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For those of you who want to skip the video, here are the mistakes I discuss:

1.  IP Ownership.  Some entrepreneurs make the mistake of creating IP for their new venture while they are still working for someone else.  They then quit and launch their startup, not realizing that the IP is actually owned by their prior employer.  This is a tricky issue, and you should carefully review all employment-related agreements to determine if there are any provisions that may inhibit your new venture, including IP ownership.  I discuss this issue in detail in paragraphs 2 and 4 of my blog post regarding formation issues (part 2).

2.  Choice of Entity.  Some entrepreneurs make the mistake of forming the wrong entity.  Investors generally invest only in corporations – not LLC’s or partnerships.  You should thus form a corporation – and consult with an accountant as to whether you should make an S corporation election (and then convert to a C corporation down the road).  I discuss the issue of choice of entity in detail in my blog post “Choice of Entity for Entrepreneurs.”

3.  Place of Incorporation.  Some entrepreneurs make the mistake of incorporating the company in the wrong state.  You should incorporate in Delaware – that’s what investors generally require.  You should then qualify the company to do business in California and/or any other State in which it is “doing business.”  I discuss this issue in paragraph 1 of my blog post regarding formation issues (part 1).

4.  Vesting Restrictions.  Some startups make the mistake of issuing stock to co-founders without imposing vesting restrictions.  Then, one of the founders ends-up leaving in a few months and keeps all of his or her equity.  You should make sure you and your co-founder execute a restricted stock purchase agreement with reasonable vesting schedules (typically four years) upon the issuance of the company’s stock.  I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

5.  Securities Law Issues.  Some startups make the mistake of not complying with applicable securities laws; for example, they issues shares to “friends and family” who are not “accredited investors” without proper disclosure documents; or they retain a consultant who is not a registered “broker-dealer” to sell company stock for a commission.  You should be very careful when issuing any kind of securities; non-compliance could cause severe consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.  I discuss this issue in detail in paragraphs 2 and 4 of my blog post “Five Common Mistakes Entrepreneurs Make in Raising Capital.”

6.  Splitting Equity.  Some startups make the mistake of splitting equity equally between or among the co-founders.  The splitting of equity is a significant business decision which must be negotiated between or among the co-founder based upon their respective contributions to date and their expectations going forward.  Simply dividing the shares equally may sound fair on its face, but it’s usually not the correct decision.  I discuss this issue in detail (and the various factors to consider) in my blog post “Ask the Attorney – Splitting Equity.”

This is part 2 of 2 of my post regarding the excellent book Do More Faster, which is a collection of articles/blog posts by successful entrepreneurs and investors, including the editors David Cohen, the founder and CEO of TechStars, and Brad Feld, the managing director of Foundry Group.

As Brad noted on his blog: “Our goal was to write a unique book full of useful information for any early stage entrepreneur.  Rather than give advice or simply tell an entrepreneurial success story, we decided to blend the experience of the TechStars entrepreneurs and the TechStars mentors in an organized fashion.”

Below are ten solid quotes from the second half of the book; you can review the first-half quotes here.   One quick correction, which I tweeted about recently:  Entrepreneurs seeking venture funding should form a corporation in Delaware, not an LLC.  Indeed, as I noted in my post, “What’s Wrong with an LLC?”:

There are also three major disadvantages to utilizing an LLC, the most significant of which for entrepreneurs is that VC funds and other institutional investors usually do not invest in pass-through entities such as LLC’s.  Accordingly, if a venture will be seeking VC funding, an LLC is generally not a good choice of entity; and converting an LLC to a C corporation (which is the typical entity in which VC’s invest) can be tricky and expensive.  In fact, a new client of mine ended-up paying tax attorneys close to $15,000 in legal fees to effect such a conversion.

Thus the comment on page 246 by Brad Bernthal is incorrect — i.e., that “the conversion from something like an LLC to a C-Corp is relatively straightforward.”

Quotes

• “If you are a technical founder, please listen carefully: You don’t need to build a bunch of new features to make your startup successful. Trust me, I know.” –Andy Smith, co-Founder and CEO of DailyBurn (p.161)
• “As my friend Josh Newman says, there are only two steps to entrepreneurship: start, and keep going—and you lose most people at the first step.  That’s because talk is easy.” –Ben Casnocha, entrepreneur and author (p.165)
• “Always trim away what you don’t need to be doing and ask yourself, ‘What is the thing that matters most to making progress right now?’” –Dick Costolo, CEO of Twitter (p.182)
• “What’s really hard is simplifying your product and building a great user experience.” –Dave McClure, venture capitalist & founding general partner of 500 Startups  (p.183)
• “There is one thing that the hundred of founders I meet each year have in common, and that is that their plan is wrong…Founders who can pivot to a new idea given what they learn will survive….” –Rob Hayes, partner at First Round Capital (p.201)
• “Beware of angel investors who aren’t.  They’ll put you through endless diligence, play bait-and-switch with your financing, and generally waste your time.” –David Cohen, founder of TechStars (p. 217)
• “You either have users (alpha, beta, gamma, whatever you call them doesn’t matter) or you don’t.” –Jeff Clavier, founder of SoftTech VC
• “So, to be successful at fundraising, I practiced like crazy.  I must have rewritten our pitch 100 times and practiced it 500 times…. People want to invest in winners.  Winners are confident, and confidence comes from practicing like you play.”  -Alex White, co-founder and CEO of Next Big Sound (p. 224)
• “Show, don’t tell….I don’t want to hear you describe what you are going to do; I want to see it.”  -Brad Feld, Managing Director at Foundry Group (p. 231)
• “Because we neglected to send in a very simple document [i.e., an 83(b) election], we ended up paying a lot more tax than we needed to when we sold our company.” –Matt Galligan, co-founder & CEO of SimpleGeo (p. 271).

Conclusion

Kudos to David and Brad for pulling this book together and for their success with TechStars.  Cheers, Scott

I just finished reading the book Do More Faster, which is a collection of blog posts/articles by successful entrepreneurs and investors edited by David Cohen, the founder and CEO of TechStars, and Brad Feld, the managing director of Foundry Group.  As Brad noted on his blog: “Our goal was to write a unique book full of useful information for any early stage entrepreneur.  Rather than give advice or simply tell an entrepreneurial success story, we decided to blend the experience of the TechStars entrepreneurs and the TechStars mentors in an organized fashion.”

Below are a few nuggets from the first half of the book; I will share some second-half quotes in my next post.  Cheers, Scott

Solid Quotes

• “There are few things as rewarding as starting a business from nothing, creating jobs and building something that matters.” –Mark Pincus, co-founder and CEO of Zynga (Foreward, p.xi)
• “If you have a brilliant idea, it’s safe to assume that a few very smart people are working on the same thing….” –Tim Ferriss, best-selling author and serial entrepreneur (p.4)
• “When you’re selling a solution to a problem and you find that nobody is saying no to your prices, you’ve found some serious pain.” –Isaac Saldana, founder and CEO of SendGrid (p.11)
• “Getting feedback and new ideas is the lifeblood of any startup.  There is no point in living in fear of someone stealing your idea. . . . [Y]ou can steal ideas, but you can’t steal execution.”  -Nate Abbott and Natty Zola, co-founders of EverLater (p.15)
• “Usage is like oxygen for ideas.  You can never fully anticipate how an audience is going to react to something you’ve created until it’s out there.  That means every moment you’re working on something without it being in the public arena, it’s actually dying, deprived of the oxygen of the real world.” –Matt Mullenweg, founder of Automattic (creator of WordPress) (p.21)
• “Focus on the smallest possible problem you could solve that would potentially be useful.” – Ev Williams, co-founder of Twitter (p.24)
• “Instead of just assuming that we knew what our users were doing, we figured it out by carefully monitoring our logs and studying our analytics.” –Darren Crystal, co-founder and CTO of Photobucket
• “As long as I listen to my customers, I never need to have another original idea.”  -Niel Robertson, founder and CEO of Trada (p. 35)
• “Build the smallest possible product that allows you to test assumptions and answer questions about your business, and then get it out there.” –Sean Corbett, co-founder of HaveMyShift (p.37)
• “Creating a company is really hard and there is way more work than you can even begin to grasp.  Having someone to share your burden, walk side by side with you into battle, and sing you show tunes when you’re feeling blue is invaluable.” – Mark O’Sullivan, founder & CEO of Vanilla (p. 65)
• “I was so obsessed with the idea for oneforty that I literally couldn’t quit.  I had to see it come to light…  If you can’t quit no matter how hard you try, then you have a chance to succeed.” –Laura Fitton, founder & CEO of oneforty (p.80)
• “Salespeople hunt pink Cadillacs. Startups seek friends.” –Micah Baldwin, CEO of Graphic.ly (p. 88)
• “You can literally feel it when you walk into a great startup culture. The room has energy.  There’s a buzz. Doors are open. Whiteboards are filled with hieroglyphics.  People are getting stuff done.  Meetings are short and to the point.”  –Greg Gottesman, managing director of Madrona Venture Group (p. 98)
• “[L]iving the startup life requires both art and science and is simultaneously qualitative and quantitative.  Take all the inputs you can gather and then make the decisions that feel right to both your head and your gut.”  -Ryan McIntyre, co-founder of Excite.com and Managing Director at Foundry Group (p. 130)
• “For a startup, having great sales DNA is a wonderful asset.  But at the early stages, it can devour the company’s future.” –Eric Ries, author of The Lean Startup Methodology (p. 134)
• “Remember that human nature has a tendency to admire complexity, but to reward simplicity.  Complexity has an inverse effect on the ability to scale your business.  The more complicated you make your business, the harder it is to expand it.” Ben Huh, CEO of The Cheezburger Network (p. 146)
• “[D]on’t hide your failures. Wear them as a badge of honor. And most of all, learn from them.” –Fred Wilson, Managing Partner at Union Square Ventures (p. 160)

As I have previously discussed, I began my legal career as a corporate associate at two major law firms in New York City.  After nearly eight years, however, I realized I wanted to spend the rest of my life helping entrepreneurs (like my father) — not executing large, complex transactions for multi-national corporations and private equity funds.

