Panel Participants:
Chris Anderson, Snell & Wilmer
Sam Gardiner, Dorsey & Whitney
Ken Muller, Morrison & Foerster
Robert O'Connor, Wilson Sonsini Goodrich and Rosati
This session is sponsored by Morrison & Foerster
Legal Panel
Fund formation is more than capital. There are myriad kinds of funds.
Look at the core economics. Set up a fund and back office, leverage their experience.
The VCs themselves are key players. They have a reputation and integrity of relationships to maintain.
As groups start to be successful, the amount of leverage they have tends to be reduced.
The role of VCs in this process of fund creation revolves around these relationships. Their roles have evolved over time. In 2000, optical equipment was all the rage. In 2001, it was medical devices. The last four years, it has been all about international strategies.
Make sure you know the legal processes that are involved
Top 10 legal mistakes of portfolio companies:
creating a “cheap stock” problem
failing to obtain good title to intellectual property
failing to institute a trade secret program
not adopting an appropriate employee stock option plan
blowing the section 83(b) election
selling securities to unaccredited investors
not properly maintaining organizational records
not conducting a timely trademark search
incautiously hiring former employees of a competitor
not properly licensing technology patented by others
Make sure you have enough people surrounding you and a good incentive plan in place so that you get the tax treatment that you want to have.
The filing must be done as soon as possible.
Robert: if you offer securities to a bunch of people, you place yourself in a legal position that is different. When you violate state or federal securities laws, you give them the right to rescind the deal at a tremendously discounted rate. When you raise venture capital, you will be required to demonstrate that you are complying with every securities law possible. You may lose credibility, the market may change, etc. It may seem like technicality, but it's the law.
Chris: Assuming you jump through all the hoops right, you still have to give detailed reports to all your investors.
Robert: Before you sell any security (stock, option, etc.), call the lawyer to make sure it's legit. The environment has changed and people are less tolerant of shoddy business compliance practices. VCs are more nervous. If you maintain order well and hold regularly scheduled board meetings, etc., it's like maintenance on your car – keeps everything running smoothly. When you're doing a trademark search to make sure you're legal, a Google search is just not good enough. You have to dig deeper to make sure that you do not commit trademark infringement. Also, just because you have a name locally doesn't mean that you've got it in the next state or the next country – make sure to comply with all those laws, too. Even Google has had legal problems with things of this type.
Sam: Startup companies often want to sell preferred stock to people for as high a price as possible. But they also want to offer common stock for a low price. There are many issues that go into calculating those values. If you value your common stock too low, the IRS will call you on it and treat you as though they were sold at a higher price – so you might receive serious tax consequences. There is a new emphasis on companies doing a proper job of valuing their stock.
General notes: Importance of equity valuations:
internal revenue code section 409a
incentive stock options
cheap stock
audited financials
SFAS 123(r)
The IRS is cracking down on corruption involving deferred compensation. This places more pressure on clients to correctly value their stock.
Ken: Section 409a deals with safe harbor valuation methods. For publicly traded companies, the stock trading price generally provides a reliable measure of fair market value. Everything here involves written reports, and there are very specific rules that will influence the legitimacy of a valuation based on the age and size of the company, the identity and status (employee or not) of the person who generates it, etc. before you get into the process of creating a fund. If you have done your homework, the process will be simpler and easier.
