VW Podcast

4 Years with a 1-Year Cliff is the typical vesting schedule used by startups. A one year cliff means that nothing vests for the first year, but after a year the vesting would catch-up to 12/48, and then the remaining balance would vest over three years (typically 1/36 a month for 36 months).

An 83(b) Election is an election made under the Internal Revenue Code that allows a person receiving shares (or units) under a vesting schedule to recognize income based on the entire value of the shares as of the date of the grant – instead of as the shares vest. Basically, you accelerate the ordinary income taxes. In the context of a startup, the ordinary income liability at the time of the grant is negligible because the value of shares early on is so nominal. You want this. But if you fail to file an 83(b) election, then you will be liable for paying ordinary income taxes on the difference between fair market value and the grant price when the shares vest. If your company’s value is increasing over time, this could be a nasty consequence.

Accredited Investor is defined under the Securities Act of 1933. Anyone (individual or entity) who meets the definition is able to invest in certain private offerings. Simply put, an accredited investor is an individual with a net worth (individually or with a spouse) of at least $1,000,000 exclusive of a primary residence, or who has earned at least $200,000 individually, or $300,000 jointly with a spouse in each of the last two years. There is also a long list of ways that an entity can qualify as an accredited investors.

Angel Investors are individuals who provide seed or startup finance to entrepreneurs. In addition to an investment, angel investors may also provide industry contacts and knowledge.

A C-Corporation is a legal entity that allows for limited liability. C-Corporations are legally considered separate entities from their owners. Income is taxed at the corporate level and is taxed again when it is distributed to owners, potentially resulting in double taxation. Despite the double taxation, C-Corporations are the preferred entity for a startup because of familiarity and their ability to scale. That said, a C-Corporation is not right for everyone. Consult with your legal and tax advisors regarding the best structure for your startup.

Capital Gains is the profit from the sale of an asset or property. Taxes on capital gains are typically much lower than taxes on ordinary income.

A transaction or series of transactions whereby a startup raises investment dollars (or “capital”) to grow the company. Capital raises can be debt, convertible debt, or equity.

A Capitalization Table or Cap Table is a record of the owners of a company and their ownership percentage of the securities issued by the company. It is typically presented in a spreadsheet.

A Carveout is an exception from a stated provision in a contract.

Control terms are terms that allow a VC to exert positive or veto control in a deal.

Corporate Governance is the manner in which an entity is governed and regulated. The term is used across all entity types – corporations, LLCs, and partnerships. Corporate governance documents include the certificate of formation/incorporation and bylaws for a corporation, and the certificate of formation and company agreement (or operating agreement) for an LLC.

A Data Room is an online repository of company docs. Typically, a startup will create a data room of relevant company docs to share with potential investors. This is preferred to emailing out docs because the startup can keep them all in one place and update them as necessary. The company can also password protect the data room in order to limit access.

Distribution is a payment by a company to its shareholders (or members in the context of an LLC).

Early-Stage Financing refers to investments that happen early in a company’s lifecycle.

Equity broadly refers to the ownership of a company, which can be represented by stock or other units of ownership. When an investor has ownership of a company, he or she has equity in the company.

Fair Market Value is the price that a reasonable third-party would pay for a given asset in the open market.

Fiduciary Duty is the legal and ethical duty that an individual has to an entity, which includes the duty of care and the duty of loyalty.

General Solicitation is a company or fund publicly advertising its securities. General solicitations offer the potential to reach more investors. However, general solicitation may cause the company to have to comply with more stringent security registration requirements at the state and federal levels.

Generally Accepted Accounting Principles (GAAP) are mandatory financial accounting procedures and methods that public companies must comply with when reporting their financials. Private companies are not required to use GAAP as their accounting method, but many do.

The Growth Stage generally begins once the startup is generating revenues and is now investing more in marketing and user acquisition than in product development.

A Holding Period is the amount of time that a person or entity owns an asset or security.

The Issue Price is the price at which a company’s securities are sold.

An Limited Liability Company (LLC) is the best of both worlds when it comes to entities. An LLC offers the benefits of limited liability, taxations as a partnership, and management flexibility. An LLC can elect to be “manager-managed” or “member-managed.”

Limited Partners (LPs) are partners in a limited partnership that are not personally liable for the company’s debts or liabilities. The limited partner invests in the company but cannot exercise control over the day-to-day operations of the company. If the limited partner does exercise such control, the limited partner may lose its limited liability protection.

Market Terms are terms in an agreement that are standard or “market.” In regard to venture capital agreements, most startups and investors use SeriesSeed.com and NVCA.org as a baseline for setting terms for those rounds.

Section 1202 of the Internal Revenue Code provides for beneficial tax treatment for investors who purchase Qualified Small Business Stock (QSBS) in a company. If a stock qualifies as QSBS, investors may exclude up to 100% of the federal capital gains tax associated with the sale of the QSBS, subject to certain limitations. In order for stock to qualify as QSBS, the company and investor must each meet and maintain compliance with a list of certain requirements by the IRS. The primary requirements include, but are not limited to, the following: 1) the company must be a C-corp, 2) the company must be engaged in a “qualified” trade or business, 3) the company must have less than $50 million in assets at the time of the stock issuance, 4) investors cannot be a corporation, and 5) investors must hold the QSBS for at least 5 years prior to selling. Given the complexity associated with QSBS requirements, we recommend consulting with legal and tax advisors before taking steps to qualify any stock as QSBS.

