Category Archives: Startup Investment

Revisiting “Should I Incorporate my Canadian Startup in Delaware?”

It seems Canadians are still wrestling with whether to incorporate their startup in Delaware.  I wrote about this question back in September 2014  and since then the post has racked up over 1,000 views.  Back then, I concluded with this piece of advice, which I still stand by:

Don’t lock yourself into Delaware before you know where your investment comes from.  Based upon the cost and complexity of operating a Delaware startup from Canada, I recommend that you incorporate in Canada at the start.  Where a future U.S. investor requires you to incorporate in Delaware (or another state) your legal advisors can assist with this transition.  Conversely, Canadian investors may prefer to invest in a Canadian company!

Tip:  your product/service is important, not the place of incorporation.

Fully-Diluted Calculations

Congratulations, you received a term sheet!  While the main terms, such as valuation, are certainly important, there are numerous less noticeable terms that can have just as great an impact.  One such term is “fully-diluted”.

What is a fully-diluted calculation?

A fully-diluted calculation assumes that all options, warrants and other rights to acquire stock have been exercised or converted, regardless of whether they are actually vested or exercisable at the time of the offering.

Let’s illustrate the impact of a fully-diluted calculation compared to a funding round without full dilution.

Startup has issued 1,000,000 shares and 100,000 options.  None of the options are vested.  Investor desires to take 10% interest in the company.

Not fully-diluted:  Startup will use the number of issued shares only to calculate the 10%  and will issue investor 111,100 shares (representing 10%).

Fully-diluted:  Startup will use the total number of issued shares and options to calculate the 10% and issue the investor 122,200 shares.  However, since none of the options are vested, and may never vest, investor actually acquired a present-day interest of 10.89%.

While the above example seems benign given the .89% difference, that percentage could be worth a large sum if the company exits in the future.  What if you are selling an almost controlling interest in the company, perhaps 23.5%?  In that case, a fully-diluted calculation could result in a sale of a 25%+ (and controlling) present-day interest depending on the number of outstanding options etc.  In other situations, an investor may request that the entire option pool (even if no options have been granted) be factored into the fully-diluted calculation – in the case of a 12% option pool, this term would have a substantial impact.

In sum: while you may not be able to avoid a fully-diluted calculation in a term sheet, it’s important to understand its impact and to negotiate with that impact in mind.

So, You’ve been Accepted to a Startup Accelerator

Startup accelerator acceptance season is upon us and those lucky startups are now going through the vetting process that follows acceptance into an accelerator.  In order to simplify the lives of founders and lawyers everywhere, I’ve put together a list of key items that often need to be addressed as part of the accelerator vetting process:

1.  IP Ownership.  Make sure all intellectual property developed relating to your startup has been assigned to the company through separate assignment agreements or as part of employment/independent contractor agreements.  Remember, this is where the value in your startup lies.

2.  Clean up the CAP Table.  This is the time to clean up your CAP table and make sure that everyone you’ve “promised” equity is issued their shares and represented on the CAP table.  There’s nothing worse than calculating the number of shares of the company to issue to the accelerator only to realize that you forgot an intended shareholder – your uncle granted 0.5% (undocumented) for doing company taxes a year ago.  Go in with a clear picture, and proper documentation, of company capitalization.

3.  Lock Down Founders.  The accelerator will want to see that the founders and key persons are tied to the company, whether by an employment or contractor agreement.  If your resources are limited, a reverse vesting agreement for founders should suffice.  In addition to IP, founders are a key startup asset.

4.  Canadian Company?  Determine Cross-Border Structure.  If the accelerator is in the U.S., Canadian startups have the extra steps of determining what Visa will allow them to work in the U.S. while at the accelerator and what cross-border company structure will meet company and accelerator needs.  A discussion of company structure can be found HERE.

If you’re not in an accelerator yet, the above are important considerations to keep in mind for running any company and will make future accelerator vetting a seamless process.

Share Structure: do you need so many classes?

I frequently encounter early-stage startups with too many share classes.  If you have read previous posts, you know that I advocate for a simple share structure for early-stage companies (usually common and, if needed, non-voting common).  If more complex structures are required in the future, they can be created then.

When you are considering your startup’s share structure, consider creating only those share classes that you know you need now or will need.  To that end, ask the following questions before creating any share class:

1.  What is the share class to be used for?  You need to understand the purpose served by each share class.  Don’t create share classes because a third party tells you to or because you see other companies with similar structures.  Each share class should have a reason for existing.

2.  When is the share class to be used?  If the share class is to be used at some point in the future, consider whether that class will 100% be suited to that hypothetical future event or will it need to be modified to suit that future event?  Further, what is the likelihood of the future event occurring?  If it seems unlikely the shares will be used in the future, consider not creating that class.  For example, I question the value in creating preferred shares to be used for future investors as you currently do not know what terms those hypothetical investors will want on the preferred share class.

3.  Will your share structure agitate investors?  Perhaps you do have a future use for 4 share classes but what is the impact of this share structure on your capital raising activities?  Will startup investors, used to seeing common share structures (and maybe a non-voting common), take issue with your complex share structure?  This especially could be the case where you can’t explain the reason for the structure.  Always consider how outsiders will view your share structure.

In sum: don’t create share classes without a reason – even if your lawyer says so!  A founder should know their company structure and why it was created that way.