This week we’re having tea with John Bautista, Partner and Board Director at Orrick. As a partner in the Silicon Valley office, he co-leads the Emerging Companies Group, which advises emerging companies and venture capital firms. He is also a board member and co-founder of the Long-Term Stock Exchange, as well as an advisor and co-founder of Clerky.com.
Highlights from Series Tea with John Bautista
This interview has been lightly edited for length and clarity.
What are optimizations that people don't think about but should do before incorporating?
Determine who you're going to found the company with, and be comfortable with your co-founders. For tax and other reasons, it's important to have every co-founder join the company and be issued their stock and equity at the same time.
Figure out those allocations of ownership to determine what the vesting schedule will be. Determine what is the IP: if there is some pre-existing IP that the various founders have worked on as part of the project, what IP is going to go into the company and what IP is not? What IP is going to remain with the founder as individually owned IP?
So these are the decisions to be made prior to incorporating. Most companies will incorporate in Delaware.
What is Founders Preferred and do you have to do it at incorporation?
Founders Preferred stock is confusing because it is not preferred stock. It's a form of common stock that's just like the common stock that the founders will have in any company that you form in Delaware, but it has one distinct difference: it has a conversion rate. If you decide to sell your shares to a future investor in a secondary transaction, that investor’s shares will automatically be converted into the then existing series of preferred stock.
For example, if the company has already done a Series B preferred stock financing and you hold some Founders shares in the form of Founders Preferred stock, if you were to sell those to a Series B investor either in connection with the financing or shortly thereafter, they will own it in the form of Series B preferred stock. They never take it as common stock. That's helpful for a number of reasons:
- First, investors want to own preferred stock. They don't want to own common stock. Preferred stock has a liquidation preference. So if you're doing a Series B financing round, investors will be indifferent if they can buy the Founders Preferred from you because they will own it in the form of Series B preferred stock.
- The second thing is if investors cannot buy Founders Preferred, they will try to negotiate a discount. As a founder, your objective is to achieve the highest price per share for your common stock. If you can deliver common stock to your investors in the form of Series B preferred stock, there's no reason why an investor should demand a discount. This enables you to achieve the highest price per share for your common stock.
- The third reason is it provides a separate security. If you're selling Founders Preferred stock and putting a value on it, the reference value being the Series B preferred stock price, it will not have an adverse impact on your common stock price. If you're selling common stock as a founder, a preferred stock prices evaluation firm is going to scratch their head and say, "Well, there's a secondary market going on in common stock, and therefore we can no longer afford you that significant discount.” Founders preferred allows you to keep those operations separate.
Stripe Atlas and Clerky don't do Founders Preferred. Will this slow down the formation of the company?
Don’t slow down the formation of the company. Go to Clerky or Stripe Atlas and create the company. Then we have a module at Orrick where we've got the forms ready to convert a portion of your common stock into Founders Preferred.
Bear in mind that whenever you decide to push the button, any person who's a stockholder of the company is entitled to the same ratio of Founders Preferred as you are. If you are a team of two or three founders, and you've brought on board another five or six people who are equity holders in the company before your preferred financing round, all nine people will get Founders Preferred in the same ratio of their total holding. This is why it's important to make these decisions earlier.
Get high-impact tips from top investors, sent right to your inbox.
Why not just convert all the Founders stock into Founders Preferred? Is there a correct ratio?
What we see most of the time is to have 15% of your holdings as Founders Preferred and 85% as common stock. The reason you don't have 100% Founders Preferred is it cannot be subject to vesting. This is important for founders to consider because you're coming together with a group of people, some of whom you've worked with before in other enterprises, some of whom you may not have worked with. If someone leaves the company and they have 15% of their holdings subject to Founders Preferred, then they're going to keep those shares.
But it is a governing mechanism. If one person leaves the company, the company will have the right to repurchase the invested shares. Those invested shares get retired but the ownership is equally divided among remaining founders.
I know some founders don't do Founders Preferred because they think investors are scared by it.
I don't think the perception of investors not liking it is a reason not to do it. I also think the perception that investors don't like Founders Preferred is not correct.
I was in a board meeting with a client one time and the company was doing well, the founders wanted to get some liquidity on their shares. Sequoia was represented on the board and they wanted to buy some shares. One of the Sequoia partners asked me, "I wonder if we have Founder Preferred stock in this company?" because they wanted to buy, and they would much rather hold preferred stock. So long as you keep the Founders Preferred ratio to 15%, it's not a problem. Why 15%?
Typically, going back in the history of Silicon Valley and the way these forms evolved, the maximum de minimis percentage that most investors would agree to was 15%. By setting Founders Preferred at 15% and no higher, I don't think you're sending a signal that you want to get out of the company earlier than normal.
If you only have common stock, haven't done a preferred round, and want Founders Preferred, what's a rough cost for conversion?
If it's a Delaware company, from Clerky or Stripe Atlas, and if there's only a couple of founders, it's $3,000 to $5,000. Typically the common stock is already subject to vesting, a four-year vesting schedule. That vesting schedule has to be amended because the new Founders Preferred will not be subject to vesting.
Let’s talk about board composition. If you’re about to raise a Series A, what’s an ideal board pre-Series A to put you in the best position?
I recommend at least two founders on the board. Those founders are representative of the common stock (for the foreseeable future of the company, the founders will hold a majority of the common stock.) It's also okay to have three. It would send the wrong signal to the investors for the company to have four or five on the board.
