How to Share Equity

By Nikki Piplani and Joe Wallin

If you are a startup company founder, one of the first questions you will have will be about sharing equity with your early hires. Once you start asking, you will hear plenty of advice about this.

You will hear— “Be generous”. You will also hear— “Worry about dilution”. The concerns around dilution are fair, but you do need to form a team, and if you are a very early stage startup, your most powerful incentive, aside from an interesting problem to solve, is a generous equity offer.

Immediately after the issuance of the founders’ shares, the general consensus seems to be to reserve between 15- 30% of the issued and outstanding shares in a stock incentive plan for your key hires. (Meaning, if you have issued 4M shares to your founders you would set aside about 600,000 shares in the stock option or stock incentive pool.)

But beyond reserving some amount of shares in a stock incentive plan, there are still plenty of questions to work through.

“Is there a right or suggested amount of equity for the positions startups typically want to fill?”

“Is there a published schedule somewhere, where I can read about what to give out in equity to my early hires, and that shows how this changes as my startup matures? Sort of like what you see on the Founder’s Institute Fast Form site for advisory board members?”

“Or is hiring and sharing equity something that varies so much depending on the particular facts that no industry standards or guidelines exist?”

And then, “Once I find out the number of shares to give someone, from a legal and tax point of view, what do I need to think about?”

And finally, “How do I document this all correctly so as to not step off some unknown legal or tax ledge where I hurt myself, my company, or the person I was trying to incentive with the equity award in the first place?”

Based on our experience navigating these questions, we’ve put together a brief guide for helping you think through the process.

How Many Shares?

Unfortunately, determining exactly how much equity to grant to your early team is not easy. There are no scheduled or published guidelines. It is all very fact specific.

As Sam Altman said in a recent blog post, “It’s very difficult to put precise numbers on this because the specifics of every situation matter so much.” http://blog.samaltman.com/employee-equity . Information is scattered and may be hard to find, but there is some data out there on how many shares to issue to members of the team. Quora.com and blogs like AVC.com are good places to start. Again, Sam Altman’s recent blog post is helpful. Here is what Sam says:

“I think a company ought to be giving at least 10% in total to the first 10 employees, 5% to the next 20, and 5% to the next 50.”

And then, of course, there is this post from Guy Kawasaki. And here is another article with data as well.

Calculating the Actual Number of Shares

A lot of people get confused on this point. Truth is, there are a lot of different ways to take a given percentage and translate it into an actual number of shares. For instance, you can calculate the number of shares based on:

  • The corporation’s issued shares outstanding shares
  • The corporation’s issued and outstanding shares plus the number of shares already covered by stock options that have been granted
  • The corporation’s issued and outstanding plus the corporation’s entire stock option or stock incentive pool

(By the way, you never translate a percentage interest into a number of shares based on the corporation’s authorized shares; that number is made up. What matters are how many shares are actually issued.)

What if your company has already issued a Series Seed or Series A? Do you count those toward the percentage?

The most important thing to do in translating a percentage into an actual number of shares is to do it in a way that can be easily and transparently described by you to your new hires.

Here is how you do this calculation:

A percentage is translated into a number of shares based on the issued and outstanding shares (not authorized!), on a fully diluted basis, but not taking into account convertible debt and convertible equity that will convert to shares on the closing of the next round.

The fully diluted share count includes:

  • All issued and outstanding common shares;
  • All issued and outstanding preferred shares;
  • All of the shares in the equity plan; and
  • Sometimes the shares underlying any outstanding warrants (this depends on the characteristics of the warrants; whether they are warrants to purchase shares on the next financing whose share impact can’t yet be calculated or whether their dilutive impact is already understood and baked into the cap table ).

Convertible notes or convertible equity that are waiting to convert to shares on the next fixed price round are usually left out. The reason? It is hard to know how many shares will be issued for these instruments. Plus, the award recipients and the founders will equally be diluted in the next round. It makes sense that your award recipients would incur the same dilution on the next financing as the founders.

Another reason to include the entire pool (rather than just the number of shares that are covered by currently issued awards under the plan) is for ease of calculation.

