Forming Your Startup the Silicon Valley Way
In most jurisdictions, all you need to do to legally incorporate is submit your articles of incorporation to the Secretary of State of the jurisdiction in which you want to incorporate and adopt a set of bylaws, and many online companies (and attorneys) will take care of these two things for you for a nominal price. However, in the case of high growth technology startups, the formation of the company typically requires much more than just articles of incorporation and bylaws. If you plan on rapidly growing and scaling your business, issuing equity incentives to employees and service providers, preserving the value of your business, and setting your company up to be attractive to, and able to take on, outside investments, then you will generally want to form your company in the same way that most Silicon Valley startups form. I call this process forming your startup “the Silicon Valley way.” Whether you’re a fan of The Valley or not, there is a way of organizing your startup that investors are used to seeing, and they typically expect the following:
Incorporation in Delaware
Nearly all Silicon Valley startups are formed as corporations. Furthermore, nearly all Silicon Valley startups form as corporations in Delaware. You don’t have to form your company in Delaware in order to get funded, and anyone who tells you otherwise is misinformed. However, Delaware is a very management friendly jurisdiction, and most Silicon Valley startups form in Delaware because California’s corporate laws can be very burdensome for early stage companies. For those who live outside of California, forming your company in your home state is probably not going to greatly disadvantage you from a corporate governance standpoint (and will generally save you a few hundred dollars per year in Delaware franchise tax and registered agent fees), but because so many technology startups form in Delaware, most technology investors (and their lawyers) are familiar with Delaware law, and are comfortable with investing in corporations formed in Delaware. If you form anywhere else, there is always the chance that a potential investor will make their investment contingent upon you reincorporating in Delaware. On the other hand, if you form your company in Delaware, you’ll likely never be required to reincorporate in any other jurisdiction.
Articles of Incorporation/Bylaws
The two documents that every corporation must have are a certificate/articles of incorporation (which get filed with the Secretary of State of your state of incorporation) and bylaws. The certificate/articles of incorporation are like your startup’s birth certificate – they identify the legal name of the corporation, how many shares of stock (and classes) it has authorized, and a few other key pieces of information about the corporation. Silicon Valley startups typically authorize 10,000,000 shares of common stock in their initial certificate of incorporation, with approximately 8,000,000 shares issued among the founders and approximately 2,000,000 shares left as authorized but unissued shares of stock (to be reserved for issuance under the equity incentive plan (discussed below) and for other unforeseen situations where the startup may need to access shares of stock). The bylaws are typically a distillation of certain provisions of the corporate law in your startup’s state of incorporation and they provide for such things as how to call board of directors and shareholder meetings, how much notice is required, and when a quorum is present for such meetings.
Stock Purchase Agreements
Once the corporation has been formed, the issuance of stock to the founders needs to be documented. Generally the payment for the stock by the founders is some combination of a nominal amount of cash (typically a few hundred dollars), and contribution of all of the intellectual property created by such founders that relates to the business. In the typical emerging technology company scenario, the founders will subject their stock to vesting over time (or, in some cases, upon completion of certain milestones), and the stock purchase agreements will define the terms of such vesting. Founders of Silicon Valley startups generally subject their stock to monthly vesting over four years, with a one-year cliff (meaning no shares vest until the one-year anniversary of the date of issuance, at which point 25% of the shares vest, and then the remaining 75% of the shares vest in equal installments on each monthly anniversary thereafter until the four year anniversary of the date of issuance). Further, if founders’ shares are subject to vesting, an 83(b) election should be filed with the IRS within 30 days of the date of issuance.
When serving as an officer or director of a corporation, there is always the chance you may be sued (by shareholders, or by other third parties, such as vendors, service providers, etc.) for actions you took, or decisions you made, on behalf of the corporation. The corporate statutes of Delaware, Washington, and other jurisdictions provide that their corporations may indemnify officers and directors under certain circumstances. An indemnification agreement typically elevates the corporation’s responsibilities for officer and director indemnification from something the corporation is authorized to do, to something it is obligated to do. It is typically recommended that officers and directors enter into indemnification agreements with the corporations they serve so they are not left on the hook personally for decisions they made on behalf of the corporation.
Confidential Information and Invention Assignment Agreements
Founders of technology startups usually contribute intellectual property they have created to the newly formed company as partial consideration for their shares of stock at formation, and a well drafted stock purchase agreement should capture that assignment. However, a separate agreement must be entered into between the founder (and all employees and service providers) and the company, assigning to the company all inventions and other intellectual property developed by such founder (or employee or service provider) while performing services for the startup. This second agreement is typically called a Confidential Information and Inventions Assignment Agreement (“CIIA”). Each founder should enter into a CIIA at formation of the entity, and the CIIA should be included in the package of onboarding documents for every employee and independent contractor of the startup. The CIIA also contains confidentiality provisions that limit founders, employees and service providers from disclosing confidential information about the company or its intellectual property to outsiders.
Service Provider Agreements
When hiring service providers, you always want to have a written agreement so that everyone is on the same page, especially with regard to important matters such as compensation, responsibilities, and expected time commitments. Another reason to always have a written agreement with your service providers is because it allows you to define who owns any materials, work product, and related intellectual property created while the provider is performing services on behalf of the company. Without a written agreement requiring the assignment of inventions and other intellectual property to the company, the service provider may retain such rights even if the company has paid a substantial amount for the services. Agreements with service providers should explicitly state that the startup will own all inventions and other intellectual property developed by the service provider while performing services for the startup.
When discussing your startup’s confidential information with any “outsiders” (i.e., those who are not otherwise bound by confidentiality agreements with the company, those who do not owe fiduciary duties to the company, or those who are not under a duty of confidentiality by the nature of their profession – such as attorneys), including potential strategic partners, channel partners, joint venturers, and distributors, they ought to sign a non-disclosure agreement (“NDA”) before you begin disclosing such information. A good NDA identifies the scope of the confidential information and the recipient’s limited authority to utilize such confidential information, provides remedies if an unauthorized disclosure is made, and serves to put everyone on notice that confidential information is about to be disclosed and that the recipients will be charged with obligations in connection with their receipt of such disclosures.
Equity Incentive Plan and Stock Option Agreements
As an early-stage startup, stock is probably cheaper than cash, so you’ll likely want to incentivize your employees and service providers with stock options. If you’re going to issue stock options, you’ll want to have an equity incentive plan that authorizes the reservation of a certain number of shares of common stock for issuance under your equity incentive plan, and sets forth the provisions for administering the equity incentive plan. In conjunction with the equity incentive plan, every recipient of an award of equity out of the plan should also receive a stock option agreement. The stock option agreement informs the recipient of the specifics of their award (e.g., the number of shares, the vesting schedule, the vesting commencement date, the exercise price per share, etc.), and summarizes the key provisions of the plan, the recipient’s obligations under the plan, and how to exercise their award. Generally, Silicon Valley startups initially reserve between 10% and 20% of their fully-diluted outstanding stock for issuance under their equity incentive plan.
Forming your startup “the Silicon Valley way” won’t guarantee success, or even that your startup will get funded, but it will prepare your startup to scale quickly and keep you from standing out to investors for the wrong reasons.