A question we get asked on a regular basis is: where should I incorporate? An interesting question with lots of possible different answers and solutions. There are a number of considerations with regards to incorporation:
Each of these will have an impact on where you incorporate. US Investors do not generally invest into entities that are incorporated outside of the US (A Delaware C-Corp would be the standard investment entity used in the US). This is due to onerous tax filing and information requirements on US citizens for off-shore investment activity.
Alternatively, if you have been accepted to one of our MOX or China Accelerator Accelerator and would like to incorporate a Hong Kong Limited Company please see Otonomos, an online incorporation agent here.
The moment you decide to take your idea and make it a reality, you and your co founders’ should sit down and draw up a proverbial pre-nup! Just like any partnership, it is everyone’s intent that everything runs smoothly, but things change so it’s best for all parties to decide on the “What If’s” now.
A Founders’ Agreement is a clear, uncomplicated written agreement between the founders outlining the understanding and expectations of each party on a number of key issues such as:
It allows the founders to build a solid foundation and nurture one of the most important relationships as a co-founder.
Many co-founders think that splitting equity evenly is the fairest and easiest way to maintain harmony in the camp. Whilst this approach is understandable it may not be the wisest decision once all matters are considered.
It is important to remember that all equity should be subject to vesting which I will discuss further below. Vesting means that rather than receiving all shares in one lump sum, the shares are held by the company pending the completion of certain milestones. For example, after one year of service 25% of the founder’s equity will vest and the remaining equity will vest on a monthly basis thereafter over a number of years as agreed.Here is a list of factors to take into consideration when considering how to divide the equity:
The importance of vesting provisions are demonstrated in the event of a sale of the company, which had a founder who quit prematurely. With the protection of vesting provisions the quitting founder would only be entitled to benefit from the sale proceeds to the extent of the value that they added during their time in the Company i.e. to the amount of the fully vested shares in his/her name prior to departure. By way of example, if there are two founders with 40% ownership of the company each, and they’re vesting is over four years, and one founder quits after one year, they’d only have vested 10% of that 40% (one quarter of their shares). So the other 30% of the company would be repurchased by the company (and perhaps re-issued to a replacement co-founder).
SOSV is committed to our accelerator companies long-term, and we want to see benefit accruing to founders who demonstrate their long term commitment to the startup. Vesting facilitates this and all investors seen order to ensure that founders stick around over time, vesting permits the startup to retain the right to repurchase (at a nominal value), some or all of these founder shares in the event that a founder decides to quit the company.
The vesting of founders’ shares should be seen as “founder-friendly” and should be implemented in the form of vesting schedule in order to protect each founder & the company. Vesting provisions will ensure that all founders are focused on achieving ultimate success for the startup.
A standard vesting agreement would have equity vesting over 4 or 5 years, with the first 25% of shares vesting after one year and the remainder vesting in monthly or quarterly increments. Standard vesting provisions would allow an additional year of accelerated vesting in the event of a sale, merger, consolidation, etc., provided that such founder is still with the company at the time of sale, and would have contributed to the value being added that attracted the interest of a purchasing party.
The options granted from the ESOP are generally subject to similar vesting provisions (except in that case the options are just cancelled instead of the issued stock being repurchased).
Roles and Responsibilities
Whilst founder roles and responsibilities can be broad at the beginning and can change over time you should set out the main responsibilities each founder will be accountable for. A comprehensive job specification is not required however the most important duties should be prioritised and agreed upon.
Remember, the founders’ agreement and designation of roles is a moving piece that can be amended and molded to suit the company’s needs over time.
Whilst decision making procedures can be daunting and uncomfortable at first, they can be broken down into regular procedures such as, weekly reviews of operational expenses and larger decisions such as capital spending or hiring and firing.Some of these decisions are simple and can be assigned to one founder to manage whilst other decisions are more substantial and may require a decision making procedure involving all co founders.
With regard to spending and as referenced above it is a good idea to designate the everyday operational spending to one person however there should also be a high level review of this function on a monthly or bi-monthly basis with the intention of tweaking the process to cater for the growing needs of the business. Larger spending may require a different approvals process whereby all founders must be consulted.
With regard to hiring and firing it is not only the hiring and firing of employees that should be discussed. What happens in the event that a founder needs to be let go i.e they are not performing etc. You may want to consider events that would necessitate the use of a mediator, arbitrator or another independent third party to help in reaching workable solutions for the tough questions.
100% of the intellectual property (IP) must belong to the company. This means that the company will own all registered IP ( patents, trademarks, trade secrets, design rights etc) and all IP held by the founders, employees and/or consultants with regard to all work and projects conducted for the benefit of the company.
In addition to including an IP section in your Founders’ Agreement, it is important that you sign a Confidential Information and Invention Assignment Agreement. This ensures that all IP, in all forms, whether registered or merely in the realm of idea’s and concepts are the property of the company and shall remain the property of the Company whether the developer of the IP remains with the company or not.
