Setting Up a Company: Formation & Governance

Class 2 - February 3, 2025 Agenda:

• Class 1 Recap and Housekeeping will be discussed
• Formation and Organizational Matters will be discussed
• Constituents will be covered
• Corporate Governance will be covered
• There will be a Q&A session

Setting up the Company

• A corporation is formed by filing a certificate of incorporation, signed by an individual acting as the “incorporator"
• The charter typically sets a simple common stock-only capital structure
• An initial board of directors is appointed through action by written consent of the sole incorporator
• Initial formation actions of the incorporator are ratified, officers are elected, bylaws are adopted, and bank accounts are authorized through action by written consent of the initial board of directors
• Ratifying initial issuances of stock to founders may be achieved
• Foreign Qualifications are needed to perform business where the Company "carries on its business." like if it involves employees, physical presence, or operations

Choice of Entity

• A typical "Silicon Valley" startup forms as a Delaware corporation because corporations are preferred for companies that reinvest profits and use IPOs or sales to deliver shareholder returns
• LLCs might be employed
• It is a preferred vehicle for businesses intending to distribute profits
• Delaware organized entities are preferred by most institutional investors because of the familiarity with Delaware corporate/LLC law and its predictability
• To move to another state, some states require the use of a merger

Setting Authorized Capital Stock

• Growth stage companies typically have only common stock at the start
• No need to create preferred stock before investors set terms for preferred stock financing
• Authorizing a lot of shares, like ~40,000,000, allows recipients to receive a large number of shares
• Classes or series of shares should be designated with a low par value of $0.001 or $0.0001 per share because Delaware determines its annual franchise tax on the basis of aggregate par value in some instances

Initial Issuances of Capital Stock

• A company will issue common stock to founders at a nominal or low price
• Founders must consider the number of shares to issue and anticipated issuances to others, plans for raising capital, and the desired size of the incentive equity pool for employees and consultants
• Founders may want to impose "vesting” on their and/or others shares so that the company can repurchase shares at the original cost if a recipient ceases involvement with the company
• Vesting involves the company gaining the right to repurchase shares, with the repurchase right falling away in ratable amounts over an agreed period, such as a monthly time-based approach over 4 years with a "one-year cliff", but this could be less for founders
• A common stock purchase agreement or a restricted stock purchase agreement documents each issuance
• An applicable securities law exemption must be found for each issuance

Employees and Incentive Equity

• Before hiring, obtain an Employer Identification Number (EIN)
• Adopt forms of:
  • Employee Offer Letter, tailored for the employee’s state of residence but usually "at-will."
  • Confidentiality and Invention Assignment Agreement
  • Consulting Agreement
• A company may adopt an equity incentive plan
• A typical "long term incentive plan" is like a Swiss army knife because it covers issuances of options, restricted stock, phantom equity, and other equity-linked incentives forms
• Stockholders need to approve the equity incentive plan
• Per the plan's terms, the Board must approve each option grant
• Option grants must comply with state and federal securities laws

Intellectual Property Protection

• It's key to maintain a clean break from prior employers and partners
• Founders must document contributions of their IP
• A company must ensure it has Confidentiality Agreements / NDAs, Inventions Agreements / Proprietary Rights Agreements, and assignments for all Patents, Patent Applications, Trademarks, Copyrights, and Trade Secrets

Constiuents

• Founders
• 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

• Duty of Care: Directors must act with diligence and prudence and ensure thoughtful deliberation and adequate information gathering for decisions
• There are 2 instances in which a breach of the duty of care can occur with liability:
  • When a board decision results in the loss that was ill advised
  • When the failure of the board to act in circumstances could have prevented the loss
• Duty of Loyalty: The company’s interests must be prioritized above directors' own interests
• "[Corporate officers and directors are not permitted to use their position of confidence to further their private interests. The rule requires there should be no conflict between duty and self-interest"
• Derivative Obligations include oversight and monitoring of the corporate entity, disclosing information to shareholders, and avoiding wasting corporate assets

Business Judgement Rule and Entire Fairness

• Business Judgement Rule (BJR): Delaware courts evaluate board decisions with the BJR, favoring directors who act with rational business purpose
  • includes financial investments or approving down round financing
• Entire Fairness Standard: used in conflict-of-interest or other heightened scrutiny scenarios
• Directors need to affirmatively show their decisions or transactions are entirely fair in process and pricing
  • includes burden shifting mechanisms

Best Practices: Financial Distress

• Shift of Duties: A company must account for the whole “community of interests,” including creditors, once a corporation becomes insolvent.
• Derivative Status: If a company becomes insolvent, creditors gain derivative status to assert a possible breach of fiduciary claim

Conflicts of Interest

• The business judgment rule evaluates duty of care claims but doesn’t cover conflict-of-interest transactions which require heightened scrutiny
• There needs to be specific allegations and later, actual evidence to find that the director faced a conflict on the facts of the case
• Transactions can be "cleansed" if approved by a majority vote of completely informed and disinterested directors or stockholders