I also saw a big problem in the legal marketplace: entrepreneurs and their companies were paying a small fortune to have their legal work done by junior associates getting on-the-job training; or, put another way, the big-firm template just didn’t work for entrepreneurs.  (I discuss this issue in detail in the video on our home page.)

Accordingly, I decided to open my own shop in California, the land of the entrepreneurs.  So in 2005, my wife and I headed west; and, after passing the California Bar exam (and getting the lay of the land), I launched Walker Corporate Law Group, a boutique corporate law firm specializing in the representation of entrepreneurs.

“The NYC Tech Scene is Exploding”

But a funny thing happened while I’ve been out here in California: the startup scene in New York City began “exploding” (to use Chris Dixon’s term).  Indeed, super angel Ron Conway wrote in an email to Chris about a year ago:

The pace of innovation in the New York area is very impressive right now. Some of the top entrepreneurs in the country are building and scaling companies in the NY ecosystem.

Paul Daversa, CEO of Daversa Partners (an executive search firm to VC’s and the start-up community), wrote a few months ago that:

[F]or the first time in my 20 years of search, the deal flow and investment lines have begun to blur as NY has become a hot-bed for building great tech companies, and leadership talent is migrating to New York.

And just a couple of days ago (in an article about Jonathan Teo, formerly of Google), Joel Cutler, managing director of General Catalyst Partners, stated that:

New York’s start-up culture is booming, and there’s so much brilliant talent that it’s attracted one of the Valley’s rising stars.

Not to mention all the emails and phone calls I was receiving from New York City entrepreneurs, who were all saying the same thing: “if you only had a New York office.”

OK – I cry uncle.

Our New New York City Office

Welcome to our new office on the 26th floor of the Seagram Building at 375 Park Avenue in Manhattan.  Welcome also to my two new colleagues in New York: Daniel Chakrin and Philip Kahn.

Daniel is great and is already helping me with an exciting, new client in Manhattan named Cheek’d — a cool, online dating service.  He has 10+ years of corporate law experience, including nearly five years at Skadden, Arps, Slate, Meagher & Flom LLP and 2+ years at Schulte Roth & Zabel, LLP.  He also has a strong accounting background, having spent two years as a certified public accountant at Deloitte & Touche, LLP prior to attending law school.  Daniel graduated from the University of Pennsylvania, Wharton School of Business (B.S. in Economics, cum laude), where he was a Joseph Wharton Scholar and Benjamin Franklin Scholar, and New York University School of Law (J.D., cum laude).

Phil is also great.  He has 15+ years of corporate law experience, including as (i) a corporate associate at Debevoise & Plimpton and Akin Gump in New York City; and (ii) Associate Counsel at Major League Baseball Enterprises.  Phil has extensive experience in mergers and acquisitions, public and private financings, joint ventures, securities law matters (including distressed-debt trading), and corporate governance matters.  Phil graduated from Vassar College (B.A.), where he majored in History and minored in Economics; and Benjamin N. Cardozo School of Law (J.D., magna cum laude), where he was Editor-in-Chief of the Cardozo Law Review.

Conclusion

Here’s a shout-out to all the entrepreneurs in New York City: there’s a new law firm in town, with a new business model that is designed to help entrepreneurs succeed.  If you’d like to grab a beer with me or one of my colleagues, just call me directly at 212-631-4221.  Cheers, Scott

www.youtube.com/watch?v=cYhNQ8vDlAs

I’ve worked with hundreds of entrepreneurs over my 17+ years of practicing law, and clients and friends ask me all the time: “What makes a great entrepreneur?  Why do some entrepreneurs make it and others fail?  Hey Scott, what’s the secret sauce to being a successful entrepreneur?”

I’ve given this issue considerable thought, and obviously there are lots of variables to success, including lady luck.  But, in my mind, there are three keys that stand above all others: guts, desire and passion.

(By the way, this post was originally part of my “Ask the Attorney” series for VentureBeat.  Below is a longer, more comprehensive version.)

The Three Ingredients to Success

#1 – Guts.  To be a great entrepreneur, you have to have guts – or, as we say in New York, cojones.

You have to have the guts to pull the trigger, to quit whatever you’re doing and to jump into the abyss (and believe me, this is easier said than done).  Most people just talk; few execute.

Guts is quitting Harvard, like Bill Gates and Mark Zuckerberg did.  Picture that phone call to their parents: “Hey Mom, Hey Dad, I have some good news, I’m quitting Harvard.”

Guts is quitting a lucrative job on Wall Street, like Jeff Bezos did.  He was Senior Vice President at D. E. Shaw (the youngest in the firm’s history), and he had the guts to quit and to pack up his car, drive cross-country to Seattle and launch a bookstore out of a garage.

Guts is selling everything you own to raise money for your new venture, like Tony Hsieh did.  He sold everything (including his loft in San Francisco) — everything that was left from his $40 million exit from LinkExchange — and put the money into Zappos.

Successful entrepreneurs are different.  They have the inner strength to choose their own path – to follow their dreams – despite the pressure from their parents, or wife or boyfriend or whomever.

Entrepreneurship is a lonely, painful path; and it takes a lot of guts to choose it.

#2 – Desire.  The second ingredient to success is desire or, as Jessica Livingston, co-founder of  Y Combinator and author of the book Founders at Work: Stories of Startups’ Early Days, calls it: determination.

How badly do you want it?  What price are you willing to pay?  How much are you willing to sacrifice?

To succeed at anything (sports, music, school), you have to work your tail off; you have to want it.  To succeed as an entrepreneur, you can multiply that by a factor of two.

You need to make your venture the number one priority in your life.  In short, you have to become obsessed.

Mark Cuban, the billionaire owner of the Dallas Mavericks, said he didn’t take a day off for seven years when he launched his first venture, MicroSolutions; not one day off – not one vacation.  In fact, he said would spend all day banging on doors selling and at night he would pull all-nighters reading everything he could about computers – teaching himself.  Working by day, learning by night.  That’s the kind of desire that you need.

Gary Vaynerchuk (the founder of Wine Library TV and the so-called “Social Media Sommelier”) made a similar point in a speech at the Web 2.0 Expo in New York: “I used to work in a liquor store from seven in the morning until ten at night for seven straight years, and the only days-off I took were to watch the New York Jets.” [starting at the 3:20 mark]

That’s desire – and that’s what it takes to succeed.

#3 – Passion.  The third ingredient for success is passion – or maybe a better word is “love.”  You have to really love what you’re doing.  As startup guru Steve Blank puts it, “entrepreneurship is a calling.”  You have to find your calling.

And this means something more than making money.  It means finding your passion so, in effect, work turns into play; and instead of dreading Monday morning, you can’t wait to get to work because it’s what you love doing.

The best example of passion in an entrepreneur is Steve Jobs.

From the time he was a child, Steve’s passion was to build products that could change the world.

Indeed, when Steve was trying to convince John Scully, then the president of Pepsi-Cola, to head west and join Apple, he challenged Scully with the question, “Do you want to spend the rest of your life selling sugared water, or do you want to change the world?”

And then when Steve got fired from Apple, what did he do?  He launched two new companies: Pixar and Next.  Why?   Because that’s what he loved doing.  Then he came back to Apple and the rest is history.

You need to find what get’s you excited — your calling.

Conclusion

I know how hard it is to succeed as an entrepreneur, and I understand that there are a number of different variables to success.  But I also know, having spent years representing entrepreneurs, that if you have guts, desire and passion, your chances of success will increase dramatically.  If you want it, go get it.  Cheers, Scott

This is the story of my father, Burt Walker, a poor kid from Brooklyn who made millions taking the company he founded public — and then lost it all when he left my mother for a younger woman.  I am sharing this personal story to help entrepreneurs.

Background

My father was raised in Brownsville, a poor section of Brooklyn, New York.  He had an absentee father, a crazy mother and a wild younger brother.  He worked from the time he was 9 or 10 years old, including selling ice-cream sandwiches at the Coney Island beach.

My father’s father, Arnold Walker, was the son of immigrants who arrived in this country with nothing but the shirts on their backs.  Grandpa Arnold was a tough, Golden Gloves boxer, who worked at the local railroad and then opened a hardware store with his brother.

Grandpa Arnold

My father’s mother, Goldie, was a High School beauty and then lost her mind somewhat due to medication administered to her during my father’s birth.  Grandma Goldie stayed at home and raised the two boys, but had few tools to cope.  For example, she rarely cleaned the apartment and kept three types of milk in the refrigerator: fresh for my father’s brother; a few days’ old for my father; and sour for my father’s father (who was rarely around in any event).

My father was a good High School student and was accepted for admission at the Brooklyn Polytechnic University, where he studied electrical engineering and paid his way by going ROTC (i.e., by joining the army).  Upon graduation, he married my mother and was stationed at Fort Bragg, North Carolina for two years, where I was born.

Mom and Dad

Scott (the author)

Andy (younger brother) and Scott

Lesson #1: Work Hard and Be Patient.

My father was intensely driven to prove himself.  Deep down, he always felt like “the poor kid with the crazy mother” (as my mother’s mother referred to him when she initially forbade my mother from marrying him).  But his insecurity and drive created in him a powerful work ethic and singular focus to succeed.  Indeed, this is why many CEO’s and other business leaders prefer hiring hungry, working-class guys over the wealthy Ivy-leaguers.

In addition to his strong work ethic, my father had an extraordinary ability to be patient – and this is lesson #1 for entrepreneurs: work hard and be patient.

Step Grandpa Lee, Grandma Goldie, Mom & Dad (MBA Graduation)

My father spent the first 12+ years of his career working his tail off at several different companies.  He even went back to school at night for four years and obtained an MBA-equivalent in electrical engineering.  I remember as a little kid watching him come home from his “day job,” have a quick dinner, and then get back into his car to go to “night school.”  In fact, looking back, it seemed like he had a master plan that he knew from the start was going take many years to execute.

