One question almost every first-time entrepreneur (and most second-timers) have is “How do I incorporate?” When you do it properly, this isn’t particularly earth-shattering legal work; I’ve done this sort of work for companies using firm quotes of $2000 + state filing fees for a full incorporation package, including a lot of form documents necessary to engage new employees, issue stock to founders, etc. That figure includes my time advising on everything from the number of directors to how to divide up stock to what provisions founders need to protect themselves from each other. It’s clear that the fee involves mostly the ancillary advice about what to do, not filling out forms.

For the purposes of this question, you should have already determined that you (a) need to form an entity, (b) that entity should be a corporation, and (c) you want to be expedient while avoiding future expenses.

In general, companies should incorporate in Delaware if they’re going to be venture-funded and have the modest amount of extra money to lay out for administrative costs. That said, many, many companies in the SF Bay Area simply incorporate in California to reduce those expenses, particularly if they’re going to bootstrap for a while. VCs and other investors in the area are very familiar with California companies and don’t get bothered by it at all. What I would recommend against, in general, is incorporating anywhere else besides those two states. The costs will go up for regular compliance and administration, and you’ll only have to reincorporate later if you get funding.

You will likely  need specific advice on the entity selection question, which depends heavily on the type of business you’re considering and the plans you are making. Sometimes a corporation isn’t the best choice.

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A project that is called a joint venture might legitimately be structured like any of these:

• a brand new entity with shared ownership
• a subsidiary of one partner
• a ‘project’ with some shared or contributed resources

The differences between these are huge, and yet there’s no right answer without knowing the specifics of any situation. Well, I take that back: the *right* answer is knowing what you want, what you’re dealing with, and how to figure out if there’s a good fit between the two. If I had to pick a default answer, I’d say always form a new company so that everything that’s in the box is in the box, who owns what’s in the box is easy to figure out, and the rules about the box are well-known and clear to everyone, inside and out.

Someone recently asked “what is an equity share profit interest?” in a joint venture?

The specifics matter greatly, including the language of the terms, the type of entity, if any, that the joint venture is, and what is intended.

Usually, however, someone using the phrase “profit interest’ should mean that there is an interest in a piece of the profits that does not include ownership rights (or responsibilities) in the joint venture entity itself. This type of structure, like phantom equity, shadow equity, or other stock-option equivalents or even dual-classed common stock, is designed to separate the returns on the business from the ownership and control of the business. And most people don’t really care: they want the portion of the money that their stake represents as if it were true equity ownership. But many people don’t vote their shares in big publicly held companies nor do they want to be engaged in day-to-day management. Accenture and KPMG Consulting are two companies that come to mind where stock option equivalents were used as part of employee compensation.

Back to joint ventures: the idea of a profit-only stake might be appropriate when the joint venture doesn’t have a separate existence. It might be a true project operated by two or more companies: there’s no way to give anyone ownership in anything and so profits are all that can be shared. Or someone might be a much smaller participant than others who are determined to control the direction of the joint venture.

1. Why are the shares divided into preferred and common?
2. Why does the preferred stock have a limited “1x” return?
3. What will happen with liquidation preferences in future rounds?
4. What will happen with dividends?
5. Does the preferred stock have to convert to common to get more than its money back? Why? How?
6. Don’t these restrictions make preferred shares seem less “good?”

The short answer is that this is a standard seed round term sheet that balances all the issues in a reasonable industry-standard way that won’t hamstring follow-on rounds. What that means is that venture investors, and also their lawyers, expect to see companies with a structure that is within the normal variation of such things. The standard, as I’ve written before, is to see a Delaware C-corp with a reasonable division of equity among the founders, some sort of vesting, a clean balance sheet, and a reasonably clean cap table overall. Complications on any of these points can arise, and some variation is certainly common, and some variation is actually meaningful, purposeful, and beneficial to the company.

Of course there are two positions on each of these kinds of issues, but if you think about contracts as mechanisms for transferring risk from one party to another, then some structures make less sense because they’re economically inefficient by  not assigning a risk of loss to the person best able to prevent that loss.

