Startup Law 101 Series – Why Founders Should Use Cheap Stock in Capitalizing Their Startups.
Founders will normally want to use so-called cheap stock when they capitalize their startups.
When you form a startup, you contribute cash or other assets to it in exchange for stock. You can also loan money to the entity. The ratio of debt to equity should be modest – normally not more than 3 to 1 (check with your business lawyer or CPA). While capitalizing with debt is common for small corporations, it is less so for startups, where straight equity capitalization is the norm. That capitalization normally involves cheap stock.
Why use cheap stock?
Cheap stock is important because founders will often earn their equity over time as they perform services for the company. The IRS may treat the value of that stock as taxable compensation. If you want to minimize tax, keep the value of the stock low.
The idea is to value your IP as low as possible and to assign it to the company along with modest cash contributions while pricing the shares themselves at a nominal price. If a company has modestly valued IP and nominal cash, it is not worth much and neither is its stock.
Founders may chafe at the idea of placing a low value on their IP. Not to worry. At the time of funding, investors will see this strictly as a positioning move.
A common model for startups is therefore to authorize millions of shares of low-priced common stock, with some percentage allocated to founders, some reserved for an equity-incentive pool, and some reserved for future investors. For example, 10 million shares might be authorized, of which 4 million could be issued to founders, 2 million reserved for an incentive pool, and 4 million reserved for investors. In this example, the founders might price the stock at a tenth of a penny ($.001) per share and thus contribute a total of $4,000 for the 4 million shares issued to them.
Large share numbers can give startups a psychological edge in recruiting. The more shares, the larger the option grants. Which would you rather get, 1,000 or 100,000 options? Each might represent an identical interest in a company but the psychological question answers itself on which sounds better. Startups set up their structures accordingly.
How does a cheap-stock strategy play out when it comes time for funding? In our example above, let’s say that our startup with 10 million authorized shares does a Series A preferred stock round at its first funding. Assume that this startup amends its articles to authorize 4 million shares of preferred stock and that it raises $4 million, with (1) the investors getting 4 million shares of preferred stock at $1.00 per share (convertible one-for-one into the 4 million shares of common reserved for investors); (2) the founders continuing to hold their original 4 million shares purchased at $.001 per share; and (3) the remaining 2 million shares either issued or reserved under an equity incentive plan for key service contributors.
The startup now has a post-money valuation of $10 million (10 million shares times $1.00 per share). Factoring in the dilution that will result once all 10 million shares are issued, the founders now own 4 million out of 10 million shares, or 40% of the company. If the company as a whole is valued at $10 million, that 40% interest has a paper value of $4 million. The founders paid only $4,000 to acquire that interest, say, 12 months earlier. Yet if all other formation issues were handled properly (including the filing of timely 83(b) elections), the founders will not normally risk incurring tax liabilities from the paper gain they have already realized.
Was their interest worth $4 million at the time of company formation? Who knows? At that stage, all numbers are nebulous. This is generally safe territory for using low valuations.
What do founders accomplish by using cheap stock? If the startup fails, they lose nothing more than the value of their labor. If it succeeds, they can ride through its ups and downs on the strength of capital investments made by others via outside funding. They pay no tax along the way. Any gain realized from the ultimate sale of their stock will be taxable only when they get tangible value in return and then most likely at favorable long term capital gain rates.
Thus, cheap stock lets founders position themselves optimally from a tax and economic perspective to benefit from any ultimate success they may have.
Cheap stock also benefits other key people besides founders. Options may not be issued at founder pricing but normally are issued at a significant discount from what investors ultimately pay. As long as the startup is careful to avoid steps that cause a large upward valuation on the stock price during the early stages, the discount model can be maintained and significant equity incentives offered to key service contributors who come in after the founders.
As a startup matures, the use of cheap stock is normally neither feasible nor desirable. At that time, its use may be unfair to existing shareholders and may also run afoul of a special Internal Revenue Code provision (409A) that imposes penalties if stock used for deferred compensation is not valued correctly.
In the early stages, though, the cardinal rule is to use cheap stock. It pays dividends for all concerned. Don’t neglect this fundamental aspect of setting up your startup.
One caveat: a corporation that is under-capitalized for the business it conducts can be at risk for having its “corporate veil” pierced. Work with your business lawyer to ensure that you do your startup capitalization properly.