Unfortunately, many entrepreneurs today are looking for the quick homerun — the lottery ticket.  Other than in very rare circumstances, however, it just doesn’t work that way.  You have to grind it out for years to succeed: seven years, ten years – maybe even longer.  Day in and day out – pushing that big rock up the hill, one step at a time.

As David Heinemeier Hansson (the creator of Ruby on Rails and a partner at 37signals) notes in a recent speech to Stanford students: “Nobody is an overnight success.  Most overnight successes you see have been working at it for ten years.  And that’s exactly how it was for us.” [starting at the 0:12 mark]

Gary Vaynerchuk (the founder of Wine Library TV and the so-called “Social Media Sommelier”) made a similar point in a speech at the Web 2.0 Expo in New York: “I used to work in a liquor store from seven in the morning until ten at night for seven straight years, and the only days-off I took were to watch the New York Jets.” [starting at the 3:20 mark]

Mark Cuban (billionaire entrepreneur and owner of the Dallas Mavericks) has a similar story, as he discusses in this video: “I went seven years – literally seven years – without a single vacation.  I didn’t take a day off – I didn’t go anywhere – I didn’t do squat.”  [starting @ the 4:07 mark]

Work hard and be patient.

Lesson #2: Build Strong Relationships with Key People in Your Industry.

When I was about 14 years old, my father quit Comtech Telecommunications Corp., a small public company in Long Island where he was the Director of Marketing, and launched his own consulting firm.  This was the beginning of something big – very big.  While at Comtech, my father had developed strong relationships with a few key senior executives at Nissho Iwai Corporation, a huge Japanese trading company.  They now wanted to retain his services to help them sell satellite earth stations and other telecommunications equipment to US-based companies.

This relationship with Nissho Iwai would become the foundation of Walker Telecommunications Corporation — and it took years for my father to nuture and grow.  I remember him reading book after book about the Japanese culture and customs, and I remember his many trips to Japan — when my mother, brother and I wouldn’t see him for weeks at a time.  I still have a few of his postcards in my childhood scrapbook.

And this is lesson #2 for entrepreneurs: build strong relationships with key people in your industry.

Many entrepreneurs don’t understand the importance of building strong relationships — or even understand what a strong relationship is.  Building a strong relationship requires time and effort and usually requires providing the other party with some kind of value.  Yes, give and you shall receive.

Strong relationships aren’t built overnight.  Nor are they built by merely following someone on Twitter or friending someone on Facebook.  Perhaps that’s a start, but that’s all it is.  The same way passing-out business cards at an event is just a start.

Indeed, building a strong relationship takes time because the other party must learn to trust and respect you.  That’s why college or business school is often a good place to build relationships.  You are spending years with your fellow classmates; you are developing friendships and trust; and you are working on projects/schoolwork together.

A job is also a great place to build strong relationships – with your boss, your co-workers and/or your customers.  How?  By working hard, by producing, by acting with integrity and by being likeable.

As Tina Seelig, Executive Director for the Stanford Technology Ventures Program, explains in this video clip:  “It is a very small world….You are going to bump into the same people again and again and again….You need to make sure that the relationships you build now and as you move forward are ones that you’re proud of . . . and are not going to come back and bite you in the behind.”

Gagan Biyani, the Co-Founder and President of Udemy, discusses in this video interview with Andrew Warner of Mixergy.com how his initial fundraising failed because did not have any strong relationships.

[N]one of these people knew us. . . . We’d show up at the pitch meeting, and we were some random guy who came in through an introduction.  It was really hard to convince them that we were worth their time.

So what I did for the next six months after that, after we had failed and closed down the fundraising process, . . . I spent the entire time meeting as many people as possible.  So I’d go to tons of Silicon Valley events.  At night when I was dead tired from working all day, I would get myself up and get in the car and drive over to San Francisco or drive over to Palo Alto and attend an event and give out my business card and get business cards.  And that was super important because I got to know a lot of these investors.  Like Dave McClure definitely saw me 15 times before he invested in my company.  He met me at conferences, he met me at dinners.  I attended his events.  I was friends with all of his friends. . . . So when I go to raise money, he’s like, “Oh, I kind of know this guy.” [starting at the 35:39 mark]

Again, build strong relationships with key people in your industry.

Lesson #3: Don’t Mix Business with Pleasure.

My father was highly successful in his consulting position and was instrumental in a number of significant sales of earth stations and satellite equipment.  Accordingly, Nissho Iwai developed a lot of confidence in my father’s business acumen and offered him the exclusive right to sell in the United States high-tech business telephones manufactured by a top Japanese company.  As a result, Walker Telecommunications Corporation was born.  This exclusive distribution agreement was indeed so valuable that my father was able to sell the story to Wall Street and go public, raising millions of dollars to scale his new company.

From there, the company’s growth was extraordinary – with expansion into other markets, including car phones, cell phones, fiber optic networks and other telecommunications equipment, and offices in New York, San Francisco and Toronto.  In fact, by the time I was a freshman in college, Inc. magazine named Walker Telecommunications Corporation one of the nation’s fastest-growing companies.

But then it all came crashing down about five years later.  Why?  Probably a few different reasons, but the one that stands-out above all others is my father’s relationship with the wife of the company’s West coast distributor, whom he eventually married (and then divorced shortly thereafter).  She was also a headhunter, and my father started utilizing her firm to hire key executives at the company.

Moreover, so-called “business trips” became secret rendezvous with his paramour.   As my Uncle Herb euphemistically put it: “Your father’s priorities have changed.”  In short, this relationship was the beginning of the end for Walker Telecommunications Corporation – and the third and final lesson for entrepreneurs: Don’t mix business with pleasure.

Now, no matter how many times entrepreneurs hear this basic advice, there will always be a handful who will ignore it.  “What’s the big deal?”  “Who’s going to find out?”  “Why should anyone care?”

Jodie Fisher

Folks: it doesn’t work!  Do not mix business with pleasure!  To put it more bluntly: Don’t sleep with your team!  You have to separate your company and running a business with your personal life.  Just ask Mark Hurd, the former CEO of Hewlett-Packard, who was terminated as a result of his relationship with Jodie Fisher, an actress and reality-show contestant hired as a contractor for H-P.

As the Wall Street Journal aptly points out in their post, “When Workplace Flirtations Go Bad”:

[T]he [Hurd] fracas serves as a reminder that office relationships can be fraught with landmines.  Even strong flirtations among co-workers that don’t culminate into full-blown affairs can have real and serious consequences — and can change the mood and equilibrium of the office.  For one, it can be tough for other co-workers to concentrate when two colleagues are engaging in flirty banter or making googly eyes at each other.  And if feelings change or aren’t fully reciprocated within the couple, then office tensions can run high.

David Letterman also learned the hard way about office affairs and discussed this issue and the related alleged extortion on The Late Show about a year ago.

Conclusion

The foregoing lessons are simple: (i) work hard and be patient; (ii) build relationships with key people; and (iii) don’t mix business with pleasure.  Like anything else, however, it’s the execution which is so difficult. (Note: the foregoing post was originally published on “A Smart Bear,” a great site for entrepreneurs.  This is an updated version, with new family photos.)

This post is part 2 of my three-part series: “How do I raise seed capital if I don’t know any investors?”  In part 1, I discussed the importance of hustling and building relationships in order to get warm introductions to investors.  In this post, I will discuss a different approach: applying to one of the mentorship/seed capital programs.

Mentorship and Seed Capital Programs

A very exciting and relatively recent development in the startup world is the proliferation of mentorship programs for entrepreneurs.  Indeed, these programs typically include not only teaching and coaching, but also seed capital (as well as introductions to investors).  Thus, for first-time entrepreneurs who have little experience, money or contacts, these programs offer a “win, win, win” opportunity.  Below is a brief description of the top three programs.

1) Y Combinator

Y Combinator (YC) was founded in 2005 by startup guru and essayist Paul Graham and author Jessica Livingston and is the crème de la crème of mentorship programs.  As noted on the Y Combinator website:

Y Combinator does seed funding for startups.  Seed funding is the earliest stage of venture funding.  It pays your expenses while you’re getting started. . . . We make small investments (rarely more than $20,000) in return for small stakes in the companies we fund (usually 2-10%).

YC runs two three-month programs per year: one from January through March and the other from June through August.  Entrepreneurs  must move to the Silicon Valley area to participate.  As Paul discusses at length in his essay, “What Happens at Y Combinator,” each program includes (i) weekly “dinners” with successful startup founders as speakers; (ii) “office hours,” which comprises unlimited individual conversations with the YC partners over the course of the program (and half of the founders’ time); (iii) “Angel Day,” at which each startup is paired with two angel investors who will meet with the founders regularly thereafter; and (iv) “Demo Day,” the program’s culmination – a three-day event, with 4+ presentations to an audience of approximately 400 (including many of Silicon Valley’s top investors).

YC has funded over 200 startups, including Loopt, Reddit, Wufoo, Scribd, Disqus, Dropbox, Justin.tv and Posterous.  You can apply to YC here; and check out their FAQ’s here.  (See also “How Y Combinator Is Remaking Silicon Valley in Its Image.”)

2) TechStars



TechStars is a similar three-month program, which was founded in 2007 by investors David Cohen and Brad Feld; it is offered once per year in four different cities: Boulder, Boston, New York and Seattle.  Startups receive up to $18,000 in seed funding for a 6% equity stake, intensive mentorship and the chance to pitch to investors at the end of the program.

As noted on the TechStars website:

About two or three nights a week, we’ll organize informal educational sessions with our mentors.  We also expect many of the mentors to drop in to TechStars at various times throughout the program.  In general though, you’ll be working on your product each day, just like all of the other founders in the program. We don’t tell you what to do or when, but we create an environment that is conducive to helping your startup every day.  And we’ll make sure you have lots of experienced mentors around to help you.

TechStars provides a detailed web list of all companies that have participated in its programs, together with their full historical results.  There is also a 5 minute video by Current TV which provides a sense of what TechStars is like, and you can watch “The Founders,” which consists of 14 five-minute episodes that follow three teams through the 2009 program.

