Ten Common Startup Mistakes – Part 1

Today seems like a good day to tie together a number of subjects I’ve written about in the past, as a list of the Ten Biggest Legal Mistakes Startups Make. Here are the first five:

Number 1 – Choosing the Wrong Form of Entity

All too often, I encounter startup founders and would-be founders that reflexively think they need to set their company up as an LLC (a limited liability company). So I ask them, “are you thinking about getting venture capital funding?” If the answer is yes, then right away I tell them they need a C corporation, because venture capital investors will not invest their money in LLC’s. This isn’t some well-kept secret, either. A simple internet search on the subject will quickly show that VC’s require that the startups they invest in be set up as corporations, and preferably, Delaware corporations. So it is always frustrating to me when someone has wasted time and money setting up an LLC, when he or she really needs a corporation. Even more frustrating is when that founder had a lawyer set them up with an LLC; that’s sloppy lawyering, at best. Aside from the VC issue, I find that the corporate structure is generally simpler and easier to work with than LLCs, which are really jumped-up partnerships with complex tax issues. Many startups want to compensate employees with stock options, but options are a corporate concept. You can’t do stock options with an LLC. Finally, the dreaded “double taxation” you get with corporations is not really an issue for startups, because they generally don’t have profits and aren’t making dividends.

Number 2 – Failure to Split Founders’ Equity Properly

Following fast on the heels of picking the wrong entity is failing to properly split up the equity among founders. I’ve written a full post about this subject, so I’ll just write a brief summary here. Founders often just reflexively split the equity into equal shares. The truth is, different founders contribute differently to the startup. Some of those contributions are more valuable than others. It is an uncomfortable and difficult discussion, however, and while opting for equal shares seems like an attractive, less controversial alternative, the discussion is going to happen sooner or later. Better to have it happen sooner, before issuing founders shares.

Number 3 – No Vesting or Buyout Provisions

It is very common for startups to fail to include vesting and buyout provisions that apply to founders’ equity. This is particularly the case when the founders go cheap and use DIY services like LegalZoom to set up their corporation (or worse, their LLC). Everything might seem warm and fuzzy among the founders when starting out, but over time, frictions arise or someone gets burned out, and a founder leaves. What you don’t want is for that founder to leave with all her shares. By vesting those shares over time, and having the option to buy back vested shares at a nominal price, a startup protects itself against having an ex-founder out there with 40 or 50 percent of the ownership. You can read more about this subject here.

Number 4 – Forgetting the 83(b) Election

When you have founders’ stock or stock options that vest over time, you want to make sure that you do a timely 83(b) election. This is one of those wonky tax issues, and you can read more about it here, but I’ll give a brief rundown. When you receive stock that vests over time, you recognize taxable income as the stock vests, because in theory, that stock has increased in value since it was originally granted. The 83(b) election allows you to recognize income on the increase in value at the time you receive the stock, rather than when it vests. There should be minimal increase in value (if any) at that earlier point in time, so there should be almost no tax liability. You have to make the 83(b) election within 30 days of receiving the restricted stock or stock options, however. Not 31 days later. Not 50 days later but I can pay a penalty. Thirty days. Failing to do this can be a huge and costly mistake. Don’t make it.

Number 5 – Failing to Lock Up Intellectual Property

It is crucial for startups to lock up their intellectual property at every opportunity. When setting up the startup, one or more founders may have developed IP that is important to the enterprise. The startup should have the founder execute an IP assignment agreement in exchange for receiving her founders’ shares. By doing so, the startup now owns the IP, and if the founder leaves, she can’t take the IP with her. In addition, other employees may be developing IP for the company, and they should all execute contracts that specify that the IP belongs to the company, not the employee. Finally, if some of the founders are still working “day jobs” at other companies, it is important to review their employment agreements with those other companies. IP that they think they are developing for the startup may actually belong to the day job.

Those are the first five common startup mistakes. The next five will be in Part 2, which is here. Thank you for reading!

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Five Things You Should Know About Stock Options

Startups often use stock options to attract, retain, and motivate talented employees. Stock options are complicated, however, so here are five key things any startup founder (and startup employee) should know about stock options, as well as two freebie tips.    

What Kind of Option Is It?

There are two kinds of options: incentive stock options (ISO’s) and non-qualified stock options (NSO’s). ISO’s can only be issued to employees of the company. NSO’s, on the other hand, can be issued to non-employees, such as directors, advisors, and consultants. The tax treatment of ISO’s and NSO’s is quite different.

