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AdobeStock_419006596-300x200Equity compensation is an important tool employers use to attract – and retain – talented employees. Before you begin offering stock options, it is important to consider the amount of stock being issued to employees and how issuing it could affect the value of your business. There are many ways to structure an equity compensation package. Consult with a California startup lawyer to structure compensation packages that are best for your business, your future funding rounds, your shareholders, and your employees.

Before issuing any equity compensation, it is important to understand how this will affect the value of your business. Many businesses consider stock options as an inexpensive part of a compensation package. There is no accounting cost and no cash outlay required, so stock options might seem like an attractive option. There is even an added tax benefit: the difference between the stock price and the exercise price is a tax deduction to the business. But the National Bureau of Economic Research reports that this perception does not form an accurate picture of the actual economic cost of stock options. Understand the long-term costs of stock options – and how they will affect the valuation of your business over its lifetime – before making any decisions about how many employees will be awarded what amount of stock options.

The Total Percentage of Your Employee Stock Options

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AdobeStock_73458159-300x157Venture capital is a critical source of capital for any new startup. However, venture capital does not need to come with overly draconian conditions. Venture capital may be contingent on the funders receiving Board seats, and funding is typically offered in exchange for equity. But just how much equity should venture capital investors receive? If too much is given away, founders may lose control of their own business. Founders must understand how to use equity strategically in order to get the maximum benefits.

Typical Apportionments or Dilution At Each Round Of Funding

Funding must account for the competing interest of founders, the initial seed investors, venture capital investors, and employees who receive equity compensation. This can make it difficult – if not impossible – to come up with a split that everyone considers to be “fair.” While each company has different needs, here is a common scenario at a Series A round of funding with venture capital:

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AdobeStock_414456803-300x118Both employees and employers need to understand how stock options work. Employers who issue stock options without understanding them can lose significant value or control of their businesses. Employees who do not understand their stock options could miss out on a significant part of the compensation they are owed for their employment. The experienced California stock option lawyers at Structure Law Group help employers and employees understand their legal rights and obligations regarding stock options.

A Timeline Of the Stock Option Life Cycle

Like other financial assets, stock options have a life cycle. Understanding this life cycle can help you understand the true value of the asset. There are three general phases in the life cycle of stock options:

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AdobeStock_239826817-300x200The Board of Directors is a critical factor in the success – or failure – of any new startup company. Entrepreneurs must therefore be strategic about if and when they give Board seats to investors. Entrepreneurs must also be cautious of the total number of seats that are given away. Board seats represent voting power, and if investors create a voting block, they could change the entire direction of the company. They could even vote the founders out entirely.

The Difference Between the Board Of Directors and an Advisory Board

The key difference between a board of directors and an advisory board is the authority to make binding decisions on behalf of the company. An advisory board provides strategic – but non-binding – advice about the management of a company. The Board of Directors has the authority to make binding decisions of a company. Some investors may be satisfied to receive a seat on an advisory board and simply consult about the direction of the company. Others may require a seat on the Board in order to retain the authority to make binding decisions. This is especially common in when financing from venture capitals. Because venture capitals usually involve a larger investment than angel or seed money, finance professionals want to protect their investment by staying directly resolved in the management of the startups.

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AdobeStock_299947443-300x162It is important to structure a business entity that will best meet your needs before starting a new business. Even once you have selected a corporation over a partnership or LLC, there are still choices to be made. S corporations and C corporations have some similarities. There are also critical differences, and it is important to understand how each type of corporation functions before selecting the one that will best meet your business needs. 

Only One Class Of Stock

There are several key differences in how ownership may be held in S corporations and C corporations. S corporations may issue only one class of stock, while C corporations can have multiple classes. S corps are limited to a maximum of one hundred shareholders – all of whom must be United States citizens or lawful residents. C corporations have no such restrictions on ownership. S corporations also cannot be owned by other S corporations, C corporations, LLCs, partnerships, or trusts. These stock and ownership restrictions make an S corporation unsuitable for many corporations. Be sure to consult with your business lawyer about your specific plans for issuing stock and apportioning ownership in your new business.

