Term Sheets: Important Negotiating Issues

It is customary to begin the negotiation of a venture investment with the circulation of a document known as a term sheet, a summary of the terms the proposer (the issuer, the investor, or an intermediary) is prepared to accept. The term sheet is analogous to a letter of intent, a nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. The advantage of the abbreviated term sheet format is, first, that it expedites the process. Experienced counsel immediately know generally what is meant when the term sheet specifies “one demand registration at the issuer‘s expense, unlimited piggybacks at the issuer‘s expense, weighted average antidilution,” it saves time not to have to spell out the long-form edition of those references.

Important Negotiating Issues

Entrepreneurs who are in the process of effecting a venture capital financing for their start-up or emerging companies will negotiate with one or more venture capital firms on a number of fundamental and important issues. These issues are generally initially set forth in a “Term Sheet” which will serve as the basic framework for the investment. It is important that the company anticipate these issues and that the Term Sheet reflect the parties’ understanding with respect to them.

The following are some of the more important issues that arise:

  • The Valuation of the Company. While valuation is often viewed as the most important issue by the company, it needs to be considered in light of other issues, including vesting of founder shares, follow-on investment capabilities by the venture investors, and terms of the security issued to the investors. Significant financial and legal due diligence will occur and entrepreneurs should ensure that their companies’ financial projections are reasonable and that important assumptions are explained. Venture investors will consider stock options and stock needed to be issued to future employees in determining a value per share. This is often referred to as determining valuation on a “fully diluted” basis.
  • The Amount and Timing of the Investment. Venture investors in early stage companies often wish to stage their investment, with an obligation to make installment contributions only if certain pre-designated milestones are met.
  • The Form of the Investment by the Venture Investors. Venture investors often prefer to invest in convertible preferred stock, giving them a preference over common shareholders in dividends and upon liquidation of the company, but with the upside potential of being able to convert into the common stock of the company. There are strong tax considerations in favor of employee-shareholders for use of convertible preferred stock, allowing the employees to obtain options in the company at a much reduced price to that paid by the venture investors (a pricing of employee stock options at 1/10th of the price for preferred stock is common among Silicon Valley companies). Often times, venture investors will seek to establish interim opportunities to realize a return on this investment such as by incorporating a current dividend yield or redemption feature in the security. [Redemption rights allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemptionrights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.]
  • The Number of Directors the Venture Investors Can Elect. The venture investors will often want the right to appoint a designated number of directors to the company’s Board. This will be important to the venture investors for at least two reasons: (1) they will be better able to monitor their investment and have a say in running of the business and (2) this will be helpful for characterization of venture capital fund investors as “venture capital operating companies” for purposes of the ERISA plan asset regulations. Companies often resist giving venture investors control of, or a blocking position on, a company’s Board. A frequent compromise is to allow outside directors, acceptable to the company and venture investors, to hold the balance of power. Occasionally, Board visitation rights in lieu of a Board seat is granted.
  • Vesting of the Founders’ Stock. Venture investors will often insist that all or a portion of the stock owned or to be owned by the founders and key employees vest (i.e., become “earned”) only in stages after continued employment with the company. The amount deemed already vested and the period over which the remaining shares will vest is often one of the most sensitive and difficult negotiating issues. Vesting of founder stock is less of an issue in later stage companies. Another issue with the founders can arise if the VC insist that the founders lock-up the issuer‘s representatives and warranties. Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. [Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders.
  • Additional Management Members. The investors will occasionally insist that additional or substitute management employees be hired following their investment. A crucial issue in this regard will be the extent to which the stock or options issued to the additional management will dilute the holdings of the founders and the investors.
  • The Protection of Conversion Rights of the Investors from Future Company Stock Issuances. The venture investors will insist on at least a weighted average anti-dilution protection, such that if the company were to issue stock in the future based on a valuation of the company less than the valuation represented by their investment, the venture investors’ conversion price would be lowered. The company will want to avoid the more severe “ratchet” anti-dilution clause and to specifically exempt from the anti-dilution protection shares or options that are issued to officers and key employees. It is also sometimes desirable from the company’s perspective to modify the anti-dilution protection by providing that only those investors who invest in a subsequent dilutive round of financing can take advantage of an adjustment downward of their conversion price, a so-called “pay to play” provision. If the formula states that if the number of shares in the formula is “broadest” based, this helps the common shareholder. [If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.]
  • Pre-emptive Rights of the Investors to Purchase any Future Stock Issuances on a Priority Basis. The company will want this pre-emptive right to terminate on a public offering and will want the right to exclude employee stock issuances and issuances in connection with acquisitions, employee stock issues, and securities issuances to lenders and equipment lessors.
  • Employment Agreements With Key Founders. Management should anticipate that venture investors will typically not want employment agreements. If they are negotiated, the key issues often are: (1) compensation and benefits; (2) duties of the employee and under what circumstances those duties can be changed; (3) the circumstances under which the employee can be fired; (4) severance payments on termination; (5) the rights of the company to repurchase stock of the terminated employee and at what price; (6) term of employment; and (7) restrictions on post-employment activities and competition.
  • The Proprietary Rights of the Company. If the company has a key product, the investors will want some comfort as to the ownership by the company of the proprietary rights to the product and the company’s ability to protect those rights. Furthermore, the investors will want some comfort that any employees who have left other companies are not bringing confidential or proprietary information of their former employer to the new company. If the product of the company was invented by a particular individual, appropriate assignments to the company will often be required. Investors may require that all employees sign a standard form Confidentiality and Inventions Assignment Agreement.
  • Founders Non-Competes. The investors want to make sure the founders and key employees sign non-competes.
  • Exit Strategy for the Investors. The venture investors will be interested in how they will be able to realize on the value of their investment. In this regard, they will insist on registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions. The company will need to consider and negotiate these rights to assure that they will not adversely affect any future rounds of financing.
  • Lock-Up Rights. Increasingly, venture investors are insisting on a lock-up period at the term sheet stage where the investors have a period of time (usually 30-60 days) where they have the exclusive right, but not the obligation, to make the investment. The lock-up period allows the investors to complete due diligence without fear that other investors will pre-empt their opportunity to invest in the company. The company will be naturally reluctant to agree to such an exclusivity period, as it will hamper its ability to get needed financing if the parties cannot reach agreement on a definitive deal.