When considering your Board Procedures you should draw up a list of matters that require a majority or unanimous board consent. Below is a list of matters to consider:
It is Not a Debt Instrument
Unlike a convertible note, an ACE is not a debt instrument. The advantage of this is that the ACE does not create the risk of insolvency, there are fewer regulations to incorporate into the document (that would otherwise apply to a debt instrument) and there is no maturity date.
It Does Not Accrue Interest
Because the money invested via the ACE is not a loan, it will not accrue interest. This is particularly beneficial for startups. This also reflects the true intention of the investor, who never sought to be lenders in the first place.
It Saves Startups Money and Time
As the ACE is a more simplistic security type it overcomes many of the difficulties associated with convertible loan notes. For example an ACE has no interest rate, maturity date or repayment obligations (with the exception of a dissolution or liquidity event). These advantages should save start ups both time and money with regard to legal fees and time spent negotiating.
The primary triggers for the conversion or termination of an ACE are generally an “Equity Financing”, a “Liquidity Event” or a “Dissolution Event”. The actual number of shares the ACE will convert into will have to be calculated in accordance with the agreed terms of the ACE. If none of the above events occur prior to the “Anniversary Date” the ACE-holder will have the right to “Review” the ACE and the start-up’s progress and can choose to:
(i) convert all or any part of the Purchase Amount to common stock at a conversion price set out in the ACE, or; (ii) allow the ACE to remain unconverted and review the ACE on a future date as determined by the Investor.
It is important to note that SOSV’s intention is not to seek our investment amount back. We invest in your startup at an early stage with the intention of building a long term supportive relationship to help you build and scale your company over a period of 10 years or so. Our ultimate goal is to maintain equity in your company whilst it grows and becomes more valuable as opposed to seeking our original investment amount back from your company.
Conversion Upon an Equity Financing
The ACE will generally contain a clause allowing for automatic conversion of the purchase amount when the startup achieves an Equity Financing. An Equity Financing is generally a stock financing round by the startup to raise capital from investors in exchange for shares in their company at a predetermined level for Equity Securities.
Equity Securities are usually the class of share in a qualifying equity round (normally preferred stock), for example a Series Seed round. Once the Equity Financing level, is raised by the startup, the ACE will automatically convert to the Equity Securities.
SOSV would get a number of shares of preferred stock calculated using the Valuation Cap as set out in our ACE. The higher valuation cap of the next round would not be used to calculate our conversion.
However, the preferred stock issued to SOSV as an ACE holder will have a liquidation preference that is equal to the original ACE investment amount, rather than based on the price of the shares issued to the investors of new money in the financing. This feature means that the liquidation preference for ACE holders does not exceed the original investment amount (a 1x preference).
The Valuation Cap is inapplicable in this situation. An ACE holder gets the same preferred stock, at the same price, with the same liquidation preference, as the other investors of new money in the financing whilst applying the discount as per the ACE.
If a company goes public, an ACE will convert into shares of common stock calculated based on the Valuation Cap (or the ACE holder can cash out the ACE).
A liquidity event is generally a good thing for the company. With this in mind we seek a higher return on investment than we would in a Dissolution Event for example. Generally a liquidity event includes a change of control, an acqui-hire or an, Initial Public Offering (IPO). If a liquidity event occurs prior to the expiration or termination of the ACE then the startup will generally be liable to pay the Investor the greater of:
(i) twice the purchase amount, or; (ii) the amount the Investor would have received in connection with such Liquidity Event had the Investor’s purchase amount converted to equity immediately prior to the effectiveness of the Liquidity Event
Most people don’t realize that, for example in an aqui-hire situation the founders do very well via stock options in the purchasing entity, enhanced salary levels, etc etc while accelerator programs and angel investors do not get their money back. This clause aligns the investors with the founders so that investors can get some level of return on their investment.
A dissolution event is quite different to a Liquidity Event in that it generally means that the startup has voluntarily or involuntarily decided to dissolve or wind up the company. In this case SOSV has a Liquidation Preference.
A Liquidation Preference provides protection to SOSV as SOSV will seek to have a preferential entitlement to, generally, a 1x liquidation preference, which would be equal to the direct cost of having a company in the accelerator program via program costs & equity investment monies.
We invest in accelerator companies with the view to being involved with these companies for the next 7-10 years while building a strong relationship with the founders and the company. Put simply, this clause ensures that we can recover the costs of putting you through our program, so that we can find a new long term investment for the next program.
The amount of Equity Securities that the ACE can convert into will depend on the share price of the next round and two key elements – the Discount Rate and the Valuation Cap. Both of these clauses give the ACE holder the benefit of being one of the first to invest i.e. a maximum price that will be paid (Valuation Cap) or a discount on the price the next investor is paying (Discount Rate). Without the Discount Rate or the Valuation Cap, the ACE would essentially convert into the Equity Securities at the same price as the equity issued in the next round. The Discount and the Valuation Cap are provisions that attempt to remedy this.
The Discount Rate
The discount rate acknowledges that the ACE holder has taken on additional risk in investing at such an early stage in the startup. The ACE holder gets a level of protection on the basis that the ACE holder will have the entitlement to a discount against the future stated value of the company at the time of conversion. The discount rate 20%.
