Starting a Company: Formation and Governance

Class 2 Agenda: February 3, 2025

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

Setting Up a Company

• To form a corporation, a certificate of incorporation must be filed.
• It must be signed by an individual acting as the "incorporator".
• The charter typically sets a simple common stock-only capital structure.
• The sole incorporator appoints the initial board of directors via written consent.
• The initial board of directors ratifies the incorporator's actions via written consent.
• This includes electing officers, adopting bylaws, and authorizing bank accounts.
• It may also ratify the initial issuances of stock to founders.
• Foreign qualifications are required to do business where the company carries on its operations, has employees, or has a physical presence.

Choice of Entity

• Silicon Valley startups are often formed as Delaware corporations.
• They're the preferred vehicle for reinvesting profits, and ultimately using an IPO or sale to deliver shareholder returns.
• Delaware is chosen compared to other states.
• LLCs are sometimes used as a business structure.
• They are preferred by businesses intending to distribute profits.
• The entity may have already been formed in a non-Delaware jurisdiction, and has to reincorporate/re-domesticate.
• Investors typically prefer Delaware-organized entities due to familiarity with Delaware corporate/LLC law and predictability.
• Some states require the use of a merger to move to another state.

Setting Authorized Capital Stock

• Growth companies typically have only common stock at initial formation.
• There is no need to create preferred stock due to unknown terms until the company or investors set terms for preferred stock financing.
• It's best to authorize a lot of shares at ~40,000,000.
• This ensures recipients of stock can receive a large number of shares even if the specific share number does not actually matter.
• Classes or series of shares should be designated with a low par value of $0.001 or $0.0001 per share.
• Delaware determines its annual franchise tax on the basis of aggregate par value.

Initial Issuances of Capital Stock

• Companies typically issue common stock to founders at nominal or low prices.
• Founders need to decide how many shares to issue.
• This is done considering anticipated share issuances to others, plans for raising capital, and desired size of incentive equity pool for employees and consultants.
• Founders can impose "vesting" on their and/or others shares.
• This allows a company to repurchase shares at original cost if recipient ceases involvement with the company.
  • Vesting is often achieved by giving the company the right to repurchase shares.
  • The repurchase right falls away in ratable amounts over an agreed period (e.g., in quarterly installments over four or five years).
• Typical vesting is monthly time-based over 4 years with a "one-year cliff" (could be less for founders).
• Each issuance must be documented with a common stock purchase agreement or a restricted stock purchase agreement.
• An applicable securities law exemption must be found for each issuance.

Employees and Incentive Equity

• Companies obtain an Employer Identification Number (EIN) before hiring.
• Companies use various forms.
• The Employee Offer Letter should be tailored by state where employees reside, often an "at-will" offer.
• These forms include Confidentiality and Invention Assignment Agreements, and Consulting Agreements.
• 409A Valuations are performed.
• Companies may adopt equity incentive plans.
• A typical "long term incentive plan" is a Swiss army knife covering issuances of options, restricted stock, phantom equity, and other forms of equity-linked incentives.
• Equity incentive plans require stockholder approval.
• Each option grant requires board approval per the terms of the plan.
• Option grants must comply with state and federal securities laws.

Intellectual Property Protection

• There needs to be a clean break from prior employers and partners.
• There is a contribution of IP by Founder(s).
• Use Confidentiality Agreements / NDAs.
• Use Inventions Agreements / Proprietary Rights Agreements.
• Use Assignments of any Patents, Patent Applications, Trademarks, Copyrights and Trade Secrets.
• Trademark for Company Name, Logos, Slogans, etc.
• Assignments / Licenses from Incubators, Universities, etc.

Constituents

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

Introduction to Fiduciary Duties

• Duty of Care: Directors must act with diligence and prudence.
• Decisions should occur after adequate information gathering and thoughtful deliberation.
• There are two contexts in which liability for a breach of the duty of care can arise.
  • Liability may be said to follow from a board decision that results in a loss because that decision was ill advised or 'negligent'.
  • Liability to the corporation for a loss may be said to arise from an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss.
• Duty of Loyalty: Directors must prioritize the company's interests above their own.
• Directors should avoid any personal gain from business opportunities and potential conflicts of interest.
• Corporate officers and directors cannot use their position of confidence to further their private interests.
  • The rule enforces undivided and unselfish loyalty to the corporation.
  • It also demands there shall be no conflict between duty and self-interest
• Derivative Obligations: Corporate directors have several other fiduciary obligations derivative of the duties of care and loyalty.
• These include obligations to exercise proper oversight.
• Directors should candidly disclose information to shareholders under certain circumstances.
• Directors should avoid wasting corporate assets.

