Legal Issues

MIT Course 15.S21 - January 28, 2014

Joe Hadzima
(MIT S.B., M.S. in Management; J.D. Harvard Law)
Senior Lecturer, MIT Sloan School

President and Co-Founder, IPVision, Inc.

For Background Education Only – NOT LEGAL ADVICE

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 Life Cycle

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 Idea Stage and Pre-Financing

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 Idea Stage and Pre-Financing

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 INTELLECTUAL PROPERTY helps translate
your technology into a business
• Four Key Ideas for Startups (From Fiona Murray)
– Intellectual Property
• Controlling the knowledge underlying an innovation
– Secrecy
• No-one else knows how to do this
– Speed
• Moving rapidly beyond current competition and keeping ahead
– Lock-in customers
• Making it costly for customers to switch or becoming the
standard

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 How Can IP Help Your Business Plan

• It is a Valuable Asset
– You can use it to raise capital
• Correlation with Success
– IPVision study: Top Quartile of Patent Ratings for
VC backed companies => 85% were Winners
• You can establish you are a good manager of
technology
– Do you own the IP you say you have?
(prior employers, employee assignments, open source)
– Have your competitors blocked you out?

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 Types of IP Protection

• None
• Trademark Can Enhance Value
• Copyright But Don’t “Block” Others
• Trade Secret Can “Prevent” Others
• Patent Cuts Both Ways
• Combinations of Protection
– i.e. Software can be protected by Patent and Copyright

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 Trademark/Servicemark

• Developing a name for yourself – Customers Think of You

When They See/Hear the Mark
• A Mark under which you sell goods and services
– House Mark - IBM, Virtual Ink
– Product mark – Thinkpad, Mimio
– Rights arise from use in commerce
– Federal Registration
• Pick a “fanciful mark:
– Apple, iPod, Mimio
• Do NOT pick descriptive words/phrases
– Storage Technology, Analog Devices
• For the Business Plan;
– Check availability at US Trademark Database www.uspto.gov

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 Copyright
• The right to make copies
– Arises from creating a work
– Federal Registration is a plus
– Protects the expression - NOT FUNCTION

• great fit for music, poor fit for software

• For your business plan:
– make sure you have the rights you need
• Owned by Author unless Employee or Work for Hire
– Check open source issue

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 Trade Secret

• Secrets you use to give yourself an advantage in

the marketplace
– formula for Coke
– protection granted varies from state to state
– lasts as long as you can keep it secret – Nondisclosure
Agreements (NDA)
• For your business plan
– note that you have trade secrets - keep the secret out of
the plan

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 Patents = Limited Time Monopoly

• A Federally granted right to any system or method that is

new, non-obvious and useful
– It has to be applied for
– It has to be granted from the Patent Office
• Very Much Like Real Estate
– Right to Prevent Trespassers
– Prevent others from making, using, selling, or distributing the
patented invention
• Ownership: Not = Right to Use
– Real Estate Analogy: Access Rights, Zoning, etc
• Claims of Patent = Fence Around Property
• Duration = 20 years from filing
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 Requirements to Obtain a Patent

• Novel – Something “New”

– Prior Art must be cited
• Useful
• Patentable Subject Matter
• Not previously sold or publicly described
– Enabling Disclosure
– One Year Window in U.S. Only
• Not obvious “to one of ordinary skill in the art”

– Prior art “teaches against”

– Commercial success can show non-obviousness

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 Patents and Business Plans

• Freedom to Make, License and Sell your Product

• Does Your Company Own the Technology?

– Assigned by Inventor to Company?
– Licensed from University?
– Did it go into the Public Domain?
• Public Disclosure/On Sale Bars
• What is your Strategy?
– Patenting vs Disclosing to Prevent Others from
Patenting

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 Obtaining a Patent
• The Application Process breaks down into four
main projects
– Determining What to Patent
– Determining When to File
– Preparing one or more Patent Applications
– Prosecuting the Applications

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 What to Patent

• Determining What to Patent

– Probably the most important step
• Do NOT ask “What can I get a patent on?”
• Ask instead “What do I want a patent on?”
– What is of commercial value to my company?
– How would my competitors use my technology?

