Founders will normally want to use so-called cheap stock when they capitalize their startup. Below I discuss why this is best for most startups.
When you form your startup, you need to contribute cash or other assets to the entity in exchange stock. This is called equity capitalization. You can also loan money to your entity at inception and have the entity use the borrowed proceeds to fund initial operations. This is called debt capitalization. The ratio of debt to equity should not be too high – normally not more than 3 to 1. The issues can get tricky here. Check with your business lawyer. In any case, capitalizing with debt is a fine tool for family corporations but is not used as often in startups, where straight equity capitalization is the norm. That capitalization normally involves cheap stock.
Why use cheap stock?
Cheap stock is normally crucial for startups because founders will need to earn their equity over time. In such cases, the IRS will treat the stock as being granted in exchange for services and will tax it accordingly. If you want to avoid significant tax problems, then, keep the value of the stock law.
Using a cheap-stock strategy, founders typically capitalize their startup by valuing any IP rights contributed to the startup as low as reasonably possible and setting the stock price as low as possible — on the theory that a company with only modestly valued IP rights and nominal cash contributions is not worth much.
Sometimes founders will chafe at the idea of placing a small value on their IP. They believe that doing so will hurt them later when they go for funding. In theory, it could. In practice, it doesn’t. Investors almost universally recognize that the cheap-stock setup is a positioning move and nothing more.
A common model for startups is therefore to authorize millions of shares of 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 use a $.001 per share pricing and contribute a total of $4,000 for the 4 million shares issued to them.
Why 10 million as opposed to 10 thousand? Purely psychological. In later stages, if a startup draws from a pool containing 2,000 shares and issues options in increments of, say, 100 units, that startup will be perceived as offering less value than will a comparable one that draws from a pool containing 2 million shares and issuing options in 100,000-unit increments. Legally, the company may be issuing options having identical value, but one will be perceived as more valuable simply because it involves a larger number. It makes no objective sense legally but, as they say, go figure.
The theory behind this strategy can be seen if the startup in our example above later does a Series A preferred stock round at its first funding. Assume that the startup with 10 million authorized shares later 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 at company formation, e.g., 12 months before the first round funding. Yet if all other formation issues have been handled properly (including the filing of timely 83(b) elections), the founders will not normally risk incurring a tax liability from the paper gain they have already realized.
The company may or may not succeed. They may or may not ultimately realize a monetary gain that matches or exceeds the paper gain. But in terms of optimum positioning they will have achieved 100% of their goal: If the startup fails, they will lose the value of the labor invested for their founders’ shares, but nothing more. If the startup succeeds, they will be able to ride through its ups and downs, with all major capital investments made by outside investors. Any gain realized from the ultimate sale of their stock will be taxable only when they receive tangible value for the stock and then most likely at favorable long term capital gain rates.
Thus, the use of cheap stock enables founders to position themselves optimally from a tax perspective to benefit from any ultimate success they may have.
The cheap-stock approach also benefits service contributors who receive stock options or other equity grants. For example, a 100,000-share option grant in the example above would have a prospective value of $100,000 at the time of the Series A funding. Most early-stage startups will not offer founder pricing on the equity incentives made available to second-tier equity recipients, but will nonetheless offer those incentives at bargain prices (e.g., at $.10 per share rather than $.001). Although not receiving quite the same bargain as the founders, the second-tier equity recipients risk no capital investment of their own until they can determine later whether it is worthwhile to convert their paper into stock which can then be sold. The startup has thus positioned the service providers’ equity interests for excellent incentive value.
The reason low IP valuations can be used at inception within the bounds of the law is that normally no one can tell at that time — other than by a very subjective determination — just how valuable the IP rights underlying the startup are or will become. For every founder who winds up with a $300 million company and a substantial personal reward after having used a cheap-stock strategy, there are many more who wind up with little or nothing over a comparable period of time with comparable effort. Thus, the value placed on initial contributions of IP normally can be kept minimal without creating undue IRS audit risks.
Section 409A of the Internal Revenue Code requires that certain steps be taken to avoid penalties when a board of directors places a value on certain forms of deferred compensation. This can sometimes creates traps for startups. In practice, though, for any startup that has not yet taken in outside funding, it is normally safe to use the low valuations customarily associated with a cheap-stock setup. While 409A theoretically applies, the IRS has almost no basis in the normal case for challenging the valuation used by the founders. Best to double-check with your business lawyer to make sure, but this should not normally raise concerns at this stage.