This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the founder of a mobile apps startup, and we’re starting to get some incredible traction.  I’ve been bootstrapping the venture for the last year, but I’d really like to raise about $2 million to scale this thing.  If a VC invests $2 million, what percentage of the company will he own?

Answer

It depends upon the value of your company prior to the investment (commonly referred to as the “pre-money valuation” or “pre”).  For example, if the pre were $4 million, the VC would get one-third ($2,000,000 divided by $6,000,000); on the other hand, if the pre were $1 million, the VC would get two-thirds ($2,000,000 divided by $3,000,000).

As you can see, the VC’s percentage ownership is calculated by dividing the amount of its investment by the post-money valuation of the company (which is equal to the pre plus the amount of the investment).

The real issue then is — how do you determine the value of your company prior to the investment?  Let’s look at that.

I come from the M&A world in New York, where the valuation of target companies was more science than art.  Indeed, targets were valued based upon a number of different methodologies, the most significant of which is the discounted cash flow method (DCF).  As discussed in this excellent article from the Darden Graduate School of Business, DCF basically estimates the net present value of the target’s future cash flow, discounted to reflect the Weighted Average Cost of Capital or “WACC” (which, in simple terms, is the risk).

In the startup world, however, DCF doesn’t work because there is little or no historical financial data and projected cash flow is thus pure speculation.  Accordingly, the valuation of startups is highly subjective and is more art than science.  To put it bluntly: your startup is worth whatever the market says it’s worth, which was starkly demonstrated during the dot-com bubble and subsequent crash.

So what does this all mean in practical terms?  It means you need to get out there and effectively pitch a handful of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.  This is akin to what investment bankers do when they’re selling a company: they create a competitive environment (or the perception of one) to drive-up the purchase price and to provide negotiating leverage.

As legendary investor John Doerr, a partner at Kleiner Perkins, notes in the video I posted on Monday, “Helping Entrepreneurs Succeed: John Doerr”: “Valuations and how way to negotiate them?  I think the best thing to do is to talk to two or three venture capital groups at once – at the same time; not ten, but three.”

That being said, you should be aware of the following caveats:

• Creating a competitive environment and playing VC’s off of each other is very tricky and best done with the help of an experienced lawyer and/or consultant.

• At the end of the day, you will still need to convince the VC’s that you can deliver a 10X return (i.e., that they will make 10 times their investment).  VC’s will thus take into account certain significant factors such as the quality of your management team, the size of your market, etc.

• As I have previously discussed, startups often make the mistake of focusing too much on valuation.  Indeed, there are other important terms that affect the economics of a financing, including the liquidation preference and the size of the option pool.

Conclusion

I hope the foregoing was helpful.  And if you’re wondering how to get a meeting with a VC, I briefly discussed this issue in my post “Ask the Attorney: What Are the Most Common Mistakes Startups Make Dealing with VC’s?” (see #1).  In a nutshell, you need to hustle and build relationships so that you can get a “warm” introduction — i.e., an introductory phone call/email from a middleman or woman whom the VC trusts and respects; it takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

This week, we present legendary investor John Doerr, a partner at Kleiner Perkins.  Eric Schmidt calls John “one of Google’s best board members”; and Jeff Bezos noted that “Doerr (and Kleiner) is the center of gravity in the Internet.”  In this interesting, one-minute clip from 2005 (courtesy of Stanford University’s Entrepreneurship Corner), John discusses how to negotiate valuations with VC’s and related issues.  

I included this clip as a supplement to my blog post today on VentureBeat in which I advised entrepreneurs that: “[Y]ou need to get out there and effectively pitch a bunch of VC’s in your space and get them excited about your venture.  By doing so, you can, in effect, drive the market by creating a competitive environment and playing the VC’s off of each other.”  Many thanks, Scott

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.  Many thanks, Scott

Question

I’m the co-founder and CEO of an e-commerce startup, and I’ve been meeting with different VC firms regarding an initial round of funding.  I’ve started doing some reading on term sheets and the issues we will need to address, and I’m a little confused with some of the VC terminology.  Could you please explain to me what a liquidation preference is and how we should negotiate it.  Thanks!

