How Tech Company Formations Are Different (Part 1 – Equity)

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Forming a tech company is like forming a non-tech company, but different. There are two factors that drive the differences: equity and IP. It is essential that entrepreneurs and the lawyers who help form their companies understand and can work with these differences.

Part 1 of his two-part article addresses the impact of equity on tech company formation, including the choice of entity and various starting agreements. Part 2 will take up the IP considerations in tech formations.

The same…

At one level, forming a tech company is like forming any other company. “Tech company” isn’t a type of legal entity. It’s an LLC or corporation (usually a corporation for reasons discussed below). The form to register a tech company with the state, the LLC Certificate or the Articles of Incorporation, isn’t different for tech companies. Equity in a tech company takes the same forms as in other companies: common, restricted, preferred, options, et al. The basic governance document, the LLC Operating Agreement or corporate Bylaws, is the same in at least basic form and structure. And yet, equity issues loom large in tech formations, beginning with choice of entity.

Different: Choice of Entity

Equity structure, or planned equity structure, usually dictates the corporate form for tech companies. Tech companies can choose to be LLCs, but outside investors normally don’t’ invest in LLCs. Since outside equity investment is a requirement or at least a desire for most tech companies, most tech companies form as corporations or convert early on from LLC to corporation. In terms of where to incorporate, angel investors and VCs tend prefer Delaware corporations. So, beginning as early as the seed-funding round and no later than Series A funding, the company will have to be a corporation, preferably a Delaware corporation.

For the rare tech ventures that don’t need or desire outside investment, the LLC is a viable option. In fact, for most businesses being formed, the primary (only?) reason to go with a corporation over an LLC is to be able to attract and accommodate outside investors.

Different: Beginning Equity Structure

Tech companies utilize the same types of shares (common stock, convertible preferred stock, restricted stock, stock options, et al.) as other corporations. What’s unique about tech companies is the variety of shares they use and the sequences in which they use them. Some tech companies authorize multiple classes of common shares and preferred shares upon formation, knowing each will be needed from the outset or at least early on. They tend to authorize large numbers of shares (10 million shares is a frequent starting point, especially for Delaware corporations). This facilitates having multiple shareholders and multiple groups of shareholders (founders, employees and advisors, investors) without having to deal with small quantities or fractional shares.

Different: Equity Compensation (Equity Incentives)

“Sweat equity” is not unique to tech companies, but equity compensation seems more the rule than the exception in tech. We all know the formula: get in early (at low or no salary), accumulate options, get vested, cash in on the sale or IPO. This was a central theme of the greatest tech startup comedy ever (OK, small sample):

Many tech companies find themselves issuing incentive stock (restricted stock or options) to employees and advisors very soon after issuing the founders’ shares, or even at the same time. If that’s going to be the case, companies should include equity compensation documents among their starting documents. These include an Equity Incentive Plan and Restricted Stock Agreement and/or Stock Option Agreement. The attorney helping to form the company needs to understand these documents and how they work.

Tech companies rely heavily on stock restrictions, i.e. vesting requirements and/or transfer restrictions, to control their stock. It is essential that tech entrepreneurs and the lawyers who help them understand how restrictions work, including both ownership-wise and tax-wise.

Equity structure and ownership agreements are elements of any business formation, but uniquely so in tech formations. Tech companies normally incorporate rather than going the LLC route and their capital structures can get pretty complicated pretty quickly, with various types and classes of shares and equity incentives being the norm.