Legal Diligence on Corporate Formation and Stock Documents

7 minutes, 2 links

You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.

It is a typical part of legal due diligence to review a company’s charter documents.

In the corporate context, charter documents are a company’s articles or certificate of incorporation, bylaws, and any other corporate agreements, such as shareholder agreements, voting agreements, and so on.

dangerMake sure the company is in “good standing”—that is, the company has not let its corporate charter lapse. You can usually find out if a company is in good standing by reviewing the Secretary of State’s website in the state in which the company is formed. Similarly, if you wanted to, you can check that the company has the appropriate business licenses.

Where Is The Company Incorporated?

Most startups incorporate in Delaware as C corporations, if not in the state in which they are headquartered. Delaware is a common choice because of its corporate law history and business-friendly laws.* In fact, many VC firms require that companies be incorporated in Delaware or reincorporate as a Delaware company.

dangerBeware of companies that are incorporated in places other than either Delaware or their home state. For example, if a company is headquartered in California but incorporated in Nevada, it might be a red flag that the corporation is trying to avoid California income tax. State taxes do not depend on where you are incorporated, and so this is a fruitless strategy. Companies incorporated in unusual places may also incur additional legal cost and expense as a result of their bespoke domicile choice.

Cap Table And Stock Ledger

Cap tables are critical in understanding a business.

The capitalization table (or cap table), is a document showing each person who owns an interest in the company. Usually this is broken out by the name of each equity holder, and shows what type of equity instruments they hold. It is set up as a ledger, so that all share issuances and transfers can be tracked. Many companies use Excel or services like Carta to keep their capitalization table. They will create a worksheet for each type of equity security outstanding, such as common stock, Series A Preferred Stock, Series B Preferred Stock, and so on, including convertible debt and equity instruments that are issued. Included in the cap table is the stock ledger, showing all issuances of equity from the company to equity holders and all transfers of equity from one equity holder to another. There may be multiple ledgers for each type of stock or convertible security the company has ever issued.

founder The company’s cap table should show you everything having to do with the equity structure of the company—not just who owns how many shares, and what type of shares they own. If the company has issued convertible notes, there should be a note ledger; if the company has issued SAFEs, there should be a SAFE ledger. Done correctly, the ledgers will tell the complete story of the company’s life, including all of the company’s stock issuances from inception, and all of the stock transfers of all shareholders, for the entire life of the company. For example, the first entry on the stock ledger would be the company’s first stock issuance, to the founder who received stock certificate number 1.

It can be enlightening to see how the company has allocated stock among its founders. You can also get insight into whether all the key personnel are adequately incentivized.

caution One cause for concern may be a large amount of stock that is owned by an early founder or employee who is no longer with the company. This suggests that the company may not have had a stock vesting plan in place for founders early on. You will want to make sure at a minimum anyone who has already left has signed an IP Assignment Agreement. We’ll discuss employee issues later.

danger If the company has not maintained its cap table appropriately, it is a red flag. You need to know how much of the company you are going to own after you invest. You can’t know this unless the company’s cap table is complete and correct and reflects all outstanding ownership. Many, many companies have wound up in protracted and expensive lawsuits because they did not carefully document stock ownership, and then someone made a claim that they were owed a certain amount of the equity of the company.

Securities Law Compliance

founderEvery time a company issues stock or options or warrants to anyone, it has to either register the securities with the SEC or a state securities regulator (a very expensive process), or it has to find an exemption from registration, as we discussed in Fundraising and Securities Law. In addition to those exemptions used to raise money from investors, there are a number of exemptions available to companies when it comes to giving stock or options to employees, but they each come with their own limitations and conditions.

exampleIf a company issues stock options to employees, it should comply with federal securities Rule 701 with respect to those option issuances. Rule 701 has mathematical limitations on how many options can be granted to services providers during any 12-month period. A company issuing options to employees also has to comply with state securities law requirements, and may have to make a filing with a state securities administrator (as is required in California, for example).

Ideally, the investor would learn in diligence that the company is not self-administering its stock option plan, but relying on competent legal counsel to administer the plan.

danger If a company has issued securities for which no exemption is available, the company may have to make a rescission offer to the recipient of the securities. This can be true even if the recipients of the securities didn’t pay anything to receive them (as is the case for optionees). This is a very expensive and time consuming thing you never want to see one of your portfolio companies go through.

danger If a company has not been working with competent securities counsel, this is a red flag. The company may have issued securities to prior investors or service providers that might have to be rescinded, with the money you invest funding those repurchases.

Compensatory Equity Awards

One of the ways startups conserve cash and attract talent is to pay employees lower cash salaries but reward the risk they’re taking on the startup by promising them a portion of ownership in the company—equity. Typically, employees are not given ownership directly, but the option to purchase stock in the company, an option that can be exercised not right away but over time, referred to as vesting.

Equity can be awarded in different ways, most typically through stock options, but also through warrants and restricted stock awards.*

You’re reading a preview of an online book. Buy it now for lifetime access to expert knowledge, including future updates.
If you found this post worthwhile, please share!