Form of Term Sheet.

They are intended to set forth the basic terms of a venture investor’s prospective investment in the company. There are varying philosophies on the use and extent of Term Sheets. One approach is to have an abbreviated short form Term Sheet where only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and not be hampered by argument over side points. Another approach to Term Sheets is the long form all-encompassing approach, where virtually all issues that need to be negotiated are raised so that the drafting and negotiating of the definitive documents can be quick and easy. The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage and, if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal. The disadvantage of the long form approach from the venture investors’ perspective is that it may tend to scare away unsophisticated companies.

Lagniappe Terms:

The Charter: (Certificate of Incorporation) is a public document, filed with the Secretary of State of the state in which the company is incorporated, that establishes all of the rights, preferences, privileges and restrictions of the Preferred Stock.

Accrued and unpaid dividends are payable on conversion as well as upon a liquidation event in some cases. Most typically, however, dividends are not paid if the preferred is converted.

PIK” (payment-in-kind) dividends: another alternative to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

“Opt Out”: For corporations incorporated in California, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock. The purpose of this provision is to “opt out” of DGL 242(b)(2).

Preferred Stock: Note that as a matter of background law, Section 242(b)(2) of the Delaware General CorporationLaw provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.

The per share test: ensures that the investor achieves a significant return on investment before the Company can go public. Also consider allowing a non-QPO to become a QPO if an adjustment is made to the Conversion Price for the benefit of the investor, so that the investor does not have the power to block a public offering.

Blank Check Preferred: If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.

Redemption rights: allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.

Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders. Note that Founders/management sometimes also seek limited registration rights.

Registration: The Company will want the percentage to be high enough so that a significant portion of the investor base is behind the demand. Companies will typically resist allowing a single investor to cause a registration. Experienced investors will want to ensure that less experienced investors do not have the right to cause a demand registration. In some cases, different series of Preferred Stock may request the right for that series to initiate a certain number of demand registrations. Companies will typically resist this due to the cost and diversion of management resources when multiple constituencies have this right.

Break Up Fee: It is unusual to provide for such “break-up” fees in connection with a venture capital financing, but might be something to consider where there is a substantial possibility the Company may be sold prior to consummation of the financing (e.g., a later stage deal).