(For another reference on this point, see this article by Matthew Bartus : https://www.cooleygo.com/option-grants-fully-diluted-issued-outstanding/)

Let’s say you’ve settled on a 2% option grant for a new hire. How do you translate that 2% into an actual number of shares?

Your corporation will probably have a pretty big number of “authorized” shares. For example, you might have 20M total shares authorized. But, you might have only issued your founders 4M in total, and set aside in an option plan 600,000 shares. In this example then, your fully diluted share number would be 4.6M. How do you calculate 2% in this scenario?

You calculate the 2% based on the issued and oustanding common plus the entire pool. So you multiply 2% times 4.6M.

The main reasons to include the entire pool (rather than just the number of shares that are covered by awards under the plan) are: (i) ease of calculation, (ii) for the sake of consistency – this is how percentages of start-ups are typically calculated (e.g., this is how an angel or VC investor does this calculation), and (iii) this way the next person you grant options to you can use the same method of calculation and 2% in the next grant will result in the same number of shares.

Of course, if your new team members have questions on how you calculated the number of shares, tell them how you did it. Forthrightness in this area is important.

Your new team members might ask—”But won’t I be diluted in the future?” And the answer is— “Yes, all of us will.” This is the way it is in startup land.

What Type of Award?

Once you have decided on how much equity to give to someone, the next question is—what type of award should you give this person? There are really on a couple of choices in startup land:

  • Stock Options; and
  • Restricted Stock Awards

Bigger companies sometimes use RSUs. A good example of this is a company like Twitter, when it was ramping up to its IPO. It was using RSUs by this time. There comes a time in a startup’s life when RSUs start to maybe make sense, but not at the outset of the company’s life. At the outset, the way to go is either stock options or restricted stock awards.

Restricted stock awards, however, are really only helpful when the value of the company is really, really low. Like right at the start of a company. The reason? Taxes. Once a company’s value has become say, a quarter of a million dollars or more, award recipients either won’t be able to afford or not want to pay the income and employment taxes on stock awards.

For example, say you want to give an early developer 5%. If your company is worth $250,000, 5% of $250,000 is $12,500. This is $12,500 of taxable income. The taxes, counting employment taxes, will be several thousand dollars. Many people would rather not come out of pocket several thousand dollars to receive an illiquid stock award.

When this happens, you will then have moved into the zone where stock options are the only type of equity award that makes sense for the time being.

The Two Types of Stock Options

There are two types of stock options:

  • nonqualified or nonstatutory stock options (NQOs); and
  • statutory or incentive stock options (ISOs).

Only employees can receive ISOs. So independent contractors and directors who are not employees must receive NQOs.

ISOs can be more valuable to employees. But ISOs are more complex than NQOs to explain and administer. The exercise of ISOs can give rise to complex Alternative Minimum Tax consequences. Plus the company loses a tax deduction on an ISO. These are all reasons to keep your life simple and just grant NQOs across the board.

How to Document the Offer in an Offer Letter

This is another place where companies make mistakes.

Your offer letter should always say the equity grant is subject to board approval. This is not only a good practice but a requirement because an equity award is not legally granted unless the board approves. It is also smart because what if the board doesn’t approve? Or what if your optionees suddenly quits the company under unfriendly or hostile circumstances?

Example offer letter languge:

“Subject to the approval of the Company’s Board of Directors, you will be granted an option to purchase _____ shares of Company common stock under the Company’s stock option plan at an exercise price equal to the fair market value of that stock on your option grant date. Your option will vest over a period of four years, and will be subject to the terms and conditions of the Company’s stock option plan and standard form of stock option agreement, which you will be required to sign as a condition of receiving the option.”

In the offer letter, do not refer to a percentage. You have to specify the actual number of shares covered by the award.

Once you offer someone a percentage you have entered into the unknown. As explained above, there are many different ways to translate a percentage interest into an actual number of shares. You don’t want a dispute over that. Put in a hard number. You can explain to the optionee the summary cap table so that they can understand how the percentage interest can be calculated.

