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.

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)?

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.

In reference to a post on the use of the term aggressively, I wrote:

These comments seem like nitpicking and pedantry until you start to listen carefully and accept the empirical, outcome-based approach that Ken Adams has followed. What do courts do with our contract language? Isn’t that a significant goal of drafting? To tell parties to what standards they can expect to be held?

Every time I read one of these posts it energizes me to re-read my form contracts for even simple things like entity formation (startup and nonprofit), founder’s documents, and venture financing.

I have been in discussions with some of my colleagues around the country on creating both a new new set of startup and venture documents and some additional materials (still in stealth mode!) for entrepreneurs. If you’re interested in hearing about these directly when they’re available, sign up for free RSS updates, or send me an email at rick@rickcolosimo.com.

Do I need to have a nonprofit status to become a social entrepreneurial enterprise?

I found this LinkedIn question to be interesting for two reasons: first, it’s very related to a nonprofit question I field all the time, and second, I have a current client that is very socially conscious, both in terms of their personal focus as individuals and as a major goal for the company.

Here’s the answer and my advice:

What’s a social enterprise?

First, the “social enterprise” moniker is a red herring. There is no such thing as a unique type of company. (The L3C, the “low-profit limited liability company,” is a very distinctive special purpose entity, only available in a few states, that only really has a precise regulatory function. This almost certainly doesn’t apply UNLESS the major portion of your funding will come from large private foundations.)  I’ve read the heck of the L3C documentation, and it’s not the answer that people are looking for.

There are nonprofits and for-profits. For-profits can do whatever they choose with their profits or pre-operating profit cash flow, as determined by the board as elected by the shareholders. For example, does a for-profit company that donates software licenses qualify for your “definition?” Maybe, but so what? The best “proof” that what I’m saying is true comes from looking at one of the references in another (helpful but ultimately uninformed) answer to that same question:  the B-Corporation folks use traditional corporate governance to institutionalize broad social goals as explicit goals for a particular company. I think that’s dead-on.

What structure is the right one for these companies?

The real question is what *your* organization wants to do, and what corporate form is best suited for that purpose. Good corporate lawyers will never make the tail wag the dog: we find the right organizational and operational and contractual structure to help you accomplish what you want.

So please, do yourself a favor and start out with a vision, then find a lawyer to implement that vision.

I have clients that run the gamut of arrangements: for-profits, nonprofits, discounts for nonprofits, donations of services, cash donations, and side-by-side related for-profit and nonprofit entities. Every plan is different: what’s yours?

To get more information about this last point, read these posts on planning a nonprofit and forming a nonprofit; they describe the importance of starting with your vision, and then a plan, and only then turning to someone like me for actionable, firm recommendations that I stand behind.

What’s a convertible bridge note?

A convertible bridge note is a not-uncommon financing instrument in venture capital. This instrument is very common when an investor has effectively decided to invest and wants to give the company operating capital while the investment is finalized.But that’s typically just referred to as a bridge note whereas “convertible bridge note” is more a term of art referring to the instrument and technique I describe here.

This type of note functions like any other, but a few additional terms are often added: first, the note has more particularized conversion requirements that are tailored to what the parties expect will be an outside round with a more reasonably precise valuation; second, the return for the note investor will include both some element of interest and some additional return; third, the additional return, which is designed to mimic or at least make up for the equity return that would have otherwise been gained via a seed equity investment, consists of either a fixed return, regardless of time, or a fixed rate of return, regardless of amount.

Why would anyone do this?

The rationale for convertible bridge notes is part of the continuing fuzziness of venture investing (still reaching back, in my mind, to the dotcom bust), along with some recent discussion by Fred Wilson of why he finds himself not attracted to these sorts of deals. (I’ve got a need to do a whole series of posts on some of the issues Fred raises in this post; the guy writes stuff that opens a whole host of issues, which might be one reason this post, by no means unusual, had 135 comments at last visit.)

For the earliest stage startups, there is a high variance in terms of coming up with a reasonable valuation. Standard seed round terms and conditions make it easier to avoid trying to price any of those items (which I’m convinced no one does, has done, or will likely ever do with intent or knowledge). But every company still faces the three inherent risks (the VC triumvirate): technology risk, market risk, and operations risk (aka team risk). These have otherwise been described as “Is there a real market?” and “Is this the right team?” These risks don’t go away just because you standardize terms, and their impact on valuation often falls into the realm where reasonable people might disagree — can prices be maintained? How much can sales be ramped up? How long will the sales cycle be?