Treatment of Confidential Info

• Breach of Duty of Loyalty: Unauthorized sharing that harms the company can result in a breach of the duty of loyalty
• Directors must safeguard the information
• Example - A director shares information to a PE firm and it is later used against the company
• Example - A director at a portfolio company shares insider information with a PE firm
• Establish a LPAC to assist with the review of confidential information and decision-making
• Define separate internal roles so there is equity for other investments (such as debt)
• Monitor the internal compliance team to ensure there are walls put up

Fiduciary Duty Waivers

• Delaware Chancery Court supports contractual waivers of fiduciary duties among sophisticated parties as long as they are tailored and negotiated, and there’s valuable consideration
• LLCs have the flexibility of waiving fiduciary duties through operating agreements and define their own duties
• It is helpful if provisions are specific, clear, and narrowly tailored for particular transactions to avoid unenforceability
• Engage counsel to represent all parties in negotiations to ensure fairness in the agreements
• Negotiate waivers in exchange for consideration
• Limited Scope: No protection from liability for bad faith or other intentional harm

Class 3 - February 10, 2025 Agenda:

• Class 1 Recap and Housekeeping will be discussed
• Co-Founder Relationships will be covered
• Capitalization will be taught
• There will be a Q&A session
• Assigned Readings for Today's Class will be completed

Co-Founder Relationships

• Choosing your co-founder(s) based on good to great people, mission statement, core values, skillset, network and symbiosis
• Structuring your co-founder partnership through vesting and founders' equity
• Case studies for Zuckerberg/Saverin and Cruise Automation / YCombinator

Contractual Terms for Co-Founders

• Ensure there are equity splits among co-founders
• It is helpful to issue restricted stock
  • Why restrict stock instead of options?
  • complete form 83(b) filings
  • timing of incorporation and stock issuance
• Enforce vesting
  • a founder’s stock be subject to vesting
  • Ensure there are vesting schedules and understand acceleration and forfeiture

Form Documents

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

Real World Examples

• Facebook: Zuckerberg/Saverin
• Cruise Automation: Vogt/Guillory

Capitalization Tables

• It tracks stock transactions and new issuances of any equivalents
• Helps in understanding who owns a company
• Someone at a minimum, should be able to explain who owns a company, discuss the impact of financings, and allocate payments in connection with a sale
• Some things to understand are basic math for pricing a new round, dilution (impact of new issuances on existing equity), and the impact of down-round pricing on pricing terms

Capitalization Table Iterations

• Version 1 - Founder Stock
• Version 2 – Founder Stock + Stock Options

Class 4 Agenda:

• Housekeeping / Check-In
• Key Terminology and Ubiquitous Provisions
• Legal Requirements for an Enforceable Contract
• Preliminary Contracts
• Commercial Contracts
• Strategic Contracts
• Remedies
• Q&A

Key Terminology and Ubiquitous Provisions

• Parties
• Preliminary Contract
• Contract: Legally Enforceable Agreement
• License
• Representations and Warranties and Disclaimers of Warranties
• Covenants like Promises to Do/Refrain and Compliance with Applicable Law
• Conditions
• Indemnification and Limitations on Liability
• Termination
• Remedies
• Effect of Change of Control and Assignability
• Governing Law and Forum/Jurisdiction vs. Arbitration vs. Mediation (Binding vs. Non-Binding)

Legal Requirements for an Enforceable Contract

• It must have Legal Capacity.
• Mutual Assent (Written vs. Verbal that includes a valid offer and acceptance with no counter-offers)
• Intent to Contract is key
• Consideration of a value exchange is important
• Possible issues include Authority (Designated Authority; Board Approvals) and Certainty/Clarity (vs. Ambiguity and/or Material Holes)

Draft with Specificity

• Draft with Specificity Unless Tactically Determined
• Journalistic Approach is helpful:
  • Who
  • What
  • Where
  • Why
  • How
  • When

Preliminary Contracts

• Non-Disclosure Agreements:

  • Establish confidentiality obligations between the disclosing party (seller) and the receiving party (potential buyer or investor), and states what is confidential and uses of it
  • It defines what types of information is protected, like: financial records, customer data, intellectual property, and trade secrets.

