Startup Formation and Corporate Governance

• Class 2 is on February 3, 2025
• Today's agenda includes Class 1 Recap/Housekeeping, Formation/Organizational Matters, Constituents, Corporate Governance, and Q&A

Formation and Organizational Matters

• Forming a corporation involves filing a certificate of incorporation
• The certificate must be signed by an individual acting as the incorporator
• The charter sets the capital structure as simple common stock-only
• The sole incorporator appoints the initial board of directors via written consent
• The initial board of directors ratifies the actions, elects officers, adopts bylaws, and authorizes bank accounts
• Actions may include ratifying initial stock issuances to founders
• Foreign Qualifications are needed to do business where the Company "carries on its business"

Choice of Entity

• "Silicon Valley" startups typically form as Delaware corporations
• Corporations are the preferred vehicle for companies reinvesting profits for IPO or sale
• Limited liability companies (LLCs) are used sometimes
• LLCs are a preferred vehicle for businesses distributing profits
• Entities previously formed in a non-Delaware jurisdiction have to reincorporate/re-domesticate
• Investors favor Delaware entities due to familiarity with Delaware corporate/LLC law
• Some states require a merger to move to another state

Setting Authorized Capital Stock

• Growth companies typically have only common stock at the start
• Preferred stock isn't created until the terms can be set by the company or investors
• Best practice: authorize a lot of shares, around 40,000,000, to allow recipients to receive more shares even if the absolute number doesn't actually matter
• Classes or series of shares should have low par value ($0.001 or $0.0001 per share) due to Delaware's franchise tax calculation

Initial Issuances of Capital Stock

• Companies issue common stock to founders at nominal or low prices
• Founders must decide how many shares to issue and plan for future issuances for employees and capital raising
• Founders may want to impose vesting on their and/or others' shares
• Companies can repurchase shares at the original cost if the recipient leaves
• Vesting gives the company the right to repurchase shares, with the right falling away over time
• Monthly time-based vesting over four years with a one-year cliff is typical
• Each issuance of stock is documented with a common stock purchase or share restriction agreement
• An applicable securities law exemption is needed for each issuance

Employees and Incentive Equity

• A company needs to obtain an Employer Identification Number (EIN) before hiring
• Adopt forms such as Employee Offer Letter, Confidentiality and Invention Assignment Agreement, and Consulting Agreement
• Employee Offer Letters should be tailored to the state where employees reside and are usually "at-will"
• 409A Valuations
• A company may adopt an equity incentive plan
• A typical "long term incentive plan" is a Swiss army knife covering options, restricted stock, phantom equity, etc.
• An equity incentive plan and each option grant must be approved by stockholders and the Board
• Option grants must comply with state and federal securities laws

Intellectual Property Protection

• A clean break from prior employers and partners is needed
• Founders should contribute their IP
• Agreements needed include: Confidentiality Agreements, Inventions Agreements, and Assignments
• Assignments of Patents, Trademarks, Copyrights, and Trade Secrets
• Assignments or Licenses from Incubators, Universities, etc.

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

Fiduciary Duties

• Duty of Care: Directors act with diligence and prudence, decisions made after adequate information gathering and deliberation
• Liability for breach arises from ill-advised decisions or failure to act
• Duty of Loyalty: Directors prioritize the company's interests avoiding personal gain/conflicts of interest
• Corporate officers can't use their position to further their private interests, because duty and self-interest can not have conflict
• Derivative Obligations: Directors exercise oversight over the entity they serve, disclose information to shareholders, avoid wasting corporate assets

Business Judgement and Fairness

• Business Judgment Rule (BJR): Delaware courts evaluate board decisions under the BJR, favoring directors acting with a rational business purpose
• Financial Investments: boards may divest a subsidiary to reinvest elsewhere, which demonstrates a rational business purpose
• Approving Down-Round Financing: boards can approve down-round financing during financial strain when assessing options
• Entire Fairness Standard: Conflicts-of-interest or heightened scrutiny scenarios
• Directors must prove their decisions/transactions are entirely fair regarding process and pricing
• Burden Shifting Mechanisms used include a special committee or approval

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 and can claim breach of fiduciary duties

Managing Financial Distress

• Assume Insolvency: Presume insolvency in precarious financial situations
• Meeting Frequency; Access to Information: Hold frequent meetings, keep all decision-makers informed
• Address Conflicts of Interest: Use special committees and independent directors to avoid conflicts
• 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 D&O insurance and contractual exculpation clauses

Conflicts of Interest - BJR

• Business judgment rule evaluates duty of care claims but doesn't cover conflict-of-interest transactions needing scrutiny
• Allegations or evidence must be specific to permit a finding that the director faced a conflict or acted to be found to have an improper purpose
• If a director holds dual fiduciaries, there is no conflict if the beneficiaries' interests are aligned
• Decisions to maximize the value of the entity, don't directly benefit a fiduciary, affiliated party, or class of claimants, and do have the protection of the BJR
• It's not unusual for lenders to have designees on a company's board, specifically in distressed companies, to protect their investments
• "Cleansing" Conflicted Transactions: Transactions are "cleansed" if approved by a majority vote of fully informed and disinterested directors/stockholders

Managing Conflicts cont.

• Maintain Detailed Records: Record rationale behind decisions, document steps ensuring fairness
• Secure Fairness Opinions: Obtain fairness opinions from independent financial advisors to reinforce transactions fairness
• Depend on Independent Advice: Rely on independent management/external advisors
• Require Director/Stockholder Approvals: Get approval for transactions by disinterested parties after conflict disclosure
• Transparency: Any deals involving directors who are also lenders/equity holders must be reported/reviewed
• Separation of Roles: Enforce separation of duties/roles to prevent conflicts, using different committees is important
• Establishment of LPAC: A Limited Partner Advisory Committee (LPAC) may be advisable (particularly when a sponsor has dual roles, such as equity investor and lender)

Treatment of Confidential Info

• Risks of Sharing Confidential Information: Unauthorized sharing can breach loyalty duty
• Duty of loyalty demands sensitive information to be safeguarded to preserve trust
• Treatment of Confidential Information and Breach Scenarios
• Example 1: director that discloses confidential information to a PE firm constitutes a breach of loyalty
• Example 2: director that shares insider information with a PE firm leads to illegal consequences for insider trading activities
• Managing Dissemination of Confidential Information: Implement LPAC, separate roles, internal compliance teams

Fiduciary Duty Waivers

• Corporate Context: Delaware Chancery Court supports contractual waivers with sophisticated parties, when tailored and negotiated
• LLC Flexibility: LLCs can waive fiduciary duties in operating agreements
• Best Practices for Waivers:
  • Specificity; Narrowly Tailored: Ensure provisions are applicable
  • Use of Counsel: Engage counsel to representing all parties during negotiation
  • Consideration: Ensure a bargained-for exchange
  • Limited Scope: No protection against those committed to bad faith or intentional harm

Fact Pattern Assignment

• The Board of Directors is comprised of a CEO/Founder, two Series A Investors, one common stockholder representative, and an independent director, for a total of 5 seats
• A majority of the Board is required to make decisions
• The Company needs $5 million, Series A Investors are proposing to invest that amount for a new class of Series B Preferred Stock
• Break-Out 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?