Distinctive legal aspects of forming a startup business with a founding team.
A startup with a founding team requires a special kind of company formation that differs from that used by a conventional small business in several key ways. Below, I identify and explain these differences so that founders can avoid mistakes in doing their setup.
Attributes of a Typical Startup Business
A startup is a type of small business, of course, and its founders want to make substantial and long-term profits just as any small business does. Perhaps some of the empty “concept companies” of the bubble era did not ever intend to build for 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. Nonetheless, a startup that is anything other than a solo effort does differ strikingly from a conventional small business. Why? Not because the enterprise itself has any different goal other than that of building long-term and sustainable value but because of how its founders view their short-term goals in the venture.
Unlike a small business, a startup founding team will adopt a business model designed to afford the founders a near-term exit (typically 3-5 years) with an exceptionally high return to them if the venture is successful. The team will often want stock incentives that are generally forfeitable until earned as sweat equity. It will typically want to contribute little or no cash to the venture. It will often have valuable intangible IP that the team has developed in concept and likely will soon bring to the prototype stage. It frequently encounters tricky tax issues because the team members will often contribute services to the venture in order to earn their stock. It seeks to use equity incentives to compensate what is often a loose group of consultants or initial employees, who typically defer/skip salary. And it will seek outside funding to get things going, initially perhaps from “friends and family” but most often from angel investors and possibly VCs. The venture will then be make-or-break over the next few years with a comparatively near-term exit strategy always in view for the founding team as the hope of a successful outcome.
The blueprint here differs from that of a conventional small business, which is often established by its founders with substantial initial capital contributions, without emphasis on intellectual property rights, with their sights fixed primarily on making immediate operating profits, and with no expectation of any extraordinary return on investment in the short term.
Given these attributes, company formation for a startup differs significantly from that of a small business. A small business setup can often be simple. A startup setup is much more complex. This difference has legal implications affecting choice of entity as well as structural choices made in the setup.
Startups Generally Need a Corporate as Opposed to an LLC Setup
An LLC is a simple and low-maintenance vehicle for small business owners. It 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 the LLC is adapted to the distinctive needs of a startup? When restricted units are issued to members with vesting-style provisions? When options to buy membership units are issued to employees? When a preferred class of membership units is defined and issued to investors? Of course, the simplicity is gone. In such cases, the LLC can do pretty much everything a corporation can do, but why strain to adapt a partnership-style legal format to goals for which the corporate format is already ideally suited? There is normally no reason to do so, and this is why the corporate format is usually best for most founding teams deploying their startup.
A couple of other clinkers inject themselves as well: with an LLC, you can’t get tax-advantaged treatment for options under current federal tax laws (i.e., nothing comparable to incentive stock options); in addition, VCs will not invest in LLCs owing to the adverse tax hit that results to their LP investors.
LLCs are sometimes used for startup ventures for special cases. Sometimes founders adopt a strategy of setting up in an LLC format to get the advantages of having a tax pass-through entity in situations where such tax treatment suits the needs of their investors. In other cases, a key investor in the venture will want special tax allocations that do not track the investors percentage ownership in the venture, which is attainable through an LLC but not through a corporation. Sometimes the venture will be well-capitalized at inception and a founder who is contributing valuable talents but no cash would get hit with a prohibitive tax on taking significant equity in the company – in such cases, the grant of a profits-only interest to such a founder will help solve the founder’s tax problem while giving that founder a rough equivalent of ownership via a continuing share of operating profits.
In spite of such exceptional cases, the corporate format is overwhelmingly favored for startups because it is robust, flexible, and well-suited to dealing with the special issues startups face. We turn to some of those issues now.
Restricted Stock Grants – Rare for Small Business – Are the Norm for Startups with Founding Teams
An unrestricted stock grant empowers the recipient of such stock to pay for it once and keep it forever, possibly subject to a buy-back right at fair market value. This is the norm for a small business; indeed, it is perhaps the major privilege one gets for being an entrepreneur. It may not be worth much in the end, but you definitely will own it!
Unrestricted grants can be problematic in a startup, however. If three founders (for example) form a startup and plan to make it successful through their personal efforts over a several-year period, any one of them who gets an unrestricted grant can simply walk off, keep his or her equity interest, and have the remaining founders effectively working hard for a success to which the departing founder will contribute little or nothing.
Note that a conventional small business usually does not face this risk with anywhere near the acuity of a startup. Co-owners in a conventional small business will often have made significant capital contributions to the business. They also will typically pay themselves salaries for “working the business.” Much of the value in such businesses may lie in the ability to draw current monies from it. Thus, the chance for a walk-away owner to get a windfall is much diminished; indeed, such an owner may well be severely prejudiced from not being on the inside of the business. Such a person will occupy the no-man’s land of an outside minority shareholder in a closely held corporation. The insiders will have use of his capital contribution and will be able to manipulate the profit distributions and other company affairs pretty much at will.
