This is part of my set of notes from the Startup School 2006 sessions at Stanford.
Page Mailliard is a partner at Wilson Sonsini Goodrich & Rosati, a law firm that has been responsible for taking many companies public. In her session, she covered the basics of setting up a company.
Setting Up a Company
Every company is different, and everything you face will be unique to you. You need to be sure to do it right the first time – get a lawyer who knows what they’re doing, and get the tried and true documents in place. Page, for example, is going to give you one option plan, one proprietary inventions agreement, etc. These are documents that have been distilled to perfection from experience. Doing it wrong can ruin your company, so get the legal structure in place correctly. Get it done, so you can get it out of the way and focus on your business. Doing so will save time, money, and, potentially, catastrophic errors.
Page recommends formation as a Delaware corporation, a C corporation; this is a company under which you can provide options to employees. Incorporation in Delaware is preferred because it has better case law – simple is better. The basic steps to incorporation (not doing into great details, given the audience) as a Delaware corporation:
- Decide the amount of authorized stock: 20M common stock, 10M preferred, 3-5M founders’ shares
- File your certificate of incorporation with the state: With Delaware, you can fax it direct to them and it will be handled immediately.
- Establish the Board of Directors and the Officers of the company: Don’t distribute these too freely. Be very careful before you put someone on the board, because the board has a lot of power over you. Maybe start with a small board – maybe one or two members. The alternative is to put people you trust on a board of advisors instead of the Board of Directors. They can still be given options and help you, they just won’t be on the Board of Directors.
- Enter into a stock agreement with the founders: Consider a vesting schedule for founders which distributes stock over time. This protects the company against a founder walking away with a stake in the company without staying and contributing to the company. If you come with more than one person and you don’t put vesting in place, there will be trouble when circumstance either fall out between the founders, or force them to leave the company for personal reasons.
- Make sure the founders assign all their intellectual property to the company
- Adopt standard documents: Adopt standard documents for the company bylaws, proprietary information agreements, option plans, etc – it just makes the whole thing a lot simpler. One thing to think about at this stage is what happens to options in the event of an acquisition. This is a big decision. You probably will want to reward your employees by accelerating options in the case of acquisition; however, many VCs will not invest if you have 100% acceleration in the event of acquisition. The reason is that they want to see that people still have a stake in the company and stick around after the acquisition to continue operating the business.
- Seek trademarks and patents: This will be covered in another section during the sessions.
Two Important Questions to Answer
- Who owns the technology?If you can’t say who owns the technology, you don’t have a company. Investors will scrutinize if you own what you say you own. Three problem scenarios:
- The former employer: You want to start a company, and have an idea while working at another company. They own ideas created on their time, with their resources. Example scenario: One company they worked with involved a programmer who used his current employer’s server to check out something he was working on – they’re had to rewrite some of the code, and give his employer some money because of his error.
- The Microsoft intern: Let’s say there’s bunch of friends working on stuff. One of the friend gets and internship with Microsoft. Microsoft generally owns everything you dream up while working for them. To avoid this situation, you shouldn’t have anything to do with that person for the summer.
- The Genentech Material Transfer Agreement: Company had used some genetic material from Genentech in their project for a technology to grow heart cells. Took the company years to get out of the agreement.
- Who owns the company?
- No napkin promises: You should know who has the stock, shares, options, and can prove it. Don’t want some person to come out of the woodwork. They always show up at the acquisition or IPO, touting previous promises. Get the deal in writing. Always.
- No tithing: For one company in the midwest, they got forecast of the revenues that had a funny vague footnote. Turned out the company had tithed 10% of their revenues to God. In the end, the lawyers had to argue scripture in order to have the 10% of revenues tithed to God to come out of the founder’s piece, not everyone’s.
- Note on preferred stock: Always give preferred stock to investors; this forces them to pay more for those shares.
- Interesting consideration: As employee option pool is non-voting, don’t forget to look at the effective voting rights distribution in a deal. Otherwise, a 50/50 split between the current company investors and a new investor in a new round may result in the new investor effectively running the company.
What About That First Term Sheet? (And How Do You Get It?)
- Be very clear on the value proposition, the market opportunity and the significant ramp-up in the value your company can achieve.
- Keep your slides and presentation short (10 slides – 15 minutes). These guys have listened to sooo many pitches and they have short attention spans. You need to talk to people about your idea and your presentation, revise each time. Don’t show all the backup evidence, but have it ready for when they ask.
- Be credible. Do your homework on the fund, the people you will be meeting, your market projections, and your reference accounts
- Bring “A” players on your team
- Listen to others
- Listen to yourself. While it’s true that you should get information from others – but at the end of the day you need to be able to go with your gut.
- Your best leverage is another term sheet. Avoid the “no-shop” agreement; unless you completely have a deal in place, you will end up shooting yourself in the foot.
- Get the best business partner you can – not necessarily the highest valuation – and the best board representatives
- What other recommendations do you have to avoid getting sued by current company? When you’re at the company, ask yourself is what you’re working on similar to what they’re doing. If it’s not significantly different, you might consider sitting down and talking with them. It’s all about relationships – talking with them will affect how they respond. If you give them time, tell them what you’re doing, you’re much less likely to have a problem. It’s always good to know who’s litigious.
- What does it cost to get a lawyer? In this area, it’s more common for the lawyers to want to be part of risk of the company. At the same time, lawyers are very expensive. The way it usually works with their firm: if you’re really legitimate, we’ll write it such that there is a limit ($10-15K) that you can use without having to pay in the event you aren’t funded.
- Is it normal for the seed investors to be diluted the same as the founders? Sometimes it can be a situation where they’re treated exactly the same, sometimes there may be an extra “kicker” for the seed round investors.
- How can you resist bloat on the Board of Directors as you take on investors and complete subsequent investment rounds? It is really difficult to get people off the board. One entrepreneur commented that the biggest thing they learned was not to give away titles, as it made it difficult to hire new “A” players into the right position. Avoid putting people on the board in the first place if at all possible, or limit the number of seats taken by investors in each stage.
- Is it common for the law firm to take a stake in the company? In some cases, yes. They may want to participate in the upside, perhaps even putting in money themselves. They have to be careful to avoid conflict of interest. But in general, no, they don’t expect to take any stock in the company.
- How do you avoid innovating during “company time” when you’re salaried? One entrepreneur took an extended vacation to avoid this completely. As a general rule, make sure it’s not during normal business hours (9am-6pm), Monday-Friday.
- But how do you avoid innovating using company resources when you have company-provided ADSL or cell phones? Don’t think they would win based on that, but easy to mitigate by buying another cell-phone, or paying for the service yourself.
- What do lawyers like to hear from a company, as opposed to VCs? Are they credible, passionate, professional, and committed to the business? If you believe in what you do and have back-up for it, then they will too.
- What’s the compensation you give to the board of advisors? 25K shares, regardless of the outstanding shares (which is kind of ironic). In the case of really big names, they might demand a percentage of the company, like 1%. It may be the right decision, given who they are and what they can do for the company. Of course, it would be a good idea to put vesting on it.
- How do you protect yourself against corporate proprietary agreements? Make sure to disclose your prior inventions. As long as you’re doing it on your time, you should be protected.