VENTURE CAPITAL

Strategic Issues for High Tech Entrepreneurs

April 2000

By Dodd S. Griffith, Esq.*

It has always been important for entrepreneurs to plan well for growth. Now that businesses are subject to "Internet time", the window of opportunity to achieve first mover status in a particular market is likely to be very narrow. In order for the founders of a high tech company to achieve exponential growth and have the opportunity to take the company public, the founders must be prepared to deal with the strategic issues that will make this growth possible. The following is a brief overview of some of these key issues.

How do I structure the company for growth?

A company's structure depends on a variety of factors, including how quickly the company expects to grow, and when it expects to seek financing from outside investors. Most high tech companies expect to grow rapidly and to fund that growth by selling stock to Venture Capitalists ("VCs") and other private investors. For reasons discussed below, a company typically will want to offer a different class of equity to founders and employees than it offers to VCs (i.e. common stock and preferred stock). This two-tier equity structure, and the likely goal of going public, usually dictates that the company organizes as a C-corporation. However, if a company expects to be able to spend a significant amount of time developing a product before it will need equity financing, it may consider organizing as a limited liability company, partnership, or S-corporation, with the plan to convert to a C-corporation prior to obtaining outside financing. In addition, many VCs will prefer that a company be organized in Delaware due to their familiarity with Delaware corporate law and the Delaware Chancery Court.

How do I structure my stake in the company?

The founders of a high tech growth company will want to structure their equity stake in the company to minimize the potential for any ordinary income tax liability for the equity they are issued in the company for no or nominal cash consideration. This is most easily done by issuing stock to the founders immediately on the formation of the company, when the value of such stock is usually nominal since the company typically will not have any assets and there has been no equity investment which established a fair market value for the founders' securities. The nominal or relatively low consideration paid for common stock issued to founders and employees can also be supported by creating a two-tiered capital structure (i.e. common and preferred stock). The preferences granted to holders of preferred stock can help to justify the price differential between the preferred stock issued to investors, and the common stock issued to founders and employees.

Founders should also consider establishing up-front vesting requirements for equity issued to themselves and key or other employees. While many founders may think it wholly against their interests to impose vesting requirements on the equity issued to themselves on forming the company, such requirements can prevent divisive situations later on when one of the founders leaves the company prematurely. These situations can be very destructive if it is perceived that the ex-founder is reaping the benefits of the sweat equity of the remaining founders, who stay on to finish the job.

Moreover, vesting is likely to be required in order to attract VCs, and can be an important tool in retaining the company's key employees. If stock subject to vesting or buyback rights has arguably been issued for less than fair market value, careful consideration should be given to making a Section 83(b) election to pay ordinary income tax on the stock's value as of the date of its issue. If the stock is granted for what is then fair market value, the grantee will pay no ordinary income tax as a result of the election. The grantee will also avoid paying ordinary income tax later on the difference between the price paid for the shares and the fair market value of the shares when they vest. This difference can be substantial if a company is on track to achieving the desired growth.

How can I position the company to attract venture capital?

In order to grow your company rapidly, you will likely need more than one round of venture capital investment. VCs are typically looking for companies that can produce revenues of $100 million or more within ten years. Companies that can achieve such growth typically have a business plan that identifies a large market for a product that the company plans to develop. A demonstrable potential market is often more important than a demonstrable product. A VC may be willing to gamble on whether the product can be developed from a technical standpoint, but will not be interested in technology if no potential market can be shown (ironically — if the market is too obvious, the investment may be likewise unattractive because the VC deems that there is not the possibility for the explosive growth that comes with a truly new idea). Moreover, the most important factor in obtaining venture capital is the strength of a company's management. VCs invest in the people who have the management skills to grow the company, not merely the concept being developed by the company.

How do I protect my intellectual property?

Ultimately, a company will want to take the formal steps required to obtain the protections offered by patent, trademark and copyright laws. While a company may not initially have the capital to take these steps, it can always take certain relatively inexpensive steps to protect itself. These steps may include having all founders, officers, employees, consultants and other contractors execute non-disclosure and inventor's rights agreements, which bind these individuals to keep confidential all non-public company information, and assign to the company all inventions developed through the use of company assets or while working on company projects. Likewise, the company will want to have key officers and employees execute appropriate employment and non-competition agreements.

Where can I learn more about these issues?

Gallagher, Callahan & Gartrell is a founding underwriter of the annual Private Equity Forum sponsored by the University of New Hampshire's Center for Venture Research. The Forum is scheduled for May 9, 2000 at the Crowne Plaza Hotel in Nashua, New Hampshire. The Forum is adding an additional full day event this year focused on teaching individuals about seed investing. This event will be limited to approximately 50 people and will occur on May 8, 2000 at the same location. Please contact us for additional information on these events.

*Dodd S. Griffith is admitted in New Hampshire.

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