Answer

Welcome to the world of venture capital.  A liquidation preference is one of the essential components of preferred stock and is generally considered to be the second most important deal term in a VC investment (the first being the company’s valuation prior to the investment, commonly referred to as the “pre-money valuation” or “pre”).

Let’s start with the basics:  A VC investor will be issued shares of preferred stock, not shares of common stock.  Preferred stock, as the name suggests, is preferable to common stock because it grants certain key rights to the preferred stockholders – making it far more valuable than common stock.  One such right is a liquidation preference.

The word “liquidation” is broadly defined in the VC documentation to include not only the actual liquidation of the company (i.e., the disposition of the company’s assets) upon dissolution or bankruptcy, but also the sale of the company (whether via stock, assets or merger) to a third party or a change of control.

The word “preference” flows from “preferred” and means that the shares of the preferred stock will have a priority over (i.e., will be treated better than) the common stock in the event of a liquidation.  For example, in bankruptcy, once the company’s creditors have been paid off, any remaining assets would be distributed to the holders of the preferred stock prior to the holders of the common stock.

Similarly, if the company were sold, the proceeds of the sale would be distributed first to the holders of the preferred stock and then to the holders of the common stock, based upon the terms of the liquidation preference.

There are three types of liquidation preferences:

• Straight (or Non-Participating) Preferred – this liquidation preference is most favorable to the company/founders.  Upon the sale of the company (or any other liquidation), the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders.  Alternatively, the preferred stockholders could choose to convert their preferred stock to common stock and simply be treated the same as the common stockholders (i.e., share ratably in the proceeds).

• Participating Preferred – this liquidation preference is most favorable to the investor (and is sometimes referred to as “double-dip preferred”).  Similar to straight preferred, the preferred stockholders would be entitled to the return of their entire investment (plus any accrued dividends) prior to the distribution of any proceeds to the common stockholders; however, the preferred stockholders would then also be treated like common stockholders and would share ratably in the remaining proceeds – thus, in effect, being paid twice (or “double”).  Indeed, issuing participating preferred has the same economic effect as issuing a promissory note and shares of common stock (or a warrant) to the investor.

• Capped (or Partially) Participating Preferred – this liquidation preference is often viewed as an intermediate approach.  The preferred stockholders have the same rights as participating preferred (i.e., return of investment, plus share ratably in the reminder), but their aggregate return is capped; once they have received the capped amount, they no longer have the right to share in the remaining proceeds with the other common stockholders.

Fully participating preferred is the exception (about 20% of the deals today) — particularly in the Series A round of funding.  You should thus push hard for a straight preferred liquidation preference and settle for capped participation as a fallback position.  Remember, whatever you agree to with your initial investors will carry forward to future rounds; that’s why fully participating preferred should be avoided.

As part of the negotiation of liquidation preferences, there is also a concept called a “multiple” (e.g., “2X multiple,” 3X multiple,” etc.).  Watch out for this one!  It means the preferred stockholders are entitled to a multiple of their original investment (e.g., double or triple the amount) before the common stockholders get anything.

Based on the foregoing, it is imperative that, before you agree to any participating preferred and/or multiples, you should require the VC to run spreadsheets/models demonstrating how much you and the other founder(s) will receive based on various sales price scenarios.  For example, if your company were sold for $40 million, and the VC had invested $5 million for one-third of the company, with a 2X participating preferred, the VC would receive $10 million off the top (not including any accrued dividends, if applicable), plus another $10 million (one-third of $30 million), for a total of $20 million.

The VC would thus receive 50% of the sale proceeds even though it only owned one-third of the company.

Conclusion

I hope the foregoing is helpful.  My colleague, Susan Morgan, has actually created proprietary software to help entrepreneurs create spreadsheets relative to liquidation preferences and the amount of proceeds they would receive under different sales scenarios.  Indeed, liquidated preferences (particularly when they are stacked onto different series of Preferred Stock) can be quite difficult to understand – until it’s too late.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  Please feel free to call me directly if you have any questions (415-979-9998).  Thanks, Scott

Question

My co-founder and I are crushing it, and we’re getting ready to approach VC’s for some cash.  We’re both first-time entrepreneurs, and we don’t want to make any rookie mistakes.  What are some of the common mistakes that you’ve seen guys like us make dealing with VC’s?

