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What trademark and other legal issues are involved in selecting a company name?

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[The following post is courtesy of John Slafsky and Aaron Hendelman in WSGR’s Trademarks and Advertising Practices Group.]

Among the most important tasks in the founding of a new company are the development and clearance of a company name.  There are two very different sets of legal issues, and a host of business issues, involved in the process.

Legal Issues

One set of legal issues concerns availability of the name under state law relating to entity names.  In the case of corporations or limited partnerships, this involves checking with the Secretary of State of the states where they are formed and where they must “qualify” to do business (usually where they have offices or resident employees or a sales force).

The Secretary of State checks the state records to ensure that there is no other corporation or limited partnership with an identical or closely similar name; if one is found, the new name is generally not permitted.  This happens even if the two companies are in vastly different lines of commerce; the sheer similarity of the name bars the second name.  (On some occasions, consent of the earlier company or a relatively minor alteration of the name, such as “ULTIGRA, INC.” to “ULTIGRA SOFTWARE, INC.,” may increase the chances that the state will allow the new name.)

The second set of legal issues concerns trademark law.  The Secretary of State’s approval of a business name does not grant trademark rights or authorize a company to use a particular business name in commercial activities.  (Nor does registration of a corresponding domain name result in any significant legal rights.)  A company may have incorporated under a name but find itself liable for trademark infringement or dilution — with potential risks of an injunction, disgorgement of profits, payment of damages, and more — for use of the name.

Trademark infringement occurs when a person or company uses a name or mark in a way that causes a likelihood of confusion with another person or company with respect to source, sponsorship, or affiliation of products, services, or commercial activities.  Thus, “McCoffee” may infringe upon the marks of McDonald’s Corporation by leading the public to believe that “McCoffee” is a product or an affiliated company of McDonald’s.  A company also may be liable for trademark dilution by using the famous mark of another company even if there is no competitive overlap or likelihood of confusion. For example, the name “Pentium Petroleum Corporation” may well dilute the PENTIUM trademark of Intel Corporation.  It therefore is important to assess the potential trademark law risks of a name before adopting it as a company name.

The fact that a company still has a low public profile, or does not yet have products on the market and does not yet have a website, does not immunize it from challenges.  Some companies have been sued for allegedly causing confusion through their financing activities or for use of a pre-release code name for a new product.

Some companies, in a rush to form a company, devise names in a hurry and do not clear them for trademark purposes.  Often, they consider the name a “place holder” until a later time when they can invest the money and effort to attend to a new name.  This creates a number of risks.  First, there is the risk of liability.  Second, management may “fall in love” with the placeholder name and become unwilling to give it up later.  Third, the company may develop goodwill under the placeholder name that will be lost upon a name change.  Fourth, the company may incur significant legal and administrative costs when it later undergoes a name change.

Our Assessment

Legal assessment of a business name involves several steps.

We check the availability of the name with the Secretary of State for the relevant states; if the name is available with the Secretary of State, we reserve it pending an in-depth search.  The Secretary of State availability check and reservation require only nominal fees.

We also perform searches of trademark databases in-house using on-line services or other research materials.  The purpose of the searches is to determine whether a name is so likely to be unavailable that a more comprehensive search would be wasteful.  A preliminary screening search is not sufficient diligence to assess the real issues in adoption of the name.

After the screening search, we obtain an in-depth trademark search from an outside search company.  It examines federal and state trademark registers and a large number of sources of unofficial information about company and product names in relevant fields.  We obtain an extra copy of the search report for our client and expect it to review the report carefully for potential conflicts; we then discuss our assessment with the client. 

Once a company is comfortable with the level of risk of its chosen name, it is important to find ways to protect the name.  If the name will be used on products, or in connection with the advertising or promotion of services, it often is a good idea to file an application for federal registration of the name based on the company’s intent to use the mark.  This will help establish rights to the name; more importantly, it gives early notice to others who might otherwise overlook the company’s name when they do searches to develop their own names.

For further information, please contact John Slafsky or Aaron Hendelman in WSGR’s Trademarks and Advertising Practices Group. 

What’s the difference between an ISO and an NSO?

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[The following is not intended to be comprehensive answer. Please consult your own tax advisors and don’t expect me to answer specific questions in the comments.]

Incentive stock options (“ISOs”) can only be granted to employees.  Non-qualified stock options (“NSOs”) can be granted to anyone, including employees, consultants and directors. 

No regular federal income tax is recognized upon exercise of an ISO, while ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NSO exercises by employees are subject to tax withholding. However, alternative minimum tax may apply to the exercise of an ISO.