In a startup, the dynamic is different because the main contribution typically made by each founder consists of sweat equity. Founders need to earn their stock. If a founder gets a large piece of stock, walks away, and keeps it, that founder has gotten a windfall. This risk is precisely what necessitates the use of so-called “restricted” stock for most startups. With restricted stock, the founders get their grants and own their stock but potentially can forfeit all or part of their equity interest unless they remain with the startup as service providers as their equity interest vests progressively over time.
The Risk of Forfeiture Is the Defining Element of Restricted Stock
The essence of restricted stock is that it can be repurchased at cost from a recipient if that person ceases to continue in a service relationship with the startup.
The repurchase right applies to x percent of a founder’s stock as of the date of grant, with x being a number negotiated among the founders. It can be 100 percent, if no part of that founder’s stock will be immediately vested, or 80 percent, if 20% will be immediately vested, or any other percentage, with the remaining percentage deemed immediately vested (i.e., not subject to a risk of forfeiture).
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 as a founder, and get one million shares, you pay $1,000. If you walk away from the startup immediately after making the purchase, the company will normally have the option to buy back your entire interest for that same $1,000. At the beginning, this may not matter much.
Now 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, we 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 all means consider using the LLC as a vehicle. If, however, forfeiture risks will be in play and hence restricted stock will be used (among other tools), there likely is no special benefit in using the LLC. In such cases, it is usually best to use a corporate format and a good business lawyer to assist in implementing the setup.
Startups Also Use Other Equity Incentives Besides Restricted Stock
Unlike a conventional small business, a typical business startup will want to offer other equity incentives to a broad range of people, not just to founders. For this purpose, an equity incentive plan is often adopted at inception and a certain number of shares reserved to it for future issuance by the board of directors.
Equity incentive plans usually authorize a board of directors to grant restricted stock, incentive stock options (ISOs), and non-qualified stock options (NQOs). Again, complex decisions need to be made and a qualified lawyer should be used in determining which incentives are best used for which recipients. In general, though, restricted stock is normally used for founders and very key people only; ISOs can be used for W-2 employees only; NQOs can be used for W-2 employees or for 1099 contractors. Lots of issues (including securities law issues) arise with equity incentives – don’t try to handle them without proper guidance.
All too many startups form their companies only after efforts have been well under way to develop some of the key IP. This is neither good nor bad – it is simply 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 good number of individuals may hold rights in aspects of the intellectual property that should properly belong to the company. In any setup of a startup, it is normally imperative that such IP rights be captured for the benefit of the company.
Again, this is complex area, but an important one. Nothing is worse than having IP claims against the company pop up during the due diligence phase of a funding or an acquisition. IP issues need to be cleaned up properly at the beginning. Similarly, provision needs to be made to ensure that post-formation services for the company are structured so as to keep all IP rights in the company.
Startups have very special tax considerations at inception owing to the way they typically are capitalized – that is, with potentially valuable IP rights being assigned, and only nominal cash being contributed, to the company by founders in exchange for large amounts of founders’ stock.
Tax complications may arise if the founders attempt to combine their stock 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 50% of the stock, and they make simultaneous contributions, one of not-yet-commercialized IP rights and the other of $250,000 cash. Because the IRS does not consider IP rights of this type to be “property” in a tax sense, it will treat the grant made to the founder contributing such rights as a grant made in exchange for services. In such a case, the grant itself becomes taxable and the only question is what value it has for determining the amount of taxable income earned by the founder as a result of the transaction.
In our example, the IRS could conceivably argue that, if an investor were willing to pay $250,000 for half of a company, then the company is worth $500,000. The founder who received half of that company in exchange for a “service” contribution would then realize taxable income of $250,000 (half the value of the company). Another argument might be that the IP rights really didn’t have value as yet, but in that case the company would still be worth $250,000 (the value of the cash contributed) and the founder assigning the IP rights would potentially be subject to tax on income of $125,000 (half the value of the company, owing to his receipt of half the stock).
There are various workarounds for this type of problem, the main one being that founders should not time their stock grants to coincide in time with significant cash contributions made by investors.
The point, though, is this: this again is a complex area and should be handled with the help of a qualified startup business lawyer. With a business startup, watch out for tax traps. They can come at you from surprising directions.
All in all then, a startup has very distinctive setup features – from forfeiture incentives to IP issues to tax traps. It typically differs significantly from a conventional small business in the way it is set up. The issues touched upon here illustrate some of the important differences. There are others as well. If you are a founder, don’t make the mistake of thinking you can use a do-it-yourself kit to handle this type of setup. Take care to get a good startup business lawyer and do the setup right.