If your startup just got a term sheet from an investor saying that they want to invest in your company and want to receive participating preferred stock with all of these other rights, you may be a bit overwhelmed. First off, congratulations on the proposed investment. Next, I’ll explain what all of those terms on the term sheet mean in this post starting with the participation component of participating preferred shares.
Tag: stock purchase agreements
As I’ve written about in the past, founders of a startup should have their equity vested. There are times when you may not want to, but the majority of the time it is beneficial. Some investors may insist upon it, although its one of the things in the negotiations. If the founder’s stock is vested, they should make an 83-b election. To not do so could turn into a lot of tax due to the IRS over the years the stock will vest. We’ll discuss how it works and how to make the election here.
This is a very important topic to ensure that your startup continues to be controlled by founders dedicated to its cause. What you want to avoid is a situation where a group of founders form a startup and each hold a similar percentage of the issued shares – without any restrictions on such shares. If only one or two of the original founders continue working for the corporation, and the rest stop, and either get other full-time jobs, move away, leave the country, etc., then the founders that are still around can be stuck and essentially handcuffed from making certain corporate decisions. If the corporation, as most due, requires the majority of the issued shares to take certain actions, and the corporation brings in other people from the outside as shareholders and/or directors (usually investors), then the founders who have stuck around will have essentially less of a say in major corporate actions. And if there is a liquidation event, then the founders who have left will get paid without having to put in the hard work.
One of the most important things founders of a startup have to do is make sure that everyone, and I repeat everyone, that has performed services, or provided goods, ideas, etc. to and for the company signs an assignment form transferring any and all such interests to the company. This can be done in connection with a subscription agreement or stock purchase agreement where the founders are receiving shares, or in connection with an employment/contractor agreement for previous and/or current employees or contractors.
The nightmare situation, and one that does still occur, is that a few years after a company begins to make substantial revenue, a person will claim that they are entitled to a portion of the ownership of the company based on what they performed prior to the company being formed (whether it be a design, software programming, idea, etc.). The company is in the position of either having to give up some ownership of the company, thereby diluting the current owners interests, or the company has to take a stand, hire a litigator and defend any action in court. This issue has been on the front of people’s minds due to the recent Zuckerberg portrayal.
It’s easy to prevent this. Get those assignments signed and lock down all of the intellectual property as soon as you form your business entity.