Answer

Obviously, that’s a pretty broad question.  Here are five quick ones:

1) Cold Calls.  One of the classic rookie mistakes is cold-calling or emailing a VC you don’t know personally; in short, you’re wasting your time.  The only way you will get a meeting with a VC is through a “warm” introduction – that is, an introductory phone call or email from a middleman (or woman) whom the VC trusts and respects.

The ideal middleman is a successful entrepreneur whom the VC has backed; investors can be good middlemen; and lawyers, accountants or recruiters may also be helpful.  As the guys at Venture Hacks so aptly put it in their book Pitching Hacks: “Getting an introduction is a test of your entrepreneurial skills.”

2) Not Doing Your Homework.  Startups often make the mistake of not doing their homework regarding the different VC firms.  Prior to approaching middlemen to make introductions, you first need to do some research and figure-out which VC firms are a good fit for your startup based on a number of different factors, including (i) their space/industry focus, (ii) their investment criteria, (iii) their fund size, (iv) their geographic focus, (v) their “sweet spot” and (vi) their track record.

You also need to do your homework (including speaking to other founders) with respect to the particular partners with whom you are interested in working, including determining their reputation, domain expertise and capacity to take-on a new deal.  (See paragraph #3 of my post “Angel Financings: Legal Tips for Entrepreneurs – Part 1.”)

3) Requesting an NDA.  Another classic rookie mistake is asking a VC to sign a Non-Disclosure Agreement (“NDA”); it ain’t going to happen.  VC’s are inundated with business plans and executive summaries and are constantly talking to entrepreneurs whose ideas may be similar to yours.  Indeed, there is no way a VC is going to risk getting sued as a result of funding a startup with a similar idea or business plan to yours.   Moreover, they would need to hire a lawyer to review and negotiate NDA’s – which from their perspective is a waste of time and money.

To the extent you have any “secret sauce” or proprietary technology that you’re concerned about disclosing, you should just not share it with the VC.  (I discuss NDA’s in detail in my post “Ask the Business Attorney: Non-Disclosure Agreements.”)

4) Obsessing Over Valuation.  Another common mistake startups make is focusing too much on valuation.  Obviously, the pre-money valuation (or “pre” as it is commonly referred to) of the company is an important deal term; however, inexperienced startups make the mistake of obsessing over pre – and will often a sign a term sheet with the VC firm that gives them the highest pre.

This is the wrong approach for two significant reasons: first, there are other important terms that affect the economics of a financing, including the size of the option pool and the liquidation preference; and second, a top-notch VC firm (like a Sequoia) can add extraordinary value to a venture.  Thus, even if they come in with a lower pre than another VC firm, a smaller piece of a huge pie is better than a bigger piece of a little pie.

As Alan Salzman and John Doerr note in Chapter 7 of the book, Startup and Emerging Companies: “Unfortunately, those actively involved with start-up companies encounter numerous instances in which the focus on [valuation] is somewhat out of balance and tends to prejudice the discussions with venture capitalists.”

5) Not Retaining Strong Counsel.  Finally, rookies often make the mistake of trying to negotiate VC term sheets (or some of the key investment terms) without having spent the time to fully understand them and/or retaining strong, experienced counsel.  Needless to say, term sheets are complex and a potential minefield for first-time entrepreneurs.  Moreover, the VC guys (and gals) spend their careers negotiating term sheets and know every term (including every nuance) inside out.

Accordingly, startups need to be smart (and demonstrate a certain level of credibility with the VC’s) by getting a good corporate lawyer involved early on, among other things, to coach and prepare them for their preliminary negotiations with the VC’s.  As I note in the comments to Mark Suster’s post, “Want to Know How VC’s Calculate Valuation Differently from Founders?”: a good corporate lawyer will also run spreadsheets/models to show the founders how the purchase price will be disbursed (i.e., the waterfall) in different M&A exit scenarios.

Conclusion

I hope the foregoing is helpful; and if you’re interested, Sachin Agarwal, co-founder of Posterous, wrote an excellent post regarding the “personal side” of dealing with VC’s: “If you can’t buy your investor a beer, don’t take their money.”  You should check it out.