A Partnership is created, without filing anything with the state, when two or more individuals go into business for profit. Partners are personally liable for all of the partnership’s debts and liabilities, but the partners receive the benefit of pass through taxation. Partnerships are rarely intentionally created now because of other limited liability options that exist.

A Portfolio Company is a company that is part of a venture capital or private equity fund’s investment portfolio.

A Private Company is a company whose shares are privately sold and owned and are not traded on a public market. Unlike public companies, private companies’ stock is often owned by a few shareholders.

A Private Offering is a company selling its securities to private-accredited investors without registering the securities with the SEC.

A Private Placement Memorandum (PPM) is a document to raise capital that provides potential investors with information about the type of investment, the company’s financial health as illustrated by financial statements, the risks associated with the investment, and the company’s objectives during the term of the investment.

Registration is the process of notifying the SEC that the company plans to sell shares to the public and to register the shares with the SEC under the Securities Act of 1933.

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. The exemptions are commonly known as Regulation D, and the ’33 Act contains three rules (Rule 504, Rule 505, Rule 506) which provide exemptions from the registration requirement, allowing some companies to offer and sell their securities without having to register the securities with the SEC. (You might still be subject to state security clauses and anti-fraud clauses, even if you do have exemptions). Please consult with an attorney.

Regulation D Rule 504 provides an exemption for the offer and sale of up to $5,000,000 of securities in a 12-month period. General offering and solicitations are permitted under this rule as long as they are in accordance with state law and restricted to accredited investors. Rule 504 allows companies to sell securities that are not restricted if the securities are only sold to accredited investors and the securities meet certain state registration rules commonly referred to as “Blue Sky” rules. Please consult with an attorney.

Regulation D Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, securities may be sold to an unlimited number of “accredited investors” and up to 35 “nonaccredited investors,” who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are restricted, in that the investors may not sell their securities for at least six months, oftentimes up to two years, without registering the transaction. Any offering under Rule 505 should provide significant disclosures in the offering memorandum. Also, Rule 505 exemptions impose a level of financial reporting that Rule 504 companies do not have to meet. Note: the SEC has repealed Rule 505, to be effective on May 22, 2017. Please consult with an attorney.

Regulation D Rule 506 is a “safe harbor” for the private offering exemption. Under this rule, companies can raise an unlimited amount of capital to an unlimited number of accredited investors and up to 35 other purchasers. Also, subject to certain restrictions, the company may use general solicitation or advertising to market the securities. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated –  that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. Further, purchasers receive restricted securities, which may not be freely traded in the secondary market after the offering. Lastly, the seller must be available to answer questions by prospective purchasers. Please consult with an attorney.

Revenue is money that is brought into a company by its business activities (typically from sales).

The Securities Act of 1933 was the first federal legislation regarding the registration of the sale of securities. The Act’s extensive registration and disclosure requirements allow potential investors to have all relevant information needed to make informed investments.

The Securities and Exchange Commission (SEC) is the federal regulatory agency that enforces federal securities laws (such as Sarbanes-Oxley, the Securities Act of 1933, the Securities Exchange Act of 1934, and other securities regulation), proposes rules for the regulation of securities, and regulates the nation’s stock and option exchanges. The SEC works to maintain fair, orderly, and efficient markets, protect investors, and facilitate capital formation.

A Security is used to describe a tradable asset of any kind and generally represents an interest of equity in a company. Stock, membership units, and convertible notes are all forms of a security.

The Seed Stage is the initial stage in the life of a startup where a startup looks to establish its business venture or idea using seed capital. A Seed Stage round is sometimes referred to as a Series AA round.

A Series A Round is generally the first significant capital funding event taken on by a startup, usually after that startup has raised some initial capital through a Friends and Family round, Seed round, or both. In a Series A round, the stock issued will typically be preferred stock designated as Series A stock. You may also hear this financing event referred to simply as an “A Round.”

Sophisticated Investors are, in essence, investors who are capable of fending for themselves in a prospective transaction. The term is most often used in the context of discussions about whether a private securities offering qualifies for an exemption from registration under federal and state securities law.

In order to qualify for the Rule 506(b) exemption, for instance, the SEC requires all non-accredited investors to be sophisticated. For the purposes of Rule 506(b), the SEC defines a sophisticated investor as an investor possessing sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment. 

Stock Options are an option to purchase a fixed amount of shares at a fixed price that typically vest over time.

Venture Capital Funds are investment funds that invest in startups and seek high returns in exchange for the risky nature of investing in startups.

Vesting is the period of time that securities (usually stock options) may be subject to forfeiture or repurchase based on meeting certain time or milestone criteria. Vesting co-founder equity helps to protect the company’s equity – so that a departing co-founder doesn’t depart with a lot of equity, but rather only the equity that has vested.

A Vesting Schedule is the timeline over which a stock recipient’s equity (usually stock options) vests. The typical vesting schedule is four years with a one year cliff. See Four Years with a One Year Cliff.