If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss. An earlier sale or other disposition (a “disqualifying disposition”) will disqualify the ISO and cause it to be treated as an NSO, which will result in ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price.

A company may generally take a deduction for the compensation deemed paid upon exercise of an NSO.  Similarly, to the extent that the employee realizes ordinary income in connection with a disqualifying disposition of shares received upon exercise of an ISO, the company may take a corresponding deduction for compensation deemed paid. If an optionee holds an ISO for the full statutory holding period, the company will not then be entitled to any tax deduction.

Below is a table summarizing the principal differences between an ISO and an NSO.

  ISO NSO
 Tax Qualification Requirements: * The option price must at least equal the fair market value of the stock at the time of grant.

* The option cannot be transferable, except at death.

* There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a NSO).

* All options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier.

* The options must be exercised within 10 years of grant.

* The options must be exercised within three months of termination of employment (extended to one year for disability, with no time limit in the case of death).

 None, but an NSO granted with an option price less than the fair market value of the stock at the time of grant will be subject to taxation on vesting and penalty taxes under Section 409A.
Who Can Receive: Employees only Anyone
How Taxed for Employee: * There is no taxable income to the employee at the time of grant or timely exercise.

* However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax.

* Gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise).

* Disqualifying disposition destroys favorable tax treatment.

 * The difference between the value of the stock at exercise and the exercise price is ordinary income.

* The income recognized on exercise is subject to income tax withholding and to employment taxes.

* When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

What is qualified small business stock?

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Under Internal Revenue Code Section 1202 , a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of “qualified small business stock” held for more than five years may exclude 50% of such gain from gross income for regular income tax purposes.  The amount of gain that may be taken into account for purposes of the exclusion is subject to a limitation equal to the greater of: (i) $10,000,000 (less previ­ously excluded gain attributable to the disposition of other shares issued by the company), or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.

Under IRC Section 1045, an individual may roll over proceeds from the sale of a qualified small business stock held for at least six months, when the proceeds are used to purchase qualified small business stock in another company. This effectively defers the tax due on any gain on the stock.

However, the maximum tax on long-term capital gains is 15% for most taxpayers and a 28% rate applies to gain on qualified small business stock.  The effective tax rate after the 50% exclusion is 14%.  Therefore, there is no substantial benefit to qualified small business stock unless the gain is rolled over into other qualified small business stock.

Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. 

Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify.

In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.

Please note that certain redemptions, including (i) redemptions of stock from the holder of qualified small business stock (or a related person) and (ii) certain significant redemptions occurring within one year before or after a stock issuance may disqualify any newly issued stock.

[Note: please go ask your own tax advisors any questions about qualified small business stock because I will not answer technical questions in the comments.]

What is an 83(b) election?

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Failing to make a timely 83(b) election with the IRS is something that could lead to disastrous tax consequences for a startup company founder or employee.

Founders typically purchase stock pursuant to restricted stock purchase agreements that allow the company to repurchase “unvested” stock upon termination of employment. Similarly, employees may “early” exercise options subject to the company’s ability to repurchase “unvested” shares upon termination of employment.

Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize income (the difference between fair market value and the price paid) until the stock vests. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock.

Typically, the purchase price for the stock and the fair market value are the same. Therefore, if an 83(b) election is made, there is no income recognized. Thus, a founder/employee should almost always make an 83(b) election. The benefits of an 83(b) election generally are starting the one year capital gain holding period and freezing ordinary income (or alternative minimum tax) recognition to the purchase date.

If the founder/employee does not make the 83(b) election, then he or she may have income at the stock “vests.” The income will be substantial if the value of the shares increases substantially over time.

For example, assume that a founder purchases stock for $0.01 per share (fair market value is $0.01) and the stock is subject to four year vesting with a one year cliff. The founder does not make an 83(b) election. At the end of the one year cliff, if the stock is worth $1.00/share, then the founder would recognize $0.99/share of income. As the remaining stock vests each month, the founder would recognize income equal to the difference between the fair market value and $0.01/share. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

If the founder had made an 83(b) election, the founder would not recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date.

In order for an 83(b) election to be effective, the individual must file the election with the IRS prior to the date of the stock purchase or within 30 days after the purchase date. There are no exceptions to this timely filing rule. The last possible day for filing is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. For example, if the stock is purchased on May 16, the last possible day for filing is June 15. The official postmark date of mailing is deemed to be the date of filing. The election should be filed by mailing a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his or her tax returns. If the election is mailed after the 27th day, the individual should hand deliver the letter to the post office to obtain an official date-stamp on the certified mail receipt. A copy of the election should be provided to the company, and another copy should be attached to taxpayer’s federal income tax return for the year in which the property is acquired.

