When your startup company raises capital, valuation is a key question that must be tackled Rey Maualuga style. (If you are unfamiliar with “Rey Maualuga style,” click here for a Youtube example.) The two main valuation concepts in a venture capital financing are pre-money and post-money valuation.

In a venture capital transaction, the venture capital firm invests cash in the startup company in exchange for newly-issued (preferred) stock. The startup company’s value immediately before the funding is called “pre-money valuation” while the startup company’s value immediately after the transaction is called “post-money valuation.” (Technically, pre-money and post-money are more about price than a startup company’s valuation.)

Pre-money Valuation and Post-money Valuation Equations

(1) Pre-money Valuation = Post-money valuation - Venture Capital Investment

(2) Post-money Valuation = Venture Capital Investment/Venture Capital Ownership Percentage

You can determine share price by the following equation:

(3) Share Price = Pre-money Valuation/Number of Pre-money shares.

You can determine how many shares to issue the venture capital firm by this equation:

(4) New Shares Issued = Venture Capital Investment/Share Price

Pre-money Valuation and Post-money Valuation Examples

Example 1

Let’s say Google’s new venture fund comes to you and offers to invest $3MM into your startup for 30% of the company. Plugging the numbers into equation (2), we get:

Post-money valuation = $3MM/.30 = $10MM

Thus, to calculate pre-money valuation, we use equation (1) as we now know the post-money valuation and the investment amount:

Pre-money valuation = $10MM - $3MM = $7MM

Example 2

Now let’s say a venture capital firm offers your startup company a $4MM investment at a $6MM pre-money. To determine how much your startup would give up in exchange for the $4MM, we use equation (1) and get:

$6MM = Post-money valuation - $4MM, and solving for Post-money valuation (Post-money = Pre-money + Investment) gives us $10MM

Next, we use equation (2) to find the Venture Capital firm’s percentage:

$10MM = $4MM/Venture Capital Firm Ownership Percentage (VCFOP), solving for VCFOP (VCFOP = $4MM/$10MM) we get 40%.

The Wall Street Journal, Yahoo, and VentureBeat are reporting this morning that Google is currently putting the pieces together to launch an internal venture capital arm.

This isn’t the first time rumors have swirled about Google launching a venture capital fund, but the speculation is increasing based upon Google’s hiring of William Maris, a former web hosting entrepreneur, to (allegedly) set up the venture capital arm. Another thought is that Google is planning to launch the venture capital fund to coincide with the release of its Android mobile platform–and therefore Google would be targeting the telecom sector.

While Google surely brings the name factor to any business or service it plans to launch, it will be interesting to see if Google can pull it off. Google has been an acquirer of companies in the past, but Google’s biggest obstacle will be whether it can give their portfolio companies the requisite time and attention to develop the startup. There are a lot of private venture firms that already do.

Read the WSJ article here. Read the Yahoo article here. Read the VentureBeat article here.

Ernst & Young LLP filed a complaint yesterday in federal court against Entrepreneur Media, Inc. (publisher of Entrepreneur Magazine) alleging that Entrepreneur Media is infringing upon Ernst & Young’s “Entrepreneur of the Year” trademark registered with the USPTO.

For more than 20 years, Ernst & Young has bestowed an “Entrepreneur of the Year” award upon successful and innovative business leaders in the United States and around the world. Prior winners include Michael Dell (Dell), Steve Case (AOL), Jeff Bezos (Amazon), and John Mackey (Whole Foods).

In the complaint, Ernst & Young alleges that Entrepreneur Media first infringed in 1994. At that time, Ernst & Young objected in writing and Entrepreneur Media stopped using the phrase “Entrepreneur of the Year” in conjunction with a contest. In fact, Entrepreneur Media’s corporate counsel at the time thanked Ernst & Young’s counsel for “bringing the matter to Entrepreneur Media’s attention.” This 1994 letter is now Exhibit 2 of the 2008 complaint.

Now, Entrepreneur Media is currently running a 2008 Entrepreneur of the Year contest. And just like 14 years ago, Ernst & Young sent Entrepreneur a ceast & desist letter. But this time, Entrepreneur Media rejected Ernst & Young’s demand to stop using the phrase.

Enter lawsuit.