You can apply to TechStars here; and check out their FAQ’s here.

3) The Funded Founder Institute

Founder Institute (FI) was founded by Adeo Ressi, a serial entrepreneur and founding member of TheFunded, Incorporated, in 2009 and is different from YC and TS in the following material respects.  First, rather than receive seed capital, entrepreneurs are required to pay a $50 application fee and a $900 course fee upon acceptance.

Second, FI takes a small percentage (3.5%) of warrants in the startup, which provides FI with an option to buy stock at the price set during the company’s first qualified financing round; warrants are deposited in a “Bonus Pool” that is shared among the other founders, the mentors, the local operators and FI.

Third, if the startup is successful and receives financing in excess of $50,000, it is “asked” to pay FI a one-time “Tuition Fee” of $4,500. And, finally, FI only requires a commitment of approximately 15 hours per week (a mandatory three-and-one-half-hour weekly session and between five and ten hours of assignment work that needs to be completed before the following session).

FI currently offers programs twice per year in Silicon Valley, Singapore, Seattle, Los Angeles, San Diego, Denver, Houston, Boston, New York, Washington DC, Paris, Brussels and Berlin.  As noted on the FI website:

The Founder Institute is a technology startup accelerator and entrepreneur training program currently on pace to launch over 500 companies per year in over 13 cities worldwide.  The program identifies high-potential entrepreneurs using predictive social science testing, and then guides them through weekly company-building sessions featuring a network of over 250 CEO Mentors.  All program stakeholders, including the participating founders and CEO Mentors, share in the equity generated by companies formed in the program.  In addition, participants get access to free and discounted services, and are not required to quit their day job.

You can apply to FI here; and check out their FAQ’s here.

4) Other Programs.  Below are some of the other mentorship programs:

ShotPut Ventures – Atlanta, GA

Capital Factory – Austin, TX

LaunchBox Digital – Durham, NC

SeedCamp – London (and mini-events throughout Europe)

Launchpad LA – Los Angeles, CA

DreamIt Ventures – Philadelphia, PA

Conclusion

I hope the foregoing was helpful.  Next week, in part 3, I will discuss applying directly to angel groups, such as AngelList and Open Angel Forum.  If you have any questions, please feel free to call me directly at 415-979-9998.  Many thanks, Scott

]]> http://walkercorporatelaw.com/entrepreneurship/how-do-i-raise-seed-capital-if-i-don%e2%80%99t-know-any-investors-%e2%80%93-part-2/feed/ 2 http://walkercorporatelaw.com/entrepreneurship/determination-via-jessica-livingston/?utm_source=rss&utm_medium=rss&utm_campaign=determination-via-jessica-livingston http://walkercorporatelaw.com/entrepreneurship/determination-via-jessica-livingston/#comments Wed, 22 Sep 2010 17:09:48 +0000 Scott Edward Walker http://walkercorporatelaw.com/?p=1358 Introduction

I’ve been reading the book Founders at Work: Stories of Startups’ Early Days written by Jessica Livingston, a co-founder of Y Combinator (a seed-stage venture firm) and a very smart and interesting individual.  The book is a collection of extensive interviews with founders of high-profile technology companies with respect to their earliest days, including Steve Wozniak (Apple), Craig Newmark (Craigslist), Mitch Kapor (Lotus), Caterina Fake (Flickr), Max Levchin (PayPal), and Sabeer Bhatia (Hotmail).  There are many important takeaways and lessons to be learned, but the one that really struck a chord with me (as a former minor-league tennis player and now a corporate lawyer for entrepreneurs) is the importance of determination.

The Single Most Important Quality

In January of this year, I wrote a guest post for VentureHacks in which I quoted my old tennis coach Harry Hopman (a tough, Vince Lombardi-type and the winningest coach in Davis Cup history): “It all comes down to one word — desire.  How badly do you want it?  How much are you willing to sacrifice?”

Jessica reached the same conclusion: “[D]etermination is the single most important quality in a startup founder.  If the founders I spoke with were superhuman in any way, it was in their perseverance.  That came up over and over again in interviews.” [Founders at Work, p. xiii]

There it is: desire, determination, perseverance.  Indeed, whether you’re launching a startup or trying to succeed as a professional athlete, without that burning hunger and incredible work ethic, it just ain’t going to happen.

As Gary Vaynerchuk (the founder of Wine Library TV and the so-called “Social Media Sommelier”) noted in a speech at the Web 2.0 Expo in New York: “Hustle is the most important word – ever. . . . I used to work in a liquor store from 7 in the morning until 10 at night for seven straight years, and the only days-off I took were to watch the New York Jets.” [starting @ the 3:16 mark]

Mark Cuban (billionaire entrepreneur and owner of the Dallas Mavericks) has a similar story, as he discusses in this video: “I went seven years – literally seven years – without a single vacation.  I didn’t take a day off – I didn’t go anywhere – I didn’t do squat.” [starting @ the 4:07 mark]

That’s determination, folks.

Paul Graham, the other co-founder of Y Combinator, wrote an outstanding essay entitled “The Anatomy of Determination,” in which he points out that:

We learned quickly that the most important predictor of success is determination. At first we thought it might be intelligence.  Everyone likes to believe that’s what makes startups succeed. It makes a better story that a company won because its founders were so smart.  The PR people and reporters who spread such stories probably believe them themselves. But while it certainly helps to be smart, it’s not the deciding factor.  There are plenty of people as smart as Bill Gates who achieve nothing.

In most domains, talent is overrated compared to determination—partly because it makes a better story, partly because it gives onlookers an excuse for being lazy, and partly because after a while determination starts to look like talent.

Conclusion

Let me conclude by directing you to another video: “How Badly Do You Want It?”  If you have five minutes, I strongly recommend it.  And I’ll end with my favorite quote from Jessica (the last sentence of her Introduction): “I hope a lot of people who read these stories will think, ‘Hey, these guys were once just like me.  Maybe I could do it too’.”  Cheers, Scott

This week, we present Keith Rabois, Executive Vice President of Strategy & Business Development for Slide and a very smart investor (courtesy of GigaOm TV).  In this interesting, 20-minute interview, Keith discusses, among other things: (i) the recent increases in the size of angel rounds, (ii) making investment decisions, (iii) how “cool” it is being a seed investor, (iv) the changing role of the VC, (v) how to choose the right investor and (vi) the excitement of being an entrepreneur.  I hope you enjoy it.  Thanks, Scott

This week, we present Jeff Bezos, the founder, CEO and Chairman of the Board of Amazon.com and an extraordinarily smart entrepreneur, who discusses the importance of (i) obsessing over customers, (ii) inventing to solve problems and (iii) thinking long-term.  I hope you enjoy it.  Thanks, Scott

www.youtube.com/watch?v=-hxX_Q5CnaA

Welcome to our weekly series entitled “Motivational Clips for Entrepreneurs.”  Each week, we post a short video or movie clip to inspire and motivate our fellow entrepreneurs.  Why?  Because it’s fuckn tough trying to build a company – and we all need a little juice to help us push the ball forward.  Hopefully, these videos are a little juice.  Cheers, Scott

www.youtube.com/watch?v=7LoN_AzPxQw

This post is a longer, more comprehensive version of the post I wrote a couple of weeks ago for VentureHacks, one of the best websites for startups, in which I recommended five New Year’s resolutions for entrepreneurs.  Indeed, as I noted in that post, during my 15+ years as a corporate lawyer (including nearly eight years at two major law firms New York City), I have seen entrepreneurs make certain fundamental mistakes over and over again in connection with doing deals.  So what better way to welcome in the new decade than to provide seven basic tips for entrepreneurs.

(Message to all of my female clients and readers: (i) the term “guys” includes “gals”; and (ii) in tip #6, you can decide what the term “balls” includes.)

Tip #1 – “Diligence the Guys on the Other Side of the Table”

Here’s the advice that I have written about often and give to all of my clients who are contemplating doing a financing: diligence the guys on the other side of the table.  Indeed, this is the number one mistake I have seen entrepreneurs make in any dealmaking context.  Remember, in financings and certain other deals (e.g., an acquisition by a private equity firm), you will, in effect, be married to those guys for a number of years.  Accordingly, entrepreneurs must do what any bride or groom does prior to tying the knot – date for a while and, of course, meet the family.

What does this mean in practical terms?  It means surfing the web and learning everything you can about the particular firm and, more importantly, the particular individuals with whom you are dealing; it means breaking bread and having a couple of beers with them; and it means getting references and talking to other entrepreneurs and founders who have done deals with them.  Issues to address include:  How have they treated their other portfolio companies?  Are they good guys or jerks?  Can they be counted-on and trusted?  Will they add significant value (e.g., through contacts, domain expertise, etc.)?

There is an outstanding video discussion on Mixergy.com between Brandon Watson, a smart entrepreneur (currently at Microsoft), and Andrew Warner, the founder of Mixergy, as to what could happen if you don’t adequately diligence your investors.  Brandon is extremely candid and discusses how he got “bullied” by his Board.  Moreover, he expressly notes in the comments section of the post that: “The diligence factor was that I knew them, but had never taken money from them.  It’s hard to know how people are going to react when they are at risk of losing money because of something you are directly responsible for until you are actually at that point.”

Tip #2 – “Check Your Emotions at the Door”

You have to think with your head, not with your heart – particularly when you’re doing deals.  The best deal guys are masters at taking their emotions out of transactions and being extremely disciplined.  They will just walk from a deal if they get out of their comfort zone (e.g., with respect to the price, risk profile, etc.) regardless of how much time and money they have expended.

Most entrepreneurs, on the other hand, become emotionally wedded to a particular transaction and are unable to maintain their objectivity the further along they get in the process.  They get all excited as soon as someone waves some money at them and allow themselves to get drawn into the money guy’s web.  It is critical that entrepreneurs understand this dynamic.  Entrepreneurs will generally be negotiating with guys on the other side of the table who are far more deal savvy than they – e.g., venture capitalists, private equity guys, etc. – guys who are masters at playing on their emotions.