– Compare against the prior art

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 What to Patent
• Prior Art – Find What Is Out There Already

see-the-forest.com

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 Prior Art

PRIOR
ART
PATENTS

FIRST
VIRTUAL INK
PATENT

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 Virtual Ink U.S. Patent Portfolio
Patents Citing
Virtual Ink Patents

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 When to File

• Determining When to File

– Before you lose U.S. or Foreign rights
• Before a public disclosure
• Before an “on sale” bar
– First To File Wins under AIA
– In time to have a patent to protect your
product or service

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 Provisional Patent Applications
• Requires a meaningful description of the invention

– Claims NOT required

• Protects invention for one year
• Fast and Cheap ~$130 for small entity, $65 micro
• Nothing happens at the PTO
• What you fail to disclose may not be protected

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 What Is In A Patent?

• A Patent Application is like a term paper – a set of figures and

accompanying text
– Field of the Invention
– Background of the Invention
• Describe the “prior art” – what is out there
• List advantages vs Existing - What is broken that you fix?
– Summary of the Invention
– Detailed Description
• Give examples of use
• Best Mode: What is the best way to implement your invention.
This is the bargain: you get a limited time monopoly if you educate
the world
– Claims
• What exactly is your invention
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 Costs

• U.S. patent applications

– $5,000 to $15,000 for preparing the application
– U.S. Filing fee is about $280/$140
– Prosecution $5,000 to $15,000+
• Foreign Patent Applications
– PCT filing fee is about $2,500 to $4,000
– PCT demand is about $1,000 to $2,500
– European Filing fee is about $6,000 to $8,000
– Japanese Filing/Trans. fee is about $7,000 to $10,000
– National Fees – it gets expensive. Government
Accounting Office study: $300k to $500k in 10
countries over the life of the patent
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 University Licensing Background

• Sponsored Research: Who Pays/ Who Owns?

• Bayh-Dole Act of 1980 (“BDA”)
– Prior to the enactment of Bayh-Dole, the U.S. government
had accumulated 30,000 patents.
– Only licensed non exclusively
– Few patents were commercialized.
• Only approximately 5% of these patents were commercially licensed.
• BDA permitted Universities to Retain Ownership of IP

– Permitted universities to license exclusively

– Dramatically accelerated their commercialization

See Wikipedia

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 Bayh-Dole Act Requires Universities to:
 Retain ownership of innovations created under government
funding
 File patents on inventions arising from government funding
 Give licensing preference to small businesses
 Provide government with royalty-free non-exclusive license to
use, make, or have made on behalf of federal government
(limited to government use)
 Develop programs to commercialize these patents to benefit
society
 Share royalties with the inventors

Source: AUTM

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 Mission of MIT Technology
Licensing Office (TLO)
• Facilitate the transfer to industry of technology from MIT,
Lincoln Laboratory, and Whitehead Institute, and thereby
to benefit the public good through the development and
subsequent sale of commercial products.
• Secondary goal is to generate unrestricted funds to
motivate inventors and to support research and
education at MIT
• web.mit.edu/tlo/www/
Report to the President
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 MIT IP Ownership Policy

• MIT owns the patent or copyright if:

– significant use was made of MIT facilities
or
– MIT administered funds were used
– Textbooks are an exception
• Never assigns ownership to a licensee
or research sponsor
• Guarantees sponsors first rights to

inventions made using their funds

Source: TLO and Stephen Brown

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 MIT IP Ownership Policy

• MIT can waive invention to inventor if

– No sponsor’s rights and
– No significant use of MIT facilities and
– No use of MIT administered funds and
– No plans to use MIT facilities to reduce to practice

Slide Credit: Stephen Brown

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 Voluntary Prosecution of non-MIT owned
inventions

• Any MIT employee or student may ask to assign

his or her personally owned invention to MIT.
• If the TLO accepts the invention, it will be handled
in the same manner as other MIT inventions, with
the usual royalty-sharing arrangements.