Ernst & Young seeks a permanent injunction, destruction of all Entrepreneur Media materials related to their contest, an order directing the USPTO to cancel Entrepreneur’s Media’s registrations, Entrepreneur Media’s profits from the use of the “Entrepreneur of the Year” mark, damages, attorneys’ fees, and any other relief the Court deems proper.

Like reading legal complaints? Click here to get the PDF of EY’s complaint.

Have you ever tried to polish your sneakers? I have. And no matter what method or device I used to refurbish my sneakers, they remained unrefurbished sneakers. The problem wasn’t my washing machine, detergent, or shoe polish–it was that my sneakers just weren’t worth the attempt. Unlike other forms of footwear, sneakers just aren’t made to be polished.

This can be a valuable lesson for startups attempting to incentivize their employees: not all employees have the ability to be incentivized.

A startup can choose from a variety of carrot-and-the-stick incentive options to get the most out of their employees (capital-willing, of course). These options include salary, commission, bonus, stock, vacation, health insurance, retirement accounts, stock options, warrants, phantom stock, and other deferred compensation plans. But a startup must realize that some employees will not respond to any combination of incentives. Thus, your startup may have the right incentive plan but the wrong employee.

In Economics, the problem of motivating an employee to act on behalf–and in the best interest of–the startup company is known as “the principal-agent problem.” This problem arises when a principal compensates an agent for performing certain acts that are useful to the principal and costly to the agent, when it’s costly for the principal to supervise the agent. (Sound like your startup?) Basically, you solve the principal-agent problem by finding the right combination of incentives for the employee. However, the difficulty of selecting the optimal structure is reflected by the multitude of carrot-and-the-stick compensation mechanisms.

Economics assumes a lot of things, and the biggest assumption Economics makes is that people will act in a rational manner. But as we all know, people don’t always act in a rational manner.

Thus, you should not assume that your employee will respond in a rational way to your startup’s incentive offering. It may not matter what or how many carrots you dangle in front of your employee. Not all employees are made to be incentivized, just like not all footwear is made to be polished.

#5 - In your latest attempt to go viral, you call in to the Suze Orman Show and ask if you can afford to purchase your startup company, constantly letting her know how fantastic it is.

#4 - You start a blog about your blog about your startup company.

#3 - To get more street cred with VCs, you and your 2 co-founders change your names to Brad Feld, Paul Graham, and Dharmesh Shah, respectively.

#2 - Your startup company’s twitter account has less followers than I have.

#1 - You offer to pay your pizza delivery guy by issuing him common stock, and he counters with preferred stock and a 10x liquidation preference.

The limited liability company (LLC) is a relatively new legal entity which got its start in the late 1980s. As the name implies, an LLC provides limited liability to its participants called “members” while containing the assets and operations of the business enterprise. Please keep in mind that LLCs are regulated at the state level, therefore management and formation matters may vary from state to state.

How to Form an LLC

LLCs are formed by filing an articles of organization (or other similarly titled document) and submitting a filing fee with the Secretary of State.

You’ll have to make sure the LLC’s name complies with applicable state rules or else the Secretary of State will reject the filing. The most common reason a name is rejected is that the proposed LLC’s name is too similar to that of an existing entity, whether the existing entity is an LLC, corporation, limited partnership, etc. Some states can be very laid back with regards what constitutes a similar name, while others are hyper-sensitive sticklers (hello Texas!).

You will also have to appoint a registered agent for your LLC. A registered agent is a business or individual designated to get served when your LLC is a party to a legal action such as a lawsuit or summons. Failure to maintain a registered agent or keep your registered agent’s address updated can produce undesirable effects for your LLC.

The Management and Operations of an LLC

An operating agreement typically determines the management and operational functions of the LLC. This agreement is made between the LLC’s members (the owners of the LLC) and the LLC. The operating agreement will also determine the allocation of income and tax liabilities. These documents can be extremely short or extremely long.

In the typical default management structure, the management of the LLC is vested in the members in proportion to their ownership interest in the LLC. However, the members can agree, either in the articles of organization or operating agreement, to vest management in a “manager” rather than each of the members.