My colleague, Susan Morgan, conducted a webinar yesterday with respect to venture capital term sheets for the “CFO University,” which is group of Chief Financial Officers convening monthly webinars via CFOwise.  As I have previously discussed, Susan recently joined our team and has strong financing experience, including 7+ years at Fenwick & West in Silicon Valley where she closed more than 30 financings.  (You can learn more about Susan’s background on her bio page.)  In conjunction with the webinar, Susan also wrote a brief post on convertible notes.  You can see the webinar and read the post below.  Many thanks, Scott

Webinar: Venture Capital Term Sheets

CFO University:  VC Term Sheet and Deal Point Discussion

Guest Speaker:  Susan Morgan of Walker Corporate Law Group, PLLC

Date:  April 14, 2010, 9:09 am (Denver Time)     

Summary:  This webinar runs for about 55 minutes and covers all of the key venture capital terms, including liquidation preferences, dividends, redemption rights, conversion rights and anti-dilution provisions.  

Link:  Please click the following link to play the webinar (you can start at the 3:30 mark): 
https://cfowise.webex.com/cfowise/ldr.php?AT=pb&SP=MC&rID=11196707&rKey=ebb4537ffb730d0b

Why I Recommend Convertible Notes for Entrepreneurs by Susan Morgan

The vast majority of startup entrepreneurs obtain their first few morsels of financing from friends and family, founder infusions and/or (with some luck) small, but sophisticated angels.   These infusions may aggregate up to $500,000 or less, and every penny is desperately needed by the entrepreneur to reach the “next stage” of development – which would then allow the entrepreneur to obtain more serious capital from more institutional investors.  At the point in time in which these initial small infusions are made, the company is often unknown, their products undeveloped and their markets unrealized.  What then is the best financing structure for these initial investments?  I would argue that it is convertible promissory notes (or “Bridge Financing”).

The alternative to a Bridge Financing – issuing the first round of preferred stock – requires (i) the valuation of the company for pricing the stock and (ii) the determination and documentation of all of the rights, preferences and privileges of the stock.  How do you price the company at this stage?  Any metric you use can easily produce a number that turns out to be “way off the mark” when the company later completes its development (or whatever progress it has made using the initial funds), and then seeks to obtain subsequent funding.  Accordingly, the founders could be substantially diluted at this early stage.

At the “second funding” stage (the so-called “Series A” round), a larger institutional angel or VC will evaluate the company’s progress and determine a valuation (and price per share) for the more substantial infusion that they are proposing to make.  The rights, preferences and privileges of the preferred stock will also be negotiated at this stage, and the Bridge Financing notes will simply convert to the preferred stock on those terms.  The advantage for the entrepreneur, of course, is that the documentation for the Bridge Financing is far simpler and therefore much cheaper than that of the preferred round.  With a Bridge Financing, the shares will thus be priced much later on when the company has more to show, yielding a potentially higher, more realistic price for the funds infused.

So, what is to induce the early stage investors to invest in the convertible notes?  Typically, they are offered “equity sweeteners” in the form of either (i) conversion at a discount (generally from 10% to 40% discount) or (ii) warrants to purchase shares in the future (preferred or common shares).  These are somewhat equivalent economically, and usually either one or the other is used. 

As my colleague Scott Edward Walker discusses in his post on types of angel financing, the disadvantage of issuing convertible notes is that the founders’ interests and the angels’ interests may not be aligned because it’s in the angels’ interest for the Series A valuation to be low.  Indeed, angels who think they can make a significant contribution to a venture (e.g., as a result of their introductions or domain expertise) want to share in the increase in value they are creating.  Accordingly, if angel investors do agree to the issuance of convertible notes, they will often push for a “cap” on the Series A valuation — which is obviously not in the founders’ interest and is heavily negotiated.

Conclusion

This post obviously covers a lot of territory, but hopefully introduces entrepreneurs to some of the key issues with respect to angel and venture capital financings.  If you have any questions, please shoot them to us via the comments section.

I am pleased to welcome officially Susan Morgan to our team.  Susan has 10+ years of sophisticated corporate law experience, including 7+ years at Fenwick & West in Silicon Valley where she closed more than 30 private financings; she is an Adjunct Professor at Golden Gate University, where she teaches a course on Business and Legal Issues in High Technology Startups; and she is a highly successful entrepreneur, having co-founded two software companies.  (You can learn more about Susan’s background on her bio page.)