If you have an NSO, you recognize ordinary income when you exercise the option, regardless of whether you sell the underlying stock at the time of exercising the option. Consequently, you may have a tax bill but no cash to pay it. If you have an ISO, you don’t recognize taxable income until you sell the underlying stock, and you get capital gains treatment if the shares acquired through exercising the options are held for more than one year after the exercise date, and are not sold prior to the two-year anniversary of the option grant date (among other conditions). This makes ISO’s much more favorable than NSO’s.

Better Price the Option at Fair Market Value

Under Section 409A of the tax code, the exercise price of the options must be equal to the fair market value (FMV) of the underlying stock as of the option grant date. Otherwise, the option grant will be treated as deferred compensation, with adverse tax consequences for the employee, and withholding obligations for the employer.

The Securities Laws Apply to Options

Stock options are securities, and therefore federal and state securities laws apply. Under the securities laws, a company cannot offer or sell securities unless (a) the securities are registered with the SEC, or (b) there is an exemption from registration. Fortunately, there is an exemption for offers or sales of securities pursuant to the terms of a compensatory benefit plan or written compensation agreement. Most states have a corresponding exemption. So, you need a stock option plan to take advantage of that exemption. This leads us to…

Do the Paperwork

The paperwork associated with a proper stock option plan is well-defined and complex, and it will cost money. This is when you really need to consult an experienced attorney, rather than trying to do things yourself at one of those legal document websites. You will need a stock option plan (and plan summary), a stock option agreement, stockholder resolutions approving the stock option plan, board of directors resolutions approving the stock option plan, and board of directors resolutions approving each option grant. Expect this to cost at least $1500.

Don’t Forget the Option Pool

The company will need to reserve a pool of stock for the option plan. While the pool should be big enough so that you can grant meaningful options to employees (and remember, your headcount will grow over time), you want to minimize dilution. A good size for your option pool is 10-15% of the total amount of authorized shares.

As promised, here are a couple extra tips:

Include Vesting

Make sure the options are subject to vesting. A typical vesting schedule is 4 years with a 1-year cliff. That means that the first 25% of the options will vest at the end of the first year, and the remainder will vest on a monthly basis over the next three years. You want to keep employees motivated, and if their options are fully vested from the outset, they won’t have an interest in sticking around.

Consider Using Restricted Stock Instead of Options

For earlier stage startups with few employees, it may be easier and less expensive to issue restricted stock, rather than stock options. There are several advantages. First, restricted stock is not subject to the fair market value rule of Section 409A. Second, because the recipients are getting actual stock, rather than options, the motivation may be somewhat stronger. Third, with restricted stock, the capital gains treatment and holding period begin at the date of the stock grant, provided the recipient files his 83(b) election on time. Fourth, you can use restricted stock with directors, advisors, and consultants, so you don’t have to worry about the ISO-NSO distinction. You’ll still need a restricted stock purchase agreement and some other paperwork, but the cost should be less than what is involved with a stock option plan. Just as with stock options, it is a good idea to have the restricted stock vest over time – 4 years for employees, and 2 years for directors and advisors.

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83(b) Basics for Startup Founders and Employees

Typically, any blog post or article about a section of the tax code promises to be a snoozer, but knowing about Section 83(b) is crucial to any startup founders and employees. It’s pretty easy to do it right, but if you are sloppy or uninformed, and you mess it up, and you are in a world of pain. This could be the most important blog post any startup founder or employee reads.

Why is Section 83(b) so important? Typically under Section 83 of the tax code, a founder or employee does not recognize income on stock until the stock vests. When I refer to income, I mean the difference between the fair market value of the stock and the price paid for the stock. Section 83(b), however, allows the founder or employee to make a voluntary election to recognize income upon purchase of the stock, rather than waiting until the stock vests. If the founder/employee does not make the 83(b) election, she may have a great deal of income by the time the stock vests, particularly if the stock value increases substantially over time. OK, I know your eyes are glazing over, but indulge me a bit longer.

Let’s look at two different scenarios — failing to make the 83(b) election, and making the 83(b) election. Suppose we have two co-founders, Reggie and Daniella. Each gets 1 million shares of stock when they form their corporation, at a price of $0.001/share. The stock is subject to four year vesting with a one year cliff (see my other blog post on the importance of vesting). Reggie does not make an 83(b) election. By the end of the first year, 25% of Reggie’s stock is vested, and because of the efforts of the founders and the interest shown in the company by investors and the public, the stock is now worth $1/share. Reggie recognizes income on the vested stock equal to the difference between $1/share and $0.001/share, or $0.999/share. Multiply that by the number of his vested shares, and you’ll see that Reggie has recognized income of $249,750 on his vested shares. As time goes on and more of Reggie’s stock vests, he will continue to recognize income equal to the difference between the FMV of that vesting stock and the original price of $0.001/share. In addition, the company has to pay the employer share of FICA tax on the income, and withhold federal, state and local income taxes. Both Reggie and the company are taking a big tax hit because he failed to make that 83(b) election.

