselves for acquisition.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• A copyright protects artistic, literary, or intellectually created works.

• A trademark protects a word, phrase, or design that identifies goods and services.

• A patent protects technical inventions.

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Copyrights, trademarks, and patents protect different forms of intellectual property. Certain products and services may touch upon more than one of these intellectual property rights, and as a startup its important to know which apply to your new business.

Copyrights give rights to authors regarding their original creative works. These protections are applicable for creations like films, songs, paintings, books, software codes, website designs, marketing reports, etc. The author of such copyrighted work has the exclusive right to publish, perform, display, reproduce, or record creative content. They are also granted the sole right to create derivative works from the original, whether it is a revision, summary, translation, or adaptation. Copyright exists automatically in an original work of authorship, but an owner can register with the U.S. Copyright Office to increase the protections, specifically in the event of litigation.

Trademarks can be used to protect a symbol, slogan, color, logo, design, or word that identifies the source of a product or service, making it distinguishable from those provided by others. Some examples of this include a product name like that of the iPhone, or a feature on a product like FaceTime, or the manufacturer or provider like Apple. The owner of a trademark has the right to prevent unfair competition by using language or logos that are confusingly similar. Trademarks in the US should be registered with the U.S. Patent and Trademark Office in order to give owners the legal presumption of trademark ownership and certain enforcement rights in court. Registering also allows for the use of the federal trademark symbol. 

With a patent, the U.S. Patent and Trademark Office grants exclusive property rights for an invention. This bars others from using, selling, or making an invention using the art covered in the patent. There are three types of patents: utility, design and plant. Utility patents are granted for inventions or discoveries of processes, machines, articles of manufacture, or compositions of matter. Design patents apply to new, original, and ornamental articles of manufacture. Plant patents are granted for inventions or discoveries and asexual reproduction a distinct and new variety of plant. Patent applications in the US are filed with the U.S. Patent and Trademark Office.

For startup founders, it’s vitally important to understand the differences of copyrights, trademarks and patents. Intellectual property is the heart of innovation, and innovative companies that aim to disrupt need to focus on copyrights, trademarks and patents from inception.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.

Key Takeaways

• SAFEs accomplish similar goals as convertible notes, but are not debt instruments.

• SAFEs give investors the right to stock in a future equity round if a triggering event occurs.

• Startups might use SAFEs because the process is simpler, cheaper, and faster than priced equity rounds.

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Simple Agreements for Future Equity (SAFEs) have become increasingly common in the startup world. The concept was formalized by Y-Combinator lawyer Carolyn Levy as a replacement for convertible notes. They were historically used by top startups in Silicon Valley raising money from angel investors, but now see much broader use in a variety of contexts.

SAFEs accomplish the same goals as convertible notes, but they are not debt instruments. They do not accrue interest, do not have a maturity date, and there is no legal obligation for funds to be paid back.

The document acts as an agreement between a company and an investor. The investor invests money in the company, and the SAFE grants the investor a right to receive some of the company’s stock in a future equity round. The investor receives an equity stake if a triggering event occurs and the terms of the SAFE are met. Typical triggering events include future fundraising rounds, acquisition of the company, or an IPO of the company. The number of shares the SAFE investor receives depends on the terms of the SAFE. As an example, when a subsequent fundraising round triggers a SAFE, the equity received by the SAFE investor will likely depend on the share price at which the subsequent fundraising round is conducted, and furthermore likely subject to a discount rate as pre-determined in the SAFE.

Startups should seek the advice of a startup lawyer in determining whether a SAFE is an appropriate fundraising option given the company’s specific needs and requirements.

Questions? E-mail us at insights@chatterjeelegal.com.

Startup Law Insights is a thought leadership production of Chatterjee Legal, P.C. and is presented subject to certain disclaimers, accessible here.