For Susan’s first assignment, I asked her to review and comment on the new “Series Seed” financing documents posted by Ted Wang and the related posts by Brad Feld, Fred Wilson, Yokum Taku and Jason Mendelson.  Indeed, I concurred with Jason in the comments section of his post that “there will never be a standard set of seed documents” because of the lawyers and their own self-interest (as I discuss in my VentureHack’s post “Top Ten Reasons Why Entrepreneurs Hate Lawyers”).  Susan, however, surprised me and actually sided with Ted and Brad and their optimism.  Below are her thoughts.  Many thanks, Scott

Series Seed Documents

By Susan Morgan

Much has been written recently regarding the concept of standardizing a “lite” version of first round financing.  The compelling idea is that a small, early-stage “seed round” financing should not include all of the massive documentation, negotiation and legal expense that accompany a more substantial later financing round.  Ah, but the problem is that each law firm (and institutional investor) has its own well-used and well-loved proprietary set of form documents which they trot out as the starting point for any financing.  Because these forms are of a “one-size-fits-all” variety, they tend to include all of the complex, intricate and specialized terms that might be appropriate to negotiate in a later-stage financing, but needlessly drive up the costs and complexity of an early-stage seed round financing.

How to solve this problem?  Enter the “lite” versions.  Over the past couple of years, several attorneys and/or law firms have created a publicly-available, “stripped-down” set of form financing documents which eliminate some of the “less essential” terms for an early stage seed financing and thereby streamline the process and reduce costs.  The most recent iteration of such documents are the “Series Seed” documents post by Ted Wang, an attorney at Fenwick & West (my former law firm).  In fact, a recent post by Brad Feld lists four such sets (including Ted’s) and proposes that we “finish the job” by getting “everyone” in a room together to hammer out a single set of final terms and documents, which the entire industry can then standardize around.   A nice idea, but will it work?

Jason Mendelson (Brad Feld’s partner) thinks not.  In a recent post, Jason predicted a stunning failure of this effort to standardize.  Why?  Because Jason believes that the two constituent groups that will need to come to agreement on a standardized set of forms (i.e., lawyers and VCs) are, to some extent, inherently motivated not to do so.  Lawyers like to put their own proprietary stamp on things (including these seed financing documents), and VCs tend to trust and support the lawyers they have hired to protect their interests.  Jason fears that an all-day meeting with 50+ lawyers (who would all insist on being included) and any number of VCs and other parties will deteriorate into an “ego fight” – each participant insisting on including his or her own special tweaks into the documents.  Jason’s fears are not entirely unfounded – he has witnessed this before in drafting sessions of the National Venture Capital Association (the “NVCA”) for their model venture capital financing documents.

So, should we abandon this effort as a potential waste of time?  I don’t think so.  For one, we should consider re-defining what we mean by “success.”  If our only standard for success is perfect agreement on a single set of seed documents; well, then that is a very high standard indeed and we just may not reach that.  But why should that be our only gauge of success?  I would propose that we have already reached some measure of success!  Just look at the term sheet comparison produced by Yokum Taku.  There is far more agreement in terms among these term sheets than disagreement.  In fact, it’s not hard to take the next step and put together a composite term sheet (with some alternative terms, as the NVCA does) that encapsulates everything in this comparison.  The composite term sheet would look like this:

                                                                  Seed Financing Term Sheet

Of course, this hasn’t melded the underlying text in the documents together, but if we do no more that just get everyone (or a core subset of attorneys and VCs) to agree on this term sheet as a starting point, we have already achieved a significant milestone!  In one quick stroke, we have eliminated a considerable volume of drafting and negotiating:  anti-dilution provisions, registration rights provisions and legal opinions – gone.  This alone would save entrepreneurs a huge chunk of legal fees.  And I would propose we use that as our measure of success – i.e., how much money we save entrepreneurs. 