• Letters of Intent:

  • Is a written document that describes how parties understand a transaction
  • It includes the express intent to make a formal agreement
  • Some key components are parties involved and an agreement description

• Exclusivity Letters:

  • Purpose is to for parties to have exclusive dealings together
  • A important term is the length of time

Commercial Contracts

• Services Contracts such as Master Service Agreements or Statements of Work
• Purchase Contracts
• End-User Agreements typically including Enterprise vs. Per-Seat
• OEM Agreements
• Distribution Agreements
• Licenses

Licences

• Definition: Partial Conveyance of Ownership; Permission to Do Something
• Inbound vs. Outbound
• Unilateral vs. Mutual/Cross-Licenses
• Scope vs. Restrictions on Use: Time, Place (Worldwide vs. Other), Manner (Fields of Use)
• Applicable Intellectual Property
• Rights to Source Code
• Maintenance and Support
• Right to Sublicense
• Exclusive vs. Non-Exclusive vs. Partial Exclusivity
• Payment Terms: Upfront vs. Scheduled vs. Royalties
• Perpetual/Time-Based
• Revocable vs. Irrevocable
• Click-Through Agreements

Other Key Provisions Sometimes Used

• Exclusive Dealing
• Most-Favored Nation (MFN) / Best-in-Class Provisions and rights/benefits
• Holistic vs. Defined Universe of Competitors
• Limitations on Liability
• Antitrust Concerns

Strategic Contracts

• Partnerships
• Joint Ventures
• Strategic Alliances
• Organizational: Charter/COI, Bylaws, Shareholder Agreements
• Employment, Incentive Equity + (Sometimes) Benefit Plans
• Financings
• M&A Agreements

Remedies

• Damages
• Liquidated Damages Provisions
• Equitable Remedies that include:
  • Specific Performance
  • Temporary Restraining Orders
  • Preliminary Injunction
  • Permanent Injunction
• Who Pays Attorneys' Fees and Other Costs of Enforcement?
• Statute of Limitations
• Equitable Tolling
• Jurisdictional Authority to Enforce (Contractual vs. Matter of Law)

Class 5 Agenda:

• Introduction to the topic
• Explanation of Employment Law 101, by Emily R. Pidot, Partner at Paul Hastings LLP

Introduction to Emily R. Pidot

• Partner, Employment Law Department at Paul Hastings LLP
• She is also the Chair of the New York office
• 20+ years of litigating disputes, and advising employers
• Recognized by Chambers and Partners, The Legal 500, SuperLawyers, member of American Employment Law Council and frequent lecturer on employment law topics

Employment Law 101 Outline

• Contracts between employers and employees
• What is EEO?
• What are "whistleblower" claims?
• Wage and Hour explained
• Post-employment restrictive covenants
• Leave laws
• Is labor law different from employment law?

Understanding of Regulation

• Common law
• Federal law
• State and local law
• Concurrent regulation
• Federal preemption
• Enforcement agencies at all levels

Contractual relationship between employer and employees

• A contract means bargained for exchange supported by consideration
• It is typically "at-will" employment doctrine
• To write an employment contract, it must include a Statute of frauds and Promissory estoppel
• Written representations can form the basis of a contract claim such as a handbook

Key Terms of Employment Contract

• Job description
• Hours of work
• Compensation and benefits
• Fixed term or "at-will"
• Consequences of termination
• Confidential information
• Inventions
• Post-employment restrictions
• Arbitration of disputes

Understanding of Equal Employment Opportunity

• It is a Statutory exception to "at-will" doctrine
• Laws protect the following:
  • Discrimination
  • Disparate treatment
  • Disparate impact
  • Harassment
  • Retaliation

Employment Laws

• 1866: Civil Rights Act (Section 1981)
• 1935: National Labor Relations Act
• 1938: Fair Labor Standards Act
• 1963: Equal Pay Act
• 1964: Civil Rights Act (Title VII)
• 1967: Age Discrimination in Employment Act
• 1978: Pregnancy Discrimination Act
• 1990: Americans with Disabilities Act

EEO Laws

• Title VII of the Civil Rights Act of 1964
• Pregnancy Discrimination Act and New York State Human Rights Law
• Equal Pay Act and New York Equal Pay Law
• Age Discrimination and Employment Act of 1964and New York City Human Rights Law
• Americans with Disabilities Act
• Civil Rights Act of 1866
• • Genetic Information Nondiscrimination Act and Pregnant Workers Fairness Act

Anti-Discrimination Laws

• Damages include recovery of damages and/or certain equitable relief.
• Limits on recovery on Title VII statutes
• Some laws, such as NYC Human Rights Law, place NO limits on monetary relief.
• All states enforce their own anti-discrimination laws enforced by agencies

Prohibited Grounds for Discrimination

• Race
• Color
• Religion/Creed
• Ethnicity
• National origin
• Sex and gender identity
• Pregnancy
• Disability
• Genetic information
• There are also certain jurisdictions for: -employment status
  • caregiver status -Weight and height
  • Hair styles
  • Arrest or conviction record
  • Status victim etc

Prohibited Conduct

• Disparate treatment involves intentionally treating an employee or applicant differently based upon who they are
• Disparate impact is employment practices that impact employees in a protected class, unintentionally
• Harassment based on a protected characteristic is not allowed
• Retaliation for reporting discrimination or harassment or cooperating with an investigation isn't permissible

Equal Pay Laws

• The laws provide equal/fair pay
• Burden shifts to employer

Affirmative Action in employment, DEI

• Need to meet self-analysis, even if there is no claim from the employee
• Response because of globalization
• Not legal construct
• ESG action