3 Important Trends When Forming A Company

It’s important to stay current with your expert skill-set. I take great care to belong to a select and limited number of membership clubs that help me increase my knowledge and expand my network in the finance ecosystem.

One of these membership clubs is called “VCBC”. It’s a group of finance and accounting professionals that work in the back offices of venture capital funds.

Here are 3 important trends to keep in mind during a company’s formation process, that were highlighted at a recent meeting:

Trend #1: Founders Preferred Shares

  • When: This is talked about with the founders of the company at incorporation.
  • What: Common Shares + Preferred Shares are now issued to the founders. Founder preferred shares are convertible into common shares at any time. They sit next to common shares on the cap table, i.e. they have the same seniority at liquidation.
  • What does this mean? When an investor buys preferred shares at the Series C round at $1/share then the founder can sell his/her preferred shares at $1/share and never at a lower price as he/she might do for the common shares.
  • Expected tax consequences: the founder selling can treat the sale as capital gain, which is a positive (vs. ordinary income which would be the amount above the 409A Valuation)
  • What do VC firms think? They don’t like it very much as management now has preferred shares as well.

Trend #2: Dual Class Voting

  • Why do these exist now? Companies without enough common stock ownership by management and the Board are under attack from activist investors to sell the company.
  • How do they work? Dual class common shares repel attacks. One class of shares will have for example 10 votes vs. the second class with only 1 vote
  • When: Set these up as early as possible so that the number of individuals with the high voting class stock is limited and well known.
  • Upside: This allows for a long-term view on strategic decisions, because management doesn’t have to worry about any short-term ROI.
  • Downside: You might end up with an incorporated company that doesn’t get off the ground and has a high degree of ownership complexity.

Trend #3: Transfer Restrictions of Preferred Shares

  • Why: These are coming into effect, as the CEO is unable to stop investors who want liquidity immediately from transferring or selling their ownership at any time they want. Although this is not seen too often yet, it’s becoming a bigger and bigger issue, as companies stay private longer.
  • How: The Board must approve the transfer of shares. Transfer restrictions can only get into the bylaws if the founders agree to it.
  • What do VCs think? They won’t agree to it

Employee equity is a complex topic and it’s important to hire an experienced startup lawyer to help you navigate the intricacies. It’s highly likely you’ll make some very expensive mistakes otherwise.

 

Today, we’ve barely scratched the surface

Whatever stage you’re at in business, you need to be all over the numbers. In posts like this, we aim to offer bite-size food for thought – but in a few hundred words, we can only do so much.

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