What inspection and information rights does a stockholder have?

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Most states allow stockholders to demand access to a corporation’s books and records, and a stockholder list, as long as the stockholder has a proper purpose and meets certain procedural requirements.

Delaware General Corporation Law Section 220(b) provides that “Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from … [t]he corporation’s stock ledger, a list of its stockholders, and its other books and records …”

A stockholder that wants to exercise inspection rights should probably engage an experienced attorney because a corporation can reject the request for failure to comply with procedural requirements.

If the corporation refuses to permit an inspection or does not reply to the demand within 5 business days, the stockholder may apply to the Delaware Court of Chancery for an order to compel such inspection.

One requirement for exercising inspection rights is a proper purpose for the demand.  Section 220(b) provides that “[a] proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder.”

Delaware courts have held that the following purposes, among others, are proper:  gather information prior to filing a stockholder derivative suit, communication with other stockholders regarding a solicitation of proxies, communication with other stockholders regarding a stockholder class action against the corporation, communication with other stockholders for the purpose of influencing management to change its policies, communication with other stockholders to encourage them to dissent from merger and seek appraisal, valuation of one’s stockholdings, and investigation of suspected mismanagement where some credible basis for the stockholder’s suspicions is shown to exist.

Courts have rejected inspections for purposes such as:  gaining information to facilitate a tender offer when the stockholder has already been enjoined from pursuing a tender offer, valuing the company as a whole in order to determine whether to increase one’s bid in a tender offer, gathering information for use in a stockholder’s individual employment-related claims against the corporation, obtaining information to use to exert economic pressure upon a third party in connection with a labor union’s strike, or satisfying idle curiosity.

If a stockholder seeks to inspect only the corporation’s stock ledger or list of stockholders, the burden of proof is on the corporation to establish that the inspection if for an improper purpose.  If the stockholder seeks to inspect the corporation’s books and records, other than its stock ledger or list of stockholders, then the burden of proof is on the stockholder to show a proper purpose.

A stockholder will be entitled to inspect documents that are essential and sufficient to the accomplishment of the proper purpose.  The Court of Chancery may “prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper.” A stockholder may be required to execute a confidentiality agreement in order to exercise inspection rights.

Given that disgruntled stockholders can create problems by exercising inspection rights, companies should be careful about their stockholder base.

How do you calculate Delaware franchise taxes?

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A corporation’s Delaware Annual Franchise Tax Report is prepared by Delaware calculating the corporation’s annual tax obligation using the “authorized shares” method, reflecting a very large annual franchise tax obligation for most corporations.   However, use of the optional “assumed par value capital” method of tax calculation will typically result in a lower tax obligation than the amount shown in the “amount due” box online for the tax bill.  A corporation has the option of using whichever method of tax calculation results in the lower tax.  Explanation of the Delaware tax calculation methods are posted on the Delaware Division of Corporations’ web site as set forth below.

HOW TO CALCULATE FRANCHISE TAXES

All corporations formed in the State of Delaware are required to file an Annual Report and to pay a franchise tax. The Annual Report filing fee for all domestic corporations is $25.00. Taxes and Annual Reports are to be received no later than March 1st of each year. The minimum tax is $35.00 with a maximum tax of $165,000.00. Taxpayers owing $5,000.00 or more make estimated payments with 40% due June 1st, 20% due by September 1st, 20% due by December 1st, and the remainder due March 1st.

The Annual Franchise Tax is calculated based on the authorized shares method. Use the method that results in the lesser tax. The total tax will never be less than $35.00 or more than $165,000.00.

Authorized Shares Method

For corporations having no par value stock the authorized shares method will always result in the lesser tax.

  • 3,000 shares or less (minimum tax) $35.00
  • 3,001 – 5,000 shares – $62.50
  • 5,001 – 10,000 shares – $112.50
  • each additional 10,000 shares or portion thereof add $62.50
  • maximum yearly tax is $165,000.00

For Example

A corporation with 10,005 shares authorized pays $175.00 ($112.50 plus $62.50)
A corporation with 100,000 shares authorized pays $675.00 ($112.50 plus $562.50[$62.50 x 9])

Assumed Par Value Capital Method

To use this method, you must give figures for all issued shares (including treasury shares) and total gross assets in the spaces provided in your Annual Franchise Tax Report. Total Gross Assets shall be those “total assets” reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company’s fiscal year ending the calendar year of the report. The tax rate under this method is $250.00 per million or portion of a million. If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $250.00.

