You may be familiar with the term angel investors but may not be quite sure who they are or exactly how they work. Most often these angels are entrepreneurs; however, they may not be what you consider the “average” entrepreneurs. Meaning, they are quite often what is referred to as “cashed out” entrepreneurs, high net worth individuals that are sometimes interested in mentoring other entrepreneurs, and occasionally they become actively involved in the business they are backing.

At the risk of over-generalizing, there are some basic profiles of angel investors and their potential motives. For example, “cashed out” entrepreneurs are individuals that have started and sold their own company. They have proven that they know how to build and run a company, they may be seeking a new opportunity and quite possibly want to get involved with the board of directors or the managerial team. Or, perhaps they are professional service providers that may include consultants or attorneys that provide services to companies. Often times these angels will get involved with an early stage company in order to grow with them and provide increased services as the company grows and matures.

Other possible profiles may include business people that are interested in funding a company that is working towards a cause that they believe in such as environmental friendly sources for oil, energy, etc. Corporate executives may also look for young companies to back that are providing a new service or product that may very well help the corporation that they work for.

Ultimately, angel investors are investing because they want a class of investment that they can participate in that offers a chance of a high return (with the downside of high risk). Naturally,  there are wide ranges of preference for what role angels want to see post-investment. Some may want to be passive and hands-off while others may want to be actively involved in helping the company grow.

The norm for technology startups is for the founders to purchase the initial common stock at a very low price at $0.01 per share or less.

I usually sell the initial common stock at $0.001 per share. Part of the reason why I do this is because I like to issue each founder 1,000,000 shares of common stock at incorporation. By selling the shares at $0.001, this gives me a nice round total purchase price per founder of $1,000 (i.e. 1,000,000 x $0.001). At $0.01, the founders would have to pay into the new corporate bank account $10,000 each. That sure is a lot more painful. Especially considering that some Web 2.0 startups do not need more than a total of $10,000 to start their company.Even less if they already know how to set up a website and program all the back-end stuff themselves. I am currently representing some amazing Web 2.0 startups that have started with around $5,000 in the bank and are doing great.

When talking purchase price, remember that anytime securities are sold, they must be sold at fair market value or there will be certain tax consequences related to recognition of ordinary income, cheap stock, etc. The reason we can have the company sell the common stock to the founders at $0.001 per share (and reasonably argue that the fair market value is $0.001 per share) is because the company is arguably not worth anything at the time of incorporation. It is at ground zero. However, as soon as the company signs a significant contract, or starts generating income, the fair market value must be more than $0.001.

You need an EIN or employer identification number to open a corporate bank account. This is equivalent to a social security number for individuals. The form you will complete is called aForm SS-4. The easiest way to file the form is online at the IRS website. Here are a few tips for completing the form:

1. Item 7b – you will need the social security number of the person who will be completing the form on behalf of the company.I almost always use the president of the company for my clients.
2. Item 9a – check off the appropriate entity, and if you are checking off corporations, make sure and fill in the applicable tax filing the corporation will be making (e.g. 1120 or 1120S).
3. Item 10 – check off “Starting new business” and provide brief description
4. Item 11 – I usually put the date of incorporation.
5. Item 12 – For most companies, there is no reason to have the closing accounting month anything other than December.
6. Item 18 – This question is referring to the “applicant entity.”In other words, the company, not the individual applying for the EIN on behalf of the company.Therefore, even if the President of the company has applied for an EIN on behalf of other companies that he started in the past, you will still check off “NO.”

That’s it. Sign it and keep it in your files. Even if you are filing it online or via the telephone, you still need to keep a signed copy in your files.

As I begin this series of posts on incorporating your technology startup, here is a quick checklist of the documents required to complete the incorporation of your new company. I will cover the issues and components of each document in detail in the posts to come.

1. Certificate of Incorporation for Delaware or the Articles of Incorporation in California
2. Bylaws
3. Determine need to qualify to do business in other states and make appropriate filings in those states. For example, if the Company is incorporated in Delaware but has its principal offices in California, file the Statement and Designation by Foreign Corporation with the California Secretary of State.
4. If the Company is incorporated in California, prepare the Statement by Domestic Stock Corporation
5. Obtain your Employer Identification Number from the IRS (Form SS-4).
6. Obtain a state employer identification number for the Company (in California, it is Form DE-1)
7. Action by Sole Incorporator
8. Written Consent of Board in Lieu of First Meeting
9. Written Consent of Stockholders (in California, they are called shareholders)
10. Indemnification Agreements
11. Confidentiality and Invention Assignment Agreement
12. Stock Purchase Agreements
13. Stock Certificates
14. Option Plan (if applicable)
15. Buy-sell Agreement (if applicable)
16. S Election (if applicable)

The liquidation preference can also have a cap if it is a participating liquidation preference:

After preferred liquidation proceeds, preferred participates in liquidation proceeds on the common with a cap on participation at [ ]x.

