Startups with founding teams require a special type of company formation that differs from those used by conventional small businesses in several key ways. This article reminds founders of these differences so they can avoid mistakes in setup.
Typical Startup Business Attributes
Startups are a type of small business, of course, and their founders want to make big long-term profits like any other small business. Maybe some empty “concept companies” from the bubble era were never meant to build long term value but that era is over. Today’s startups need to build value in a sustainable market or fail, just like any other business. However, startups that are not solo businesses are very different from conventional small businesses. Why? Not because the company itself has a different goal than building long-term and sustainable value, but because of how its founders view their short-term goals in the venture.
Unlike small businesses, a startup’s founding team will adopt a business model designed to provide founders with a short-term (usually 3-5 years) exit with very high returns to them if the venture is successful. Teams will often want stock incentives that can generally be canceled until earned as sweat equity. These usually want to provide little or no cash for the venture. These will often have valuable intangible IPs that have been developed by the team in concept and will likely be brought to the prototype stage soon. It often faces complicated tax issues as team members will often donate services to businesses to acquire their shares. It seeks to use equity incentives to compensate for what is often a loose group of consultants or early hiring, for which salaries are usually delayed/missed. And it will seek outside funding to get things done, initially maybe from “friends and family” but most often from angel investors and maybe VCs. The venture will then either succeed or disintegrate over the next few years with a short-term exit strategy that the founding team has always seen as the hope of a successful outcome.
The blueprint here differs from conventional small businesses, which are often founded by their founders with large initial capital contributions, without an emphasis on intellectual property rights, with the primary goal of generating immediate operating profits, and without extraordinary expectations. return on investment in the short term.
Given these attributes, company formations for startups differ significantly from small businesses. Small business setups are often simple. The startup setup is much more complex. This distinction has legal implications that affect the choice of entities as well as the structural choices made in the arrangement.
Startups Generally Require Companies Against LLC Arrangements
An LLC is a simple, low-maintenance vehicle for small business owners. This is great for those who want to run their business by consensus or under the direction of a managing member.
What happens to that simplicity when an LLC is tailored to the typical needs of a startup? When are limited units issued to members with vesting style provisions? When is the option to purchase membership units granted to employees? When is the preferred membership unit class determined and issued to investors? Of course, that simplicity is lost. In such cases, an LLC can do almost anything a corporation can do, but why go to the trouble of adapting a partnership-style legal format to an already-fit corporate format? There’s usually no reason to do so, and this is why the corporate format is usually best for most founding teams implementing their startups.
Several other clinkers also inject themselves: with an LLC, you can’t get tax-advantaged treatment for options under current federal tax laws (i.e., nothing compares to incentive stock options); Additionally, VCs will not invest in LLCs due to the adverse tax impact of their LP investors.
LLC’s are sometimes used for special case startups. Sometimes founders adopt regulatory strategies in an LLC format to gain the advantage of owning a tax pass-through entity in situations where the tax treatment suits their investors’ needs. In other cases, key investors in the venture will want a special tax allocation that doesn’t track the investor’s percentage ownership in the venture, which can be achieved through the LLC but not through the corporation. Sometimes the venture will be well capitalized at the start and the founder who contributed valuable talent but no cash will be subject to tax barriers to take up significant equity in the company – in such a case, giving interest only profits to the founder will help. solves founders’ tax problems while giving equal ownership to founders through continuous sharing of operating profits.
Apart from such exceptional cases, the enterprise format is highly preferred for startups as it is robust, flexible and suitable for handling the specific problems that startups face. I turn to some of those issues now.
Limited Stock Grants – Rare for Small Businesses – The Norm for Startups with Founding Teams
An unrestricted share grant authorizes the recipient of the shares to pay for them once and keep them in perpetuity, possibly subject to repurchase rights at fair market value. This is the norm for small businesses; indeed, it is probably the main privilege one gets to be an entrepreneur. It may not be worth much in the end, but you will definitely have it!
However, unlimited grants can be a problem at startups. If three founders (for example) form a start-up company and plan to make it successful through their personal efforts over a number of years, one of those who gets an unlimited grant can just walk away, retain his equity interest, and keep the other founder working effectively. it is difficult to be successful where the departing founder will contribute little or nothing.