Tax Basics

Thanks to a 1998 Internal Revenue Service ruling, LLCs are a hybrid vehicle which provides the liability protection of a corporation with the pass through taxation benefits of a partnership or S corporation. Pass through taxation means that the members of the LLC pay the taxes of the LLC on their individual 1040 tax return via a Schedule K-1. Thus, the income (or loss) is “passed through” to the members. This allows for the avoidance of double taxation on the LLC’s income.

I highly recommend seeking guidance from your CPA, as there will be tax issues–both personal and for the entity–that may influence your entity decision.

When is the LLC the best choice of legal entity?

Unfortunately, I don’t have a bright-line rule for when to be an LLC. The LLC is a very flexible legal entity combining the advantages of corporations such as limited liability and continuity of life with the advantages of partnerships such as pass through taxation and corporate informality.

Thus, if you are looking for a simple way to enjoy limited liability and you are not too concerned with raising capital or establishing a more traditional management system, the LLC is probably for you. But if you are looking to use various corporate-like methods, whether options or raising capital, the LLC may not be your best option. You can still create some corporate-like incentives for your employees, but I find that most employees have a hard time comprehending what a “membership unit” is as opposed to a share of stock.

It looks as though private equity buyers better get used to seeing reverse breakup fees and other seller-friendly provisions in their merger agreements.

TheDeal.com details how reverse breakup fees are becoming industry-standard provisions in private equity LBO deals in a new article called “Desperately Seeking Certainty:”

Starting with the 2005 sale of Neiman Marcus Group Inc., LBO merger agreements often included a “two-tier” breakup fee, in which a buyer would pay a lower percentage in the event it couldn’t obtain financing and a higher one if it decided to walk from the deal in the absence of a contractual right to do so, such as a so-called material adverse effect at the target.

The McDermott and Debevoise lawyers found that those provisions remain standard. “All of the going-private deals signed since last October have explicitly provided that the seller will have no right to force the closing,” Schmidt wrote. “At least one deal did allow the seller the right to seek specific performance of the financing covenant, but for most, the only remedy if a buyer refuses to chase its lenders would be a claim for damages.”

Paul Shim, an M&A partner at Cleary Gottlieb Steen & Hamilton LLP, agrees: “The merger agreements in the deals that have been done since the bubble burst have largely followed the reverse break fee, no-financing condition, no-specific-performance paradigm.”

The article also mentions these deals are now coming with a greater level of contractual clarity regarding the buyer’s right to specific performance (i.e., forcing the private equity firm to close the deal) thanks to the decision in the collapsed buyout of United Rentals Inc. Although the Delaware Chancellor ultimately found in favor of the buyer (Cerberus Capital Management, LP), private equity firms are now making sure their deal documents clearly state the target does not have a right to specific performance:

The run of collapsed deals has led some observers to predict that sellers would demand greater contractual certainty from PE shops in merger agreements, but so far that hasn’t happened. Instead, sellers have gained some of the certainty they seek from more secure debt and equity financing arrangements while PE buyers have become more vigilant in rooting out dangerous ambiguities in contracts.

Of course, reverse breakup fees and other seller-friendly provisions may fall out of favor with the LBO market once the credit situation comes around. But until then, get used to them.

Read the entire thedeal.com article here.

Choosing a startup’s legal entity can be a frustrating experience for the entrepreneur. Who has time to deal with the LLC, S-Corp, C-Corp, LP, GP, LLP & LLLP when you’re already buried with things like CSS, RoR, AJAX, PYTHON, PHP & ASP? Thankfully, if your startup is absolutely determined to raise venture capital, there’s only one viable legal entity decision your startup can make–the Corporation.

Does this include S Corporations?

No. While the S Corporation structure is a popular choice for entrepreneurs and other small businesses, it comes with regulatory limitations that do not make it a feasible vehicle for raising venture capital. The three main regulatory limitations are:

• S Corporations may only have one class of stock;
• S Corporation stockholders must be natural persons (except for some extremely limited circumstances); and
• S Corporations can not have more than 100 stockholders.

The one class of stock requirement is fatal to a venture capital investment since venture capital firms will demand preferred stock in return for their investment. Also, most venture capital firms are organized as limited partnerships and less frequently as LLCs–but both legal entity types aren’t “natural persons.” And finally, as your startup grows, the 100 stockholder maximum comes into play once your startup begins issuing stock and stock options to employees.