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AdobeStock_238077911-300x200A private placement memorandum (PPM) is used to offer security in a private company to specific groups of qualified investors. It is used as a marketing tool to provide information and generate interest, but it also serves to meet the requirements of SEC regulations. It is therefore important to be sure that your company’s PPM is reviewed by an experienced investment attorney. An incomplete or vague PPM can expose your business to liability or SEC fines. While investment bankers usually prepare these memos, they may not be qualified to provide legal advice. A small investment of attorney’s fees now could save your business significant fines, penalties, and legal fees later on.

United States Investors Versus Overseas Investors

Regulation S of the Securities Act of 1933 allows private securities offerings to be made to foreign investors. These offers can, however, bring up other complicated legal issues. For example: if the offer is made directly to foreign investors in another country, the offeror could be subject to that country’s securities laws and regulations.

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AdobeStock_414492192-300x169Secured creditors use collateral to protect their investments. Collateral can be a good form of financial protection, but the security only exists if creditors follow all legal requirements. If all legal requirements are not met, a secured creditor might not have priority over other creditors – or have no legal rights to the collateral at all. An experienced securities lawyer can help your business protect its assets by securing your transactions appropriately.

There are many ways that a creditor can gain priority over other creditors. Mortgage lenders, for example, file specific legal documents along with the recorded deed to ensure that they have a secured interest in the home if the borrower stops making required mortgage payments. These documents are made publicly available by the county recorder. As a result, the mortgage lender is able to claim priority over other claimants to the home and even secure priority in any bankruptcy proceedings the borrower might file.

The same principles apply to businesses that have a secured interest in collateral to protect their investments. Documents are drafted to conform to the Uniform Commercial Code. These “UCC filings” are then sent to the office of the Secretary of State to be recorded. These public records serve as notice to other creditors. Like a mortgage recorded at the county recorder’s office, the security is protected because other creditors have been notified that the secured creditor has priority.

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AdobeStock_278805688-300x200Term sheets are, by design, made to be simple. They are supposed to give a general overview of a proposed investment in very broad terms. Despite this, a term sheet can contain provisions that could create complications for your business in the future. An experienced investment lawyer can help you fully understand the implications of all term sheet provisions in order to protect your business from future problems.

Investment Amount

The amount to be invested is usually the most important provision of a term sheet. Many investors, especially new investors, get distracted by the overall amount of the proposed investment, which can distract an entrepreneur from other important investment terms. The investment could be contingent on the business being valued above a set amount. It could come in installments. The installments could also be contingent on the business meeting certain goals by certain dates. Business owners must thoroughly understand the terms of any such contingencies and how they could impair the company’s ability to secure the full amount of the proposed investment.

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AdobeStock_224157473-300x200Convertible notes are a popular method used by startup companies to raise capital for a new business. There are, however, different types of convertible notes, and it is important for new business owners to understand the pros and cons of each. It is also critical that business owners understand the long-term consequences of convertible notes on their future business operations and financing.

Maturity Date

SAFE (a Simple Agreement for Future Equity) is a convertible note in which an investor converts his or her investment into equity in the company. With a SAFE agreement, the investment converts to equity at any future equity financing. There is no maturity date. Thus, the investor could convert the debt to equity the very next day if an applicable equity financing is completed. KISS is a different type of convertible equity that may or may not have a maturity date.

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AdobeStock_312736469-300x200There are many ways to capitalize a new business. Angel financing, venture capital, and private equity are popular methods of raising capital, but it is important for business owners to understand the difference. These different methods are appropriate at different stages of your business life cycle. Successful entrepreneurs know when and how to use them effectively. 

Stages of the Business Life Cycle

Before a business starts any operations or has a single customer, it will need startup capital. It is at this beginning when angel financing (or “seed investors”) comes in. These initial investments of “seed money” allow entrepreneurs to take their initial idea and turn it into reality. The earliest phase of the business cycle, however, is also the riskiest. There is a high chance that angel financiers will lose their entire investment. But angel financing typically has the highest returns on investment to compensate for this risk.

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