Note that conventional small businesses usually don’t face this risk with almost start-up acumen. Co-owners in conventional small businesses will often make significant capital contributions to the business. They will also usually pay their own salaries to “do business”. Much of the value in such a business may lie in the ability to withdraw current money from it. Thus, the chance for the departing owner to earn a windfall is much reduced; indeed, such owners may be highly prejudiced by not doing business. Such a person would occupy the no-man’s land of an outside minority shareholder in a tightly held company. Insiders will use their capital contributions and will be able to manipulate profit distribution and other corporate affairs at will.
In a startup, the dynamics are different because the main contribution that each founder usually makes is sweat equity. Founders need to get their share. If a founder gets most of the stock, goes, and keeps it, the founder gets a windfall.
It is this risk that necessitates the use of so-called “restricted” stock for most startups. With limited shares, founders get a grant and own their shares but potentially lose all or part of their equity interest unless they stay with the startup as a service provider as their equity interest increases progressively over time.
Forfeiture Risk Is The Determining Element Of Limited Stock
The purpose of limited stock is that it can be repurchased at a cost from the beneficiary if that person ceases to continue the service relationship with the startup.
The repurchase rights apply to x percent of the founders’ shares on the grant date, where x is the amount negotiated between the founders. This can be 100 percent, if no part of the founder’s shares will immediately become vested, or 80 percent, if 20 percent will soon become vested, or another percentage, with the remaining percentage considered immediately vested (i.e., not subject to the risk of foreclosure). . ).
In a typical case, x equals 100 percent. Thereafter, as the founder continues to work for the company, this repurchase right lapses progressively over time. This means that the right applies to less and less of the founder’s stock as time passes and the stock progressively vests. Thus, a company may make a restricted stock grant to a founder with monthly pro rata vesting over a four-year period. This means that the company’s repurchase right applies initially to all the founder’s stock and thereafter lapses as to 1/48th of it with every month of continuing service by that founder. If the founder’s service should terminate, the company can exercise an option to buy back any of that founder’s unvested shares at cost, i.e., at the price paid for them by the founder.
“At cost” means just that. If you pay a tenth of a penny ($.001) for each of your restricted shares asNow let us say that half of your shares are repurchased, say, two years down the line when the shares might be worth $1.00 each. At that time, upon termination of your service relationship with the company, the company can buy up to 500,000 shares from you, worth $500,000, for $500. In such a case, the repurchase at cost will result in a forfeiture of your interest.
This forfeiture risk is what distinguishes a restricted-stock buy-back from a buy-back at fair market value, the latter being most often used in the small business context.
Restricted Stock Can Be Mixed and Matched to Meet the Needs of a Startup
Restricted stock need not be done all-or-nothing with respect to founder grants.
If Founder A has developed the core IP while Founder B and Founder C are just joining the effort at the time the company is formed, different forms of restricted stock grants can be made to reflect the risk/reward calculations applying to each founder. Thus, Founder B might get a grant of x shares that vest ratably over a 48-month period (at 1/48th per month), meaning that the entire interest can be forfeited at inception and less-and-less so as the repurchase right of the company lapses progressively over time while Founder B performs services for the company. Likewise for Founder C, though if he is regarded as more valuable than Founder B, he might, say, have 20% of his grant immediately vested and have only the remainder subject to a risk of forfeiture. Founder A, having developed the core technology, might get a 100% unrestricted grant with no part of his stock subject to forfeiture — or perhaps a large percentage immediately vested with only the balance subject to forfeiture.
The point is that founders have great freedom to mix and match such grants to reflect varying situations among themselves and other key people within the company. Of course, whatever the founders may decide among themselves, later investors may and often do require that all founders have their vesting provisions wholly or partially reset as a condition to making their investment. Investors most definitely will not want to watch their investments go into a company that thereafter has key founders walking away with large pieces of unearned equity.
Restricted Stock Requires an 83(b) Election in Most Cases
In an example above, I spoke of a $500 stock interest being worth $500,000 two years into the vesting cycle of a founder, with two years left to go for the remainder. If a special tax election — known as an 83(b) election — is not properly filed by a recipient of restricted stock within 30 days of the date of his or her initial stock grant, highly adverse tax consequences can result to that recipient .