This is why it is so important for entrepreneurs to establish a game plan (i.e., dealbreakers) before the negotiating process begins and to have the discipline to stick to the plan and be willing to walk, if necessary.  If an entrepreneur is seeking venture capital financing, for example, he should sit down with his transaction team before reaching out to the VC’s to establish his dealbreakers with respect to key terms, such as valuation, the liquidation preference, board composition, etc.  The same approach should be followed if he’s interested in selling his company:  What’s the lowest purchase price you’ll accept?  What’s the highest cap on liability you’ll agree to?  Will you agree to escrow part of the purchase price?  If so, how much and for how long?  Once you establish the dealbreakers early on, you can take your heart out of the equation and think with your head.

Tip #3 – “Create a Competitive Environment”

There is nothing that will give an entrepreneur more leverage in connection with any deal negotiation than a competitive environment (or the perception of same).  Indeed, every investment banker worth his salt understands this simple proposition.  Not only does competition validate a firm’s interest, but also it appeals to the human nature of the individuals involved.  Competitors can be played-off of each other and, as a result, the entrepreneur will be able to strike the best possible deal.

I learned this important lesson as a young corporate associate in New York City.  As I briefly discuss in my video post “Lesson Learned in the Trenches of Two Big NYC Law Firms,” I recall having two M&A transactions on my plate: one was a divestiture – i.e., the sale of a division of a multinational corporation being auctioned by an investment bank; and the other was the sale of a private company to a competitor (with no i-bankers involved).  In both deals, my firm was representing the sellers, but as we worked our way through the negotiation process of each deal, we ended-up with two completely different acquisition agreements with respect to the material terms.

In the auctioned deal, because the i-banker was able to play the prospective buyers off of each other and create a competitive environment, the final agreement was extremely seller friendly and included broad materiality qualifications, a huge basket/deductible and a cap on seller’s liability of 10% of the purchase price.  In the private-company transaction, however, there was only one prospective buyer — and the buyer’s principals knew that the seller was anxious to sell and thus were playing hardball.  Accordingly, in that deal, the deal terms ended-up being extremely buyer friendly and included a large portion of the purchase price being escrowed and a cap on the seller’s liability equal to 100% of the purchase price.

The lesson learned, of course, is that you must create a competitive environment (or the perception of same) in order to have strong negotiating leverage.  There is, however, one important caveat that entrepreneurs should keep in mind: this game must be played carefully and is better-handled by someone with experience.  The last thing an entrepreneur wants is to end-up with no deal at all.

Tip #4 – “Be Careful with LOI’s”

A letter of intent (an “LOI”) — sometimes referred to as a term sheet or memorandum of understanding — is often executed in connection with all types of deals.  The entrepreneur must understand that, depending on the deal and the context, there are different LOI strategies and considerations that must be addressed.  For example, in the acquisition context, a selling entrepreneur should try to negotiate all of the material terms of the deal in an LOI because it is at this point in time when his negotiating leverage is the strongest (see #5 of my post “Selling a Company: Ten Tips for Entrepreneurs”); on the other hand, a buying entrepreneur’s main goal with respect to an LOI is merely to lock-up the seller and prohibit it from shopping the deal for a reasonable period of time – his negotiating leverage is strongest after the LOI has been executed (see #1 and #2 of my post “Buying a Business: Ten Tips for Entrepreneurs“).

Another major concern with respect to LOI’s is that they may be deemed enforceable by a court of law (i.e., be deemed to be a binding agreement), despite language in the LOI to the contrary.  This issue often arises when entrepreneurs play lawyer — and draft and execute LOI’s without having them vetted by legal counsel.  Indeed, I represented an entrepreneur a few years ago who not only executed a LOI that he drafted in connection with an acquisition (he said it was “too small to run by me”), but also took the principal on the other side out to dinner and drinks to celebrate.  When my client refused to close the deal a couple of months later due to a significant diligence issue, the principal threatened to sue claiming they had agreed to a deal.  I was left in the awkward position of explaining to my client that as a result of the express language in the LOI and his actions subsequent to its execution, a Court was likely to agree with the principal’s position.  Accordingly, he ended-up settling the matter by agreeing to pay the target’s legal and other expenses.  Lesson hopefully learned.

Tip #5 – Watch-out for the “Good-Cop, Bad-Cop” Routine

Experienced deals guys (such as private equity guys and venture capitalists) employ all kinds of negotiating games.  One of their favorites is the “good-cop, bad-cop” routine.  Here’s how it works:  The deal guy plays the good cop and is smooth, friendly and agreeable; he makes the entrepreneur feel like all of his important issues are being taken care of.  But then the documents arrive — chock full of bells and whistles and boilerplate provisions designed to protect the deal guy’s firm/company and often with significant gaps on the deal points.  When the deal guy is questioned by the entrepreneur as to what’s going on here, the answer, of course, is “it’s my lawyer’s fault” (i.e., the “bad cop”).  This game will continue throughout the negotiating process as the deal guy charms the entrepreneur while his lawyers pound away on every significant issue.

How do I know this?  Because prior to launching my own firm specializing in the representation of entrepreneurs, I represented a number of private equity firms (both in New York City and Los Angeles) and have played this game many times.  One deal sticks-out in particular — and I remember it vividly because the private equity guy was a master.  He was a charming, good looking guy; and the target’s CEO was a woman, who appeared to become smitten with him.  Needless to say, this made my job as “bad cop” very easy.  When the target’s lawyer complained about all the draconian, pro-buyer provisions in the acquisition agreement, the private equity guy was able to convince the CEO that this is the form agreement he uses for all his deals and that he has certain fiduciary obligations to his investors.  As a result, we ended-up with extremely favorable pro-buyer terms, including a “diligence out” and no cap on the target’s or the shareholders’ liability.

Tip #6 – “Work Your Balls Off”

This is the advice a senior partner gave me when I was a young corporate associate at a major New York City law firm: “if you want to be a great lawyer, you have to work your balls off and make the practice the law the number one priority in your life.”  He explained that this means everything else in your life has to be pushed aside, and you need to “work, work, work.”  And when you’re not working, he added, you need to be reading treatises and articles discussing the deals you are working on to get a deeper understanding of the significant issues.  When I explained to him that, after three months, I had been working nearly every weekend and that my girlfriend was ready to leave me.  He told me that I need to get a new girlfriend.

I received similar advice from Harry Hopman, my old tennis coach (and the winningest coach in Davis Cup history), when I was playing tennis in the minor leagues after college.  He preached to me that: “It all comes down to one word — desire.  How badly do you want it?  How much are you willing to sacrifice?”  And he was right.  When I was traveling around and playing tournaments in Europe and South America, I noticed that the best tennis players were generally the hardest working; the qualifiers were the ones going out drinking every night, not the top seeds.  Sure there were exceptions – like John McEnroe – but the exceptions were rare.

I have seen this same pattern during my legal career: the most successful clients tend to be the hardest working.  Indeed, the private equity guys and hedge fund guys I represented in New York City were animals; working around the clock and cranking out deal after deal.  I attribute a lot of their success to just plain hard work.  In 2005, I moved out here to California to help entrepreneurs, and it’s been a mixed bag in terms of the work habits that I’ve seen.  Some of my clients are intense and put in the long hours; others, however, are just dreamers — and they are the ones who struggle.  In short, there are no shortcuts to success.

Tip #7 – “Retain a Strong, Experienced Lawyer to Watch Your Back”

This is obviously a bit self-serving, but every entrepreneur needs a strong, experienced lawyer to watch his back.  There is just too much at stake for entrepreneurs to be (i) utilizing sites like LegalZoom or (ii) pulling forms off of the web and trying to play lawyer or (iii) retaining the cheapest lawyer to save money.  Moreover, as the Madoff affair and other recent high-profile cases demonstrate, there are a lot of unscrupulous characters out there trying to take advantage of unsophisticated entrepreneurs.

There are also more subtle potential problems from which entrepreneurs need to be protected, including the inherent conflict of interest that certain service providers have.  For example, entrepreneurs need to be careful with investment bankers, who generally only get paid if a particular deal closes.  Indeed, a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.

Unfortunately, I experienced this issue first-hand shortly after moving to California when I got pulled onto an M&A deal in which an i-banker stuck his finger in my chest and warned:  “We’re going to get this deal done despite you f-ck’n lawyers.”  He then later complained to the managing partner (who had the client relationship) that I was blowing-up the deal because I had retained special environmental counsel from my old NYC law firm and we were pushing too hard on the environmental indemnity.  Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for environmental problems that it inherited as part of the acquisition.

The bottom line is that a strong, experienced corporate lawyer will sober the entrepreneur and lay-out all of the significant legal risks in a particular transaction; he will then push hard to negotiate reasonable protections.  If the deal sours and lawsuits are filed, well-drafted documents with appropriate protections become a kind of insurance policy to the entrepreneur.

Conclusion

I hope the foregoing is helpful to entrepreneurs.  I have previously covered some of these tips in both video and written format, but I tried to spice them up a little with a few war stories and a little colorful language.  Cheers, Scott

Yesterday evening, Michael Arrington of TechCrunch posted an interesting piece entitled “TweetPhoto CEO Says Too Much In Interview, Gets Fired. And That’s Just The Beginning…” (which has been subsequently re-posted throughout the blogosphere).  Unfortunately, Arrington has gotten his facts all wrong — at least according to Dan Caulfield, the CEO in question.

Arrington sets forth in his post that Caulfield “apparently said too much in [his podcast] interview [with Frank Peters], disclosing confidential information about partnerships [and] was fired by the company for the transgression.”  In the comments section to the post, however, Caulfield denied that there was any connection between his firing and the interview.  First, yesterday evening, he noted that: “I conducted this interview on [the] Morning of Nov 9th.  It had nothing to do with me leaving the company”; and then, this morning, he added that: “I was terminated a week prior to anyone hearing the interview.  Events not connected.”  Caulfield also retweeted the TechCrunch link to the post yesterday evening with a “Totally false!” insertion.

