Top Legal Mistakes to Avoid If You Want to Get Funded!

Recorded on Thursday, October 17, 2024


Venture capital and startup attorney Paul Johnson of Procopio discusses a number of case stories which illustrate frequent missteps made by entrepreneurs and startups.



In this presentation, Paul discusses:



1. The importance of understanding what’s on an investor’s diligence checklist
2. Why valuation rarely increases post-term sheet
3. What investor diligence looks like
4. Common issues:
* Failure to keep house
* Tax issues with employees / stock / options
* Cap table drama
* Strategic relationships
* Failure to sew up IP ownership



and more!



The discussion will use real case stories to illustrate each topic in a meaningful and easy to understand manner.

By understanding these common missteps, entrepreneurs and startups will be better able to more successfully navigate the pitfalls and traps that can keep their startup from getting funded.




About the Speaker:



Paul Johnson, partner at Procopio, helps entrepreneurs and their investors get companies formed, funded and sold, including initial formation of corporations and LLCs, negotiation of seed, early and mid-stage equity financings and buy and sell-side mergers and acquisitions. He is also adept at venture capital investments, public and private securities offering and compliance and general business counseling. Paul has also counseled some of San Diego’s most successful companies in Securities and Exchange Commission compliance and general corporate governance. He is the co-leader of Procopio’s Mergers & Acquisitions practice and leads its Emerging Company and Venture Capital practice.

Paul B. Johnson - Procopio | Procopio

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TOP LEGAL MISTAKES TO AVOID IF YOU WANT
TO GET FUNDED!
Paul Johnson
Partner, Chair, Emerging Technology and Venture Capital Group

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
What Message Should You Take From Me Today?
•Advanced planning for a financing can significantly smooth
the path
•The due diligence request is your frenemy

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
Diligence Request
•Asks for information regarding:
–Corporate Records—did you have meetings, take minutes? Was your
stock issued appropriately?
–Operations—who are your suppliers, customers, manufacturers? Do you
get along?
–Agreements—what are your existing obligations / rights
–IP—do you own your key IP assets, such as trademarks, processes?
–Tax—have you filed? Have you paid? All tax elections made timely?
–Legal compliance—employment; environmental
–Financial— are your accounting records reliable?
–Litigation—are you in litigation?

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
After you sign the term sheet, the valuation rarely
goes up
•But it’s after the term sheet is signed that the investor’s
attorney’s diligence request list arrives
•In other words—these are the myriad ways your business can
“leak” value and the valuation can drop
–Staying on top of these issues may not create
value, but it will
certainly help preserveit

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
Diligence
•It’s a multi-stage process:
–Pre-term sheet: confirms the interest of the investor
–Post-term sheet: legal checklist
•There may be overlap
–Purchase agreement
•Reps, warranties and schedule of exceptions
–What was previously informational is now legally binding

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 8: Failure to “keep house”
•You didn’t hold formal meetings or document board or stockholder
actions
•Some actions require board or shareholder approval
–
Bylaws: approval must either be at a meeting with noticeor by written
consent (unanimous for board actions)
•Problems:
–Approval of a key matter was given verbally (not at a formal meeting)
by a majority of the board…3 years ago
–Board votes were taken “by proxy”
–You didn’t formally record who was on the board

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
No. 8, continued
•What do boards need to approve?
–What’s “material”?
•Share issuances, option grants, material agreements
•Anything the CEO would be fired for not getting approved
•What do shareholders need to approve?
–Sales of material amounts of assets
–Amendments of charter, adoption or amendment of option plan

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
No. 8, resolved
•Delaware has a way to ratify unauthorized stock, but not an
invalidly appointed board
–Board “ratifies”;
–stockholders ratify or are notified
–file “cert. of validation”
–
Wait 120 days for a challenge
•Only works for corporations formed in Delaware
•Solution: get a minute book review. Identify issues and do it
right going forward

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 7: Employee comp / tax issues
•You thought she was a contractor so you didn’t withhold taxes
•You gave him stock as comp but didn’t withhold taxes
•83(b) elections—without one, as shares vest, taxes are due
•You granted options w/o 409A or at an exercise price below fair
market value
–Or gave people their paperwork much later, after the stock’s value had
increased from the promised exercise price
•
Solution: discuss equity compensation and
employment questions with an attorney.

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 6: Cap table drama
•Many flavors:
–Failure to track options / stock
•War story: failure to keep track of warrants killed an IPO
•War story: client re- prints lawyer’s “boilerplate” & uses it repeatedly, eventually issuing
unauthorized shares
–Poorly documented promises
•War story: company promised shares in offer letters, then did a 1,000:1 reverse split. The
letters didn’t say the shares would be reduced to account for reverse splits.
•War story: founder wanted to bring in undisclosed co- founder w/ 50% of company
•Back of the napkin promises / verbal commitments
–Lots of post-money SAFEs with low caps—can be very dilutive to founders
–
Solution: have an attorney look at all equity issuances to make sure the law was
complied with.

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 5: Federal and State Securities laws
•Must either register or have an exemption
•Main exemption: issuances that are not a “public” offering
•Federal:
–Doesn’t usually permit advertising (e.g., your website)
–Robust disclosure required if selling to unaccredited investors
•State:
–Each state has slightly different laws, some including pre- offer filings
–no unsophisticatedinvestors allowed in CA
–$2,500 per violation
•Solution: talk to an attorney before beginning offering or issuing equity

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 4: Too many shareholders
•Consents are unwieldy: like herding cats
–One VC client described it as “cap table damage”
•The smallest investors can be the hardest: their $100 means
more to them
•Solution: make an attorney your trusted
advisor.

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 3: Rights among stakeholders not defined
•Ill-advised rights of first refusal, including many SAFE holders
•What if prior investors have participation rights on a future
round? Will they waive them?
•Solution: make sure any participation rights are reviewed by
counsel

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 2: Bad exclusive / strategic business
relationships
•Exclusive relationships come with benefits and risks
•War story I:
–Buyer doesn’t like seller’s exclusive distributor
•War story II:
–Client partnered with an 800 lb. gorilla in its Series A round;
representative of the Series A gorilla sits on the board
–Soon thereafter got a nice acquisition offer
from an even bigger gorilla.
•Series A gorilla would make lots of money but hates
the deal solely because the buyer is another gorilla
•Solution: your lawyer can help understand ramifications of these trade-
offs

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
NUMBER 1: Failure to sew up your IP
•Like selling the Brooklyn bridge
–If you don’t own it, it’s hard to get paid for it
–War story: client didn’t have agreements
& was required to pay all employees
and consultants involved in
innovation $500 each to sign
an assignment of any generated
IP before the deal closed

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© 2024 Procopio, Cory, Hargreaves & Savitch LLP
Questions?
Paul B. Johnson
Partner
Procopio
Chair, Emerging Growth and Venture Capital Group
Co-chair, M&A Group; Voted Advisor of the Year
multiple years
Practice Areas
•Corporate and Securities
•Emerging Growth and Technology
•Mergers and Acquisitions
Contact Information
Direct Phone: [phone]
[email protected]