Setting up a tech business in the US: considerations on incorporation, equity and financing

Incorporating in the U.S.,
financing, and equity considerations
A founder / CEO perspective
Benoit Bergeret
Slacker Hill Strategies
ben.bergeret@gmail.com
FACCSF/BusinessBooster
September 12, 2012
San Francisco

(c) Benoit Bergeret 2012 1
and FACCSF – 09/2012

Purpose and Context
This presentation has been given to attendees ofthe
Business Booster training program
of the French American Chamber of Commerce in San Francisco (www.faccsf.com)

It is aimed at technology leaders from Europe (with a focus on France)
who are thinking about opening a presence in the US ,
either a new company or a subsidiary of an existing company

For more information contact the author:
Ben (Benoit) Bergeret
Slacker Hill Strategies and ben.bergeret@gmail.com
(c) Ben Bergeret 2012 2
FACCSF

Disclaimer
This document presents my personal view of the
subject matter based on my (limited) experience
and acquired knowledge. It is aimed at being
comprehensive or complete, and might even
contains errors, for which I will assume no liability
whatsoever. All information contained herein is
subject to correction / modification and does not
constitute legal or financial advice; neither does it
establish an attorney- or advisor-client
relationship with the reader.

Slacker Hill Strategies and
FACCSF

Contents
• Introduction
• Deep dive: CA incorporation 101
• Financing sources
• Startup equity considerations
– Preferred stock
– Convertible notes
– Equity split

FACCSF

FACCSF

First things first: why are we here?
• Expand a foreign presence into the US?
• Start a business from scratch?
NewCo vs. Subsidiary

• What are we in the market with / for?
– Product vs. Service
– Growth towards dividends vs. Exit?
 Corporate structure / equity, financing type, etc.

FACCSF

Whatever your plan is… (1)
• Choose form wisely
– C-Corp often preferred for foreign companies subsidiaries
• Customers here prefer to do business with a U.S., rather than overseas, entity.
• Provides legal firewall protecting mothership
• Low cost & capital requirements
– Most common option is to incorporate in Delaware and register in CA

• Budget beyond the obvious
– Average employee cost in SF Bay Area $150k-$180k p.a. (fully loaded)
– Benefits & Employee Taxes; local taxes
– Office Brokers & Equipment
– Property & Casualty Insurance
– Trademarks & Domains

FACCSF

LLC vs. C Corp vs. S Corp
• LLC = Limited Partnership
– Limited financial liability for partners (limited to their investment)
– Free-form governance (LLC Operating Agreement = how investors relate to each other, their respective financial rights and
obligations, how the LLC is governed)
– Best suited for companies that are limited in purpose or which otherwise do not wish to become full-blown corporations.
– “Check the box" under U.S. federal tax law: LLC can elect to be treated as a partnership or a corporation for U.S. federal tax
purposes.
– Typically receives "pass through" tax treatment (income is only taxed when distributed to the partners vs. "double taxation" for
corporations)

• C Corp = true corporation
– Incorporated under the laws of one of the states (i.e. Delaware)
– Subject to the rules of corporate governance determined by the statute under which it is organized: meetings of the board of
directors, annual filings, board/officers structure
– The rights and obligations of the shareholders, directors and officers are typically defined by statute and court precedent and are
harder to vary by contract (it is still done, by means of Shareholders' Agreements, but generally less freedom is available than is
the case with an LLC).
– Subject to "double taxation”: income earned by the corp is taxed twice: when earned by the corp and then at the shareholder
level, if/when distributed as income
– Best choice for tech startup or US sub of foreign company

• S Corp = C corp without double taxation
– But major restriction = 100 shareholders maximum, must be natural persons
(not corporate entities) who are U.S. citizens or residents.
– Inadapted to sub of foreign entity
– Poorly suited for tech startup

FACCSF

Whatever your plan is… (2)
• Understand CA employment law
– Employees benefit from high protection
– Hire at will does not mean absence of obligations and liabilities
– Harassment (incl. futile) and discrimination (gender, age, family obligations, health, etc.)
– Contractor (1099) vs. employee (w-2)

• Be aware of local tax obligations and amounts
– SF payroll tax (1.5%)
– County / state taxes (Franchise tax: 8.84%)
– Property taxes
– And more… Check this: the ‘Amazon Tax’ http://sanfrancisco.cbslocal.com/2012/09/11/bay-
area-congresswoman-online-sales-tax-for-all-50-states/

• Contract mandatory insurance policies
– Business liability
– Workers’ compensation insurance
– Key men insurance as needed

FACCSF

Ready to incorporate?