Business Judgment Rule and Entire Fairness

• Business Judgment Rule (BJR): Delaware courts evaluate board decisions under the BJR.
• The BJR favors directors if they act with a rational business purpose.
  • Examples include financial investments and approving down-round financing.
• Entire Fairness Standard: Applies in conflict-of-interest or other heightened scrutiny scenarios.
• Directors must affirmatively prove that their decisions or transactions are entirely fair in both process and pricing.
  • Examples include burden shifting mechanisms with a special committee or approval of a majority of the minority stockholders.

Best Practices: Financial Distress

• Shift of Duties: Duties extend to the entire "community of interests,” including creditors, once a corporation becomes insolvent.
• Derivative Status: Once insolvent, creditors gain derivative status to assert claims for breach of fiduciary duties.
• Best Practices for Managing Financial Distress:
• Assume Insolvency: Assume a presumption of insolvency in precarious financial situations.
• Meeting Frequency; Access to Information: Hold frequent meetings, ensuring all decision-makers are well-informed.
• Address Conflicts of Interest: Utilize special committees and independent directors to avoid self-interest implications.
• Prioritize Wage & Hour; Taxes: Focus on protecting the interests of employees and taxing authorities.
• Seek Expert Advice: Regularly consult with financial and legal advisors.
• Insurance Assessment: Evaluate the necessity and coverage of D&O insurance, and consider including contractual exculpation clauses where feasible.

Best Practices: Conflicts of Interest

• 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.
• An assertion a particular director has a conflict of interest or is acting in bad faith due to affiliation with a particular institution is not enough.
  • Specific allegations and actual evidence is required to permit a finding that the director faced a conflict or acted with an improper purpose.
• If a director holds dual fiduciaries, there is no conflict if the interests of the beneficiaries are aligned.
• Decisions that seek to maximize the value of the entity as a whole, but do not confer any direct or specific benefits on a fiduciary continue to receive the protection of BJR.
• It is not unusual for lenders to have designees on a company's board, particularly when the company was a distressed one.
  • Lenders may want designees to keep a close eye on the company's financial situation to protect their investments.
• Cleansing Conflicted Transactions: Transactions may be "cleansed" if approved by a majority vote of fully informed and disinterested directors or stockholders.

Best Practices for Managing Conflicts of Interest:

• Maintain Detailed Records: Keep meticulous records demonstrating careful and informed consideration of all relevant issues.
• This includes documenting the rationale behind each decision and the steps taken to ensure fairness.
• Secure Fairness Opinions: Obtain fairness opinions from independent financial advisors to affirm the transaction's fairness to the company.
• Using this additional layer of assurance means stakeholders can be sure that the decision aligns with the company's best interests.
• Depend on Independent Advice: Rely on insights from independent management or external advisors to minimize reliance on information from parties with potential conflicts.
• This helps maintain the integrity of the decision-making process.
• Require Director and Stockholder Approvals: Gain approval of transactions by fully informed and disinterested directors or stockholders with comprehensive disclosures of all conflicts.
• This ensures approvers are not personally benefiting from the transaction and are acting in the best interest of all shareholders.
• Transparency: All transactions involving directors who are also lenders or equity holders must be transparently reported and reviewed.
• Separation of Roles: Enforce a strict separation of duties and roles to prevent conflicts of interest.
• This includes using different committees to review transactions involving a director.
• It also provides for separate Board vs lender / equity holder representation.
• Establishment of LPAC: The establishment of a Limited Partner Advisory Committee may be advisable in some scenarios.
• A governance body within PE funds is designed to oversee and approve sensitive and conflict-prone transactions.
• This applies particularly when a sponsor has dual roles, such as equity investor and lender.