Source: MIT TLO

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 Typical Options to Startups

• Generally 6 months to 1 year

• Assumption of ongoing patent costs
• Modest up front signing fee $1K to $10K
• Exclusive or Non-exclusive
• Protects right to take a license
• Allows for time to evaluate technology and
markets
Slide Credit: Stephen Brown

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 Typical License Financial Terms

Components No Equity With Equity

• Issue fees • $50K to $150K • $5K to $50K
• Maintenance fees • ~50% of expected RR • ~50% of expected RR
• Diligence • Can’t leave on shelf • Can’t leave on shelf
• Royalty as % of Sales • 3% to 5% • 2% to 4%
• Patent costs • $25K to $200K • $25K to $200K
• Research sponsorship • Not required • Not required
• Equity on Next Slide

Slide Credit: Stephen Brown

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 Typical Startup Equity Terms

• Single digit % of equity

• % maintained thru $5M to 10M raised

• Proportional antidilution thereafter

• Future participation rights

Slide Credit: Stephen Brown

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 Typical Royalties for University

Patents

• Software 5 -15%
• Equipment/Medical Devices 3 - 5%
• Materials 1 - 4%
• Semiconductors (Chip Design) 1 - 2%
• Materials (Processes) .02 - 2%
• Materials (Commodities) .01 - 1%
• Pharmaceutical at clinical testing stage 12 - 20%
• Pharmaceuticals composition of matter 8 - 10%
• Diagnostics new entity 4 - 5%
– new method for old entity 2 - 4%
• Biotechnology exclusive process 1 - 2%
– non exclusive process .025-1.5% Slide Credit: Stephen Brown
Circa 2005
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 MIT Royalty Distribution Policy

• Deduct 15% from gross income for TLO operating expenses

• Deduct out-of-pocket, usually patent costs, expenses

• Distribute one-third of what’s left equally among inventors
• Inventors can request unequal distribution
• Adjust remainder based on actual TLO operating expenses

• Subtract out-of-pocket expenses for unmarketable patents

• (write off bad inventory)
• -One-half remainder to Departments
• -The other half to MIT General Fund

Slide Credit: Stephen Brown

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 Time Line

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 Legal Form for the Company

• In most cases, especially where outside financing will be

needed, the entity of choice is a corporation – often a

Delaware corporation
• Why you should do it sooner than later:
– Avoid personal liability - Avoid “partner” liability
– Minimize Personal Taxes – Section 83 – Procrastination Issues
• Making the “S” election – Subchapter S Corporation
– “pass through” treatment for tax purposes
– Qualfication: <= 100 shareholders, One Class of Stock
– some stockholders, foreign nationals, corporations, most venture
capital firms will disqualify the “S”
• Observing corporate formalities
– sign in the corporate name
– maintain the corporate minutes, stock records
– the challenge of picking a company name – DiVA example

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 Subchapter S Taxation
Comparison of Subschapter C and Subchapter S Taxation
(Federal only 2014)
C S

Corporation Corporation

Net Profit Before Taxes $ 100,000 $ 100,000

Corporate Tax Rate 35% $ (35,000) $ -

$ 65,000 $ 100,000

Individual Tax Rate 39.6% $ (25,740) $ (39,600)

Net Cash to Owners: $ 39,260 $ 60,400

Effective Tax Rate: 60.7% 39.6%

• But most startups have LOSSES – investing in product or service

development. Why do I care?
• Because of the EXIT – saving 20+% on an acquisition

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 Beware:

Section 83 of the Internal Revenue Code

• Rule:
– If you receive “property in connection with providing
services”..
– You have Ordinary Income (taxed up to 35%+) equal to:
Fair Market Value of Property
minus What You Paid
• Example:
– I like your idea, I will give you $1m for 50%, let’s set
up the company:
Fair Mkt Value = $500,000 Fair Mkt Value = $1,000,000
You Paid = 0 You Paid = 0
Ordinary Income= $500,000 Ordinary Income= $1,000,000
Tax @ 40% = $200,000 Tax @ 40% = $400,000
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 How to Avoid the §83 Trap
• Separate the Time When Stock is Issued to You from the
Investment by Others – i.e. Incorporate earlier, ISSUE Stock &
Make 83(b) Election
• Why does Stock not get issued in time?
– Too busy - Not sure who should get what

RELATIVE
IMPORTANCE TECHNICAL

BUSINESS

TIME
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 Time Line

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 Sort out the Relationship Among the

Founders Up Front

• Stockholders in a closely held corporation owe one

another a fiduciary duty
• Who sits on the Board of Directors?
• Who holds what corporate titles (e.g., President, Vice
President, Treasurer, Secretary)?
• Who holds what functional titles (CEO, COO, CTO, etc.)?

