Carnegie Mellon Innovation Transfer Seminar Series

1. Carnegie Mellon Innovation Transfer Seminar Series Start-ups & Financing JAMES J. BARNES Reed Smith LLP

2. Part I – Corporate Organization • General Structure • Choice of Entity • Limited Partnership • Limited liability company • S Corporation • C Corporation • Choice of entity primarily driven taxation and plans for company

3. Part I – Corporate Organization • LP and LLC • provide pass through taxation • flexibility in structure • flexibility in allocation of income, profits and loss • often disfavored by venture capital investors who are accustomed to c corporation form.

4. Part I – Corporate Organization • S Corporations • provide pass through taxation • corporate governance and structure of a corporation • subject to restrictions which often make it inappropriate for company anticipating outside funding from investors including: • only one class of stock is permitted • no corporate or other entity shareholders

5. Part I – Corporate Organization • C Corporation • double taxation (corporate level and shareholder level for salary and distributions) • customary form for venture capital investment which typically takes the form of preferred stock purchases • preferred if company expects to raise significant outside capital and/or go public

6. Part I – Corporate Organization • Post Organization Conversion to C Corporation • possible, but often creates tax and securities law complications • easier to effect if the organizational documents anticipated likelihood of conversion and do not require further consent of equity holders

7. Part I – Corporate Organization • Choice of domicile • dept and predictability of corporate law (Delaware vs. other jurisdictions) • liability protection for directors and officers

8. Part I – Corporate Organization • Equity Issues • Founders Stock • How to document • Issue as early as possible – before outside financing • Vesting – remember I.R.C. Section 83(B) Election • Stock restriction & voting agreement issues • Right of repurchase • Right of first refusal • Control rights

9. Part I – Corporate Organization • Equity Incentive Compensation for Key Employees & Consultants • Incentive Stock Options • Must comply with tax rules, e.g., option price can not be less than fair market value on date of grant, only employees eligible, generally maximum 10 year, underlying shares may not be sold within 1 year of exercise. • No tax to employee at time of grant; no tax in general to employee at time of exercise (except possibly AMT); taxed to employee at capital gains rate at time of sale if holding period met; no tax deduction for company if holding period met – now more important in light of recent increased rate differential between ordinary income and capital gains.

10. Part I – Corporate Organization • Non-qualified Stock Options • Not subject to restrictive tax rules • Can be granted to essentially anyone • No tax to optionee at time of grant; spread taxed at ordinary income rate at time of exercise; company gets tax deduction equal to income incurred by optionee

11. Part I – Corporate Organization • Accounting considerations for options • FASB proposal to expense options • Restricted stock and other equity-based awards

12. Part I – Corporate Organization • Securities law considerations • SEC Rule 701 available for compensatory issuances of securities so long as the aggregate offering price of securities being offered at any time (plus sold in the prior 12 months under Rule 701 does not exceed the greater of: • $1,000,000; or • 15% of the issuer’s total assets, measured at the end of the last fiscal year; OR • If the number of such securities (i.e. being offered currently plus those sold in the last 12 months) is less than 15% of the issuer’s outstanding securities on a fully diluted basis

13. Part II – Financing • Preliminary Issues/Overview of Early Stage Financing Process • Sources of Funding • Friends and family • Angel investors • Venture capital firms • Valuing the company • pre-money • post-money

14. Part II – Financing • Understand that you will lose some control • Perform due diligence on VC fund • Amount & Timing of the investments • Form of Investment / type of securities • Number of Directors investors want to elect • Additional management members / employment agreements

15. Part II – Financing • Proprietary rights and other due diligence issues • Exit strategy for investors • The term sheet / documentation agreements • Understand how relevant federal and state securities laws impact financing

16. Part II – Financing • Preferred Stock Provisions – Description/Terms • Dividend preference • Liquidation rights • Redemption rights • Conversion rights • Antidilution protection

17. Part II – Financing • Stock incentive plan • Voting rights – including board seats • Additional contractual rights: • Information rights • Registration rights • Preemptive rights or Rights of first refusal • Co-sale provisions • Employment and management vesting issues

18. Price Valuation and Dilution: Example • Founders – 10,000,000 shares purchased at $0.01(100% of issued and outstanding) • Pre-Money Valuation = $7,500,000 • Option Pool = 5,000,000 • VC Investment = $6,000,000 • Series A Price = $7,500,000/15,000,000 = $0.50 (preferred price = pre-money valuation/fully diluted shares) • Series A Stock Issued = $6,000,000/$0.50 = 12,000,000 shares • Founders 37%, Option Pool 19%, Investors 44% • Post-Money Valuation = $7,500,000 + $6,000,000 = $13,500,000