New Prime Unicorn Index Tracks Private Companies on the Road to IPO

Index uses Lagniappe Labs’ proprietary valuation and pricing data to track top-tier, private companies with Unicorn or near-Unicorn status

SHREVEPORT, La.–(BUSINESS WIRE)–Lagniappe Labs has launched a new, equally-weighted price return index that tracks the performance of some of the most notable privately-funded companies based in the U.S. In partnership with Prime Indexes, Lagniappe Labs created the Prime Unicorn Index as a tool to benchmark the aggregate performance of private companies who have achieved or are approaching the $1 billion valuation level. The index uses Lagniappe Labs’ proprietary research and difficult-to-source, objective data to determine true valuations of privately-funded companies in a measureable and verifiable way.

Unicorns like Uber, AirBnB, Lyft, SoFi and WeWork are well-known to investors as private companies with valuations in excess of $1 billion. While there are over 200 Unicorn companies across the globe with a combined value of over $730 billion, the Prime Unicorn Index currently includes 85 companies Lagniappe Labs has classified as a Unicorn or Approaching Unicorn based on hard-to-secure public filings and data, including federal and state filings and company disclosures. The index universe will include only U.S.-based private companies with valuations at or exceeding $500 million.

“Valuations of private companies do not need to be subjective or opaque, and in fact, an official valuation can be derived when using the right data,” explains Ross Barrett, Co-Founder of Lagniappe Labs and founder of the Prime Unicorn Index. “We differentiate ourselves in our data standards and practices by using difficult-to-access information to assign an official value to these private companies that is not available anywhere else.”

As more high-performing companies defer or eliminate plans to go public, the demand for information about and investment exposure to this growing portion of the American economy has soared. The Prime Unicorn Index aims to offer investors a means to evaluate the private company space before these highly-valued firms go public.

“In today’s market environment, there is tremendous opportunity and investor interest in the private company space. However, there is very little in terms of concrete, trustworthy information for investors to act on,” explains Kris Monaco, Co-Founder of Level ETF Ventures and the firm’s related Prime Indexes business. “The companies in the index are the same businesses modern investors are using and touching on a daily basis. They are riding Uber to work, using AirBnB to book their next vacation and taking advantage of WeWork spaces to run their small business. There is a great deal of interest in these companies, and the Prime Unicorn Index is designed to help capture that enthusiasm.”

The index will serve as a benchmark for performance and valuation among private companies and for the creation of financial products. Index values are calculated daily and distributed weekly. The index will be rebalanced quarterly to reassess companies whose values may have fallen below Unicorn status or those who have gone public.

“The Prime Unicorn Index is to private companies what the S&P 500 Index is to publicly-traded companies,” adds Barrett. “We believe investors will look to the index as a way to determine the strength and overall value of private companies where they’re seeking exposure.”

For more information, please visit PrimeUnicornIndex.com or contact info@primeunicornindex.com.

About The Prime Unicorn Index

The Prime Unicorn Index is an equally-weighted price return index that measures the share price performance of U.S. private companies valued at $500 million or more. The Index was launched by Lagniappe Labs and Level ETF Ventures. The index uses Lagniappe Labs’ proprietary research and difficult-to-source, objective data to determine true valuations for privately-funded companies in a measureable and verifiable way.

About Lagniappe Labs

Lagniappe Labs is a financial technology company specializing in the development of financial products and trading software for alternative investment professionals. The company has compiled millions of data points on privately funded companies using disparate data sources, providing investment professionals with detailed analysis of private company valuations, share prices, and securities sold.

About Prime Indexes

Prime Indexes creates financial indexes that solve problems for both professional and self-directed investors. Our index designs focus on emerging trends in the exchange-traded fund (ETF) industry, and our founders have participated in the creation and launch of over a hundred financial products and indexes across all major asset class. Prime Indexes are used as the basis for innovative new investment solutions for investors, and use intuitive design principles so that new investment products can ultimately provide low-cost, efficient, and convenient access.


Gregory FCA for the Prime Unicorn Index
Marissa Foy Comerford, 610-228-2104

Incentive Stock Options (ISOs) vs. Non-Statutory Options (NSOs)

Excerpt from Chapter 1 of VC Experts Encyclopedia of Private Equity & Venture Capital

