Corporation Formation and Stock Issuance

Class 2 - February 3, 2025 Agenda

• Class 1 will be recapped, and housekeeping matters will be addressed
  • Concepts such as Maslow's hierarchy of needs, G2G (Government-to-Government), mission statements, and core values will be reviewed

Formation and Organizational Matters

• To form a corporation, a certificate of incorporation needs to be filed with the relevant authorities
  • This document must be signed by an individual acting as the "incorporator"
• Charters typically establish a simple capital structure consisting of common stock only
• The initial board of directors are appointed through written consent by the sole incorporator
• The initial board of directors ratifies the initial formation actions of the incorporator, elects officers, adopts bylaws, and authorizes bank accounts and other initial matters through written consent

Initial Issuance of Stock

• Initial stock issuances may be ratified to the founders
• Companies must be qualified to do business in foreign jurisdictions where they conduct business, such as having employees, a physical presence, or operations

Choosing an Entity

• Delaware corporations are a typical choice for "Silicon Valley" startups
  • Corporations are preferred by companies that reinvest profits and plan to use an IPO or sale
• Limited Liability Companies (LLCs) are sometimes used by businesses intended to distribute profits
• Institutional investors generally gravitate towards Delaware-organized entities

Jurisdiction

• Entities already in a jurisdiction other than Delaware sometimes need to reincorporate or re-domesticate
• Changing states may require use of a merger

Capital Stock

• Companies usually only have common stock at initial formation
  • It is unnecessary to issue preferred stock unless investors or the company establish the terms for it
• Authorizing many shares is best practice, recipients feel that a large number of shares is preferable, even if the absolute number is irrelevant
  • Allocating around 40,000,000 shares is standard
• Designating shares with a low par value is important
  • Delaware determines its annual franchise tax based on aggregate par value, so shares should have a low par value of $0.001 or $0.0001 per share

Initial Issuance of Capital Stock

• Companies typically give founders common stock at a nominal or low price
• Founders have to work out the number of shares, future issuances, raising capital, and incentive equity pool size
• Founders can impose vesting on shares, giving the company the power to repurchase shares at the original price if the recipient leaves
  • Vesting is commonly achieved through the company’s right to repurchase shares on a ratcheting process over a time period
  • Vesting is often monthly time-based over 4 years with a mandatory one-year period

Equity

• Each capital issuance has to be documented with a common stock purchase or restricted stock purchase agreement
• An applicable securities law exemption must be found for each issuance
• Companies obtain an Employer Identification Number (EIN) prior to hiring employees
• Adopt forms like an Employee Offer Letter adapted to the residing state, typically "at-will"

Other Forms

• Confidentiality and Invention Assignment Agreements
• Consulting Agreements
• Companies may adopt an equity incentive plan

Equity Incentive Plans

• "Long term incentive plans" act as a multifaceted tool, including issuances of options, restricted stock, "phantom equity", etc
• Equity incentive plans have to be approved by stockholders, and the board has to approve each option grant
• Option grants must comply with state and federal securities laws
• Acquire 409A Valuations

Intellectual Property Protection

• Ensure a clean break from prior employers and partners
• Ascertain the contribution of IP by Founder(s)
• Employ strict Confidentiality Agreements / NDAs
• Ensure Inventions Agreements / Proprietary Rights Agreements are followed
• Assignments of Patents, Applications, Trademarks, Copyrights, and Trade Secrets are necessary
• Trademark the Company Name, Logos, and Slogans
• Assignments or Licenses from Incubators and Universities are needed

Constituents to Consider

• Founders
• Investors and Other Shareholders
• Advisory Board
• Mentors, Confidants, and Coaches
• Board of Directors
• Board Committees
• Employees
• Consultants
• Advisors
• Strategic Partners
• Licensing Partners

Corporate Governance: Fiduciary Duties

• Duty of Care: Directors must act with diligence and prudence, ensuring decisions come after thoughtful deliberation
  • Liability can arise from a board decision or failure to act that results in loss
• Duty of Loyalty: Directors must prioritize company’s interests, avoiding personal gain
  • They may not use their position of confidence to further their private interests

Derivative Obligations

• Corporate directors have oversight and monitoring obligations
  • This involves candidly disclosing information to shareholders and avoiding corporate waste

The Delaware Courts System

• Business Judgment Rule (BJR): Delaware courts use this rule, favoring directors acting with a rational business purpose
  • This can include divesting a non-core subsidiary or approving down-round financing during financial hardships.
• Entire Fairness Standard: Used in cases of conflict-of-interest, directors must prove their decisions are fair in both process and pricing
  • This can be proven by a special committee or approval of a majority of the minority stockholders

Financial Distress Best Practices

• Shift of Duties: Duties are increased to the entire "community of interests,” after insolvency
• Derivative Status: Creditors gain derivative status to assert claims for breach of fiduciary duties
• Assume Insolvency: Operate under a presumption of insolvency in precarious financial situations and consult with legal advisors
• Meeting Frequency & Access to Information: Hold frequent meeting, and keep decision-makers informed
• Address Conflicts of Interest: Appoint special committees and independent directors to circumvent self-interest
  • This includes avoiding board positions when a director represents both parties in deals
• Prioritize Wage & Hour, Taxes: Protect interests of employees and taxing authorities
  • Conduct an Insurance Assessment and consider contractual exculpation clauses if feasible