So, I don’t know whether an all-day drafting session can get us to full standardization (or even a little closer to that goal), but it certainly seems worthwhile to keep the conversation going.  As Ted so aptly put it in his comments to Jason’s post: “[L]et’s not give up just yet!  Let’s talk about ‘standard seed documents’ and see where that leads.  It may take years, but I’ve got a long horizon.”  Who knows, maybe an all-day drafting session will yield some random pieces of conformity that will, at least, save the entrepreneurs some amount of legal fees.  And that, by my definition, would be a success.

www.youtube.com/watch?v=lHtZY6kPq-w

Mistake #1 – The Failure to Diligence the Guys on the Other Side of the Table 

Whether the entrepreneur is doing a venture capital financing, a partnering agreement with another company or is selling his company to a private equity firm – he must investigate the guys on the other side of the table.  This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom he is dealing.  Who are these guys?  Are they good guys or are they jerks?  Can they be trusted?  When they say they are going to do something, do they do it?  Do they add value?  Remember, in certain deals (such as a venture capital transaction), the entrepreneur will be, in effect, married to these guys for a number of years.  Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs or CEO’s who have done deals 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. 

Mistake #2 – The Failure to Build a Strong Transaction Team

Every successful entrepreneur knows the importance of building a strong team, yet they often ignore this rule when putting together a transaction team.  Now is not the time for the entrepreneur to being using his buddy the divorce lawyer or the attorney who wrote his will to negotiate his financing or acquisition; nor is it the time to use his bookkeeper to handle tax and accounting issues; nor is it the time for the entrepreneur to play lawyer and start pulling forms off of the Web.  As I learned first-hand in New York, the quarterback of the transaction team should be a strong, experienced corporate lawyer – he’s the guy who is going to drive the deal, watch the entrepreneur’s back and help the entrepreneur build-out his team.     

Mistake #3 – The Failure to Run the Negotiations Through the Lawyers

The entrepreneur should do what he does best — i.e., build companies — and leave the deal negotiating to a strong corporate attorney (or an investment banker in the acquisition context).  Entrepreneurs are generally no match for sophisticated venture capitalists or private equity guys or corporate development guys who do deals for a living.  Accordingly, a smart entrepreneur will stay above the fray and let his corporate attorney run the deal – and business issues can easily be handled at an all-hands meeting (whether in-person or via conference call).  Experienced deal guys on the other side of the table may try to do an end-run around the entrepreneur’s lawyers, but the entrepreneur must remain disciplined and simply advise the guys that all negotiations are being run through his lawyers. 

Mistake #4 – The Failure to Check Their Emotions and to Remain Disciplined

Entrepreneurs (particularly those who haven’t had much deal experience) often become emotionally wedded to a particular transaction and are unable to maintain their objectivity the further along they get in the process.  Too often, an entrepreneur will fall in love with a particular deal — like the first-time home buyer — which will lead to poor decision-making and risky positions.  As I saw first-hand in New York City representing big, successful private equity firms, the best deal guys are masters at taking their emotions out of transactions and being extremely disciplined.  Indeed, they will generally walk from a deal if they get out of their comfort zone (e.g., with respect to the risk profile, price, etc.) — regardless of how much time and money they have expended.  It is critical that the entrepreneur understand this dynamic — and that’s why it is so important to develop a game plan early on — because once the emotions start playing havoc, you have to stay disciplined and stick to your plan (your dealbreakers, etc.) and be willing to walk, if necessary. 

Mistake #5 – Blinking First

There comes a point in time in just about every deal where both sides have dug into certain positions and the question becomes which side will blink first; e.g., in a venture capital financing, perhaps the issue is the liquidation preference or, in an acquisition, perhaps the issue is carve-outs to the cap on liability.  Whatever the issue, the lesson for the entrepreneur is clear (albeit difficult to execute): in order to maintain negotiating leverage and credibility, the entrepreneur should not blink first.  Indeed, if the entrepreneur has flatly stated that “this issue is a dealbreaker,” but then blinks and nevertheless agrees to go forward with the transaction despite not getting what he asked for, he will have completely undermined his credibility and will have his clock cleaned with respect to any other significant issues.  Like poker, if your bluff gets called, it will be difficult to bluff again.  Which brings us back to the important tip in #4 above: run the negotiations through an experienced corporate lawyer (or an investment banker) who does this stuff for a living.