Arrington responded to Caulfield in the comments section this morning that: “Whatever you did or didn’t do, I think it’s pretty obvious what the company thinks” (citing a letter from the law firm Wilson Sonsini to Frank Peters demanding that he remove the podcast interview from his site).  Caulfield did not respond back to Arrington.

Needless to say, all of this made me scratch my head and wonder what the hell is going on here.  So I picked-up the phone and called Caulfield (he had given his telephone number out during the podcast), and I got the full scoop.

Caulfield’s Version of the Facts

I had a very good telephone conversation with Caulfield, who was gracious enough to take my call and answer all of my questions.  The bottom line is that Caulfield was “voted off of the island” (as he put it).  Indeed, Caulfield reiterated that his firing had nothing to do with the Frank Peters interview — he did the interview at 9am on November 9th (and no one at TweetPhoto was aware of it) and was fired at 2pm that afternoon.  The interview was subsequently posted and available to the public on November 16th (one week later).  According to Caulfield, it was just a matter of the founders “[wanting] to go forward without me.”  He explained that he was originally brought on by the founders to help them as a Board member; he then was appointed CEO.  And he emphasized that he was very disappointed (particularly in light of all the work he has done to help TweetPhoto), but does not want to do anything to hurt the company.

Caulfield seems like a stand-up guy, and if you listen to his podcast with Frank Peters, it is clear that he added a lot of value to TweetPhoto (including executing a significant partnering agreement on behalf of the company with Kodak).

Lessons for Entrepreneurs

The foregoing may be interesting from a personal-interest perspective; however, as a corporate attorney, I am more interested in the lessons that can be learned here.  Below are my takeaways.

Lesson #1: Diligence the Guys on the Other Side of the Table. As I have discussed many times (including in “Mistake #1” in my post “Five Mistakes Entrepreneurs Make in Dealmaking”), in any deal or business relationship, entrepreneurs must investigate the guys on the other side of the table.  This means getting references and speaking with other entrepreneurs or CEO’s who have worked with the guys on the other side of the table in order to make an informed judgment as to whether they are guys with whom the entrepreneur should be doing business.  As Caulfield noted to me, “at the end of the day, people have to work in a harmonious environment.”  The implication, of course, is that things were not “harmonious” at TweetPhoto.  Did the founders diligence Caulfield?  Did Caulfield diligence the founders?  It seems like there was a trial period where they got to know each other while Caulfield was a Board member.  Accordingly, there should not have been any surprises once Caulfield became CEO.

Lesson #2: All Employment Relationships Must be Documented. As I discuss in tip #8 of my post “Launching a Venture: Ten Tips for Entrepreneurs,” if any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter agreement will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company.

Caulfield advised me that he signed the “same agreements” as the founders, which means they were likely pro-company, not pro-employee.  From an employee’s perspective, you obviously do not want your relationship to be “at will”; instead, you want a fixed term with appropriate protections against termination by the company without “cause” or if you (as the employee) terminate the agreement for “good reason” (e.g., because your title/duties have been substantially diminished or if you are forced to re-locate).  Such protections include severance payments, acceleration of vesting of options, etc.; however, as I note in tip #5 of my post, “Founder Vesting: Five Tips for Entrepreneurs,” startups will push back on this issue because (i) they need the flexibility to make personnel changes if things aren’t working out (like at TweetPhoto); and (ii) it is difficult to establish “cause” or negate “good reason” from a legal perspective.

Lesson #3: Employees and Consultants Must be Required to Execute Confidentiality Agreements. As noted above, it is imperative that all employees and consultants be required to execute confidentiality agreements to prevent them from disclosing any of the company’s confidential and proprietary information.  Such confidentiality obligations generally run indefinitely – i.e., apply even after the employment or consultancy relationship has been terminated or has expired.  Perhaps this may have caused Arrington’s confusion – not recognizing that the Wilson Sonsini letter to Frank Peters was citing Caulfield’s “continuing” confidentiality obligations (despite his employment termination for unrelated reasons).

Lesson #4: Retain a Small, Experienced Law Firm for Small Projects. As I discuss in my post “Behind the Big Law Firm Curtain: The Good, The Bad, The Ugly,” it doesn’t make practical sense to retain large law firms to handle small corporate projects.  I’d love to know how much Wilson Sonsini billed TweetPhoto for the one-page letter to Frank Peters.  Indeed, Arrington hits the nail on the head: “amateur hour.”  Having worked at two large New York City law firms, I can only imagine the hours of research and drafting by some young Wilson Sonsini associate trying to meet his annual minimum billable-hour requirements.  What are these guys thinking sending a threatening letter to a blogger for posting a recorded audio interview of a company’s CEO?

Conclusion

Arrington is a superstar blogger, but missed this one.  Caulfield is a solid CEO, but got mixed-up with a couple of flakes.  Frank Peters is sweating bullets.  Wilson Sonsini is spinning their wheels.  And entrepreneurs hopefully can take-away a few lessons.

1.  Issue Options ASAP.  Stock options give key employees the opportunity to benefit from the increase in the company’s value by granting them the right to buy stock at a future point in time at a price (i.e., the “exercise” or “strike” price) generally equal to the fair market value of such stock at the time of the grant.  The venture should thus be incorporated and, to the extent applicable, stock options should be issued to key employees as soon as possible.  Clearly, as milestones are met by the company subsequent to its incorporation (e.g., the creation of a prototype, etc.), the value of the company will increase and thus so will the value of the underlying stock of the option.  Indeed, like the issuance of shares of common stock to the founders (who rarely receive options), the issuance of stock options to key employees should be done as soon as possible, when the value of the company is as low as possible.

2.  Comply with Applicable Federal and State Securities Laws.  As discussed in my post on launching a venture (see #6 here), a company may not offer or sell its securities unless (i) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable State commissions; or (ii) there is an applicable exemption from registration.  Rule 701, adopted pursuant to Section 3(b) of the Securities Act of 1933, provides an exemption from registration for any offers and sales of securities made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation, provided that it meets certain prescribed conditions.  Most states have similar exemptions, including California, which amended the regulations under Section 25102(o) of the California Corporate Securities Law of 1968 (effective as of July 9, 2007) in order to conform with Rule 701.  This may sound a bit self-serving, but it is indeed imperative that the entrepreneur seek the advice of experienced counsel prior to the issuance of any securities, including stock options: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

3.  Establish Reasonable Vesting Schedules.  Entrepreneurs should establish reasonable vesting schedules with respect to the stock options issued to employees in order to incentivize the employees to remain with the company and to help grow the business.  The most common schedule vests an equal percentage of options (25%) every year for four years, with a one-year “cliff” (i.e., 25% of the options vesting after 12 months) and then monthly, quarterly or annually vesting thereafter – though monthly may be preferable in order to deter an employee who has decided to leave the company from staying on board for his next tranche.  For senior executives, there is also generally a partial acceleration of vesting upon (i) a triggering event (i.e., “single trigger” acceleration) such as a change of control of the company or a termination without cause; or (ii) more commonly, two triggering events (i.e., “double trigger” acceleration) such as a change of control followed by a termination without cause within 12 months thereafter.

4.  Make Sure All of the Paperwork Is in Order.  Three documents must generally be drafted in connection with the issuance of stock options: (i) a Stock Option Plan, which is the governing document containing the terms and conditions of the options to be granted; (ii) a Stock Option Agreement to be executed by the Company and each optionee, which specifies the individual options granted, the vesting schedule and other employee-specific information (and generally includes the form of Exercise Agreement annexed as an exhibit); and (iii) a Notice of Stock Option Grant to be executed by the Company and each optionee, which is a short summary of the material terms of the grant (though such Notice is not a requirement).  In addition, the Board of Directors of the Company (the “Board”) and the stockholders of the Company must approve the adoption of the Stock Option Plan; and the Board or a committee thereof must also approve each individual grant of options, including a determination of the fair market of the underlying stock (as discussed in paragraph 6 below).

5.  Allocate Reasonable Percentages to Key Employees.  The respective number of stock options (i.e., percentages) that should be allocated to key employees of the company generally depends upon the stage of the company.  A post-Series-A-round company would generally allocate stock options in the following range (note: the number in parentheses is the average equity granted at the time of hire based on the results from a 2008 survey published by CompStudy): (i) CEO – 5% to 10% (avg. of 5.40%); (ii) COO – 2% to 4% (avg. of 2.58%); (iii) CTO – 2% to 4% (avg. of 1.19%); (iv) CFO – 1% to 2% (avg. of 1.01%); (v) Head of Engineering – .5% to 1.5% (avg. of 1.32%); and (vi) Director – .4% to 1% (no avg. available).  As noted in paragraph 7 below, the entrepreneur should try to keep the option pool as small as possible (while still attracting and retaining the best possible talent) in order to avoid substantial dilution.

6. Make Sure the Exercise Price Is the FMV of the Underlying Stock.  Under Section 409A of the Internal Revenue Code, a company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value (the “FMV”) of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibilities.  The company can establish a defensible FMV by (i) obtaining an independent appraisal; or (ii) if the company is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company employee), provided certain other conditions are met.

7.  Make the Option Pool As Small As Possible to Avoid Substantial Dilution.  As many entrepreneurs have learned (much to their surprise), venture capitalists impose an unusual methodology for calculating the price per share of the company following the determination of its pre-money valuation — i.e., the total value of the company is divided by the “fully diluted” number of shares outstanding, which is deemed to include not only the number of shares currently reserved for in an employee option pool (assuming there is one), but also any increase in the size (or the establishment) of the pool required by the investors for future issuances.  The investors typically require a pool of approximately 15-20% of the post-money, fully-diluted capitalization of the company.  Founders are thus substantially diluted by this methodology, and the only way around it, as discussed in an excellent post by Venture Hacks, is to try to keep the option pool as small as possible (while still attracting and retaining the best possible talent).  When negotiating with the investors, entrepreneurs should therefore prepare and present a hiring plan that sizes the pool as small as possible; for example, if the company already has a CEO in place, the option pool could be reasonably reduced to closer to 10% of the post-money capitalization.