The principal advantage [1] of an ISO is that it postpones tax on the holder’s gain (exercise price versus sales price) until the option stock is sold; the tax on an NSO holder occurs upon exercise, measured by the difference between exercise price and fair value as of that time. [2] This is a major distinction. [3] The NSO holder has to come up with her tax money earlier in the process, provoking a potentially unacceptable investment risk unless she can sell immediately after exercise. However, as per SEC Rule 144, she cannot sell publicly; that is, she must either hold for one year or sell at a stiff discount, unless she is able to register her stock for sale. [4] Indeed, the interaction of the Code and Rule 144 can produce a script Yossarian could appreciate. On exercise, the NSO holder owes tax on the difference between exercise price and “fair market value” calculated without regard to the restriction which will lapse, [5] that is, the inability to sell publicly for one year. Let us say the trading price of the stock is $10 and the exercise price is $6. Tax is owed on $4 of gain. Mr. Yossarian can sell right away in a private transaction but at a gain of only $2. He has to pay tax on $2 of gain he cannot then realize, forcing him to choose an immediate sale at an economic loss so as to develop a countervailing loss for tax purposes. Alternatively, he can pay his tax and hold the stock one year and sell without a discount, but, Catch-22, the stock may have gone down in price in the interim. He has paid tax on a gain he has not seen and, one year later, he may have an economic loss in the stock because the price falls. Moreover, the deduction for interest on the money he has borrowed has been severely limited. [6] He gets a tax loss after one year of agony, but, by that time, he may be broke. Further, assuming the NSO is subject to vesting in the form of a right to repurchase at the option price if the executive’s service terminates prior to a specified time, the dilemma is increased when the individual must decide whether to make an I.R.C. § 83(b) election (unless the option price equals the fair market value at the time of the election), since, if he makes the election, he will be taxed on the value of appreciation he will not receive if his service terminates before the shares are vested. Note, however, certain avenues of opportunity, when the issuer goes public, it often will maintain an evergreen registration statement on Form S-8, registering shares issued upon the exercise of employee options. If the options become liquid by reason of the issuer merging into a public company for public stock, that stock can be registered under Form S-4.

There is more, however, to the comparison between ISOs and NSOs. The second major advantage of the ISO over the NSO-that the gain on sale was capital gain if the stock is held for a year after exercise (and the sale succeeded the grant by two years)-was rendered relatively immaterial by the 1986 Tax Reform Act (since the differences in tax rates became relatively small to the point of triviality). However, with the 1993 Deficit Reduction Act, [7] the distinction has been significantly restored and ISOs are back in fashion. Moreover, if the option stock is “qualified small business stock,” it may be that the spread will be even more dramatic. [8] On the other hand, exercise of an ISO [9] produces tax preference [10] in an amount equal to the difference between the “fair market value” of the stock on exercise and the amount paid unless the option stock is sold in the year of exercise-an event which voids preferential treatment under § 422. [11] This feature led some commentators to forecast the death of ISOs. [12] The alternative minimum tax (AMT) result is not an unmitigated disaster since, in most instances, the excess tax paid is recovered when and if the option stock is subsequently sold at a gain. [13] Finally, under the 1993 Deficit Reduction Act, the spread on NSOs will enter into the calculation of executive compensation for purposes of measuring whether the $1 million threshold has been achieved and, thus, deductibility disallowed. The short of the matter is that, in an era in which the tax law changes annually, there is considerable luster to what might be called the “wait and see” approach. According to that strategy, the issuer constructs a plan involving ISOs. Then, as some critical date nears-an IPO looms, for example-the employee enjoys alternatives. She can exercise the option and hold the shares if alternative minimum tax is not a problem as a practical matter, thereby postponing tax while the Rule 144 period runs, or she can do something to disqualify the option as an ISO-sell before the one-year holding period lapses, for example. [14]

In this connection, the situation must be addressed from the issuer‘s point of view as well. A corporation is not allowed a deduction at any time in connection with ISOs granted to its employees (unless there is a disqualifying disposition of the ISO). [15] A company can deduct the amount of ordinary income an employee is deemed to have received in connection with an NSO at the same time ordinary income is includable in the employee’s taxable income. The value of the deduction allowed to a profitable corporation in connection with an NSO may well exceed the value to the executive of an ISO over an NSO. Perhaps the issuer will want a tax deduction and would be willing to pay the employee a bonus, accordingly, to make a disqualifying disposition. Moreover, in the event of a disqualifying disposition, the gain is the lesser of the putative gain on exercise or the actual gain on sale. [16] [Also, as indicated, the accounting treatment of NSOs and ISOs is the same; a “hit” to earnings only if the option is granted at less than fair value, [17] ] or unless the issuer elects … see Accounting for Options Generally, § 7.01(i) infra.

