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Report
Understanding Capital Structures
& Equity Compensation
SARTA Leadership Series
August 15, 2012
David A. Richardson
DLA Piper LLP (US)
Curt Rocca
DCA Capital Partners
1
Overview

Making your company more attractive to investors

Capitalizing your business to ensure alignment of
interests

Structuring an investor friendly cap table from Day
One

Eliminating obstacles to successful fundraising
and exits

Creating employee incentives without giving away
the company

Update on 2012 JOBS Act
2
Making your company more
attractive to investors
Get your house in order
 Get your cap table in order

3
Get your house in order
Form (the right) entity
 Organize your minute book and stock
book
 Evict the skeletons
 Establish strong governance standards

4
Form (the right) entity
•
If you haven’t formed an entity, form one
•
•
•
•
•
Establishes credibility
Limits liability
Houses IP
Establishes currency
If you have formed an entity, make sure it’s
in order
• Complete organizational steps
• Consider converting (LLC to C-corp)
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Form (the right) entity
•
Types of Entities:
•
•
•
•
Partnership
Limited Liability Company (LLC)
S Corporation
C Corporation
6
Form (the right) entity

VCs like Delaware C-corps:
 Relatively cheap
 Well-established laws (statutes and case





law)
Limited liability
VC familiarity and better for fundraising
No pass-through of profits and losses
VC investment restrictions
Double taxation – who cares?
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Capitalizing your business to
ensure alignment of interests
Authorized shares (people like “000s”)
 Actually purchase shares (cash and
non-cash contributions)
 Founder share split
 Debt, Preferred Stock and Common
Equity
 Investor views of founder
ownership/incentives

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Structuring an investor friendly
cap table from Day One
Anticipate dilution over time
 Vesting and Section 83(b)
 Dealing with “dead equity”
 Maintain detailed stock ledger and
organized files
 Who’s your Paul Ceglia?

9
Sources of Funding
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Existing investors
Friends and family
Angels
Venture capital
Private equity
Strategic
Commercial loan
SBA loans
SBIR grants
Private loan
IPO
10
Don’t ignore securities laws
Federal exemptions and safe harbors
 California state exemptions
 Generally, stick to “accredited” investors
 How is the JOBS Act changing this?
(more on this later….)

11
Creating employee incentives
without giving away the company
•
•
•
•
•
•
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Employee incentives – understanding your
options
Who to incentivize
Pros and cons of target and broad-based
plans
Vesting terms
Performance based?
To accelerate or not to accelerate?
Make sure incentives are aligned
How large a pool?
12
Equity is not candy
• Options, warrants, restricted stock are
important “currency” for start-ups low on
cash, but . . .
• Mind your cap table
• Equity grants need to comply with securities
and tax laws
• Vesting
• Helps create incentive
• Helps avoid “dead equity”
13
Who to incentivize
• Early stages
• Key employees
• Key advisors and consultants
• Later stages
• Managers
• Rank and file
• Independent directors
• Adopt a compensation matrix
14
Types of Awards
• Equity
– Stock Options
• Incentive Stock Options (ISOs)
• Nonstatutory Stock Options (NSOs)
– Restricted Stock
– RSUs (public companies)
– Phantom Stock
• Cash
– Performance bonuses
– Change of Control bonuses
– Management bonus/carve-out plans
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Types of Awards
 Incentive Stock Options (ISOs):
 Can be granted only to employees
 May provide tax advantages to employees
 Must comply with Tax Code provisions
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Types of Awards

ISO Requirements
 Eligibility - May grant only to employees of company
or parent/subsidiary of company.
 Exercise Price - May not be less than FMV on grant
date (110% of FMV for 10% shareholders).
 Option term - Cannot exceed 10 years (5 years for
10% shareholders).
 Post-termination exercise – ISO treatment lost if not
exercised within 3 months of employment termination
(max 1 year if due to disability; no limit other than
option term in case of death).
17
Types of Awards
 Nonstatutory Stock Options
(NSOs):
 Can be granted to employees,
consultants and outside directors
 No special statutory requirements, but
exercise price must be at least grant
date FMV
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Income Tax Treatment of Options
NSO
ISO
No income
No income
Ordinary Income
Exercise spread
None
AMT adjustment
None
Exercise spread
Grant
Exercise
ISO Holding Period Met?
Sale
Yes
No
(Disqualifying
Disposition)
Ordinary income
Capital gain
None
None
Exercise spread
Post-exercise
gain
Exercise spread
& post-exercise
gain
Post-exercise
gain
(Assumes all shares vested on exercise.)
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IRC 409A
Adopted by Congress in 2005, enacted in
2008
 Clamps down on service providers
choosing when they’ll have taxable income