8.  Incentive Stock Options May Only Be Issued to Employees.  There are two types of stock options: (i) non-qualified stock options (“NSOs”) and (ii) incentive stock options (“ISOs”).  The key difference between NSOs and ISOs relates to the ways they are taxed: (i) holders of NSOs recognize ordinary income upon the exercise of their options (regardless of whether the underlying stock is immediately sold); and (ii) holders of ISOs do not recognize any taxable income until the underlying stock is sold (though Alternative Minimum Tax liability may be triggered upon the exercise of the options) and are granted capital-gains treatment if the shares acquired upon exercise of the options are held for more than one year after the exercise date and are not sold prior to the two-year anniversary of the options’ grant date (provided certain other prescribed conditions are met).  ISOs are less common than NSOs (due to the accounting treatment and other factors) and may only be issued to employees; NSOs may be issued to employees, directors, consultants and advisors.

9.  Be Careful When Terminating At-Will Employees Who Hold Options.  There are a number of potential claims at-will employees could assert relative to their stock options in the event that they are terminated without cause, including a claim for breach of the implied covenant of good faith and fair dealing.  Accordingly, employers must exercise care when terminating employees who hold stock options, particularly if such termination occurs close to a vesting date.  Indeed, it would be prudent to include in the employee’s stock option agreement specific language that: (i) such employee is not entitled to any pro rata vesting upon termination for any reason, with or without cause; and (ii) such employee may be terminated at any time prior to a particular vesting date, in which event he will lose all rights to unvested options.  Obviously, each termination must be analyzed on a case-by-case basis; however, it is imperative that the termination be made for a legitimate, non-discriminatory reason.

10. Consider Issuing Restricted Stock in Lieu of Options.  For early-stage companies, the issuance of restricted stock to key employees may be a good alternative to stock options for three principal reasons: (i) restricted stock is not subject to Section 409A (see paragraph 6 above); (ii) restricted stock is arguably better at motivating employees to think and act like owners (since the employees are actually receiving shares of common stock of the company, albeit subject to vesting) and thus better aligns the interests of the team; and (iii) the employees will be able to obtain capital gains treatment and the holding period begins upon the date of grant, provided the employee files an election under Section 83(b) of the Internal Revenue Code. (As noted in paragraph 8 above, optionholders will only be able obtain capital gains treatment if they were issued ISOs and then meet certain prescribed conditions.)  The downside of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election has been filed), the employee is deemed to have income equal to the then fair market value of the stock.  Accordingly, if the stock has a high value, the employee may have significant income and perhaps no cash to pay the applicable taxes.  Restricted stock issuances are thus not appealing unless the current value of the stock is so low that the immediate tax impact is nominal (e.g., immediately following the company’s incorporation).

Question #1: What are the “Securities Laws”?

When lawyers and others refer to the “securities laws,” they generally mean the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”), which were passed by Congress during the peak of the Depression in order to attempt to restore investor confidence in the capital markets.  As provided on the SEC website: 

“The main purposes of these laws can be reduced to two common-sense notions: [(1)] Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.  [(2)] People who sell and trade securities – brokers, dealers, and exchanges – must treat investors fairly and honestly, putting investors’ interests first.”

Moreover, each State has (i) its own set of securities laws (so-called “blue sky” laws), which vary from State by State; and (ii) its own State securities commission or department. 

Question #2: Do the Securities Laws Apply to Start-up Companies?

Yes, the securities laws apply to all companies that issue “securities” (which term is broadly defined).  As I have previously noted (see paragraph #6 here), pursuant to applicable securities laws, a company may not offer or sell its securities unless (1) such securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (2) there is an applicable exemption from registration.  The most common exemption for start-up companies is the so-called “private placement” exemption under SEC Regulation D, the safe harbor promulgated under Section 4(2) of the Securities Act (see mistake #2 here).  In order to comply with Regulation D, the issuer must, among other things, execute and file a Form D. The SEC recently issued rules and rule amendments adopting revisions to Form D. 

Question #3: What is Form D?

Form D is the SEC’s official notice of an exempt offering of securities in reliance upon Regulation D (or Section 4(6) of the Securities Act).  As you can see from the actual form, it requires certain prescribed information with respect to the issuer and the offering, including (i) the issuer’s identity, (ii) its principal place of business and contact information, (iii) the names and addresses of its executive officers and directors, (iv) the specific exemption claimed under the Securities Act and (v) as discussed below, the identity (and contact information) of any broker-dealer, finder or other person receiving  “any commission or other similar compensation” relating to the sale of securities in the offering. 

Question #4: Where Do I File the Form D?

An executed Form D must be filed with (i) the SEC and (ii) if the issuer is relying on Rule 506 of Regulation D, each of the applicable State securities commissions in which (A) the offer originated, (B) the offer was delivered or received and/or (C) part of the sale transaction took place.  Certain States may also require the filing of a consent to service and the payment of a filing fee.  (The SEC does not charge a filing fee for a Form D notice or amendment.)  

Question #5: How Do I File the Form D?

As of March 16, 2009, the SEC requires the electronic filing of Form Ds through the SEC’s Electronic Data Gathering, Analysis and Retrieval System (“EDGAR”).  To file online using EDGAR, an issuer must have its own filer identification number (called a “Central Index Key” or “CIK” number) and a set of password-like “access codes.”  An issuer may obtain a CIK number and EDGAR access codes at any time (even before it is ready to file its first online Form D); to do so, it must submit basic information to the SEC online at its Filer Management page and also submit a copy of a notarized paper document containing the same information on Form ID.  The paper document is called an “authenticating document,” which can be submitted either (i) by scanning and uploading it to the online submission in pdf or (ii) by faxing it to the SEC at (202) 504-2474 or (703) 914-4240.  (For more information on obtaining a CIK number and EDGAR access codes, you can review the SEC staff’s Guidance on Form D Filing Process.) 

There is currently no electronic filing with the States.  Accordingly, to the extent necessary, an issuer must file the Form D with an applicable State securities commission in hard copy.  There is nevertheless a strong desire on the SEC’s part to make the electronic system a one-stop filing center for filings with the States.

Question #6: When Must I File the Form D?

The Form D must be filed with the SEC no later than 15 calendar days after the “date of first sale” of securities sold based on a claim of exemption under Rule 504, 505 or 506 of Regulation D or Section 4(6) of the Securities Act.  For this purpose, the “date of first sale” is the “date on which the first investor is irrevocably contractually committed to invest, which, depending on the terms and conditions of the contract, could be the date on which the issuer receives the investor’s subscription agreement or check.”  In order to avoid any timing issues, an issuer may elect to file the Form D prior to its receipt of a subscription agreement or check (and merely check the appropriate box in Item 7 of the Form D that “First Sale Yet to Occur”).  If the date on which the Form D is required to be filed falls on a Saturday, Sunday or holiday, the applicable due date is the first business day following.

The timing of the filing in a particular State is governed by applicable State law or regulations; however, the SEC Division of Corporate Finance has stated (in Section 257.08 of its Compliance and Disclosure Interpretations) that an issuer’s failure to file timely the Form D in a particular State does not result in a loss of State preemption (though certain States may require a late issuer to pay a fine/penalty and/or take other administrative action). 

Question #7: Will the Information on the Form D be Publicly Available?

Yes, all Form Ds filed through EDGAR will be available for public viewing in an interactive and searchable format on the SEC’s website.  According to the SEC, the online filing system will enable interested parties “to view the information in an easy-to-read format, download the information into an existing application or create an application to use the information.”

Question #8: When Must the Form D Be Amended?

The Form D must be amended (i) to correct a material mistake of disclosure, as soon as practicable after the discovery of the mistake; (ii) to reflect a change in certain reported information (including any change in the issuer’s directors or officers), as soon as practicable after the change; or (iii) “annually, on or before the first anniversary of the most recent previously filed notice, if the offering is continuing at that time.”

The Form D need not be amended to reflect a change that occurs after the offering terminates.  Moreover, certain changes in reported information are expressly deemed not to trigger an amendment, including (i) changes in the issuer’s revenues or aggregate net asset value; (ii) changes in the amount of securities sold in the offering (or the amount remaining to be sold); or (iii) changes in the total number of investors who have participated in the offering.  

Question #9: Does the New Form D Have Any New Disclosure Requirements?

Yes, as noted above, the new Form D requires, among other things, the disclosure of the identities of all finders engaged in the offering of securities of the issuer.  This will obviously result in the increased scrutiny of finders that are not registered as “broker-dealers.”  Indeed, as discussed in paragraph #4 here, entrepreneurs often make the mistake of retaining unregistered finders to raise capital on their behalf.  If the finder is receiving some form of commission or transaction-based compensation in connection therewith, he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws (as discussed below).

Question #10: Why Should I Care About Any of This?

Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

httpvhd://www.youtube.com/watch?v=Kcty5PrNaxs

The Good 

Big law firms are very good in connection with billion dollar acquisitions, public offerings and any complex, bet-the-company type transaction (e.g., hostile takeovers).  Indeed, when money is not an issue and/or where the client needs lots of lawyers (i.e., lots of bodies), it may be prudent to retain a large law firm with strong experience to handle a particular corporate project.  I remember doing billion-dollar acquisitions as a corporate associate in New York, where we often had diligence teams of 10+ lawyers and transaction teams of 30+ lawyers.  Moreover, big law firms are also good (particularly in places like Silicon Valley) at making introductions for entrepreneurs to investors and the like. 

The Bad

The bad, of course, are the huge legal fees that big firms charge.  As I have discussed on the video on the home page of my website, there are lawyers at certain major national law firms billing out at $1,000 per hour; and there are first-year associates at big firms billing out at $300 per hour.  (Just to be clear: we’re talking about lawyers with no experience, fresh out of law school billing clients at a rate of $300/hr.)  The bottom line is that legal fees are through the roof. 