• Restrictions on Stock Transfers

– Rights of First Refusal - Tag-Along rights
– Preserve “S” treatment - Carve Out for Family Transfers
• Intramural Disputes
• See the “Founders’ Memo” on class website

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 Founder Equity Splits
• Culture/Negotiated – Kenan Systems
• Value of past contributions
• Value of future contributions
– Over next 12 months – When Do You Join?
– Over next 4 years
• Sacrifice & Commitment
• Ownership of IP
• Individual’s external or “Market value”
• Internal Equity – everyone finds out

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 Time Line

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 Philosophy on Team Building
• Work To Be Completed >> Work Completed

• Compensate for both Risk and Sacrifice

• Reward for getting to the End Zone

• Maintain Internal Equity

• EVERYONE should Vest – Typically 4 years

BUT - every situation is different and rules are made to

be broken

From Charlie Tillett slides

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 Employees - Equity
• Company’s stage
– Funding
– Revenue
– Liquidity
• Employee’s value to company
• Employee’s market value
• Internal equity

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 Who gets Pie and How Big are the Slices?
• What fraction of the equity goes into equity
compensation pool?
– Initial Pool for 2 to 3 years; tie to Headcount Plan
– First Round Venture Financing – 12% to 18% pool –
fully diluted
• Who is eligible?
– Key employees
– Middle and rank-and-file employees
– Directors
– Consultants
• Determining award size -- compensation experts
and surveys
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 Employee Specifics
(Charlie Tillett’s Slide)

Ownership % after 2 rounds of financing

CEO 5%

VP 1% to 2 ½ %

Sr Manager 0.25% (1/4 of 1%)

Sr Ind Contributor 0.1% (1/10 of 1%)

• Founding management might get 2x to 3x

• Founding employees might get 5x to 10x

YOU CAN ALWAYS GRANT MORE LATER

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 Equity Distribution Example

(From Charlie Tillett’s Slides)

After
Initial Option Pool Post Angel Post VC 1 Post VC 2
Name Title # Shares % Shares % Shares % Shares % Shares %
Founders
Jack CEO 2,000,000 50.0% 2,000,000 32.3% 2,000,000 29.0% 2,000,000 14.5% 2,000,000 7.3%
Susan CTO 1,000,000 25.0% 1,000,000 16.1% 1,000,000 14.5% 1,000,000 7.3% 1,000,000 3.6%
Anil VP Sales 1,000,000 25.0% 1,000,000 16.1% 1,000,000 14.5% 1,000,000 7.3% 1,000,000 3.6%
Total 4,000,000 100.0% 4,000,000 64.5% 4,000,000 58.1% 4,000,000 29.0% 4,000,000 14.5%
Key Early Employees
Jack VP R&D 300,000 4.8% 300,000 4.4% 300,000 2.2% 300,000 1.1%
Julie Manager 1 100,000 1.6% 100,000 1.5% 100,000 0.7% 100,000 0.4%
Sam Manager 2 75,000 1.2% 75,000 1.1% 75,000 0.5% 75,000 0.3%
Total - 0.0% 475,000 7.7% 475,000 6.9% 475,000 3.4% 475,000 1.7%

Advisors Per Person # PP

Board Members 35,000 2 70,000 1.1% 70,000 1.0% 70,000 0.5% 70,000 0.3% 0.13%
Advisory Board 15,000 3 45,000 0.7% 45,000 0.7% 45,000 0.3% 45,000 0.2% 0.05%
Total - 0.0% 115,000 1.9% 115,000 1.7% 115,000 0.8% 115,000 0.4%

Option Plan Per Person # PP

Manager 50,000 10 500,000 8.1% 500,000 7.3% 500,000 3.6% 500,000 1.8% 0.18%
Sr. Eng 25,000 20 500,000 8.1% 500,000 7.3% 500,000 3.6% 500,000 1.8% 0.09%
Jr. Eng 15,000 40 600,000 9.7% 600,000 8.7% 600,000 4.4% 600,000 2.2% 0.05%
Admin 1,000 10 10,000 0.2% 10,000 0.1% 10,000 0.1% 10,000 0.0%
Total 80 - 0.0% 1,610,000 26.0% 1,610,000 23.4% 1,610,000 11.7% 1,610,000 5.8%

Investors
Angels ($500K at $4.5MM) 688,889 10.0% 688,889 5.0% 688,889 2.5%
VC Round ($5MM at $5MM) 6,888,889 50.0% 6,888,889 25.0%
VC Round ($15MM at $15MM) 13,777,778 50.0%
Total - 0.0% - 0.0% 688,889 10.0% 7,577,778 55.0% 21,355,556 77.5%