Best Practices: Treatment of Confidential Info

• Risks of Sharing Confidential Information:
• Breach of Duty of Loyalty: Unauthorized sharing of confidential information that harms the company can result in a breach of the duty of loyalty.
• Directors must safeguard sensitive information to maintain trust and integrity. Treatment of Confidential Information and Breach Scenarios:
• Directors must safeguard sensitive information to maintain trust and integrity.
• A director at a portfolio company who discloses confidential information to a PE firm which uses the information in loan negotiations against the portfolio company likely constitutes a breach of the director's duty of loyalty.
• A director at a portfolio company who shares insider information with a PE firm, leading to insider trading activities, breaches fiduciary duties and triggers legal consequences under insider trading laws.
• Establishment LPAC: Establish a LPAC to assist with the review of confidential information and ultimate decision-making with respect to transactions involving confidential / sensitive information to guard against claims of breach of fiduciary duties.
• Separation of Sponsor Representatives: Clearly define and separate internal roles with respect to equity and other investments. Compliance Oversight: Inform the internal compliance team to ensure appropriate walls are established to restrict sharing of confidential / sensitive information and/or chaperoning conversations between internal funds.

Best Practices: Fiduciary Duty Waivers

• Corporate Context: Delaware Chancery Court supports contractual waivers of fiduciary duties among sophisticated parties.
• Provisions must be specifically tailored and negotiated, clear, and provide valuable consideration.
• LLC Flexibility: LLCs can waive fiduciary duties entirely in their operating agreements.
• Members are allowed to define their own duties and obligations more freely.
• Best Practices for Waivers:
• Specify and tailor provisions to particular transactions to avoid unenforceability.
• Engage counsel to represent all parties during negotiations to ensure agreements are fair and properly considered.
• Negotiate corporate waivers in exchange for valuable consideration to ensure a bargained-for exchange.
• There should be limited scope with no protection from liability for bad faith or other intentional harm.

Assignment Fact Pattern

• The Board of Directors is comprised of:
• The CEO/Founder.
• Two Series A Investors.
• One representative of the Common Stock holders.
• An independent director.
• there are 5 seats total.
• A majority of the Board is required to make decisions.
• The Company needs capital, and the Series A Investors are proposing to invest an additional $5m in exchange for a new class of Series B Preferred Stock.
• Break-Out Discussion Groups:
• CEO and Common Stock Board Members.
• Series A Board Members.
• Independent Board Member.
• What considerations should be taken into account in determining whether to move forward with the proposed capital raise.
• What are some procedures that should be adopted as part of the process?

Class 3 Agenda: February 10, 2025

• Topics that will be covered:
• Class 1 Recap and Housekeeping.
• Co-Founder Relationships.
• Capitalization.
• There may be a Breakout Session.
• Q & A will occur.
• Assigned Readings will be discussed.

Co-Founder Relationships

• Choosing your co-founder(s):
• Consider Good to Great, mission statements and core values.
• Consider skillset, network, symbiosis, etc.
• Structuring your co-founder partnership:
• Consider Founders' Equity and Vesting for partnerships.
• Case study discussions:
• Zuckerberg/Saverin and Cruise Automation / YCombinator are examples to be discussed.

Contractual Terms for Co-Founders

• Equity Splits Among Co-Founders occur.
• Restricted Stock:
• Why restricted stock is used instead of stock options is discussed.
• Form 83(b) filings and Timing of incorporation and initial stock issuance are important.
• Vesting:
• Should founder stock be subject to vesting?
• Vesting schedules are used.
• Acceleration and Forfeiture are potential outcomes.

Form Documents

• Certificate of Incorporation.
• Bylaws.
• Founder Employment Agreement, to include:
• Compensation: Base, Bonus and Equity.
• Vesting.
• Severance and Other considerations.
• Proprietary Rights Agreements are important.

Real-World Examples of Co-Founders

• Notable cases of co-founders are Facebook: Zuckerberg/Saverin and Cruise Automation: Vogt/Guillory.

Capitalization Tables

• Capitalization Tables are important.
• They track new issuances of stock and stock equivalents, e.g., notes, options and warrants.
• Cap tables help determine who owns a company and who ultimately gets paid upon the occurrence of a "deemed liquidation event".
• Notable items to know are:
• Explaining who owns a company.
• Discussing the impact of an equity financing or other issuance on a company's cap table.
• Payment allocation connection with a company sale.
• Must understand basics of math required for pricing a new round.
• Dilution impacts new issuances on existing equity.
• Also the impact of down-round pricing on the conversion terms of outstanding equity.

Break-Out Session topics

• Hypothetical Scenario.
• Break-Out Discussion.
• Full-Class Discussion.