The Valuation Cap
The valuation cap (the “Capped value”) again aims to acknowledge the risk taken by the early stage ACE holder as an investor in your company. The valuation cap sets the MAXIMUM price into which the ACE will convert to equity in the startup – essentially protecting the ACE holder by setting a limit on the conversion price of the ACE so that the ACE holder is guaranteed a minimum number of Equity Securities if the subsequent priced equity round is above the Capped value level.
If the next round is at a valuation level below the actual Capped Value, then the calculation may not be relevant. The Capped value is generally consistent with what the Founders consider the valuation of their startup is at the time of the ACE. Remember, the Capped Value is the maximum price that the ACE can convert. Founders should remember that if the ACE converts at the Capped Value this is generally a good sign as the actual valuation of the Company at the time of conversion is probably greater than the Capped Value.
The ACE will convert at either the discount rate or the valuation cap, whichever results in the best (i.e. lowest) price for the investor.
The Anniversary Date is generally 12 months after the effective date of the ACE. If an equity financing has not been raised within this time period SOSV will have the right to either: (i) convert to common stock in accordance with the terms of the ACE or (ii) allow the ACE to roll forward for a certain period of time at SOSV’s discretion.
Where it is clear that a company is making good progress and an Equity Financing is on the horizon we are happy to let the ACE roll forward but this is at the Investor’s discretion on a case by case basis.
We know that founders are busy developing and progressing their companies but there are real benefits to be gained from sharing information, not only for Investors but also the founders themselves.
The information prepared will help in building the relationship between your Investors and the company, will allow transparency and will maintain open channels of communication between you and your Investors.
The preparation of regular updates (financial and otherwise) also focuses the minds of founders and allows founders to assess if the company is growing at the projected pace, if there are areas that require specific attention, identify strengths and weaknesses, etc.
Once a channel of communication is opened it avoids any nasty surprises or shocks. It is no coincidence that the best performing companies at SOSV are those that have always been open and transparent with information. As well as illustrating wonderful discipline, it shows us as investors that the founders and company have a really solid handle on their financials, strategy, customers, products and vision. This frequently gives us confidence in the company when future funding rounds come around.
An SPA is an agreement which records the terms under which shares of stock (common or preferred) are issued to SOSV by an accelerator participant company.
As per the terms of the SPA, the Anti Dilution Protection clause ensures that SOSV can maintain its equity percentage for no further consideration until the company has raised an agreed minimum amount of future funding (e.g US$300,000). This is also known as a Qualified Financing.
This ensures that SOSV will not be diluted by small amounts of funding or a “family and friends round” where the amount of funding raised is below the Qualified Financing threshold.
This provision should encourage startups to raise appropriate funding which meets the Qualified Financing threshold as soon as possible.
Under the terms of the pro rata rights as detailed in the SPA, SOSV is entitled to acquire further equity in a future financing round, generally to maintain SOSV’s pro rata (pre-financing) equity stake. This will be on the terms of the first financing investment round (negotiated at that time).
The entitlement to SOSV under the pro rata rights demonstrates that SOSV is interested not just in an ultimate percentage return but in maintaining its percentage ownership in a company in which SOSV has been involved with and committed to since its beginning.
Pro-rata rights aim to ensure an ongoing, open, and productive relationship between SOSV and the startup, and we have a history of maintaining our pro rata share (if not more!) in our companies.
The benefit to the company here is that it is easier to raise future financing rounds with an existing investor who is committed to following on. Any new investor will want a capitalisation table that is working for the benefit of the company so that rather than investors who are “one round and done” you have investors who are happy to follow on at higher valuations in future funding rounds. Other investors look favorably on committed investors.
SOSV’s first financing right enables us to participate in the first qualified funding round in the startup, up to an agreed monetary/percentage cap (usually the greater of $200,000 or 20% of such new equity securities ), on the terms of such subsequent investment, with such terms to be negotiated at that time. We’ve invested a tiny bit of money and a ton of time and effort, and it’s important to us that we can stay in the game as the company moves to the next level.
Most accelerator programs don’t have the ability to fund companies that graduate the program. This is not an advantage for the participants of the accelerators. SOSV has the ability to provide and/or match first funding rounds post-accelerator. This makes it easier for our graduates to close their first funding round.
We have a history of backing our companies, through good times as well as bad, and this clause helps ensure we can continue that. In the upcoming HAX program this clause has been extended further to include a matched funding promise, if you can raise $200,000 from another Investor, then we will match it!
An ESOP is a pool of stock from which options can be issued. Options are basically a right to purchase shares in the company at a future date. They can be given out to directors, advisors, employees, officers, service providers, and just about anybody.
We require that each investee startup create and maintain an ESOP of at least 10% of the company’s total issued stock on a fully diluted basis. An ESOP enables a cash-strapped startup, that may not yet be in a position to offer market-rate salaries, to attract high-caliber employees, by affording the opportunity to those candidates to earn equity in a potentially successful startup combined with an initially modest salary.
An ESOP can give employees the incentive to commit to the startup in order to achieve ultimate value through their ESOP holdings. Employees will see the value of their contribution over time as their stock value increases.