Grand Total 4,000,000 100% 6,200,000 100% 6,888,889 100% 13,777,778 100% 27,555,556 100%

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 Common Forms of Equity Compensation

• Restricted stock
• Incentive Stock Options (ISOs) tax-qualified
stock options
• Nonqualified stock options (NQOs)

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 Restricted Stock
• Stock sold or granted outright (usually when value
is low)
• Starts capital gains / SEC holding periods running

• Subject to vesting and buyback by Company

• If 83(b) election timely:
– Modest or zero income at grant
– No further income until stock sold, then capital gain

– No employer tax deduction for increase in value

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 Incentive Stock Options (ISOs)
• Options complying with tax requirements
• Only for employees of corporation
• Exercise Price = FMV on date of grant
• Typically exercise vesting over time
• No tax on grant or vesting
• Possible alternative minimum tax on exercise
• Taxation upon stock sale--capital gain if holding
period requirements met (>1yr from exercise and >2yrs
grant date); no employer deduction
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 Nonqualified Stock Options (NSOs)
• Complete tax freedom in design, but there
may be accounting issues
– Discounted options
– Repricings
– Performance vesting
• No tax on grant or vesting
• Ordinary income (and employer deduction)
upon exercise

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 Vesting: Conditions on Keeping what

seems to have been Awarded to You

• Time-based vesting
– 3, 4 or 5 years?
– Monthly, quarterly, annual
• Performance vesting
– Design issues
– Accounting issues
• Accelerated vesting on change in control?
IPO?
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 Forfeiture and Expiration of Rights

• How long after employment ends may

vested options be exercised? (ISO rules
generally limit to 90 days)
• Forfeiture if “bad boy” provisions violated
• Consequences of violation of
noncompetition, nonsolicitation agreements

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 Buyback Issues
• Can company repurchase vested
equity for fair value?
– Always?
– When employment ends?
– If covenants violated?
– Never?

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 Time Line

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 Sell Securities and Raise Capital in

Accordance with Law

• Properly paper even friendly deals with friends, relatives ­

avoid misunderstandings
• Using the business plan to “sell securities” presents
problems beyond VC’s, corporate investors
• Under federal law all OFFERS of securities must be
registered with the SEC - an expensive process - unless
there is an exemption – e.g. private placement
• Private placements
– Use an experienced securities law attorney
– Avoid dealing with individual investors who are not
“accredited” ($200K/300K annual income or $1m net worth)
– Include “risk factors” in disclosure materials

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 Sell Securities and Raise Capital in

Accordance with Law (continued)

– Provide a capitalization table

– SEC Rule 10b-5 - don’t make material misstatements of fact or omit
to state material facts
– Legends/Control Numbering of Documents
– Regulation D: Form D Filing with SEC
• Avoid public pronouncements (newspaper articles, web site
offerings, etc.)
• Blue Sky (state securities) laws differ from state to state
• Non-compliance may trigger a rescission offer, a stop order,
personal liability
• DON’T OFFER TO SELL SECURITIES IN A BUSINESS PLAN
… “We are offering 10% of the company for $2m”
• Crowd Funding – Awaiting Rules from SEC
– Relation to Later Rounds?
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 Where Do Companies Get Money?

Where Do Entrepreneurs Get Their Money?

Video: Kauffman Foundation. "Kauffman Sketchbook - 'Money Game.'" December 1, 2011. YouTube.

Brad Feld: feld.com

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 Capital Structure Instruments

Secured Debt
Unsecured Debt
Subordinated Debt
Preferred Stock
Common Stock

- Warrants
- Options
- Convertible
Company A

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January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 59
 The Company’s Capital Structure
• Debt - borrowed money
– private individuals
– banks
– other sources (e.g. vendors, customers)
– stipulated rate of interest; no significant upside
• Stock
– Preferred Stock (see “Venture Capital Deal Terms” in course
materials – Financing Session)
• usually given to VCs and investors
• liquidation preference
• convertibility to common
• anti-dilution formulas
• board representation
• veto / approval rights
The Nuts and Bolts of New Ventures/Business Plans
January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 60
 The Company’s Capital Structure - cont’d