Here are some longer and more precise answers:

1. Preferred and common shares — this is the traditional structure for venture-financed companies. The two classes of stock help fine-tune the relationship between the investors and the founders in light of the risk/rewards appropriate for each. Preferred stock allows certain holders, i.e., the investors, to receive their investment back before any return accrues to the other holders, i.e., the founders. This is the general practice. The use of preferred stock also provides other high-level protections to investors even if they own less than a majority of the company, which would not be the case if they only held common stock; there are similar protections for founders holding common stock even if the preferred stock holders own a majority of the company on a fully diluted basis.
2. The upside on the preferred shares is not limited. It is a 1x non-participating preferred. This means that the preferred stock holders have an option in the event of a liquidation event of some kind: (a) take their money back or (b) convert to common stock. The choice means that holders of preferred stock will, in the event the company is sold very early, not face a situation where they lose money and the founders make money.
3. It is the company’s goal, and standard in the tech industry for venture-financed companies, to maintain the 1x non-participating preferred structure. Whether those terms would vary in the future for a round of venture financing with particular investors cannot be determined. But the protections of current preferred stock holders to approve certain additional issuances of preferred stock generally acts to prevent unfair future sales of stock.
4. It is the company’s goal, and standard in the tech industry for venture-financed companies, to not actually declare and issue dividends. The basic assumption is that at the discount rates implicit in angel and venture valuations, it makes more sense for the relatively small amount of cash that dividends would represent to remain invested in the company for a far greater return. Also, since few early stage companies are producing cash, dividends are generally not distributions of free cash flow but just a deduction from cash on the balance sheet. That’s a very different corporate finance strategy, one that most startup CFOs would not suggest. The same points as it #3 regarding future rounds apply here except that dividend provisions rarely change; liquidation preferences are more likely to be different from round to round.
5. Yes, conversion to common is generally deemed to occur immediately prior to the closing of the liquidity event, e.g, a merger or IPO. The specifics are spelled out in the transaction documents; the general format can be seen in the Series Seed documents linked below.
6. Preferred shares are always thought of as better because they are protected on the downside. See Fred Wilson’s example in his post linked below for the basic scenario in which preferred stock investors are protected. As a general rule of thumb, in the absence of particularized 409A valuations, common shares are thought to be “worth” approximately 10% of the value of preferred shares; this ratio reflects the partial protection against downside risk that is the preferred return.

Some links:
Series Seed documents

Fred Wilson of Union Square Ventures discussing the liquidation preference: he discusses the point often on his blog; it could be helpful to read his comments.

Here’s my answer:

Laura, the question you ask is only properly answered in light of more important questions. I’ve posed many of these in my article on social enterprises linked below.

As I tell all my clients starting organizations, you need to start with your goals and business model. (And trust me, every organization has a business model — what comes in, what you do with it, what goes out, and what you do with what’s left over.)

So start by defining what you want to do, on a day to day and big picture basis. Then, you take that description and give it to someone like me, a corporate lawyer, and you can get a specific recommendation that fits your particular circumstances. Those circumstances include the state you’re in, tax considerations, financing matters, distributing surpluses (e.g., profits), and control issues.

I’m very good at what I do, but I can’t give you a specific answer without knowing what your vision is and then sorting through your goals. No one can.

Of course, the answer is the same for every other generic business — there’s no way to properly answer the question without knowing all the details. I can tell you the basic model for a VC-financed tech startup, but I can’t advise you that it’s the right structure for you and your company. Until you get properly customized advice, your choices are to ignore the complexities or to use these sorts of answers to learn how to make a decision.

What areas of the law do you think should have more generic advice? Are there any fields where an 80% solution really works best for a lot of people? What about special needs trusts (an area I’m working myself into in the very near future)?

Startup board packages should be 80% straightforward, easy to update materials: financials, sales pipelines, technical milestone progress, option grants, etc. — it’s data/information. The remaining 20% is what the management team should be working on — knowledge & questions. That 20% will vary from company to company, from VC to VC even, but it will almost certainly revolve around these three major themes:

1. the allocation of capital (of all kinds) across the strategic and tactical opportunities in front of the company
2. the status of execution against the opportunities being pursued
3. the identification of any roadblocks to execution and success that the board can affect

Sharing the weekly version of your 3x5x15 staff planning tool is one simple, low-overhead way to keep the board apprised of ongoing developments without overloading them with details or inviting discussion on minor points.

