Company Formation: Class 2 Overview

• Class 2's agenda for February 3, 2025, includes:
• Class 1 recap and housekeeping
• An overview of Maslow, G2G, mission statements, and core values
• Formation and organizational matters
• Constituents
• Corporate governance
• A Q&A session

Setting Up a Company

• Forming a corporation starts with filing a certificate of incorporation.
• The certificate of incorporation is signed by the incorporator.
• The company charter sets the initial simple common stock capital structure.
• Appointing the initial board of directors is done via written consent of the sole incorporator.
• The initial board ratifies actions of incorporator, elects officers, adopts bylaws, and authorizes bank accounts via written consent.
• This process may be used to ratify the initial stock issuances to founders.
• To legally operate where the company "carries on its business" requires foreign qualifications.
• Activities such as having employees, a physical presence, or conducting operations.

Choice of Entity

• Most startups in "Silicon Valley" incorporate as Delaware corporations.
• Companies that reinvest profits and plan for an IPO or sale often favor corporations.
• Sometimes, LLCs are used as a preferred vehicle for businesses distributing profits.
• Entities initially formed in non-Delaware jurisdictions may need to reincorporate or re-domesticate.
• Institutional investors generally prefer Delaware entities due to familiarity with Delaware corporate/LLC law and predictability.
• A merger is required in some states for a company to relocate to another state.

Setting Authorized Capital Stock

• Typically, growth companies have only common stock at the start.
• There is no need to create preferred stock if you don't know what terms to designate until the company or investors define them.
• Authorizing a large number of shares (~40,000,000) is best, so that stock recipients can receive a large number of shares.
• Classes or series of shares should have a low par value ($0.001 or $0.0001) because Delaware sometimes calculates its annual franchise tax based on the total par value.

Initial Issuances of Capital Stock

• Founders typically receive common stock at nominal or low prices.
• Founders decide how many shares to issue to themselves, considering future issuances, capital raising plans, and the employee equity pool size.
• Founders may impose "vesting" with the company being able to repurchase shares at the original cost if the recipient is no longer involved.
• Vesting involves the company's right to repurchase shares, which decreases over an agreed period.
• Monthly vesting over four years with a one-year cliff is a common setup.
• Every issuance must be documented with a common stock or restricted stock purchase agreement.
• An applicable securities law exemption must be identified for each issuance.

Employees and Incentive Equity

• Companies must obtain an Employer Identification Number (EIN) before hiring.
• Employment forms should include:
• Employee Offer Letter, which should be tailored to the state and usually "at-will."
• Confidentiality and Invention Assignment Agreement.
• Consulting Agreement.
• Companies need to conduct 409A Valuations.
• Companies might use an equity incentive plan.
• The typical "long term incentive plan" covers options, restricted stock, phantom equity, and other equity-linked incentives.
• Stockholders must approve the Equity incentive plan.
• Each option grant needs Board approval per plan terms.
• State and federal securities laws must be followed in option grants.

Intellectual Property Protection

• Clear separation from previous employers and partners is needed.
• Contributions of IP by Founder(s) are relevant.
• Confidentiality Agreements / NDAs should be in place.
• Inventions Agreements / Proprietary Rights Agreements should be in place.
• Assignments of Patents, Applications, Trademarks, Copyrights and Trade Secrets.
• Trademark for Company Name, Logos, Slogans, etc.
• Assignments / Licenses from Incubators, Universities, etc. should be documented.

Constituents

• Key Company Constituents:
• Founder(s)
• Investors and other Shareholders.
• Advisory Board.
• Mentors, Confidants and Coaches.
• Board of Directors.
• Board Committees.
• Employees.
• Consultants.
• Advisors.
• Strategic Partners.
• Licensing Partners.

Introduction to Fiduciary Duties

• Directors must act with diligence and prudence and must ensure decisions are made after adequate gathering of information and thoughtful deliberation.
• Liability can arise from an ill advised or negligent board decision, as well as an unconsidered failure of the board to act.
• Directors must put the company's interests first.
• Personal business over company interests are prohibited.
• Corporate officers and directors are not allowed to use their position of confidence to further their private interests.
• Directors must exercise proper oversight, candidly disclose information to shareholders and avoid wasting assets.