FACCSF

Incorporating a NewCo
• OK to go with LLC (even sole proprietorship w/dba
initially) BUT
• Incorporate as soon as you are not alone anymore
• Most important decision is equity split
– Impacts ability to manage, grow, sell company
– Should reflect leadership structure through hard assets
contributions
– Sets the stage for future funding / exit discussions
– See last slide
• Next = I.P. assignment & tangible assets transfers
• While at the same time securing early stage financing

FACCSF

Opening a US subsidiary
Example 1:
Foreign company, has US sub, major US clients & multi-million USD
revenues but no employees
Example 2:
Foreign company does business in the US without a US subsidiary
(business trips, local suppliers contracts with mothership, invoicing from
abroad)

 Why open a US sub?
– Local market proximity – if your customers are real people based here
– Marketing value of US presence – key in some tech markets
– Local staff

• Incorporate in time for first payroll employee or any contract that cannot
be entered by mothership

FACCSF

Financing sources

FACCSF

FACCSF

Available funding sources
for a startup
• The usual suspects:
– Friends and family (cash loans)
– Business angels (stock or convertible notes)
– Venture capital (preferred stock)

• The little-known gems:
– Crowd-funding (i.e. Kickstarter)
– Local (US) public funding (SBIR grants)
– Asset-backed loans (venture loans) (less often
applicable but worth a look)
FACCSF

Kickstarter? Seriously?
10 most successful fundraisers to date (09/2012)
Project Seeked Raised
Pebble e-paper watch $100k >$10m Device
Ouya video game console $875k $8.6m Device / gaming
Double Fine advanture game $400k $3.3m Gaming
Wasteland 2 game $900k $2.9m Gaming
Shadowrun Returns $400k $1.8m Gaming
Elevation Dock $75k $1.45m Device
The Order of the Stick (comic) $57.75k $1.255 Book
Amanda Palmer & The Grand Theft $100k $1.2m Record
Orchestra album
Sedation Wars: Battle for Alabaster $20k $950k Gaming
TikTok+LunaTik Multi-Touch Watch Kits $15k $940k Device

FACCSF

Available funding sources
for a Subsidiary
• Good ideas:
– Funding by holding company
• Independence + flexibility
• Requires appropriate cash flow or mothership financing
– Dedicated “international expansion” VC round
– COFACE export insurance
– Local venture
• Co-investment with partner (product / sales / etc.)
• Control? Exit? Proceeds?
• More often than not: problematic / conflictual down the road
– Distribution agreements
• Manages local distribution / partnerships
• Lightweight (could have no US employees)
– Grants & loans
• Coface insurance
• Small Business Innovation Research (SBIR) grants
– For R&D-heavy organizations
– Restrictions apply; plan sub structure accordingly
• Local bank loans: if you can get them… take them!

• Bad ideas (most of the time):
– VC investment in sub (they simply won’t do it)
– Asset-backed venture loans
(too hard to enforce on foreign assets)

FACCSF

Drill-down: VC financing terms

FACCSF

Stock / capital funding considerations
for a startup (1)
• Angels vs. VCs
– Different objectives / expectations / roles
• Short vs. long term investment
• Returns expectations lower vs. higher
• Bridge money vs. growth advisor
– Different culture
• Hands off vs. ‘domain experts’
• Opportunity vs. trend
• Most commonly used tools (see dedicated sections)
– Fully-priced preferred stock
– Convertible notes

FACCSF

“We're in a bubble, right ? Who knows how
much this funding bonanza will last, how long
before the hapless VC's run like lemmings in the
other direction to lick their wounds,
demonstrating once again their fundamental lack
of appetite for risk. Better take as much as you
can on the balance sheet right now, for who
knows what will happen when the Wall gets
breached ?”
– Fred Destin
(http://freddestin.com/2012/09/penis-envy-why-you-too-should-raise-a-massive-series-a.html)