The example cited below is for a corporation having 1,000,000 shares of stock with a par value of $1.00 and 250,000 shares of stock with a par value of $5.00 , gross assets of $1,000,000.00 and issued shares totaling 485,000.

  1. Divide your total gross assets by your total issued shares carrying to 6 decimal places. The result is your “assumed par”.Example: $1,000,000 assets, 485,000 issued shares = $2.061856 assumed par.
  2. Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par.Example: $2.061856 assumed par s 1,000,000 shares = $2,061,856.
  3. Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value.Example: 250,000 shares s $5.00 par value = $1,250,000
  4. Add the results of #2 and #3 above. The result is your assumed par value capital.Example: $2,061,856 plus 1,250,000 = $3,311 956 assumed par value capital.
  5. Figure your tax by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $250.00.Example: 4 x $250.00 = $1,000.00

NOTE: If an amendment changing your stock or par value was filed with the Division of Corporations during the year, issued shares and total gross assets within 30 days of the amendment must be given for each portion of the year during which each distinct authorized amount of capital stock or par value was in effect. The tax is then prorated for each portion of the year dividing the number of days the stock/par value was in effect by 365 days (366 leap year), then multiplying this result by the tax calculated for that portion of the year. The total tax for the year is the sum of all the prorated taxes for each portion of the year.

You may also use our Franchise Tax Calculator for estimating your taxes.

How many shares should be authorized in the certificate of incorporation?

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I usually advise companies to authorize around 10 to 15 million shares of common stock. Around 8 or 9 million shares are issued to founders with a 1 million to 2 million share option pool, for a fully-diluted base of around 10 million shares. The remaining authorized but unissued shares are a reserve in the event more shares need to be issued.

From a purely mathematical perspective, it doesn’t matter whether there are 1 million or 10 million fully-diluted shares. However, when companies are granting options to new employees, even the smartest engineers feel better receiving options to purchase 100,000 shares as opposed to 10,000 shares, even if it represents the same percentage ownership of the company.

Assuming a $15/share IPO price and dilution due to financings, 20 million shares outstanding will result in a $300M market cap, which is about the minimum size necessary to complete a successful IPO. This avoids having to do a reverse or forward stock split at the time of an IPO.

What is Section 409A?

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Background

On April 10, 2007, the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. Section 409A was added to the Internal Revenue Code in October 2004 by the American Jobs Creation Act.

Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California imposes an additional 20 percent state tax, interest, and penalties.)

Implications for discount stock options

Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.

Please also see the post on “How do you set the exercise price of stock options to avoid Section 409A issues?“

Additional information

Below are links to all of WSGR’s client alerts on 409A.

You can assess the applicability of Section 409A by reviewing WSGR’s client alerts covering various aspects of Section 409A and the final Section 409A regulations in detail, including:

Highlights of the Final Section 409A Regulations (published April 16, 2007)

Stock Rights Under Final Section 409A Regulations (April 19, 2007)

Separation Pay Arrangements under the Final Section 409A Regulations (April 27, 2007)

A Road Map for Traditional Nonqualified Deferred Compensation Plans under the Final Section 409A Regulations (May 17, 2007)

Action Items for Compliance with Section 409A Final Regulations (June 12, 2007)

IRS Provides Transition Relief until December 31, 2008, for Section 409A Compliance (October 24, 2007)

Compliance Required with Section 409A before December 31, 2008 (June 12, 2008)

What does the legal opinion cover?

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Company counsel typically delivers a legal opinion to the investors at the closing of a venture financing. The legal opinion in a venture financing generally covers the following:

  • Due incorporation, valid existence, good standing, corporate power to carry on its business, and qualification to do business as a foreign corporation;
  • Corporate power to execute, deliver and perform the transaction documents and issue and sell the shares;
  • Capitalization of the company;
  • Shares issued in the financing are validly issued;
  • All corporate action has been taken;
  • The transaction documents have been duly executed and are enforceable against the company;
  • The transaction documents and issuance of shares do not conflict with the company’s charter documents, material contracts and laws applicable to the company;
  • No governmental approvals are necessary;
  • Exemption from the registration requirements under Federal securities laws; and
  • Absence of litigation

Receiving a legal opinion comprises part of an investors’ due diligence, but is not a substitute for it. Delivering a legal opinion requires a certain level of work by company counsel, which increases legal fees. Although legal opinions are typically offered and delivered in financings involving a venture capital fund, they might not be volunteered or requested in a financing involving angel investors, or a typical bridge financing.

