Why VC's Invest In C-Corps

When VCs invest in a startup they require the company to be legally formed as c-corps for a variety of reasons.  While I am not a lawyer and this is not an exhaustive list, I have attempted to articulate the key reasons for this requirement.

Liability:  C-corps appear to provide the strongest corporate veilminimizing the extent to which investors in the corporation are exposed to the company's liabilities.

Pass Through:  Most of the other legal structures do not provide complete separation between the company and its shareholders.  Complete separation between the company and shareholders not only provides VCs with greater protection from legal liabilities incurred by the portfolio company, it also simplifies the accounting.  Since VC firms are structured as limited partnerships, gains and losses realized by a portfolio company that was not a c-corp (and did not have separatation between the company and its shareholders) would be passed through to the limited partners of the VC fund.  This additional accounting would create significant work and administrative costs for these limited partners and lead to substantial fluctuations in accounting valuations of the VC portfolio.

Stock Options:  C-corps can have stock options plans, which are often valuable tools for recruiting and maintaining talent in a corporation.

Familiarity:  C-corps are well-known structures with lots case law surrounding them making navigating the legal jungle easier.

Source: http://mpd.me/how-to-form-your-company/

Why VCs Do Not Sign NDAs

First-time entrepreneurs sometimes ask VCs to sign NDAs (Non-Disclosure Agreements). They do this because they are worried that their intellectual property will not be protected without a legal agreement in place.

To the surprise of these individuals, most VCs do not sign NDAs. However, in my opinion that doesn’t mean that the entrepreneur is entirely unprotected.

While there are always exceptions, most VCs follow an informal code of ethics when it comes to intellectual property. Most VCs follow this code for a few reasons. First, they protect people’s IP because it’s the right thing to do. Second, they have a market-driven incentive to protect intellectual property, as a failure to do so would create a professional risk. A reputation of betraying this code would dissuade entrepreneurs from bringing opportunities to them, preventing them from being good at their job.

In addition to these reasons, VCs can’t afford to invest the time or money in having lawyers evaluate NDAs for every company that the review.  VCs typically review thousands of business plans a year – if they had to pay lawyers to evaluate thousands of NDAs and spend time reading thousands of NDAs they wouldn’t get much else done.  Ultimately this would create prohibitive cost and time requirements.

Furthermore, there are frequently numerous startups trying to solve the same problem.  VCs may meet with many of them and it takes VCs awhile to figure out which company they want to back. If they had to sign NDAs with each company before hearing their pitch, there would inevitably be companies taking action against them when they join the board of one of the players (even though they still follow the code of ethics).

Based on that, it’s generally not a good idea to ask a VC to sign an NDA, as it will make you look naive. If you are not comfortable with discussing your business with VCs without a legal document in place, then it may make sense for you to look for angel investors that will sign an NDA.

In my opinion, the best way to protect yourself is to make sure that you are pitching to VCs that are not on the board of a competitive company. Beyond that, VCs are generally ethical professionals and are, in my opinion, a safe group to speak with.

Source: http://mpd.me/why-vcs-do-not/

Why Employees Receive Common Stock

When employees are granted stock, or more often stock options, they are entitled to shares of common stock. Common stock offers employees access to the economic benefits of ownership, aligning incentives to focus on increasing the value of the company.

It’s worth noting that these option plans do not provide employees with preferred stock for several key reasons.

First, preferred stock is designed to offer its holders unique control over specific aspects of corporate decisions (e.g., sale of the company, compensation of senior executives, etc.). These aren’t decisions that employees are in a position to make as they aren’t always privy to all of the information required to make these decisions.

Second, investors seek preferred stock because it enables them to make the aforementioned decisions. When those decisions need to be made a vote is taken amongst the holders of preferred stock. By giving employees preferred stock investors would own a smaller percentage of the total pool of preferred stock, reducing their ability to control these votes. As a result, the distribution of preferred stock would prevent investors from providing the company with capital.

In sum, employees are granted common stock because it is designed to offer them the incentive to exclusively focus on expanding the value of the company.

Source: http://mpd.me/why-employees-receive-common-stock/