It's unusual for any investor to be a board member unless they're buying a significant block of preferred stock. If you're doing SAFE financing or convertible note financing, and someone insists on being a board member of the company, that's a red flag.
The advantage of raising from convertible notes or SAFEs is you don't give control of your board away. Once you get to preferred stock, you're going to negotiate a host of rights that investors will want. Typically only the lead investor has a board seat. In most companies, you end up with two founders and one preferred investor. Three board members in total is a good number. Any more than that makes corporate governance a bit cumbersome.
I don't know if it's obvious to people why the founders should be in control of the board.
One of the founders is going to be the CEO. The only body that's able to fire the CEO is the board of directors. Early on in the life of a company, the founders control the board so that they can not be fired as CEO. But there will come a point in time where it is expected that the founder team does not represent a majority and the CEO could be fired. That’s the reason to hold onto control.
Even if founders control the board, investors will negotiate a dozen or so items: that their consent will be necessary for certain corporate actions. Founder control of the board is not so that founders can do things, because investors will make sure that the important things will require their consent anyway. The reason to have founder control is to make sure that things can't be done to you, and that main thing is terminating the CEO.
What if you're a solo founder? Does that mean you're going to get one founder seat or can you get multiple?
If you're one founder you can designate in your company certificate of incorporation, how many seats are represented by the common stock. The standard way is if you're one founder, you would appoint yourself. Then you also have the right to appoint someone else because you control the common stock. You would appoint either another employee or someone outside of the company who is an industry expert that you trust. If you don't like that person you can replace them because you control that seat. That seat is controlled by the vote of a majority of the common stock.
You can designate one, perhaps two, seats in addition to yours, that you have voting control over. That's the simplest and most standard approach.
Under Delaware law, a board member can have multiple votes. You could ensure that the Founders seat of common stock is entitled to two votes at all times. The downside to that is investors will see it as unusual.
My recommendation is to go with multiple seats that the founder has control over. What that means is, as part of a financing round, an investor may say, "We don't like having another employee on the board in that seat. We prefer an industry representative, someone independent.” Then it's okay to replace that person with an industry expert, someone who's independent. At the end of the day, you still have the power to nominate to replace that seat.
Let's say you are doing a Series C and you don't want to give up board control. Do people just go from maybe three seats to four? Is it common to keep issuing founder seats to keep board control?
Typically the compromise is to agree that you can create a new seat. The investors are not going to like that it would be a common-only seat you have full control over, where you could appoint anyone that you want into that seat. But to make sure the investors don't have control, you add a new seat and you negotiate the mechanics around how that seat is appointed.
Typically you make sure that it's someone who you as the founder, nominate, and that it's a person who the investors would require as an independent industry expert. But you still have the power to nominate and remove that person. So it could be a seat that's determined by the common and preferred together as a class.
Should you forego funding if you don't want to lose control of the board?
Yes, if that's your singular focus. The most common process of building companies involves dilution of ownership, voting rights, and control. Your objective is to minimize dilution in those considerations. Usually, that's done by granting stock options to employees instead of giving employees voting rights upfront. And you want to maintain control over your board.
You are forming a partnership, a long-term partnership in particular with your first major investor. Your investors are going to be doing due diligence on you before they invest. And it's important that you do due diligence on them. Talk to other founders and hear their experience working with these lead investor groups. Ultimately it comes down to trust between you and your investors.
Sometimes founders get massively diluted down so they have less than 5%. Many people have IPO'd with less than 2%. When can founders push to get more equity after they've been diluted heavily?
Typically that doesn't happen until they’ve exhausted their four-year vesting schedule. But if they are dropping below levels that are representative of what an outside person would receive—for example, a CEO coming on board would receive somewhere between 7 and 10%—then there's good justification for the founder to say, "I need to be brought up at least to levels that a CEO would be brought up to."
I have seen situations, and Elon Musk is the best example in the marketplace right now, where the founder is so incredibly valuable to the company that the investors want to make sure that they're devoting as much time and attention to create value. They know this founder can read value for the company. I've seen boards agree to grant blocks of equity to founders, usually somewhere between 2% and 5% of the company, in the form of performance vesting grants.
If you're doing a new round of funding and have multiple VCs that are trying to win the round, one of them might offer equity refresher to the founders. How does that work?
The new investor, from a due diligence perspective, wants to be sure that the founder has enough skin in the game and equity. I've seen situations where investors were concerned about making an investment because the founders just did not own enough of the company.
If you feel like you don't have enough skin in the game to work with the new investor, you'll often be able to receive, as part of that term sheet, a new stock option grant in the company.
How founder-friendly are the terms right now?
It's surprisingly founder-friendly. Over the last couple of years, venture funds have raised billions of dollars that they're sitting on. The mantra is that in bad economic times, investors make the best investment decisions. I've seen the Sequoias of the world extremely active in new rounds. The terms that they're putting down haven't changed from terms that we saw pre-COVID.
Where we have seen changes is with companies that needed to raise capital have already had a number of financing rounds. They were struggling. Insiders put down new investment terms that were more favorable to them than previously.
Now's a great time to start a company. I would recommend partnering with the best investors, they are still very active in the space, and think about some of these tools that we've been talking about today and put them in place early on in the life of your company.
Get high-impact tips from top investors, sent right to your inbox.
You can also send us a note at [email protected]. We’d love to hear what you thought of the episode, or who you’d like us to have tea with next.
The Mercury Team