Managing Conflicts of Interest

• BJR is used to evaluate duty of care unless there is a conflicting interest
  • It is not enough to allege possible conflicts, but require specific details and evidence.
• Dual fiduciary positions aren't a conflict when the beneficiaries' interests align
• Decisions maximizing the entity’s value as a whole continue to receive BJR protection
• Transactions may be "cleansed" if approved by disinterested actors
• Detailed Records: Maintain careful records and consider all relevant issues, documenting all aspects of decision-making
• Secure Fairness Opinions: Obtain fairness opinions from independent advisors to affirm the transaction's fairness to the company
• Require Director & Stockholder Approvals
• Gain approval from disinterested leaders after disclosing all conflicts
• Transparency: Transactions involving directors who are lenders or equity holders need to be reported
• Enforce Separation of Roles with different committees and Board structure
• If sensitive or conflict-prone, establishing Limited Partner Advisory Committee (LPAC) may be advisable

Confidential Information Breaches

• Breach of Duty of Loyalty: Unauthorized sharing is a breach of trust resulting in harm
• Disclosing company info at a PE firm causes insider trading allegations and triggers legal events:
  • Directors need to protect sensitive information

Mitigating Disclosure Risks

• Establish a Limited Partner Advisory Committee (LPAC)
• Assists with reviewing confidential data for claims of duty breach & transactions
• The roles relating to equity vs debt require clear designation
• Conversations among internal funds need to be directly supervised by a compliance team and kept by separate entities

Fiduciary Duty Waivers

• Delaware Chancery advocates waivers of fiduciary duties among informed parties given the right considerations
• LLCs: Provide the ability to waive fiduciary duties entirely in their operating agreements
• Provisions should be clear and specific to particular transactions to maintain transparency
• Use of Counsel: Engage counsel to represent all parties in negotiations to ensure fairness and sophistication
• Consideration: Negotiate corporate waivers in exchange for valuable consideration to ensure a bargained-for exchange
• Limited Scope: No protection from liability for bad faith or other intentional harm

Class 3 - February 10, 2025 Agenda

• Class 1 Recap + Housekeeping
• Co-Founder Relationships and Capitalization
• Time Permitting Breakout Session and assigned readings
• Q&A

Choosing Co-Founders

• Factors to consider include Good to Great, Mission Statements, Core Values, Skillsets, Networks, and Symbiosis

Structuring Your Co-Founder Partnership

• Founder's Equity
• Vesting

• Real world examples: Facebook's Zuckerberg/Saverin and Cruise Automation's Vogt/Guillory

Equity Among Co-Founders

• Equity Splits should be planned and well understood
• Founders can choose Restricted Stock:
  • Why restricted stock instead of stock options?
  • Be sure to do Form 83(b) filings
• Proper Timing of incorporation and initial stock issuance is vital

Vesting Considerations

• Should founder stock be subject to vesting and consider vesting schedules?
• Discuss Acceleration and Forfeiture

Form Documents

• Certificate of Incorporation
• Bylaws
• Founder Employment Agreement
  • Compensation: Base, Bonus and Equity
  • Vesting
  • Severance
  • Other
• Proprietary Rights Agreement

Capitalization Tables

• Essential for tracking new issuances, showing who controls the company and understands payments during liquidation
  • Key aspects include identifying owners, the impact of issuances on the cap table, and payments relative to financial events
• You'll need to understand basic math for pricing a new round
  • Must know Dilution, The impact of new issuances on existing equity, the impact of down-round pricing on the conversion of outstanding equity
• Founder Stock is version one followed by founder stock plus stock options

Key Employment Law Concepts

• Emily R. Pidot, Partner at Paul Hastings LLP, will discuss:
  • Contracts, EEO, whistleblower claims, wage/hour laws, covenants, and leave laws
• Federal, state, and municipality regulate employment laws through multiple agencies
• What is a contract with bargained exchange supported by consideration?
  • Consider fixed terms or "at-will", consequences of termination, confidential information, inventions, restrictive post-employment clauses, and dispute arbitration

Enforcing Compliance

• Fair Employment Opportunity is a statutory exception to "at-will" doctrines
• Laws include protection against Discrimination via Disparate treatment and Disparate impact, Harassment, and Retaliation
• The Civil Rights Act, National Labor Relations, Equal Pay Act, Pregnancy Discrimination Act and Americans with Disabilities Act are essential protections
• Federal and State protections include genetics and pregnant workers
• Protected classes include Race, Color, Religion/Creed, Ethnicity, National origin, Sex, Includes gender, gender identity, sexual orientation, Pregnancy and related conditions, Age (typically 40+), disability, Mental and physical, and Genetic information And in certain jurisdictions add Employment status, Credit history, Caregiver status and family responsibilities, Weight and height, Hair styles and more
• Unequal pay must factor in intent, similarity of job duties, and justifications for differences
• Affirmative Action and DEI have federal contractor requirements to ensure the laws are follow

Potential claims

• Whistleblower claims are increasing and contain concurrent regulation
• Function of state law
• Termination in violation of public policy requires wide interpretations
• Look at False Claims Act & Sarbanes-Oxley disputes
• The dispute itself may be more significant

Wages and Labor

• Wage and Hour laws cover minimum wage and maximum house while delineating exempt vs non-exempt labor
• There can be complex calculations for over time
• Non-competition and non-solicitation are state laws with enforceable contracts and reasonable scope
• FTC regulates federal trade with remedies for violation

Leave Laws

• Leave guarantees, paid or unpaid
• Job protection and private action include the Family Medical Leave Act (FMLA), Uniformed Services Employment and Re-employment Rights Act (USERRA), New York Paid Sick Leave Law, and New York Paid Family Leave Law

Labor Laws

• Labor Relations govern between unions and employers
• The National Labor Relations Board enforces labor relations