Today's Agenda - Class 4

• 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: Promises to Do/Refrain.
• 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

• Legal Capacity is needed.
• Mutual Assent (Written vs. Verbal): "Meeting of the Minds" must occur.
• There should be a Valid Offer and Valid Acceptance.
• Be aware of the Effect of Counter-Offers.
• Intent to Contract is required.
• Consideration (Value Exchange) takes place.
• Other potential issues involve:
• Authority (Designated Authority; Board Approvals).
• Certainty/Clarity (vs. Ambiguity and/or Material Holes).

How to Write a Specific Contract

• The draft should have specificity unless tactically determined.
• Use a journalistic approach.
• Make sure to include the Who, What, Where, Why, How and When.

Preliminary Contracts

• Non-Disclosure Agreements:
• This is a legal contract that establishes confidentiality obligations between the disclosing party (seller) and the receiving party (potential buyer or investor).
• Non-Disclosure Agreements specify the types of information considered confidential and the permissible uses of such information.
• Scope of Confidential Information:
• Defines the categories of information subject to confidentiality protection.
• It includes financial records, customer data, intellectual property, and trade secrets.
• It clarifies exclusions from confidentiality, such as information already in the public domain or independently developed by the receiving party.
• Letters of Intent:
• An LOI is a written document outlining the preliminary understanding between parties involved in a transaction or negotiation.
• It expresses the intent to enter into a formal agreement and lays out key terms and conditions.
• Sometimes called a Term Sheet or Memorandum of Understanding.
• Strategy: Short-Form vs. Long-Form.
• Key Components:
• Parties involved.
• Description of the transaction or agreement.
• Key terms (e.g., economics, timeline, indemnification, conditions).
• Confidentiality.
• Exclusivity.
• Exclusivity Letters:
• The purpose enables the parties to deal exclusively for a set period of time
• They motivate parties to allocate time, money and other resources in pursuit of a deal.
• They are binding and legally enforceable.
• Key Terms:
• Length of time.
• Automatic extension periods-.
• Types of deals excluded.
• Unsolicited in-bound inquiries.
• Non-solicitation of employees.

Types of Commercial Contracts

• Services Contracts:
• Master Services Agreements (MSAs).
• Statements of Work (SOWs).
• Other Services Agreements.
• Purchase Contracts.
• End-User Agreements:
• Enterprise vs. Per-Seat.
• OEM Agreements.
• Distribution Agreements.
• Licenses.

Licenses

• Definition is the Partial Conveyance of Ownership; Permission to Do Something
• Classifications are:
• Inbound vs. Outbound
• Unilateral vs. Mutual/Cross-Licenses
• Scope can be Time vs Place (Worldwide vs. Other), Manner (Fields of Use)
• Applicable Intellectual Property
• Rights can be assigned to or from Source Code
• It can have Maintenance and Support
• Right to Sublicense
• Classify if 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:
• Includes Rights/Benefits with Parity or More Favorable vs Third Parties.
• May include Additional Fee/Top-Up vs Static.
• Holistic vs. Defined Universe of Competitors.
• Limitations on Liability.
• Antitrust Concerns:
• Protects (Relatively) Free Competition (Market Share Assessment).
• There is an Assessment of Market Dynamics (Monopoly, Oligopoly, Dispersed).
• Price-Fixing.

Types of 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:
• 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).

Emily R. Pidot Introduction

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

Employment Law 101 Outline

• Topics include:
• 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?

Regulation on Multiple Levels

• There are multiple levels of regulation for Employment Law.
• Common law, Federal law, State and local law, Concurrent regulation and Federal preemption.
• There are also Enforcement agencies at all levels.

Contractual Relationship Between Employer and Employees

• What is a contract?
• It's a bargained for exchange supported by consideration.
• Also "At-will" employment doctrine.
• Does an employment contract need to be written?
• Yes according to the Statute of frauds and Promissory estoppel.
• Can written representations form the basis of a contract claim?
• Maybe... if there is an example, like a handbook.

Key Terms to Consider in an Employment Contract

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

EEO: Equal Employment Opportunity

• It's a statutory exception to "at-will" doctrine.
• Laws protect against:
• Discrimination, Disparate treatment, Disparate impact, Harassment and Retaliation.