Now, in billion-dollar deals, legal fees are generally not an issue; indeed, they are just another line item in the list of transaction expenses (and generally pale in comparison to what the investment bankers are getting).  But in small deals or in connection with general corporate work, fees are often a significant issue to entrepreneurs.   

The Ugly

The ugly with respect to big law firms is pretty ugly from the entrepreneur’s perspective – and I’ve seen this over and over again.

The reality is that the smaller the client – the smaller the transaction — the further down the ladder the work gets pushed at the big law firms.  That’s the way these firms work.  The entrepreneur may meet the senior partner at the first meeting for his $15 million acquisition or $3 million financing, but that partner then goes back to his office, calls the assigning partner and gets some young associate to start cranking out the work.

I experienced this first hand as a young associate at a big, New York City law firm.  I can remember is like it’s yesterday: you get the call from the senior partner’s secretary to come up to the senior partner’s office; you run up the stairs or to the elevator; you bring your legal pad; you’re nervous and you sit down in the partner’s office (sometimes he’s on the phone and you’re sitting there for 10 minutes); and then if it’s a small deal that you’ve been tapped to handle, he either just flings a copy of the term sheet at you or just flies through the terms, hands you the form he wants you to use and then tells you to “go, get it done”; and as you’re leaving his office, he screams out “call me if you have any questions”  — which really means “don’t bother me with this little, bullshit deal — I don’t want to see you until the closing.”

 Conclusion

The takeaway here is that the big-firm template generally only works for the big deals and the big clients, and the entrepreneur needs to understand that.  I hope the foregoing was helpful.  If you have any questions or comments, please send them to me through the comments section of this post.  Thank you.

1.  Protect Yourself from Personal Liability.  The entrepreneur’s first step in connection with launching a start-up should be to form an organization that will protect against personal liability.  As discussed below, a Delaware C-corporation is the structure that VC investors will generally require; however, if a financing is not imminent, it may be prudent for the entrepreneur to form an S-corporation or a limited liability company to obtain “pass-through” tax treatment (and then convert the entity to a C-corporation down the road, if necessary) to take advantage of the company’s initial losses, if applicable.  The bottom line is that the entrepreneur should seek the advice of counsel in connection with the formation of any business organization, including the advice of tax counsel (e.g., shareholders in S-corporations — as opposed to C-corporations — are not eligible for the “qualified small business stock” capital gains tax break; and losses in C-corporations may be deductible up to $50,000/yr. or $100,000/yr. on a joint return with respect to “Section 1244 stock”).

2.  Form a Delaware C-Corporation.  VC funds generally invest in Delaware C-corporations.  From a tax perspective, funds generally avoid (and may be prohibited under their respective fund documents from) investing in pass-through entities.  From a corporate perspective, Delaware is the most common state of incorporation (regardless of where the operations are located) due to its well-developed case law, management protections and flexibility, and ease of corporate filings and related state-law administrative issues.  Despite Delaware’s appeal, however, if the business has substantial operations and a majority of its shareholders located in California (a so-called “quasi-California corporation”), it may be simpler to form the corporation in California (i) due to the uncertainty regarding Section 2115 of the California Corporations Code, which purports to apply certain significant statutory provisions to quasi-California corporations (even if they are incorporated in Delaware); and (ii) the state-law requirement that a quasi-California corporation (or a corporation that otherwise has sufficient contacts with California) that is incorporated in Delaware or any other state must qualify to “do business” in California (in effect, a mini-incorporation process).  Again, the entrepreneur should seek the advice of counsel with respect to choosing the state of incorporation.

3.  Incorporate and Issue Stock ASAP.  The venture should be incorporated and stock should be issued to the founders as soon as possible — i.e., before the company has any significant value.  Clearly, as milestones are met by the company subsequent to its incorporation (e.g., the creation of a prototype, the signing-up of customers, etc.), the value of the company will increase and therefore so will the purchase price of the stock (which could trigger significant taxable income to those founders receiving stock in exchange for past or future services).  Moreover, if a founder intends to transfer assets (e.g., technology) to the corporation in exchange for stock, Section 351 of the Internal Revenue Code (which permits a tax-free exchange under certain conditions) may only be available at the time of incorporation and not later after more stock has been issued.  Indeed, the same principle applies with respect to the issuance of stock options/equity to employees: the goal is to do it as soon as possible when the value of the company is as low as possible.

4.  Impose Reasonable Vesting Restrictions.  As discussed in my earlier post, “Founder Vesting: Five Tips for Entrepreneurs,” the founders should impose a reasonable vesting schedule on the stock issued to them at the time of incorporation for two important reasons: (i) a vesting schedule will be required by the VC investors, and if a reasonable schedule has already been established, it is more likely that the investors will simply keep it in place; and (ii) it makes good business sense because, in most cases, the stock has been issued not only for services or property relating to the conception of the venture, but also for the founders’ continuing commitment and efforts — indeed, it would be inherently unfair for one of the founders to leave the venture after a few weeks/months, but still be permitted to keep all of his/her stock.  The most common schedule for founders vests an equal percentage of options (25%) every year for four years on a monthly basis.  Vesting restrictions are addressed in a Restricted Stock Purchase Agreement, which each founder would be required to execute and which would grant the company the right to repurchase any unvested shares at the initial purchase price at the time of the founder’s departure (subject to certain exceptions).  As discussed in detail in paragraph #3 here, it is generally advisable for any founders receiving shares subject to vesting to make a Section 83(b) election with the Internal Revenue Service, which will prevent the founder from recognizing income at the time the stock vests.  Such an election must be filed within 30 days after the purchase date of the restricted stock.

5.  Execute a Stockholders’ or Voting Agreement.  If there are two or more founders, it may be prudent to execute a stockholders’ or voting agreement in order to address certain significant issues between or among the founders, including (i) the appointment of directors, (ii) veto rights and (iii) rights of first refusal (if not addressed in the Restricted Stock Purchase Agreements, as discussed in paragraph 4 above).  In the event there are only two stockholders with an equal number of shares, it may also be prudent to include certain so-called “deadlock” provisions in the agreement (such as a “Russian roulette” provision, a “Texan shoot-out” or a “Dutch auction”).  Needless to say, the closer the startup is to a VC financing, the less importance a shareholders’ agreement holds because it will be superseded by the applicable venture documents.

6.  Comply with Applicable Federal and State Securities Laws.  A company may not offer or sell its securities unless (i) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (ii) there is an applicable exemption from registration.  Fortunately for the start-up there are certain prescribed transaction exemptions which may be applicable, including the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933, as amended (the “1933 Act”), and Regulation D promulgated thereunder (as well as Rule 701 discussed in paragraph 9 below).  It is indeed imperative that the entrepreneur seek the advice of experienced counsel prior to the issuance of any securities: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  The rule of thumb in this area is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506, which preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996.  (Note: anti-fraud rules are still applicable under Rule 506.)

7. Protect Your IP.  For many start-ups, intellectual property (or “IP”), such as copyrights, trademarks, domain names or patents, is their most valuable asset.  Accordingly, a number of steps should be taken to protect IP assets, including (i) developing a comprehensive strategy for IP; (ii) establishing and implementing IP policies and procedures — e.g., concerning proper use of third parties’ IP; (iii) if appropriate for the business, filing patent applications and registering copyrights, trademarks and domain names; and (iv) as discussed below, requiring independent contractors and employees to execute confidentiality and IP/invention assignment agreements.  It may be prudent for entrepreneurs to retain separate IP counsel to address some of the foregoing issues, particularly where IP protection is significant to the business model.

8.  Address Employment Issues.  If any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter agreement will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company.  (Note: under California Labor Code Section 2870, an employer may not require an employee to assign rights in an invention that the employee developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.)  Non-competition provisions may also be appropriate; however, such provisions are unenforceable in California other than in the context of the sale of a business — though California courts may enforce contractual provisions that prohibit employees from soliciting the company’s employees, provided that such provisions are reasonable (i.e., not overbroad) in scope and duration.  Moreover, it would be prudent for the company to create an employment manual setting forth the company’s policies (including with respect to equal opportunity/non-discrimination and sexual harassment) and establishing the parameters of the employer-employee relationship.

9.  Establish a Stock Option/Equity Compensation Plan.  In order to attract and retain key employees (and to conserve cash), it usually makes good business sense for the company to establish a stock option plan or other form of equity compensation plan.  Again, the goal is to do it as soon as possible when the value of the company is as low as possible.  As noted above, any offer or sale of securities must comply with applicable federal and state securities laws.  Rule 701 promulgated under the 1933 Act creates an exemption from registration for any offer or sale of securities pursuant to certain compensatory benefit plans and contracts relating to compensation, provided that it meets certain prescribed conditions.  Most states have similar exemptions, including California, which recently amended the regulations under Section 25102(o) of the California Corporate Securities Law of 1968 to significantly liberalize the requirements under California law to conform with Rule 701.  Moreover, under Section 409A of the Internal Revenue Code, the company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibility.  The company can establish a defensible fair market value by (i) obtaining an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company employee), provided certain other conditions are met.  (Note: restricted stock is not subject to Section 409A.)  Again, the entrepreneur should seek the advice of counsel before issuing stock options or other equity.

10.  Pay To Play.  Based on the foregoing, it is self-evident that now is not the time for the entrepreneur to try to save money by doing legal work on his own or by relying on printed forms from a web service like LegalZoom (see FAQ’s).  Indeed, there are a number of significant legal issues that must be addressed to protect the entrepreneur and his venture.  Moreover, VC firms and other outside investors will be doing extensive due diligence on the company prior to making an investment and, accordingly, it is imperative that the entrepreneur demonstrate a certain level of credibility and sophistication.  Remember: “starting companies is a lot like launching rockets: if you’re a tenth of a degree off at launch, you may be a thousand miles off downrange.”  The Silicon Valley Edge, edited by C-M Lee, et al. (Stanford University Press 2000), p. 328 (quote by C. Johnson, Esq.).