When the right set of risks is hindering the deal, then a skilled corporate lawyer (e.g., me) may suggest using a convertible bridge note to allow the parties to do the deal they want, which is fundamentally about allocating capital to the pursuit of the business’s objectives, and deferring the open question, valuation, in a way that is fair to both sides, investor and company.

In short, the convertible bridge note is properly employed when both sides want to do the deal, believe in the company and its prospects, want to treat each other fairly, and would rather get the “right” answer than disagree and kill the deal. (Note how the critical point here is plainly addressed in Fred’s post:

But I am a sophisticated investor. I do this for a living. I can negotiate a fair price with an entrepreneur in five minutes and have done that for a seed/angel round many times.

Investors

For angel investors, the use of a convertible bridge note has certain advantages over either a seed-round Series A or common-stock financing. First, the question of valuation is deferred in exchange for a known return from the time of the investment to a future valuation event. This deferment reduces the risk for investor and company that the valuation arrived at may differ greatly from the future financing, thus being somewhat “unfair” to either investor or company. When the angel investor and the company both want to treat the other fairly, this financing method helps eliminate the risk of unfairness.

Second, the note is debt, which gives the investor priority over other equity investors (similar to the priority in liquidation of preferred stock).

Third, the technique is common and well-understood by venture funds, so there is little risk of inadvertently creating potential problems in the structure.

Fourth, the auto-conversion terms can protect both parties by substituting the more formal, and often more extensive, rights of a Series A holder for rights under the note that can then be tailored to specific circumstances.

Fifth, a bridge financing can be completed in days versus weeks or longer for a preferred stock financing, in part because of the seniority of the debt over the equity and different regulatory requirements.

Sixth, the bridge note is a substantially cheaper transaction in terms of legal fees and other transaction costs.

Company

What’s in it for the company and founders? Simple: they get to bet on themselves and use the investor’s capital to do so. If the only possible structure were an equity round, founders would be constantly torn between their view of valuation based on their view of the assumptions about execution and the investor’s view on the same thing. There are always ancillary ways of tweaking the analysis, but few of them work well for startups (earnouts is a good example of something that works in a public company context where the valuation is relatively fixed).

If founders execute according to their plan, they will retain more of the company (by way of an effectively lower valuation for the bridge money) than if they don’t execute as well. But under either scenario, the investor and the founders are moving in the same direction and with the same vision. Both want the company to do better rather than worse, and preserving that joint mission is, to me, the best part of why bridge notes work under the right circumstances.

The reason I list as #6 above, transaction costs,, is really one of the worst rationales, and I’m close to removing it from this list. I have a former client whose company was choked to death, and then his personal life nearly ruined, by maintaining a convertible debt structure for far too long. They just never got around to cleaning everything up, and much like my objections to LLCs, the looser regulatory framework can lead a company quickly down the path from efficiency to complacency.

You may or may not get a formal list from the other side, depending on their level of formality and the nature of their advisors. Some investors know exactly what they are looking for and will figure out what they want to do from your financial model and a series of conversations. Others assume that the only way to be sure is to review a mountain of paperwork. The real answer lies somewhere in-between for most companies.

So, to get you started or at least calm you, here is a super Short Form Due Diligence Request List for a seed round investment or low-key quasi-acquisition, such as an asset purchase or stealth acquisition.

First, keep in mind that the other party may, and probably will, ask for additional information. Our goal here is first to identify anything that might concern them so it can be defused or resolved before it’s ever disclosed. (Hint to bad lawyers: you cannot hide things; there’s always a second copy floating around; the goal is to solve the problem so you can disclose how it has already been fixed.) Our second goal is to streamline as much of your work as possible so that you are not under time pressure later. The third goal is to identify the factual support for the business plan/budget that will be a critical piece of the transaction.

Here is the list of other materials you should be gathering in the background as negotiations continue, documents are drafted, and the deal moves forward.