This is a participating liquidation preference but caps the total participation amount so that any amounts in excess of 2X or 3X (or any other multiple) of the liquidation preference is solely for the common stock. I’ve seen up to a 5X cap. Once the preferred stock have received the capped amount, the remaining liquidation proceeds go to the common stock. However, don’t forget, the preferred stock can still convert to common stock if the distribution would be greater on a pro rata basis with the other common stockholders.

The term of the liquidation preference will almost always say that it is for the original purchase price (or a multiple of the purchase price) “plus accrued and unpaid dividends.” The addition of the “accrued and unpaid dividends” to the liquidation preference in most cases does not have any impact because venture capital investors do not expect to be paid any dividends. Dividends in venture-backed companies are never expected to be declared or paid.

However, investors will occasionally negotiate for a mandatory cumulative dividend right which is a mandatory obligation of the company to declare annual dividends that is cumulative so that any unpaid amounts in any one year are added to the next year. For example, if preferred stock has a mandatory cumulative dividend preference of $0.08 per share, and the dividend is not paid in 2007 then the investor will have a dividend preference of $0.16 per share in 2008. The dividend preference continues to grow from year to year as the company does not pay any dividends. Companies should not brush this issue off too quickly because the effect of the annual accumulation can become significant. Eventually, as your company hits a liquidation event such as an acquisition, all the dividend obligations that were left unpaid over the years will be added to the liquidation preference.

I think that it is still true that east coast venture capital firms are more likely to request cumulative dividends payable upon some liquidity event – but I don’t have any substantiating evidence of this except from my own experience with the deals that come through my practice. Venture capital firms based on the west coast usually do not cumulate dividends.

As mentioned in the “Liquidation Preference 101” post, liquidation preferences can either be participating or nonparticipating. A nonparticipating liquidation preference only gives the preferred stock a liquidation preference over the common stock equal to the per share price the investor paid (or some multiple of that per share price). The effect of a nonparticipating liquidation preference is to require the preferred stockholder to convert their preferred stock into common stock to participate in any gain on their investment. Otherwise, they can choose to stay as preferred stockholders and get their liquidation preference. Therefore, if the preferred stockholder would receive a greater distribution by converting into common stock and receiving its pro rata share of the liquidation on equal ground with the other common stock, obviously, it would do so. With this structure, the investors are forced to convert to common stock if they want to participate in any gain.

For example, let’s assume that the founders of TechStartup, Inc. held 3,000,000 shares of common stock that they paid for at incorporation at $0.001 per share (or a total of $3,000), and Sandy Hill Ventures invests $2,000,000 to buy 2,000,000 shares of preferred stock (i.e. $1.00 per share). The percentage of ownership for the founders would be 60% and 40% for Sandy Hill Ventures. Sandy Hill Ventures has a nonparticipating liquidation preference at 1x of the investment amount (i.e. for the same amount that was invested).

Now, if TechStartup, Inc. was acquired for $10 million, the preferred stockholders would convert their preferred stock to common stock to participate in the gain. If the preferred stockholders did not convert they would only be entitled to their liquidation preference, or $2 million. By converting to common stock (assuming a 1 preferred stock to 1 common stock conversion ratio), the investors would receive their pro rata share of the $10 million along with all the other common stock. Therefore, Sandy Hill Ventures will now hold 40% of the common stock and entitle them to receive 40% of the $10 million, or $4 million. Clearly, it is an easy decision for Sandy Hill Ventures to convert and get a bigger bounty.

However, many venture capital investors now negotiate for a participating liquidation preference. Preferred stock with a participating liquidation preference will get their liquidation preference first and then have the opportunity to participate pro rata with the common stock. Assuming the $10 million acquisition of TechStartup, Inc., Sandy Hill Ventures would get a $2 million liquidation preference PLUS be allowed to participate in getting their pro rata share of the remaining $8 million. The residual $8 million (after the preferred stock gets paid its $2 million preference) will be divided pro rata between the common stock and the preferred stock as if the preferred stock had converted to common stock. Therefore, with a participating liquidation preference, Sandy Hill Ventures now gets a distribution of $2 million (i.e. the preference) PLUS $3.2 million in participation proceeds (i.e. 40% of the remaining $8 million) for a grand total of $5.2 million.

The price per share of the Series A Preferred Stock that the venture capital investor is willing to pay is equal to the pre-money valuation of the company divided by the total number of shares outstanding.