FACCSF

Stock / capital funding considerations
for a startup (2)
• Raise as little as possible in the early stages
– To preserve % equity later
– Pre-money value is key
– Create value at each step
– Stand your ground in negotiations
• Carefully watch size of option pool
– A required tool for hiring talent in the Bay Area
– Contributes to founders dilution if not carefully
managed
– Plan early to grow it at later stages (don’t over
allocate)

FACCSF

Why preferred stock for investors?
• The good: protection of their investment
• The bad: risk of (bad) investors securing abusive rights
• Founders need to hold their ground
• While at the same time remembering this is a team
adventure

FACCSF

Typical preferred stock terms
for early stage investment
• Most common:
– Board seats / voting rights
• A good way to secure founder’s prerogatives if negotiating power (i.e. Zuck @Facebook)
• Caution with board size: too many members can be hard to manage
– Protective provisions
– Liquidation preference
• Non-participating vs. full participating vs. capped participation
• 1x most common these days (3x typical of pre-2008 now mostly gone)
• NOT IMMUABLE
– Conversion rate (usually 1) & mandatory conversion
– Anti-dilution
– Pay-to-play (or bust = lose anti-dilution rights)
– Tag along
– Drag along

• Less common (these days)
– Ratchet
– Dividends
– Redemption rights

FACCSF

What about Convertible Notes?

FACCSF

Convertible Notes
demystified (1)
• Highly popular in early stage rounds
– Debt instrument, to be reimbursed at next financing round
– Typical terms include caps, discounts, warrants, ratchets
• Caps provide dilution protection to the investor
(founder’s interest = highest cap or no cap)
• Discounts provide investor bonus for investing early
(founder’s interest = lowest discount or no discount)
• (note: cap and discount are mutually exclusive. Only the most beneficial is used at
funding series time)
• Warrants (in lieu of a discount)
• Ratchets transfer equity to the investor in case the note can’t be repaid

• US vs. Europe
– In continental Europe, the convertible note is looked at as debt with additional
obligations
investor has leverage to reclaim the money if no provision was made
– In the US it’s the terms that matter by themselves. If they do not contain
provisions in case the funding event
does not take place, and if there is no alternative clause  investor might lose
it all
FACCSF

Convertible Notes
demystified (2)
• Pros
– Simple and inexpensive to implement
– Defers valuation decision
– Well adapted to ‘bridge’ financing (typically <$1m)
– Unsecured (no IP or other assets attached)
– Passive investor

• Cons
– Implications of cap, discount, warrants at next round can be lost to founders
– The lower the pre-money at Series A, the more equity the angel investor gets
– Beware of ratchets, damages obligations (rare but seen) clauses
– If no round happens, note is only valued at its interest rate (not what angels
want)
– ”Notes are a promise/obligation for the future and things can change between
now and then and investors have far fewer guarantees. Priced rounds give
investors stock under certain terms.” – Daniel Levine, Accel
– Passive investor
FACCSF

Equity split between startup founders

FACCSF


CONTROVERSY

FACCSF

• Forget equal split
– Equal split means trouble down the line
– Cash is king. Early cash mandates higher equity (as is any other
form of tangible contribution i.e. I.P.)
– If all bring same cash, remember that decisions will have to be
made, not necessarily consensual: identify the leader
– If already started on equal split basis, use stock options grant to
clearly identify leadership

• Protection among founders
– Vesting: nobody wants a co-founder to walk away with 30%
after 6 months of not doing much
– Solid shareholder’s agreement among founders:
tag-along, anti-dilution, etc.
FACCSF

FACCSF

Advisory services to early-stage tech startups

• Founder & CEO mentoring / coaching
• Corporate development, financing, equity structuring, go-
to-market strategy, US implantation

ben.bergeret@gmail.com
(415) 370-5603

FACCSF

Setting up a tech business in the US: considerations on incorporation, equity and financing

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Setting up a tech business in the US: considerations on incorporation, equity and financing