Business Judgement Rule and Entire Fairness

• Delaware courts evaluate board decisions under the Business Judgment Rule (BJR), favoring directors with a rational business purpose.
• Financial Investments: reinvesting in higher return areas with a non-core subsidiary, backed by extensive analysis.
• Approving Down-Round Financing: approving necessary down-round financing during financial strain after assessing all options, prioritizing company survival.
• A conflict-of-interest or heightened scrutiny scenarios calls for the Entire Fairness Standard.
• Directors must affirmatively prove that decisions or transactions are entirely fair in process and pricing.
• Burden Shifting Mechanisms: A special committee or approval of a majority of the minority stockholders.

Best Practices: Financial Distress

• The "community of interests” extend to all, including creditors, after a corporation becomes insolvent.
• Creditors gain derivative status to assert claims for breach of fiduciary duties, once insolvent.

Best Practices for Managing Financial Distress

• It is best to assume a presumption of insolvency in precarious financial situations.
• It is important to hold frequent meetings so all decision-makers are well-informed.
• Utilize special committees and independent directors to avoid self-interest implications.
• Prioritize employees and taxing authorities.
• Regularly consult with financial and legal advisors.
• The necessity and coverage of D&O insurance must be evaluated and consider contractual exculpation clauses where feasible.

BJR and Conflicts of Interest

• The business judgment rule evaluates duty of care claims but does not cover conflict-of-interest transactions which require heightened scrutiny.
• It is not enough when a director is abstractly affiliated with a type of institution to claim that the director has a conflict of interest.
• There must be specific allegations and evidence that the director acted with an improper purpose.
• If the interests of dual fiduciaries are aligned, there is no conflict.
• Decisions to maximize the entity value do not confer specific benefits continue to receive BJR protection.
• Board lenders are not unusual particularly when distressed and need to protect their investments.
• If approved by a majority vote of fully informed and disinterested directors or stockholders, transactions may be "cleansed".

Best Practices for Managing Conflicts of Interest

• Keep meticulous records that clearly demonstrate careful and informed consideration of all relevant issues.
• In includes documenting the rationale behind each decision and the steps taken to ensure fairness.
• Obtain fairness opinions from independent financial advisors to affirm the transaction's fairness.
• Rely on insights from independent management or external advisors.
• Gain approval after disclosures of all conflicts.
• All transactions involving directors who are also lenders or equity must be transparently reported and reviewed.
• A strict separation of duties and roles is needed.
• Establish a Limited Partner Advisory Committee (LPAC) to govern sensitive and conflict-prone transactions

Risks of Sharing Confidential Information

• Unauthorized sharing of confidential information harms the company and can result in a breach of the duty of loyalty.
• Directors must safeguard sensitive information.
• Examples of breach scenarios:
• A portfolio director disclosing information to a PE firm so it can be leveraged in deal negotiations.
• A director shares insider information with a PE firm that leads to illegal trading.

Best Practices for Managing Dissemination of Confidential Information

• A LPAC should be established to assist in the review of confidential information and transactions
• This can defend against claims of breach of fiduciary duty.
• There must be clear and separate internal equity and other investments roles.
• Internal compliance team compliance oversight is best to restrict and chaperone conversations.

Best Practices: Fiduciary Duty Waivers

• Delaware Chancery Court supports contractual waivers of fiduciary duties among agreements of sophisticated parties if they are clear, specifically tailored and negotiated.
• LLC flexibility can waive fiduciary duties in operating agreements.
• For waivers:
• Ensure provisions are specific, clear, and narrowly tailored.
• Counsel should represent parties.
• Negotiate waivers for valuable consideration.
• Limit scope to protect against bad faith and intentional harm.

Assignment Fact Pattern

• The Board of Directors has five seats filled by a CEO/Founder, two Series A investors, a common stockholder representative, and an independent director.
• A majority of the Board is needed to make decisions.
• Stock needs to be raised with a need for capital as the Series A Investors are proposing to invest an additional $5m in the Series B Stock exchange.
• Break-Out Groups: (a) CEO and Common Stock Board Members; (b) Series A Board Members; (c) Independent Board Member.
• Considerations should be taken into account in determining whether to move forward with the proposed capital raise.
• Procedures should be adopted as part of the process.