Per share price = pre-money valuation / total number of shares outstanding

For example, if TechStartup, Inc. has a pre-money valuation of $4.5 million and 3 million shares of common stock outstanding, the price per share of Series A will be $1.50 (i.e. $4.5 million divided by 3 million shares outstanding). However, in most deals, the total number of shares outstanding is said to be on a fully-diluted basis. Most of the time, this means that the total number of shares will include all outstanding common stock PLUS all outstanding options, warrants and other convertible securities (including any previously issued convertible preferred stock) as if fully exercised or converted into common stock. Therefore, if TechStartup, Inc. had issued options to its employees to purchase an aggregate of 1,500,000 shares of common stock, the total number of shares outstanding on a fully-diluted basis will be 4,500,000 shares. Now, the per share price is only $1.00.

By basing the per share price on the fully-diluted basis, the investors are making the existing common stockholder assume the diluting effect of the unexercised options. Sometimes, investors will also negotiate for the fully-diluted number to include unissued options and any increase in the size of the option pool in connection with the financing. Occasionally, venture capital investors will request that an option pool be increased to make sure there is enough shares to provide adequate incentives to the startup’s employees and management. This will dilute the existing common stockholder even more. More on dilution in the next post…

Before we start a discussion on the different terms of a venture capital financing, it is important that every startup seeking VC financing understand the basic language of valuation. What does the VC mean when he says that he is ready to make an investment based on a “pre-money valuation of $8 million” or a “post-money valuation of $10 million.” Or if the VC tells you that he will put in “$2 million based on a $8 million valuation, giving a $10 million post-money.”

Pre-money valuation is the valuation of the company prior to the investment. Post-money valuation is the valuation of the company after the investment.

For example, assume that TechStartup, Inc. was given a pre-money valuation of $8 million.  If Sandy Hill Ventures was interested in investing a total of $2 million, the post-money valuation would be $10 million.

There are three categories through which you can protect your valuable idea, or “intellectual property.”  The three categories are patent, trademark, and copyright.  It is important to understand the distinction among these categories, as each of them provides a different scope of protection.  At the same time, it is possible that multiple categories can be embodied in a single product.

Patent

A patent protects the idea, the invention itself.  A patent for an invention is the grant of a property right to the inventor, which in the U.S. is issued by the United States Patent and Trademark Office (“USPTO”).  Contrary to a common misconception, a patent does not give the patent owner the right to use the patented invention.  A patent right is the right to exclude and prevent others from making, using, selling, or distributing the patented invention without the patent owner’s permission.  

You may wonder what kind of ideas or concepts can be patented.   The answer is found in 35 United States Code Section 101, which provides that,

“Whoever invents or discovers any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent therefor…”

So what does this mean?  Let’s take a hypothetical example of a new kind of shoe.  Let’s say Inventor A came up with a groundbreaking new technology for lightweight running shoes that allow runners to run faster, yet provide superior protection against foot and ankle injuries.  Inventor A  can seek patent protection for the actual structure of the shoes, the method of using the shoes, and/or the method of manufacturing the shoes.  Assuming  Inventor A is granted the patent for the shoes, this means that nobody else in the U.S. can make, use, sell, or distribute these patented shoes without  Inventor A’s permission.  Notice that you can apply for a patent for an improvement of something that is already in existence.  In this hypothetical, running shoes per se are not a new invention.  However, the lightweight running shoes with new technology that allow runners to run faster and provide superior ankle and foot protection may be an improvement over the existing running shoes.  The key to patentability is novelty and usefulness.

Trademark

A trademark protects a slogan, a brand name, or a logo.  It does not protect the actual idea or invention.  A trademark is used only to identify and distinguish the source of the goods or services of one party from those of others.  For example, Inventor A develops the slogan “Run Faster” and a distinctive logo of a running man.  When consumers see the slogan “Run Faster” or the running man logo next to a picture of a shoe on a billboard, they will immediately recognize that the shoe on the picture is made by Inventor A.

Trademark right is used to prevent others from using a confusingly similar mark, but not to prevent others from making the same goods or from selling the same goods or services under a clearly different mark.  So while other athletic shoe manufacturers cannot use a mark or logo confusingly similar to Inventor A’s brand, including its running man logo and the phrase “Run Faster,” they are clearly not prevented from making athletic shoes using different brand names and different logos.

Copyright

Unlike the protection afforded by a patent or a trademark, a copyright does not protect the actual idea of the product, or the slogan, the brand name, and the logo used to identify the source of the product.  In its simplest term, a copyright prevents others from “copying” certain creative/artistic works.   Typically, literary, artistic, and creative works such as music, sound recording, movies, graphic works, books, and the like are protected by copyrights.

In the hypothetical of  Inventor A shoes above, a written description of the shoes or a marketing brochure of the shoes could be copyrighted, but this would only prevent others from copying the written description or the marketing brochure; it would not prevent others from writing a description of their own or from making and selling knock-off version of the shoes.

***This is a post by Joseph Chu an attorney at Innovation Capital Law Group, specializing in patent, trademark and copyright prosecution, litigation, and licensing.  Joseph is also a registered patent attorney with the United States Patent and Trademarks Office.***