The point is that there is no one “right” answer to the ISO/NSO decision, particularly in view of the uncertainty posed by the FASB proposals and the irresistible impulse of politicians to tinker with the Internal Revenue Code; it is impossible to set out any general rules. The ISO versus NSO question should be examined carefully in light of the facts of each case and the tax, securities, and accounting rules in effect at that time.

[Note: One (not the only) advantage of NSOs, the ability to set the exercise price below fair market value, is now, history.]

[1] Newco‘s alternatives are not “either/or.” A qualified ISO plan can be combined with an NSO plan.

[2] The tax is owed under I.R.C. § 83(a), on the receipt of “property” (i.e., the option stock) in connection with services.

[3] The ability to time one’s disposition of the underlying shares has “cash value,” even though that value is difficult to quantify in advance.

[4] Rule 144 omits options from the situations in which the “tacking” of holding periods is permissible. Compare Rule 144(d)(1) and (3).

[5] The restriction on the ability to transfer by itself does not, despite the language of I.R.C. § 83, impose a restraint which allows the holder to postpone tax under I.R.C. § 83(b). Compare Robinson v. Commissioner, 805 F.2d 38 (1 st Cir. 1986).

[6] I.R.C. § 163(d). Under the statute prior to the Tax Reform Act of 1986, the individual’s annual maximum deduction for interest on debt to “purchase or carry property held for investment,” I.R.C. §§ 163(d)(1)(A), (B), was net investment income plus $10,000; after the phaseout, it is solely net investment income. I.R.C. § 163(d)(1).

[7] The spread depends on the adjusted gross income of the taxpayer but it may be subject to AMT effects. I.R.C. § 56(b)(3).

[8] See discussion of new I.R.C. § 1202, which excludes one-half the gain on the sale of such stock if held for 5 years. See Note on Qualified Small Business (“QSB”) Stock and Rollovers Sections 1202 and 1045.

[9] The alternative minimum tax puzzle has been well summarized by the author’s then-partner (now an officer of Fidelity Corp.) John Kimpel, in these words:

The employee’s exposure to the alternative minimum tax on the exercise of an ISO can create serious problems. Consider the following nightmare: Company X grants an ISO to a key employee to purchase 100,000 shares of its stock at $.60 a share, its then fair market value (total exercise price $60,000). Four years later … the company goes public at $10 a share. The employee exercises his option and acquires 100,000 shares of stock for $60,000. The amount of the tax preference item potentially subject to alternative minimum tax is $940,000 ($1 million -$60,000). Since the alternative minimum tax is the excess, if any of (a) 20% [now 24% for individuals] of the amount by which taxpayer’s adjusted gross income plus items of tax preference less certain itemized deductions exceeds an exemption amount of $30,000 ($40,000, subject post ’86 to certain reductions, if a joint return if filed), over (b) the regular income tax paid, the employee in the example above may face a staggering tax bill without having sufficient funds to pay the tax.

Kimpel at 53.

[10] Alternative minimum tax calculations involve comparing the tax calculated at standard rates without regard to AMTI-$ 100,000 say, on $400,000 of income-with the tax which would be assessed were all income, including tax preference items, to form the base amount times the AMT rate-i.e., 24% for individuals.

[11] If the optionee “disposes” of the stock received pursuant to the exercise of an ISO in the year in which she exercised the ISO, she will not be required to add the spread to his AMTL Treas. Reg. § 1.57-1(f)(5). Generally, an optionee will be considered to have disposed of the stock if she recognizes gain upon such disposition. See I.R.C. § 425(c).

[12] The Tax Reform Act: What to Do About Stock Options” XI Corporate Counsel I (Sept.-Oct. 1986).

[13] If the exercise of an ISO results in an AMT liability, the optionee will, to the extent not limited by I.R.C. § 53(c), be entitled to claim a credit (the “AMT credit”) against his regular tax liability in the succeeding taxable year or years equal to the AMT paid. I.R.C. § 53(a). I.R.C. § 56(c) limits the AMT credit, in any given year, to the excess of a taxpayer’s regular tax liability over his AMT liability for that year.

[14] A disqualifying disposition may, however, itself raise tax issues, if, for example, the stock received upon a disqualifying disposition is subject to a substantial risk of forfeiture. Kimpel at 56-57.