Focusing on giving the board decisions to make, rather than topics to discuss, will make everyone more productive, improve the quality of the interaction, and improve overall results. There’s no issue that can’t be handled in a single meeting that should be brought up for discussion in the meeting; what this means is that as things percolate, the management team member responsible needs to *write* up an information brief to highlight the concerns and issues. (Yes, it has to be written, e.g., in a document, not a presentation, to clarify the message with the appropriate level of detail and background and allow it to be digested over time.) Then, once the informal discussions, generally outside of the board meeting schedule, have taken place, someone should write up and present a decision briefing, the purpose of which is to give the board the issues, a recommendation, and seek a decision. This structure works wonders in clarifying issues and bringing ideas together.

Decide, don’t discuss. That’s the way to rock a board meeting.

The answers point to some provisions that should be included (division of gains and losses, breakup/buyout/dissolution schemes, and tax matters). To their credit, although the typical reader in this situation won’t necessarily see it that way, the lawyers all mentioned that the poster should use a lawyer to get the right agreement.

Just because you can put down the same words on paper that a lawyer uses doesn’t mean you have a good agreement. (Personal example: I recently reviewed a document that the other lawyer assured me was used by several lawyers in that field and “no one had a problem with it.” That claim unfortunately led me to believe that several of the lawyer’s professional colleagues also could not draft well-written agreements. The caveat about copying down words not being the same as drafting applies to lawyers, too!)

After all, there is always a disconnect between the universe of possible terms and those that are right for you and your company and your team and your investors and your business partners and your suppliers and your customers.

This is why we have lawyers. I don’t create value by keeping a generic form secret from you. Good lawyers don’t create value by hiding explanations of the form from you (see my discussion of Wilson Sonsini’s term sheet generator).

Great lawyers create value by giving you reliable outcome-focused answers like these:

Here’s the absolute right answer.

Here’s the best answer for you, balancing everything in the way that I understand everything that I know is important to you and everything that I know would be important to you if you knew about it.

Here’s the mostly right answer for your situation, and the cost of having the wrong answer now isn’t worth the cost of getting the absolute right answer.

Here’s a good working answer, and we’ll hedge our bets in case I’m wrong.

I don’t know, and we’ll find the answer.

I don’t know, but I do know that this is a big freaking deal so don’t do anything until I come back to you with the absolute right answer.

… and explaining those things to you. What I do for clients, across all kinds of engagements, transactions, litigation, counseling, and advising, often falls into one of these big three areas: identifying risks, managing (by eliminating or mitigating) risk, and helping them make informed decisions.

That’s how a lawyer creates value for you. If you’re not getting that, and you don’t have the experience to supply those answers yourself, keep looking.

A column from February, “We Really Need to Talk,” (oddly renamed on the web as “Foundations’ Four Biggest Faux Pas”) is a little list of four points she’d make to foundations. To me, they boil down to versions of “we know what’s best and so just give us money to do what we want.” That sounds like I’m being critical, and I am for those nonprofits for whom the first part of that statement isn’t true: sometimes, perhaps far too often, nonprofits don’t really know whether they know what’s best. There’s no question that millions of Americans are wholly dedicated to numerous worthy causes and contribute every day with hard work, honest emotions, and hope, only to contribute further every payday with a smaller paycheck. Our country would be less friendly, more hostile, and less vibrant without their good hearts.

The question is whether organizations have established their own metrics to determine efficacy and efficiency. I’ve written before about choosing strategies and selecting performance metrics as well as admirable models worthy of emulation. Today, though, the message is simply this: you have to have some plan for figuring out how well you’re doing your job.

And yes, if you’ve been paying attention, you realize that this post isn’t really about nonprofits: it’s about performance management. Only when you have some system in place, however imperfect, can you improve it. Even public companies with constant feedback on performance and no excuse for not having near real-time operating data, often lack any considered metrics that feed into strategic decisions in scenario plans or tactical decisions on a short fuse basis.