Employment Laws: A Brief History

• 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: Concurrent Federal, State & Local Coverage

• Federal Statutes include:
• Title VII of the Civil Rights Act of 1964.
• Pregnancy Discrimination Act.
• Equal Pay Act.
• Age Discrimination and Employment Act of 1964.
• Americans with Disabilities Act.
• Civil Rights Act of 1866 (Section 1981).
• Genetic Information Nondiscrimination Act.
• Pregnant Workers Fairness Act.
• State and Local Statutes include:
• New York State Human Rights Law.
• New York Equal Pay Law.
• New York City Human Rights Law.

Anti-Discrimination Laws

• Laws permit recovery of damages and/or certain equitable relief.
• Certain statutes (e.g., Title VII) place limits on monetary relief.
• Certain statutes (e.g., NYC Human Rights Law) place no limits on monetary relief.
• Most states have their own anti-discrimination laws and agencies charged with enforcing those laws.

Prohibited Grounds for Discrimination

• Race.
• Color.
• Religion/Creed.
• Ethnicity.
• National Origin.
• Sex, includes gender, gender identity, sexual orientation.
• Pregnancy and related conditions.
• Age (typically 40+).
• Disability: can be mental and/or physical.
• Genetic Information.
• There can be certain additional grounds in certain jurisdictions:
• Employment status.
• Credit history.
• Caregiver status and family responsibilities.
• Weight and height.
• Hair styles.
• Participation in activities wholly outside of work (political activities, legal recreational activities).
• Arrest or conviction record.
• Sexual or reproductive health decisions.
• Marital and domestic partner status.
• Status as a victim of domestic violence.

Prohibited Conduct

• Disparate treatment: intentionally treating an employee or applicant differently than another employee or applicant based on a protected characteristic.
• Disparate impact: seemingly or facially neutral employment practices that unduly impact employees in a protected class, often unintentionally.
• Harassment based on a protected characteristic.
• Retaliation for reporting discrimination or harassment or cooperating with a discrimination investigation.

Equal Pay Laws

• Require proof of intent to discriminate unnecessarily.
• Focuses on the similarity of job duties.
• Burden shifts to employer to justify differences in pay.
• There are Federal and State difference.

EEO, Equal Pay, Affirmative Action and DEI

• Affirmative Action in employment:
• Federal contractor self-critical analysis to ensure EEO.
• Voluntary affirmative action preferences based on protected characteristics which are very narrowly available.
• Diversity, Equity, and Inclusion:
• There is no legal construct.
• Employer driven programs.
• Response to civil rights and social movements.
• Promote legal compliance and EEO.
• Risk calculus for goal setting.

What Are Whistleblower Claims?

• Claims can be affected by Federal, State and Local coverage.
• Common law claims can take place as an action as a:
• Function of state law.
• Termination in violation of public policy.
• There is Wide variation in how public policy is defined.
• Federal statutory claims can be made with:
• False Claims Act.
• Sarbanes-Oxley.
• An underlying dispute may be more significant.

Wage And Hour Law

• There can be Concurrent federal and state coverage.
• Basic Issues:
• Minimum wage and maximum hours.
• "exempt” versus “non-exempt".
• Calculation of "regular rate" for overtime.
• Salary basis.
• Some state laws have more complicated requirements, especially for:
• Pay frequency, pay stubs, meal and rest breaks and daily overtime.

Post-Employment Restrictive Covenants

• Noncompetition and Nonsolicitation restrictions are present.
• Function of state law is very important.
• Common law and statutory law.
• Restraints on trade are disfavored, but enforced with. ..
• Restrictions reasonable in scope and Supported by legitimate business interest.
• What remedies may be applied for violation?
• Federal Trade Commission rule from 2024 may come into play.

Leave Laws

• Key features:
• Time off permitted under specified circumstances.
• Time can be Paid or unpaid.
• Job protection.
• Private right of action.
• Examples:
• Family Medical Leave Act (FMLA).
• Uniformed Services Employment and Re-employment Rights Act (USERRA).
• New York Paid Sick Leave Law.
• New York Paid Family Leave Law.

Labor Law and Employment Law Differences

• Yes there are differences.
• National Labor Relations Act primarily governs:
• Relationship between employers and labor unions.
• Collective bargaining.
• Worker rights to self-organization, to engage in protected, concerted activity (or not).
• Can use National Labor Relations Board.
• Independent federal agency that enforces NLRA.