TMGTPS5125 Class 2: Company Formation

TMGTPS5125 The Law for Technology:

• Class 2 was held February 3, 2025
• Class 3 was held February 10, 2025

Class 2 Agenda:

• Class 1 Recap and Housekeeping included Maslow, G2G, Mission Statement and Core Values
• Formation and Organizational Matters were discussed
• Constituents and Corporate Governance were discussed
• There was a Q&A session

Setting Up The Company:

• A corporation is formed by filing a certificate of incorporation signed by an "incorporator."
• The charter typically sets a simple common stock-only capital structure.
• A sole incorporator appoints the initial board of directors via written consent.
• The initial board of directors uses written consent to ratify the actions of the incorporator, elect officers, adopt bylaws, and authorize bank accounts.
• Stock issuances to founders may be ratified.
• Foreign qualifications are required where the company conducts its business, such as having employees, a physical presence, or operations.

Choice of Entity:

• A typical "Silicon Valley" startup forms as a Delaware corporation
• Corporations are a preferred vehicle for companies that will reinvest profits to deliver shareholder returns via IPO or sale, noting Delaware has advantages over other states.
• LLCs are sometimes used if its the preferred vehicle for businesses intended to distribute profits
• Entities formed in non-Delaware jurisdictions may need to reincorporate
• Most institutional investors prefer Delaware-organized 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 have only common stock initially
• Preferred stock designation is not needed until company or investors set stock financing terms
• Best practice involves authorizing a lot of shares for example 40,000,000 so recipients of stock feel they receive a lot of shares
• Classes or series of shares should have a low par value ($0.001 or $0.0001 per share) due to Delaware's annual franchise tax being based on aggregate par value in some instances

Initial Issuances of Capital Stock:

• Issues common stock to founders at a nominal or low price.
• Founders should decide how many shares to issue and plan for future issuances, capital raising, and an incentive equity pool.
• Founders may impose "vesting" on their and/or others' shares; the company can repurchase shares at original cost if the recipient ceases to be involved
• Vesting can be achieved by giving the company the right to repurchase shares, with the repurchase right falling away in ratable amounts over an agreed period. For example, in quarterly installments over four or five years
• Typical vesting is monthly time-based over 4 years with a "one-year cliff;" might be less for founders
• Each issuance 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:

• A company obtains an Employer Identification Number (EIN) before hiring employees
• Adopt forms of:
  • Employee Offer Letter is tailored for the state where employees reside and is usually "at-will"
  • Confidentiality and Invention Assignment Agreement
  • Consulting Agreement
• May use 409A valuations
• May adopt Equity incentive plan
• A typical "long term incentive plan" is like a Swiss army knife as it covers issuances of options, restricted stock, phantom equity, and other forms of equity-linked incentives
• The Equity incentive plan and each option grant must be approved by stockholders/the board per the terms of the plan
• The option grants must comply with state and federal securities laws

Intellectual Property Protection:

• Need a clean break from prior employers and partners
• Need a contribution of intellectual property (IP) by Founder(s)
• Confidentiality Agreements / NDAs should be made
• Inventions Agreements / Proprietary Rights Agreements should be made
• Assignments of any Patents, Patent Applications, Trademarks, Copyrights and Trade Secrets should be made -Also Trademarks for Company Names, Logos, Slogans, etc.
• The Assignments / Licenses from Incubators, Universities, etc. should be made

Constituents:

• 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: Introduction to Fiduciary Duties:

• Duty of Care: Directors must act with diligence and prudence, ensuring decisions are made after adequate information gathering and thoughtful deliberation
  • There are two contexts in which liability for a breach of the duty of care can arise "First, such liability may be said to follow from a board decision that results in a loss because that decision was ill advised or 'negligent'. Second, 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, avoiding personal gain from business opportunities and potential conflicts of interest.
  • Corporate officers and directors are not permitted to use their position of confidence to further their private interests; The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest.
• Derivative Obligations: Corporate directors have several other fiduciary obligations that are derivative of the duties of care and loyalty like exercising oversight /monitoring over the corporate entity they serve and disclosing information to shareholders under certain circumstances
• Derivative Obligations also includes the avoidance of wasting corporate assets.