– Common Stock
• “plain vanilla” stock
• usually given to founders / employees
• no liquidation preference / convertibility
• Residual Value after others get theirs
– Options / Warrants
• Rights to buy shares at set times for stipulated
price

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 61
 Capital Structure Instruments
120 Percentage of Capital Structure By Stage/Type of Company

100
Secured Debt
80
Unsecured Debt
60 Subordinated Debt
Preferred Stock
40
Common Stock
20

0
Startup 1st Round LBO Microsoft

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 62
 Convertible Note Financing
• Traditionally – Bridging From One Round to Another
• More Recently, to Start:
– Quickly
– Inexpensively
– Avoiding “Valuation Issues”
• Cram Downs at Series A or B

• Pros and Cons – Good Discussion at:

– www.startupcompanylawyer.com
– http://www.startupcompanylawyer.com/category/convertible-note-bridge-financing /

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 63
 Convertible Note Financing

• Cooley LLP
– http://www.techstars.com/docs/
• Wilson Sonsini
• Goodwin Proctor
– http://www.foundersworkbench.com/
January 2014 The Nuts and Bolts of New Ventures/Business Plans © 2014,
Joseph G. Hadzima Jr., All Rights Reserved 64
 Time Line

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 65
 Major Deal Elements

• A Preferred Return
• Protection of Valuation and Position re:
Future Money
• Management of the Investment
• Exit Strategies

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 66
 A Preferred Return

• Perception of the VC Investor:

– When the Investor Writes the Check he has done
most EVERYTHING he promised
– The Entrepreneur Has Done NOTHING YET
• Result:
– The VC wants its money to be paid back BEFORE
the Entrepreneur gets his/her return.
• Instrument: CONVERTIBLE PREFERRED STOCK

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 67
 A Preferred Return: Dividends

Dividends: The Preferred Stock is entitled to an

annual $_______ per share dividend,
payable when and if declared by the
Board of Directors, but prior to any
payment on Common Stock; dividends
are not cumulative

Dividends:
-Paid to Preferred First
-Cumulative or Accruing

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 68
 A Preferred Return: Liquidation
Liquidation Preference: Preference
The Series A Preferred will have a liquidation
preference such that proceeds on a merger,
sale or liquidation (including non­
cumulative dividends) will first be paid to the
Series A and will include a 10% per annum
compounding guaranteed return calculated on
the total amount invested.
• “Straight” Liquidation Preference: The Preferred
receives its original investment amount plus accrued dividends (if
any) before Common receives anything.
• Participating (“Double Dip”) Preferred: The
Preferred first gets its liquidation preference and then shares any
remaining proceeds with Common. Increasingly subject to a cap
of 3X or 4X (including preference).
The Nuts and Bolts of New Ventures/Business Plans
January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 69
 Comparison of Straight vs.

Participating Preferred

Preferred Investment Amount $ 5,000,000

Percentage purchased 30%
Sale Price of Company $ 25,000,000

Non Participating Preferred Participating

Preference Only Converted Preferred
Sales Price $ 25,000,000 $ 25,000,000 $ 25,000,000
Amount to Preferred
Liquidation Pref $ 5,000,000 $ 5,000,000
--------------- --------------- ---------------
Amount after Preference $ 20,000,000 $ 25,000,000 $ 20,000,000
Percentage of Balance 30% 30%
As Converted $ 7,500,000 $ 6,000,000
--------------- --------------- ---------------
Total to Preferred $ 5,000,000 $ 7,500,000 30% $ 11,000,000 44%
Common Stock $ 20,000,000 $ 17,500,000 70% $ 14,000,000 56%

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 70
 Valuation and Participating Preferred

• WHICH IS THE BETTER DEAL FOR THE FOUNDERS?