 Thank you, Enron and Broadcom
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IRC 409A

Requires service provider to include in gross
income “deferred compensation” under
“nonqualified deferred compensation plans”
 Deferred comp arises when a service provider
acquires a legally binding right (even if
contingent) to compensation that is or may be
payable in a later taxable year (e.g., stock
options)
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IRC 409A

Penalties for noncompliance:
 Taxation in year of vesting, even if no payment
received
 Additional 20% penalty tax at federal level
 Additional 20% penalty tax at California level
 Ordinary income tax on the spread
○ In California, total tax equates to roughly
80%
 Company has withholding obligation
 Tax liability for not withholding appropriate
amounts at each vesting milestone
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IRC 409A


Options: no “deferred income” if granted at FMV
What is FMV for 409A purposes?
 Private company: “Value determined by the
reasonable application of a reasonable valuation
method.”

Three “safe-harbors”:
 third party appraisal
 internal report for start-ups
 repurchase formula under Section 83
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IRC 409A

Best practices for private companies:
 Earliest stages (before outside investment):
○ Grant or sell restricted stock (exempt from 409A)
 After outside investment, use safe-harbor
method:
○ Independent appraisal
○ Written report by qualified individual
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Vesting
•
“Standard” vesting:
– Employees: 4-year vesting (1/4 on one-year
cliff; 1/48 per month thereafter)
– Directors and key advisors: 2-3 year vesting
(monthly)
– Careful – vesting terms should match shortterm AND long-term goals
•
Be thoughtful about tying vesting to
performance (as opposed to timebased) metrics
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Vesting

To accelerate or not to accelerate:
 Single- and double-trigger acceleration on
change of control
 Acceleration on termination of service
 May be hindrance to exit

Don’t be surprised by “reverse vesting”
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Don’t ignore securities laws
Federal exemption for options under
Rule 701
 California state exemption under CCC
Section 25102(o) and Cal. Regs.

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Update on 2012 JOBS Act
•
•
“Things are happening!”
Four major components:
1.
2.
3.
4.
General Solicitation
IPO on-ramp
Crowdfunding
2,000 Shareholder Rule
•
SEC missed first rulemaking deadline
(revisions to Reg. D Rule 506 to permit
general solicitations to accredited
investors)
• No revised deadline.
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General Solicitation
•
Historically companies looking to raise
capital cannot run advertisements or solicit
investment from persons with whom they
have no pre-existing relationship
• Revised rules will allow broader-based
solicitations of persons with whom no preexisting relationship exists
• Other securities rules apply
• Rules are still not finalized, so be careful…
29
IPO On-Ramp
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Effective immediately on April 5, without any SEC rulemaking
Emerging growth companies may initiate the IPO process by
confidentially filing preliminary registration documents, go
public with two years of audited financials instead of three,
and receive analyst coverage immediately after going public.
Phase in full public reporting and internal controls over five
years
“Emerging growth company” = (i) a domestic or a foreign
private issuer with total annual gross revenues of less than
$1 billion during its most recently completed fiscal year and
(ii) prices its IPO on or after Dec. 9, 2011
Evidence suggests that most companies are choosing the
confidential route
30
Crowdfunding
270-day rulemaking period (i.e., no
crowdfunding until 2013)
 “Rules” expected this year, but SEC has
been explicit in its general concerns
about crowdfunding
 Expecting crowdfunding to be severely
limited

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2,000 Shareholder Rule
Effective immediately on April 5, without
any SEC rulemaking
 Alleviates the “500 shareholder rule”
threshold for registration and public
reporting (was a major concern for FB)

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How to reach us
•
David Richardson
– [email protected]
– (916) 930-3256
•
Curt Rocca
– [email protected]
– (916) 960-5353
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