Corporate Governance: Business Judgment Rule and Entire Fairness:

• Business Judgment Rule (BJR): Delaware courts evaluate board decisions under the BJR, favoring directors if they act with a rational business purpose; two examples include:
  • Financial Investments and Approving Down-Round Financing
• Entire Fairness Standard: It's applied in conflict-of-interest or other heightened scrutiny scenarios and Directors must affirmatively prove that their decisions or transactions are entirely fair in both process and pricing; a Burden Shifting Mechanisms exists

Corporate Governance: 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 in precarious financial situations.
• Hold frequent meetings with access to information ensuring decision makers are well-informed
• Address Conflicts of Interest, the Utilize if special committees and independent directors to avoid the self-interest implications
• Focus on Prioritize Wage & Hour; Taxes; protect interests of employees and taxing authorities
• Seek Expert Advice from financial and legal advisors.
• Take Insurance Assessment, evaluate the necessity and coverage of D&O insurance, and consider including contractual exculpation clauses where feasible

Best Practices: Conflicts of Interest:

• Business Judgment Rule (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.
  • Note :”[I]t is not enough argue in the abstract that a particular director has a conflict of interest or is acting in bad faith because she is affiliated with a particular type of institution that may be pursuing a particular business strategy or have a particular interest. There must be specific allegations and later, actual evidence sufficient to permit a finding that the director faced a conflict or acted with an improper purpose on the facts of the case.”
• 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 receive the protection of BJR.
• Lenders having designees on a distressed company's board is not unusual because lenders often have them to keep a close eye on its financial situation to protect 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; including documenting the rationale behind the decision and steps taken to ensure fairness
• Secure Fairness Opinions with the goal of affirming the transaction's fairness to the company and it must aligns with company’s best interest
• Depend on Independent Advice, use independent management/external advisors while minimizing information from parties with potential conflicts and maintain the integrity of the decision-making process
• Require Director and Stockholder Approvals; the goal should be to gain transactions by fully informed/disinterested directors/stockholders after disclosures of all conflicts because it ensures the transaction is not personally benefiting those that approve it
• Uphold transparency and report/review it
• Separate Roles via different committees to review transactions involving such director and providing for separate Board vs lender / equity holder representation
• Establishment a Limited Partner Advisory Committee (LPAC) – designed to oversee/approve sensitive and conflict-prone transactions

Best Practices: Treatment of Confidential Info:

• Risks of Sharing Confidential Information: Unauthorized sharing of confidential information that harms the company can cause a breach Duty of Loyalty
  • Directors must safeguard sensitive information to maintain trust/integrity.
• Treatment of Confidential Information and Breach Scenarios:
  • a director at a portfolio company disclosing confidential information to a PE firm and uses the against the portfolio company may constitute a breach duty of loyalty
  • a director sharing insider information with a PE firm, leading to insider trading activities; not only breaches fiduciary duties but also triggers legal consequences under insider trading laws.
• Best Practices for Managing Dissemination of Confidential Information:
  • Establishment LPAC; to assist with the review of confidential information and ultimate decision-making and guard against claims of breach of fiduciary duties
  • Separation of Sponsor Representatives; define/separate internal roles with respect to equity and other investments
  • Compliance Oversight; inform compliance team to ensure walls established restrict confidential sharing

Best Practices: Fiduciary Duty Waivers:

• Corporate Context: Delaware Chancery Court supports contractual waivers of fiduciary duties tailored by sophisticated parties, these provisions must be clear and provide valuable consideration.
• LLC Flexibility is when LLCs waive fiduciary duties entirely in their operating agreements to define their obligations
• Best Practices for Waivers should follow the rules of specificity and use the rules of counsel with limited protection for intentional harm

Assigned Readings:

• https://carta.com/learn/startups/private-companies/c-corp-vs-llc/
• https://technext.it/llc-vs-c-corp-vs-s-corp-for-startups/
• https://www.skadden.com/insights/publications/2020/02/directors-fiduciary-duties
• https://law.stanford.edu/wp-content/uploads/2023/01/Brief-Introduction-to-Fiduciary-Duties-of-Directors-under-Delaware-Law.pdf included Formation Documents

Assignment

• Fact Pattern: the Board of Director is comprised of (1) the CEO/Founder, (2) two Series A Investors, (3) one representative of the Common Stock holders and (5) an independent director, for a total of 5 seats that requires a majority of the Board 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 Groups for the CEO and Common Stock Board Members, Series A Board Members and the Independent Board Member
• Considerations should be taken to determine if move forward with capital raise with some procedures that should be adopted as part of the process

Class 3 Agenda

• Class 1 Recap + Housekeeping
• Co-Founder Relationships
• Capitalization
• Q&A
• Assigned Readings for Today's Class

The discussion for Class 5 was about:

• Employment Law 101

Class 5 Introduction – Emily R. Pidot:

• She's a Partner at Paul Hastings LLP
• Partner, Employment Law Department
• Chair of the New York office
• 20+ years advising employers and litigating disputes
• Recognized by Chambers and Partners, The Legal 500, SuperLawyers, a 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?