Now let’s look at Daniella. She got the same amount of stock, at the same price, and is subject to the same vesting schedule, but she made the 83(b) election. Instead of recognizing income of $249,750 at the end of Year 1 when 25% of her stock vests, she chose to recognize income at the beginning of Year 1, when she first received the stock and when its fair market value was pretty much equal to the price of $0.001. So basically, Daniella recognizes no income, because at the outset the stock had no real value.

Hopefully these two examples will make clear why the 83(b) election is a crucial issue for founders and employees. To make a timely 83(b) election, the purchaser must file the election with the IRS prior to the date of purchase, or within 30 days after purchasing the stock. No exceptions. In counting those 30 days, the IRS includes Saturdays, Sundays, and holidays. Best practice is to sign the 83(b) election form immediately upon purchasing the stock, and mail it by certified mail, return receipt requested, to the IRS that same day. Give a copy of the signed 83(b) election to the company for its records, and attach a copy to the purchaser’s federal tax return for the year in which the stock was purchased.

The Importance of Vesting

I just came across this article by Rebekah Campbell, on a topic of crucial importance to entrepreneurs — how to divvy up ownership interests in a startup. Campbell is an Australian entrepreneur, and is the founder and CEO of Posse, a mobile social network that connects customers and retailers. In the article, she talks about the rather cavalier approach she took to dividing equity among her startup team, and the problems she encountered as her team eventually drifted away. She ended up where she started, alone, but with far less equity in her company.

The proper approach, which she goes on to describe, is to incorporate a vesting plan at the outset. Her suggested vesting plan is 3-year vesting, which is shorter than the 4-year vesting that is commonplace in US tech startups. Before looking at how vesting works, let’s start with what happens without vesting. Say there are three co-founders of the company. One co-founder puts in money and is the person who had the initial product vision; she gets 40% of the equity. The other two co-founders are the chief software developer and the marketing guru; they each get 30% of the equity. After about a year of work, the chief software developer is offered a plum job at Google and leaves, taking his shares with him. The marketing guru gets burned out, and leaves too, taking her shares. Now the initial founder is left alone to do all the work, but only has 40% of the company. If she brings in new people, she has to reduce her equity stake further. Meanwhile, two people owning 60% of the company are roaming around on the outside, able to exert a significant amount of decision making power over a company they are no longer involved in. They could veto a crucial acquisition opportunity, for example, or threaten to do so as a means of extracting preferential treatment.

Now suppose there had been a vesting plan in effect. The standard vesting plan is often referred to as “four year vesting with a one year cliff.” This means that the vesting takes place over four years, and no shares are vested at all until the end of the first year. So if the chief software developer takes that job at Google in the 10th month, he forfeits all of his shares. They weren’t vested yet, and they return to the company’s equity pool. He’s not just out, he’s completely out. Before he left, the original founder had 40% of the company, now she has 57% of the company because the software developer’s forfeited shares are no longer in the mix. The marketing guru leaves after a year and a half. At the one year mark, 25% of her shares vested, and each month thereafter, another 1/48th of her shares vest. So, when she leaves, she does leave with some equity interest, but far less than if there were no vesting. She walks out with about 17% equity in the company, rather than her original 30%, or the 43% her equity interest got bumped up to when the other cofounder left. It’s fair to her, considering the time she put in, and it’s fair to the company and the remaining cofounder, who doesn’t have to worry about a significant equity holder who is not involved in the company. Meanwhile, the original founder now owns about 83% of the company due to the departure of the cofounders and the forfeiture of their unvested shares.

This kind of vesting arrangement can easily be incorporated into a shareholders agreement, which is the contract shareholders should sign when the company is formed and they acquire their equity. There’s one other component that Campbell didn’t touch on in her article, and that’s the buyout option. When one of these cofounders leaves the company with some vested shares, a buyout option gives the company (and sometimes the remaining shareholders) the option to purchase those vested shares back from the departing shareholder. It also gives the company a right of first refusal if a since-departed shareholder tries to sell her shares to someone else outside the company. The company may not have the money needed to exercise this buyout option, but the option at least gives the company the power to try to maintain control and limit ownership. While adding a shareholder agreement with vesting and buyout provisions can increase the overall startup costs for a venture, it will pay for itself many times over in saving headaches and preserving the rights of the ongoing founders.