[15] In order for the employer to take the deduction for compensation expense allowed upon a disqualifying disposition, the employer must withhold tax from the income received by the ISO upon the disqualifying disposition. In fact, the employer must deduct and withhold an appropriate amount of income tax from any wages recognized by the employee upon exercise of the NSO. The employer must also deduct and withhold the employee’s 7.65% portion of FICA taxes from such wages (although no withholding is necessary for the Social Security portion of such FICA taxes to the extent that the employee’s wages have exceeded the relevant Social Security Act contribution and benefit base limit for the current year). The employer is responsible for reporting the withheld amounts on an IRS Form 941, as well as reporting the spread as wages in Boxes 1, 3 and 5 of the IRS Form W-2. Note that if the employer timely prepares and delivers an IRS Form W-2, the employee will be deemed to have included the amount of the spread in his or her gross income such that the employer is entitled to a corresponding business expense deduction.

[16] I.R.C. § 422(c)(2). Exercise and sale within six months may pose problems for directors, officers, and 10% stockholders under § 16(b) of the ’34 Act. In order to mitigate that result, the plan (ISO or NSO) should be drafted pursuant to the provisions of Rule 16b-3.

[17] Aufmuth, Selected Tax Accounting Issues in Early and Mezzanine Financings and Venture Capital Partnerships, inVenture Capital After the Tax Reform Act of 1986, at 55, 76 (PLI Course Handbook Series No.422, 1987) [hereinafter Aufmuth].

Top 10 Mistakes Companies Make During Acquisitions

Guest Post by: Don Keller (Partner, Emerging Companies Practice in Silicon Valley, Orrick, Herrington & Sutcliffe LLP)

It used to be that when entrepreneurs started their companies, the idea of going public and making it big was on top of every founder or CEO’s checklist.  Nowadays, it seems that startups are constantly looking to build a great product that will attract the most users and then cross their fingers that the Googles or Microsofts of the world will acquire the company (or the team).  I gave a presentation yesterday at RocketSpace, an accelerator for seed-funded technologies in San Francisco, about best practices and top mistakes companies make during acquisitions. So for those of you who are interested in going down that route, here are some things to note as you prepare your company and team for the road to acquisition-ville.

1.  Founder Equity – Make sure founder equity is held in the form of shares, not options.  Shares allow founders to get all of the appreciation taxed at capital gain rates, whereas options typically result in the appreciation being taxed at ordinary income rates.  This can make a huge difference in the amount of take home pay.

2.  Protect Your IP – One of the biggest mistakes companies make in the early stages of their development, is not dotting all their i’s and crossing their t’s when it comes to protecting their intellectual property.  Make sure that when IP is involved, you work with a good lawyer to ensure that your IP is not owned by a former employer and that all of the IP has been properly assigned to the company.  The last thing you want is for your company to take off and then get hit with a notice that your IP is not actually your IP.

3.  Keep Your Options Open – To maximize your price, companies should leave themselves with alternatives to the buyers they are targeting.  You want to make sure that you’re not selling yourself short and putting all your eggs in one basket.  This does not make for a good negotiation strategy and is less likely to get you the best price.  If a buyer knows that you have only one alternative, the price will fall like a rock.

4.  What to Avoid Selling – Avoid selling the company for private company shares in a transaction that is taxable.  There is typically no market for private company shares so getting someone else’s private shares in an acquisition and having to pay tax on those shares, leaves you with an out of pocket cost and nothing to show for it other than some shares you cannot sell.  If the transaction is properly structured, the receipt of the buyer’s shares can be nontaxable (at least until you sell those shares) which is what you want.

5.  The Art of Negotiating – When negotiating on price, make sure you understand all of the adjustments to the price such as escrows, legal fees, balance sheet adjustments, and special indemnities.  Once you sign the 60 or 90 days no shop agreement, the buyer has all the leverage.  You don’t want to learn at that point that the price they said they would pay is before massive deductions.  It’s important to negotiate the terms right out of the gate so there are no surprises when it comes time to seal the deal.

6.  Open Source – Make sure you understand open source and how it’s used in your product.  Always double check to make sure that you have complied with the open source license terms.  It doesn’t happen often, but every now and then, this can be a deal breaker for buyers.

7. Keep Up with the Kardashians…I mean Housekeeping – Do not, and I repeat, do not wait until the last minute to catch up on cleaning your minute books and stock option pricing (409A issues).  It is important that your documents are maintained and updated on a regular basis.  If you wait until the last minute, it can create unnecessary headaches and disorganization.  The last thing a buyer wants to see is a company that can’t keep their documents up to par.