• Case A: Founders sell 40% of the Company for 5m

of Convertible Preferred Stock with a $5m
Liquidation preference but no participating rights.
($7.5M pre-money valuation)
• Case B: Founders sell 33% of the Company for $5m

of Participating Preferred Stock ($10m pre-money)

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 71
 Valuation and Participating Preferred

Payout Schedule for Case A: 40% of the Company for $5m of Nonparticiating Preferred

Exit Valuation ($M) 5 10 12.5 20 35 100

Investors Payout ($M) 5 5 5 8 14 40
Founders Payout ($M) 0 5 7.5 12 21 60

Payout Schedule for Case B: 30% of the Company for $5m of Particiating Preferred

Exit Valuation ($M) 5 10 15 20 35 100

Investors Payout ($M) 5 6.5 8 9.5 14 33.5
Founders Payout ($M) 0 4.5 7 10.5 21 66.5

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 72
 A Preferred Return: Liquidation

Events

• Liquidation, dissolution, sale of assets

– money comes into corporation
– money paid out to stockholders to redeem stock
• “Deemed liquidation”- merger or other
positive event
– consideration may be stock or cash
– consideration may go directly to stockholders

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 73
 Major Deal Elements

• A Preferred Return
• Protection of Valuation and Position re:
Future Money
• Management of the Investment
• Exit Strategies

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 74
 Protection of Valuation and
Position re: Future Money
• Antidilution Protection
• Approval Rights

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 75
 Protection of Valuation:

Conversion and Antidilution

Conversion: A holder of the Series A Preferred shall

have the right to convert the Series A
Preferred at the option of the holder, at any
time, into shares of Common Stock. The
total number of Common Shares into which
the Series A Preferred may be converted
initially will be determined by dividing
the Original Purchase Price by the
Conversion Price”. The initial Conversion
Price shall be the Original Purchase Price.

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 76
 Protection of Valuation:

Conversion and Antidilution

• Conversion Events: When Does Preferred Convert

Into Common?
– Voluntary
– Forced: often some % of Preferred can force conversion of all
– Automatic--upon “Qualified IPO”
• minimum total offering; minimum share price (usually 3 to 5 times initial
purchase price)

• Conversion Ratio--initially 1:1

– Adjustments--stock splits, etc; price antidilution
– Exceptions--option pool, conversion of preferred, outstanding warrants,
other existing conditions, other special exceptions

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 77
 Protection of Valuation:

Conversion and Antidilution

Anti-Dilution: Series A shall have weighted average

anti-dilution, based on a weighted
average formula to be agreed, for all
securities purchased as part of this
transaction (excluding shares,
options and warrants issued for
management incentive and small
issues for strategic purposes of
under 100,000 shares)

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 78
 Protection of Valuation:

Conversion and Antidilution

• Antidilution Adjustment increases the number of shares

received on conversion of Preferred
• What Triggers Antidilution Adjustment?
– Issuance or “deemed issuance” of Common at less than
preferred issuance price
– “Deemed issuance”--adjust upon issuance of derivative
security; if common never issued, readjust later

• options, warrants

• convertible securities

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 79
 Protection of Valuation: Antidilution

• Conversion Ratio:
– Original Purchase Price/Conversion Price
• Initially OPP=CP so Conversion Ratio =1
• “Full ratchet”: Conversion Price reset to equal
price at which diluting security is sold
• “Weighted average”: CPnew=CPold*R
– Where R = (N + M/CPold)/(N+S)
• N = old shares outstanding (fully diluted)
• S = new shares to be issued
• M = new money ($)

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 80
 Antidilution
Rounds of Financing
Series A Series B Series C
Amount Invested $ 7,000,000 $ 13,500,000 $ 5,000,000
Round Stock Price $1.00 $5.00 $2.00
Number of Shares 10,000,000 7,000,000 2,700,000 2,500,000
Normal Dilution
Common 100.00% 58.82% 50.76% 45.05%
Series A 41.18% 35.53% 31.53%
Series B 13.71% 12.16%
Series C 11.26%
----------------- ----------------- ----------------- -----------------
100.00% 100.00% 100.00% 100.00%

Percentage Ownership After Series C Round

Common Series A Series B Series C
Normal Dilution 45.05% 31.53% 12.16% 11.26%
Weighted Average 44.65% 31.26% 12.93% 11.16%
Full Ratchet 38.10% 26.67% 25.71% 9.52%

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 81
 Time Line

See “Venture Capital

Terms” on Resources Page
at nutsandbolts.mit.edu

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 82
 Tomorrow

• Negotiation Skills
• Organization and People Issues
• Executive Summaries Due Saturday by midnight

The Nuts and Bolts of New Ventures/Business Plans

January 2014
© 2014, Joseph G. Hadzima Jr., All Rights Reserved 83
MIT OpenCourseWare
http://ocw.mit.edu

15.S21 Nuts and Bolts of Business Plans

January IAP 2014

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