1. Financials — Copies of all historical financials for existing operations: Income Statement, Balance Sheet, and Cashflow statements. (A backup version of a QB file is something that I regularly work with to extract these directly if necessary.)
2. Material contracts — all contracts that are either above a specified dollar value ($10-25k) or are otherwise important to the continued operations of the business on a similar basis. This should usually include customer contracts, all leases, all promissory notes, and IP licenses, and anything to do with stock or securities (like a warrant agreement or agreement to trade stock for services of a consultant).
3. Corporate documents — Copies of current articles/certificate of incorporation & bylaws; minute book with board/shareholder consents & minutes.
4. Other risks — A description of any pending litigation, whether company is plaintiff or defendant; any audit letters from auditors if financials have been audited in last 3 years; a description of any off-balance sheet obligations or other liabilities; and a summary of any related-party transactions, individually or in the aggregate greater than $25,000.

This ThoughtStorm Due Diligence Request list is a version written from the perspective of an investor and is a little more detailed than what I have above. It’s more like a reasonably thorough list that will get you most of the way to complete for an early-stage company.

“What is a reverse merger or reverse IPO?”

Short answer: “reverse merger” is almost always spelled S-C-A-M.

There are a small handful of legitimate reasons why a non-scammy, non-scuzzy company would go through this process. It is expensive, provides little intrinsic value to the private company paying for everything, and does little else of note.

How is it structured?

Standard format: a private company enters into an agreement to merge with an existing listed (meaning on a stock exchange) company that has little or no assets, may have (preferably) gone through a bankruptcy to become a “clean shell,” and has existing stockholders whose shares probably have a fair market value of close to zero. These zombie companies may nevertheless have a stock price because of random trades, but the FMV is still close to zero. (You can do the math yourself, or just trust me.)

The merger goes through and the private company is merged into the public company with new shares issued to old private shareholders. The private company is thereby able to “take over” the securities filing status of the public company, meaning the private company is now effectively public (as if that matters!). In exchange, the shareholders of the shell get some amount of money, generally well into 6 figures (most of which will certainly go to fees for third-party advisors) and some percentage in the post-deal company (5-20% is not uncommon).

Why do people do these deals?

Because they think that now they can easily “raise money” that they couldn’t previously. Sort of true technically, but false on a practical level. Or, even worse, they think that because they’ve gone public, it magically comes with some kind of new capital. A full-form securities registration (S1) is expensive, and those companies still need brokers to sell the shares to investors. If you don’t spend the cash on the reverse merger, you could just look for underwriters to sell the shares in a regular IPO. Same result, cheaper, faster (since you don’t have to do the merger deal first), and without the equity haircut.

Are there legitimate reasons to do these deals if you’re the private company? Sure, there’s at least one: if you have an investor IN HAND who has ALREADY committed to investing but is subject to investment policy restrictions such as only investing in public companies, then the speed of getting from A to B via reverse merger might make sense. And in that scenario, the terms should be negotiated way, way down from the “typical” deal.

Bottom line?

In general, stay away and get advice from a reputable, experienced corporate/securities lawyer who has done mainstream deals before getting into this one.

Have any of you actually done one of these deals that made sense before or after? My suspicion is that it’s a null set. #FAIL

This one gets a #FAIL from me.

Hearkening back (or forward, since I don’t know if I’ve posted it yet) to my thoughts on why I write, one of them is definitely to signal to founders and directors of small and startup companies when they need to call a lawyer. I guess I’ll have to follow up soon with my hot-button post.

I think that it’s really useful for me to tell people when they absolutely need my advice (taking investment money of any kind), when I can almost certainly help (non-standard commercial contracts), when I can add value (helping negotiate a deal), and when I’m not helpful (picking colors for the website design). Honesty from me makes my clients more efficient, and I hope that it s’s more evidence to them and the not-yet clients that I fit their definition of “trusted.”

Here’s a recent Above the Law post on a job that really doesn’t appear all that worthwhile, really.

This is a downgrade from the $12 job they link to at the bottom of the post, but it’s a step up from the California job FOR AN ADMITTED ATTORNEY that paid so little it violated minimum wage laws.

Wowza. I suppose my economist friend would say this tells us something about the shape of the demand curve, right? But what, exactly?

Is this a supply problem, of there actually being too many lawyers, or is it a matter of there being such a demand for work that is legal in nature but doesn’t merit paying high costs for that work? In other words, there are lots of clients out there who aren’t Fortune 500 companies and are stretching for