8.  Don’t Wait Until the Last Minute – Rolling over from #7, another important thing to note is that you shouldn’t leave the negotiation of employment and non-compete agreements until the last minute.  These are things that should be brought up as soon as discussions begin.  Time and again, these agreements are negotiated at the last minute with lots of pressure on the founders to sign and be happy.  Don’t let that be your situation.

9. Be Wary of Earn-Outs – Earn outs are a lawyer’s dream.  They almost always end in disputes about whether the buyer tried hard enough to generate revenue to meet the earn out thresholds.  Don’t count on any earn out payments and negotiate accordingly.

10.  Pay Attention to Your Board Members and Investors – It’s very important to listen to what your board members and investors are saying during this time.  You want to keep an ear out for biases for or against a sale and also take heed to strategic investor reactions to a sale.

There is no full proof way of being certain that by following the advice above, the road to acquisition will be an easy route.  However, best practices can provide entrepreneurs a clearer path and hopefully increase the likelihood of your company’s success.

About Don Keller:  Don is a Partner in the Emerging Companies Practice at Orrick’s Silicon Valley office. He advises emerging companies, public companies, venture capital firms and investment banks and has represented clients on more than 60 public offerings, 75 acquisition transactions and several hundred venture financings.  Don has worked on transactions for companies including Apple, Google, Oracle, and Rambus and represents clients such as eHarmony, OPOWER, and LS9, among many others.  For more information, you can visit his full biography.

Valuation Uncertainty Illustrated…with balloons!

Guest post by Karl Sjogren

One can use a balloon to visualize the valuation uncertainty inherent in a venture capital investment. Imagine one that looks like a hot dog and can be twisted into animal shapes. But instead of air, this balloon is full of uncertainty. The left end of this balloon represents ownership interests in a venture-stage company, while right end represents certainty about its future performance.

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Valuation of Private Securities: The Way the Pros Handle It

In a recent opinion by Vice Chancellor Laster in the Delaware Chancery Court, he made the point, and I quote from an Orrick alert. [1]

“Among other things the Court found that the valuation firm … did not perform a comparable companies analysis even though only months before, during the ordinary course work, it deemed another transaction in fact to be comparable.”

The securities in question had been extensively analyzed as to valuation by various professionals who had focused on methods such as discounted cash flow (“DCF”), which entails an estimate of future cash flow and then discounting the number back to the present time to arrive at a valuation. And, of course, there are a number of other methods for valuing illiquid property and, in particular, securities in a company which are not traded on an exchange. [2] The problem with DCF and like valuation methodologies is that one can arrive at just about any number which is this side of the absurd, depending on how the various elements of the methodology are tweaked.

For example, in a situation in which I participated as counsel several years ago, each side had hired an internationally recognized valuation service to compute the value of the stock in the company which an individual (who was a good or bad leaver, depending on how you looked at his performance) had owned. The valuation expert retained by the company which was paying for the shares in accordance with a put/call agreement entered into when the individual joined the company came up with a valuation of $160,000. A well-known expert, which the former executive had retained, came up with a valuation in excess of $11 million. The legal fees run up while the parties went after each other, given (among other things) this disparity in opinions, were well into the seven figures because settlement negotiations were rocky from the start.

The second reason that comparables are used so frequently is my experience in the venture capital business. The fact is the way the VCs often arrive at a valuation when making, say, the Series A investment is best described as the herd instinct. The investment managers, the members of the general partner, will look at a company in the same line of business and in the same general location and their first question is, “How did Greylock or Sutter Hill value this other company?” With that information under their belts, the answer as to the ultimate valuation is tweaked in accordance with a comparison of the size and profitability of the two companies. And what counts is the comparable information.

It is available through VC Experts on a quarter by quarter basis, one can track, for example, pre- and post-money values of medical device companies in New England over the last seven quarters. That’s the kind of information the pros very much want to review when they approach this critical inquiry. It doesn’t mean they won’t use other methods as well; but comparables are the way at least to smoke out bizarre results such as the ones in the example above cited.

[1] Halper & Rooney, “Flawed Valuation Leads Delaware Court to Award Damages to Option Holders,” Orrick, Client Alert, 08/14/2015.

[2] Disclosure: I am the chairman of the Board and co-founder of VC Experts (www.vcexperts.com) which provides officially derived comparable valuations with respect to which investments have been made as contained on, e.g., the MoneyTree Survey..