Class 3: Co-Founder relationships

• Choosing co-founders includes elements like Mission Statement and core values
• Structuring co-founder partnership is about founders’ equity and vesting
• Case study discussions of successful companies for example Facebook and cruise
• Contractual Terms for co-founders must involve and equity split using restricted stock and vesting
• Form Documents: Certificate of Incorporation and Proprietary Rights Agreement
• Real World Examples: Facebook: Zuckerberg/Saverin and Cruise Automation: Vogt/Guillory
• Assigned Readings for Today's Class
• https://www.ycombinator.com/library/5x-how-to-split-equity-among-co-founders
• https://www.ycombinator.com/library/Im-keys-to-successful-co-founder-relationships
• Forms: (1) Emerging Growth Company - Employee Confidentiality and Invention Assignment (2) Co- Founder Term Sheet; (4) Certificate of Incorporation; (5) Bylaws
• Cruise Automation: https://www.vox.com/2016/4/19/11586228/cruise-autonomous-car-sues-kyle-vogt

Co-Founder Relationships: Form Documents:

• Certificate of Incorporation
• Bylaws
• Founder Employment Agreement must feature Vesting and Severance
• Proprietary Rights Agreement required

Class 3: Capitalization tables

• They important because they track issuances and who owns the company determining who gets paid in “deemed liquidation event”
• You should be able to explain company ownership, the impact of equity financing and allocation of payments
• What is needed to understand includes basics for pricing rounds including dilution
• A table can be iterated: Founders stock plus options
• Tables have assumptions including founding, equity as common and equity equal

regulation on multiple levels:

• 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 involves bargained exchange and At-will employment doctrine
• An employment contract needs to be written if its involved in a statute of frauds or promissory estoppel
• Written representations can form a contract

Terms considered in employment law:

• job description
• hours of work
• compensation and benefits
• fixed term or "at-will
• consequences of termination
• the consequences of confidential information
• inventions
• post-employment restrictions
• arbitration of disputes

Equal Employment Opportunity (EEO):

Examine all statutory exceptions and laws used to protect an “at will” doctrine against harassment or retaliation

Brief History of the Laws:

• There have been many acts, the Civil Rights Act (Section 1981 with the Pregnancy to American with Disabilities Act

Federal and State Statutes of EEO:

• Both Federal and State have many of the similar acts to prohibit inequality

Anti-Discrimination Laws:

• The laws require equitable relief with statutes placing limit or no limited monetary relief
• Each state has an agency designed to enforce/charge its respective law

Prohibited Grounds Discrimination:

• There are many grounds including Race, Color, Creed and sex
• States may have more protections including a Domestic Violence victim status.

Prohibited Conduct:

• Disparate treatment and impact and Retaliation

Legal capacity for An Enforceable Contract:

• Meeting of the Minds" with a valid offer and valid acceptance. Effect of Counter can be added
• It needs an intent to contract, value exchange, authority from the board, Board Approvals, and Authority

Class 4: Preliminary Contracts:

• A journalist helps the company be very specific in the way they act by doing what and when. This helps for certain legal actions

Class 4: More legal jargon:

• A contract is made by parties, needs licensing, representatives and have ways to make the act lawful

Best practice for Financial Distress:

• The party must assume they are in a financial distress to prevent issues later on.
• To properly handle the situation the meeting needs to have important things to be set in order
• Prevent other companies or groups self-interest in the process with special committees
• There should be advice and insurance for all actions and legal advice For all the other parties

Prohibited Conduct:

• Disparate treatment and impact and also Retaliation
• The parties must equal or provide fare pay to the parties

EEO, Equal Pay, Affirmative Action and DEI

• It’s important to act in voluntary affirmative action

What are whistleblower claims?

• In order for an act to qualify, a whistleblower claim must be made
• There are different federal statutory claims available

Wage and Hour law:

• There must be a minimum and maximize of all wages
• Other laws may be more complex

Exclusivity Letters:

• Purpose with motivating the parties
• key terms in length

End user Agreement:

End must be in compliance with other agreements

Licenses:

• Definition with Partial Conveyance of Ownership, the Licenses need be in compliance with the ownership laws

Post-employment restrictive covenants:

• There must be an enforceable contract for any of this to apply
• There are restraints
• There should be no Violation

Leave laws:

• Time set is permitted under specification