1.  Impose Reasonable Vesting Restrictions Upon Incorporation to Address  Issues between or among the Founders.  If there are two or more founders, they should impose reasonable vesting restrictions on the stock issued to them at the time of incorporation because, in most cases, the stock has been issued not only for their services or property (e.g., technology) relating to the conception of the venture, but also for their continuing commitment and efforts.  Indeed, it would be inherently unfair for one of the founders to quit the venture after a few weeks or months, but still be permitted to keep all of his stock.  The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis; however, it may be appropriate (depending upon the founders’ respective contributions and relationship) (i) to impose a one-year “cliff” and/0r (ii) to vest a portion of the stock “up front.”  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.  

2.  Impose Reasonable Vesting Restrictions Upon Incorporation to Address Issues with the Series A Investors.  A vesting schedule will usually be required by the investors in connection with a Series A financing.  Accordingly, it would be prudent for the founders to impose a reasonable vesting schedule upon incorporation for a second reason: if a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place.  If the founders have not established a vesting schedule or a large percentage of the founders’ stock has already vested (due to either the lapse of time or the unreasonableness of the schedule), the investors will impose their own vesting schedule, which means that vesting will, in effect, force the founders to “earn” stock they think they already own.  This may be a difficult pill for the founders to swallow; however, from the investors’ perspective, this is a significant issue — i.e., they believe they are paying for the founders’ long-term commitment and “sweat” — and thus one that they will rarely give-up.  If a founder has strong leverage, the best deal he can likely negotiate with respect to a vesting schedule is the following: approximately 25% of his stock deemed vested at the closing of the Series A financing and the balance of the stock vesting on a monthly basis over the next three years. 

3.  Make an “83(b) Election”.  Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock (i.e., stock subject to forfeiture) to the grant date, rather than the vesting date.  As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock was purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale.  Absent an 83(b) election, any subsequent appreciation of the stock would be subject to ordinary income tax rates at the time of the vesting — which could create a situation where the founder has significant tax liability, but no cash to pay it.  It is therefore advisable (subject to consultation with tax counsel) for any founders receiving restricted stock to make an 83(b) election with the Internal Revenue Service (the “IRS”).  Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable).  Finally, Section 83 may also apply in situations where the founder has purchased or been granted stock that is fully-vested, but then later agrees to the imposition of vesting restrictions. 

4.  Push for Acceleration Upon a Change of Control.  As Brad Feld aptly points out: “Acceleration on change of control is often a contentious point of negotiation between founders and VCs, as the founders will want to ‘get all their stock in a transaction – hey, we earned it!’ and VCs will want to minimize the impact of the outstanding equity on their share of the purchase price.”  From the potential acquiror’s perspective, full acceleration is generally not a good thing because the founders have no incentive (i.e., “skin in the game”) going forward, and the acquiror will thus have to come out-of-pocket to re-incentive them.  Accordingly, a common solution is for the founders to push for either (i) partial acceleration upon a change of control (i.e., some percentage of vesting is accelerated, with the balance continuing to vest perhaps at an accelerated rate provided the founder remains employed by the acquiror); or (ii) as Chris Dixon suggests, full vesting upon a change of control after a transition period (e.g., after the founder remains employed by the acquiror for one year).  The investors will likely push back and will generally only agree to a partial acceleration in the event of a “double trigger” (e.g., a change of control and a termination without cause within one year).  Founders should push back on this and require full acceleration in the event of a double-trigger.  Bottom line: this issue must be resolved in the context of the negotiation of all of the significant issues and will obviously depend upon the parties’ respective bargaining power. 

5.  Discuss Partial Acceleration Upon a Termination Without Cause.  Another potential hot button is what happens if a founder is terminated without “cause” or he quits for “good reason” (e.g., his job responsibilities have been substantially diminished).  This is a tricky issue.  Obviously, from an individual  founder’s perspective, there should be full acceleration of all of his unvested shares if he is terminated without cause or he quits for good reason because he has, in effect, been denied the opportunity to “earn” his stock.  From the investors’ and the other founders’ perspective, full acceleration is a problem for two significant reasons: (i) startups need the flexibility to make personnel changes if things aren’t working out, and it is difficult to establish “cause” or negate “good reason” from a legal perspective (and startups certainly do not want to expend time and money litigating this issue); and (ii) a replacement will likely need to be hired and additional stock/options will thus need to be issued.  A compromise position, which may be amenable to all of the parties, is a partial acceleration akin to the amount of severance (e.g., six-months’ acceleration).