Most arguments among attorneys about legal opinions generally relate to the scope of the legal opinion and seem to revolve around what is customary and the amount of time required to deliver the opinion.

The American Bar Association has a collection of articles for attorneys regarding legal opinions. The Business Law Section of the State Bar of California has also published various Opinion Reports.

What is Series FF stock?

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[Note:  this post will likely get updated in the near future.] 

I’ve been asked by a few people about the Series FF stock that has been advocated by the Founders Fund. Matt Marshall of Venture Beat reported on this invention in December 2006. See here for an Inc.com report in March 2007. Michael Martin blogs about economic incentives associated with the Series FF and founders receiving some liquidity in connection with a venture financing. Series FF stock has also recently received some attention due to the announcement of the Founders Fund raising a $220 million fund in December 2007. See additional coverage from Venture Beat, TechCrunch and the Mercury News.

I’ve reviewed the Certificate of Incorporation of a couple of WSGR clients that have implemented Series FF stock. (Please note that anyone can obtain the Certificate of Incorporation of a Delaware company from the Secretary of State of Delaware.)

The Series FF is an interesting mechanism for founders to obtain liquidity in connection with a venture financing. Below are the main features of the Series FF stock:

  • The Series FF is basically identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer of the Series FF purchases it in connection with the equity financing.
  • The conversion into preferred stock can only occur if the buyer of the Series FF pays the same price per share as the shares of preferred stock sold in the equity financing.
  • The conversion into preferred stock can only occur if the board approves the conversion.
  • The Series FF is convertible into common stock at any time at the option of the holder.
  • The Series FF automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of Series FF.

By the way, the Series FF preferred stock doesn’t need to be called Series FF.  It can be called Series A, Series Q, Series Z, Series X, etc.  The Founders Fund has managed to do some branding by referring to it as Series FF.

Below are some things to keep in mind about Series FF stock:

  • Pricing of the stock is complicated. Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the Series FF is not issued at initial incorporation, then issuing the Series FF stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares. As I will describe in a later post, founders stock is typically issued at a very nominal price per share, such as $0.001, so that the company may initially issue 10,000,000 shares for $1000.
  • If the Series FF is issued immediately prior to the Series A financing, then the price per share of the Series FF probably should be at least the same as the Series A. In some respects, the Series FF may be more valuable than the Series A in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because the board might not allow a conversion to occur (or investors may not be willing to purchase).
  • Legal fees incurred in issuing Series FF may be higher. This is because the Series FF receives some amount of custom drafting and tweaking compared to a typical incorporation. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting everyone comfortable. The additional costs involved in setting up the Series FF may be wasted if the future board does not allow the founders to obtain liquidity.
  • It is unclear whether venture funds are willing to allow founders to sell a portion of their stock in connection with a venture financing. Implementing the Series FF before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be a good thing to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in the following situations:
    • The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
    • The company is doing well (i.e. valuations above $100M and nearing an IPO) and the founders would rather sell the company that wait longer for liquidity.
  • Investors prefer to purchase newly issued shares supported by a legal opinion, representations and warranties and various contractual rights. I’m not sure what benefit the company receives by facilitating the sale by the founders as the company does not receive the funds from the investors.
  • Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies can repurchase founders common stock for cash, subject to various limitations. The main issue that the Series FF solves is the price difference between preferred stock and common stock. If common stock is repurchased by the company at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes probably should be the preferred stock price. However, in a company nearing an IPO, the common stock FMV will likely be very close to the preferred stock price anyway. Therefore the Series FF stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early stage venture financing. (I’ll write a future post about option pricing and 409A in the near future.)
  • Because the Series FF will likely only be issued to founders due to timing and pricing issues associated with issuing the Series FF, other employees may be upset that founders are receiving some liquidity.
  • There is some risk of claims against the founders that sell (and the board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.
  • Despite carefully drafted releases, venture funds may reluctant to purchase the shares due to potential claims by disgruntled founders that they were forced to sell their stake at a low price compared to the price in an eventual liquidity event.

I am curious to see whether the Founders Fund has managed to invent something that will be broadly accepted or just a novel feature that is occasionally used by companies that have a connection to the Founders Fund.

I will likely update this post (without warning) with more thoughts as I hear feedback from various people.