Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

I recently have had the misfortune of having to counsel a client on the general subject of closing down a business including the duties and liabilities of directors and officers who find their companies in this circumstance. Depressing as it sounds, I have the sense that there may be more of this in the near future. So, below is a punch list (not comprehensive or detailed) of some of the things you should be aware of, if you find yourself in this horrible situation.

Here are the disclaimers:  

The content of this blog posting is in no way an adequate substitute for actual legal advice. The laws governing these topics are detailed and complex, and the brief descriptions below are not adequate synopses of these laws. The content of this blog posting is taken from memoranda prepared by our firm in connection with advice to clients operating under specific circumstances and may not be applicable to your particular circumstances. If you find yourself involved as an officer, director or otherwise with an insolvent company, consult an attorney knowledgeable in this discipline.

Credit for the research and writing of memoranda from which I have taken most of the below belongs other attorneys at Foley Hoag LLP, particularly Mark Clark whose carefully written, thoroughly researched, and detailed memorandum I have grossly butchered in an effort to provide readers of this blog post with the gist of the most important concerns applicable to officers and directors of insolvent companies. To the extent that errors and inaccuracies have crept into this information, they are, of course, my sole responsibility.

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It will come as no surprise that the number of exits (IPO and M&A transactions) for venture financed companies is way off this year -- compared to last year. As I noted in a prior posting, Series A transactions are off year on year. Although some industries are faring well (greentech for one), on a macro level, series A deals in New England are down approximately 30% in the first six months of 2008 compared to the first six months of 2007. You can get more detail on this in our EEC Perspectives October 2008 issue. In addition, however, the statistics for M&A and IPO transactions are worse according to the CNET NewsBlog which points out that as of July 1, 2008 there had been no IPOs for venture backed companies and that in the first half of 2008 there were 56 M&A transactions compared to 97 in the same period last year. We are still compiling the statistics for New England based Series B and later stage deals for the most recent quarter, but these numbers should be available shortly, and I expect they will be consistent with what we are seeing in Series A deals and exits. To some extent the problem begins wiht exits. If investors  don't have good visibility on potential timing or valuation of exits, it becomes very hard to complete a later round deal. If investors are anticipating difficulty raising Series B and later rounds, they are reluctant to take the risk on the early round. The silver lining may be that there is a lot of money sitting on the sidelines, and when the market turns this money will be looking for deals.

Further to cloud computing as one of the next hot things, take a look at this article on Rackspace in TechDirt and this article from Always On.

A question that comes up with some frequency is how many options to grant to an advisory board member. One of my partners advises his start up clients not to issue more than 1% of a company’s equity to the entire advisory board. I think this is a pretty good goal. My experience, however, is that some advisory board members should be paid more than others because they ad more value, either because they undertake to do more than others or because they bring more visibility and credibility than others. One advisory board member that I know insists on half of a percent for her commitment, but she is a rock star in her industry and agrees to make phone calls and provide introductions. In effect, she adds more value than simply her good advice. So, those are some guideposts, but when considering a new advisory board member you should consider the contribution that is expected as well as the dilutive effect of the option grant.

11/04/08 update -- One of my start-up clients just faced this issue and settled on a pool of 1.5% for all advisory board options.

Everyone on is always wondering what will be the next hot thing in the high tech world.  We all know about energy and  green and clean.  Here are two more candidates for what may be hot in the next couple of years.  (1) Mobile -- take a look at this article by Mark Horan of MassNetComms.  (2) Cloud computing.  MassNetComms strikes again -- they hosted a panel discussion on this topic.  the panel included C level people from three very hot private companies Bill Blake from Interactive Supercomputing, Foster Hinshaw from Dataupia, and Bob Zurek from EnterpriseDB.  It also included David Skok from Matrix.  It is clear that there are a lot of entrepreneural opportunities in this space.

One thing that I find many entrepreneurs (particularly first time entrepreneurs) struggle with is the distinction between options and restricted stock and why one would use restricted stock instead of options.  See also the following link:  Stock Options and Restricted Stock.

I think it is fair to say that most, perhaps all, entrepreneurs have heard of options.  But, just in case, options are contractual rights to purchase shares of stock (usually common stock) at a fixed price.  In the employment context, options typically vest over time.  For example, four year vesting is a common provision in a venture financed company.  A typical arrangement would be for options to vest 1/4 on the first anniversary of employment  and 3/4 ratably (monthly or quarterly) over the subsequent 3 years.  This is the arrangement included in the National Venture Capital Association form of Term Sheet. Vesting refers to the right to exercise the option and purchase stock at the option price.  Since the employee cannot exercise options unless they are vested, to the extent that options have value, the employee is motivated to remain with the company and realize that value.

Restricted stock is actual stock (as opposed to options which are a right to acquire stock).  Restricted stock can be made to provide an incentive similar to that of options by requiring, as a condition to the grant of restricted stock, that the employee receiving the restricted stock enter into an agreement providing for "vesting."  In the context of restricted stock, it is often referred to as "reverse vesting" and it works like this:  The employee is granted shares of common stock subject to the condition that the company will have the right to buy back the shares at a trivial price (often par value).  The concept of reverse vesting comes in because the company loses its repurchase rights over time.  So, on the first anniversary of employment the company may loose the right with respect to 1/4 of the shares and so on.  In this way restricted stock mimics options.

Having said all this, there are important tax differences between options and restricted stock.  Options can be incentive stock options or non-qualified options.  Incentive stock options are options that meet certain requirements set forth in the internal revenue code and, if all conditions are met, can provide the option holder with capital gains treatment (as opposed to ordinary income treatment) upon the sale of stock acquired through the exercise of these options.  Among the requirements are that the options be held for at least one year and that the stock acquired upon exercise of the options be held for at least one year.  Since most option holders commonly sell the stock they acquire promptly upon exercise of the option, they rarely achieve capital gains on the excess of the sale price of the stock over the exercise price of the option.  Non-qualified options do not provide the possibility of achieving capital gains treatment on the excess of the sale price of the stock over the exercise price of the option (although you might, depending on how long you hold the stock, achieve capital gains on the difference between the fair market value on the date of exercise of the non-qualified option and the eventual sale price of the stock).

With respect to restricted stock, the holding period for capital gains treatment begins upon the date of grant, if the holder files a so-called 83(b) election under Section 83 of the Internal Revenue Code.  As a result, most employees who are granted restricted stock will achieve capital gains treatment.  The dark lining on this silver cloud, however, is that when you file an 83(b) election you must take the then fair market value of the stock into income (for purposes of income tax) without regard to whether or not it is vested.  So, if the stock has a high value, the employee receiving the stock will have a lot of income and no cash to pay the tax.  If the 83(b) election is not made, then the employee has to take into income the fair market value of each share of stock at the time that it vests.  If the value of the stock is increasing (as with the customary hockey stick projections) you can imagine that the income to be realized could become substantial.  To avoid these situations, use option grants.  However, early in the life of a company, its stock may have little value, with the result that using restricted stock and increasing the odds of getting capital gains upon a sale of the stock may make good sense.