In the example just cited, without an 83(b) election in place, the founder would likely have to pay tax on nearly $500,000 of income as the remaining stock vests over the last two years of the cycle. With an 83(b) election in place, no tax of any kind would be due as a result of such vesting (of course, capital gains taxes would apply on sale).
Tax issues such as this can get complex and should be reviewed with a good business lawyer or CPA. The basic point is that, if an equity grant made in a startup context is subject to potential forfeiture (as restricted stock would be), 83(b) elections should be made in most cases to avoid tax problems to the recipients.
Restricted Stock Grants Are Complex and Do Not Lend Themselves to Legal Self-Help
Restricted stock grants are not simple and almost always need the help of a lawyer who is skilled in the startup business field.
With restricted stock, complex documentation is needed to deal with complex issues. This is why the LLC normally does not work well as a vehicle for startup businesses. The value of the LLC in the small business context lies in its simplicity. Entrepreneurs can often adapt it to their ends without a lot of fuss and without a lot of legal expense. But the LLC is ill-suited for use with restricted grants without a lot of custom drafting. If your startup is not going to impose forfeiture risks on founders or others, by
Unlike conventional small businesses, business startups usually want to offer other equity incentives to many people, not just the founders. For this purpose, equity incentive plans are often adopted at the outset and a certain number of shares are reserved for it for future issuance by the board of directors.
Equity incentive plans typically authorize the board of directors to grant restricted stock, incentive stock options (ISO), and non-qualified stock options (NQO). Again, complex decisions need to be made and a qualified attorney must be used in determining which incentives are best used for which recipients. However, in general, limited stock is usually reserved for founders and very important people only; ISO can only be used for W-2 employees; NQO can be used for W-2 employees or for 1099 contractors. Many problems (including securities law issues) arise with equity incentives — don’t try to deal with them without proper guidance.
Make sure to Capture IP for Company
Too many startups form their companies only after efforts have gone well to develop a few key IPs. This is neither good nor bad – it’s just human nature. Founders don’t want to focus too much on structure until they know they have a potentially viable opportunity.
What happens in such cases is that a large number of individuals can hold rights in aspects of intellectual property that would otherwise belong to the company. In any setup of a startup, it is usually very important that the IP rights are taken for the benefit of the company.
Again, this is a complex, but important area. There’s nothing worse than having an IP claim against a company that comes up during the due diligence phase of a funding or acquisition. IP issues need to be cleaned properly at the start. Similarly, provisions need to be made to ensure that post-establishment services for enterprises are structured to safeguard all IP rights in enterprises.
Don’t Forget Tax Risk
Startups have very special tax considerations at the start because of the way they are typically capitalized – that is, by the potentially valuable IP rights that are granted, and only nominal cash donated, to the company by the founders in exchange for a large amount of founder stock.
Tax complications may arise if founders try to combine their share grants of this type along with cash investments made by others.
Let’s assume that two people set up a company in which they each own a 50% stake, and they make simultaneous contributions, one of the IP rights that have not been commercialized and the other of $250,000 cash. Since the IRS does not consider these types of IP rights to be “property” in a tax sense, it will treat grants granted to founders who contributed those rights as grants provided in exchange for services. In such a case, the grant itself becomes taxable and the only question is how much it is worth to determine the amount of taxable income the founder earns as a result of the transaction.
In our example, the IRS could argue that, if an investor is willing to pay $250,000 for half of the company, then the company is worth $500,000. Founders who receive half of the company in exchange for “service” contributions will then earn $250,000 in taxable income (half of the company’s value). Another argument might be that the IP rights really don’t have any value yet, but in this case the company will still be worth $250,000 (the value of the money donated) and the founder who grants the IP rights could potentially be taxed on $125,000 in income (half of the value of the company, since he or she receives half the share).
There are various solutions to this type of problem, the main one being that founders should not time their share grants to coincide with the time of significant cash contributions made by investors.
However, the bottom line is this: this is again a complex area and should be addressed with the help of a qualified startup business attorney. By starting a business, beware of tax traps. They can come at you from surprising directions.
Overall, a startup has very distinctive regulatory features – from foreclosure incentives to IP issues to tax traps. These usually differ significantly from conventional small businesses in terms of their setup. The issues discussed here illustrate some important differences. There are others too. If you’re a founder, don’t make the mistake of thinking that you can use a do-it-yourself kit to handle this type of setup. Be careful to get a reviewer