Thus, the C Corporation will be the only type of corporation viable for a venture capital investment.

Why not an LLC?

While the LLC is also a common startup vehicle, the C Corporation wins hands down when it comes to raising venture capital. The following 4 reasons explain why:

1. Pass Through Entity

While the pass through feature (income/losses are passed down to the shareholders rather than dealt with at the entity level) of LLCs are desirable to most entrepreneurs, venture capital funds do not find pass through taxation to be a similarly desirable feature. The venture capital firm does not want the accounting and tax matters of a funded venture to be passed down to the firm, and thereby be attributed to the venture capital firm’s tax exempt and foreign limited partners. Such a scenario could create unrelated business taxable income (UBTI) issues or have their foreign investors be deemed “doing business” in the United States and thus have to file a U.S. tax return.

2. Transferability

The membership interests of an LLC are typically not freely transferable by state statute. This makes the LLC a lousy entity for one of venture capital’s exit strategies: the IPO. (Not that IPOs for venture backed companies are hot at the moment.)

3. Predictability

Started in the late 1980s and only made more popular in the last decade or so, LLCs are a relatively new type of legal entity. Thus, there just isn’t a well developed set of laws and regulations for LLCs. Corporations, on the other hand, provide a larger degree of predictability with regards to corporate governance and stockholder rights.

4. The Venture Capital Firm’s Organizational Documents

Primarily due to the reasons outlined above, many venture capital funds will have specific provisions in their own organizational documents that prohibit them from making a venture capital investment in an LLC, or any other legal structure than a C Corporation. Thus, if your startup is absolutely against being a C Corporation, you could be declined by the venture capital firm regardless of how spectacular your startup is.

The Conclusion

The C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment. When the to-be-venture-funded startup is a C Corporation, various administrative and other burdens are minimized for the venture capital firm, which allows them (and their capital) to focus on developing the startup company’s business.

While no true definition of a private placement exists, it is commonly used to refer to the raising of capital (i.e., “securities”) without making a registration with the United States Securities and Exchange Commission (SEC).

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. The most commonly used method to obtain an exemption when conducting a private placement is Regulation D, which contains two exemptions in Rule 504 and Rule 505 and one safe harbor in Rule 506.

In order to conduct a private placement properly, the issuer must follow a multitude of requirements. Some of these requirements encompass:

-How much capital can be raised
-Who can be offered the securities
-When can the securities be offered
-Who can offer the securities
-Advertising and soliciation
-Information requirements
-Where the securities are offered

Many entrepreneurs begin their startup as a sole proprietorship. Eventually, some sole proprietors desire to incorporate so they can reduce their personal liability and protect their personal assets. But the act of incorporating a going business does not, by itself, transfer the current business being conducted as a sole proprietorship to the new corporation.

The 2 main issues when incorporating a sole proprietorship

The 2 main issues involve the transfer of assets from the going business to the new corporation and the tax consequences from such transfer. [This article will address the transfer and not the tax issues.] Since the assets of the sole proprietorship will need to be transferred, formal conveyances of such property must be made from the sole proprietorship to the new corporation.

The process

The first step is to incorporate the new legal entity. The next step is to execute various transfer documents by the sole proprietorship, by the new company, and some by both the sole proprietorship and the new company. In return for the conveyance of property to the new corporation, the owner of the sole proprietorship usually receives corporate shares of the new corporation.

You’re not done yet

While the transfer is now complete, additional administrative steps may need to be completed depending on the nature of the business:

-Transfer assumed name
-Handle workforce commission issues
-Close sole proprietor bank account and open account in new corporation’s name
-Make necessary changes to insurance policies
-Transfer permits and licenses
-Contractual obligations
-Apply for new federal tax ID number
-Make appropriate revisions in estate planning documents

Furthermore, while there’s no requirement to publish notices of the intent to incorporate, creditors should be notified of the sole proprietorship’s termination and the existence of the new corporation. This will help prevent liability if creditors continue to believe the business is operating as a sole proprietorship.

While incorporating a sole proprietorship may seem like a large and painful task, I believe the benefits such as reduced personal liability outweigh any headache from completing the transaction.