Is there a checklist of all the paperwork required?

Yes.

Prior to Granting Stock Options or Restricted Stock Awards:

First, work with a lawyer to prepare a plan and the standard award agreements under the plan. Work with your lawyer to make sure that the board and shareholders adopt the plan in accordance with state corporate law. If shareholders do not approve the plan, you cannot grant ISOs, and you may be required to make additional, special filings with state securities regulators.

Grant all of your awards under the plan-If you are granting awards outside of your plan, you may not have a securities law exemption for the issuance of the award. This is the kind of mistake that can cost a lot of money to fix later. So, make sure you comply with the law in this area. There is a reason everyone adopts a plan and grants awards under the plan. The reason is that the path to compliance with the securities laws is easier and much less expensive with a board and shareholder approved plan than with other alternatives.

Make sure all of your awards are approved in unanimously executed Board Consents or appropriately documented in minutes of correctly noticed and called board meetings at which a quorum of directors was present. Again, work with your lawyer to make sure this is done right. If you do not do this right fixing it can be extremely expensive.

Confirm that you have sufficient shares in your plan to cover the award – Prior to granting awards, confirm you have the number of shares under the plan to grant the new batch of awards.

Rule 701- Before every grant of awards, confirm that you are compliant with Rule 701′s mathematical limitations. Rule 701 has mathematical limitations, meaning–there is a limit to the number of securities you can issue under Rule 701, and you do not want to exceed that limit. For a summary of these limits, see Rule 701: http://thestartuplawblog.com/rule-701/

Prospectus– If you have granted more than $5M in awards during the last 12 months, make sure to provide the prospectus required by Rule 701.

Eligible recipients– Confirm each prospective award recipient is eligible under the plan. Generally, only individuals qualify. Non-employee consultants can qualify as long as they are natural persons providing bona fide services and not receiving the options in connection with a capital raising transaction.

Confirm the residency of recipients – Before every grant of stock options, confirm the residency of the prospective award recipients and confirm that you are compliant with the Blue Sky law of each state in which the award recipients are resident.

If you are granting options to optionees in California, special attention will need to be given to California’s requirements. In California you have to file a form and pay a fee to grant stock options. The same goes for New York State, where you actually have to apply to the Attorney General for an exemption to grant stock options.

Fair market value- Make sure that options are being granted at fair market value in compliance with Section 409A of the Internal Revenue Code.

Board approval– Have the Board approve the option grants pursuant to a Board Consent or resolutions adopted at a meeting. If the vesting schedules for any of the options are different from the standard specified in the standard agreements, make sure the Board consent describes the vesting schedule.

Signed agreements– After each grant of an award, give each recipient a copy of the plan and their award agreements, and have them sign the agreements required under the plan.

Capitalization ledger– Update the capitalization ledger once the option is approved.

In Summary

There are guidelines in this area, but this is also a complex area of your startup. With equity compensation you hit all the hard issues:

  • How much equity will you share to incentivize key hires;
  • How will you explain it to them so that they understand it and fully appreciate the incentive (after all, how much is an incentive worth if not understood?)
  • And then of course there are all of the legal and tax complexities on top of that.

To make things easier on yourself, It makes sense to follow industry standard practices as much as possible. And don’t try to tackle this one without a lawyer. The legal details are really important in this area, so make sure you get good advice. Good luck!

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Incentive Stock Options: The Qualifications and Limitations

In startup land, aside from cash compensation, stock options are the most important part of employee compensation. (This is the case because once a startup is beyond the very early, initial startup phase, no other form of equity compensation–such as restricted stock or RSUs–works very well from a tax point of view for employees.)

Because equity compensation is such an important part of your overall employee compensation, it is important to maximize the benefit of your stock option plan to your employees.

How do you do this? Well, probably the most important thing to do is clearly communicate with your employees on the type of options they are receiving, what their options entitle them to, and how they work.

Employees frequently have a lots of questions about their options, including questions on how they work, and the tax consequences to them of receiving and ultimately exercising the options.

There are only two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NQOs).

You will have to choose what type of options to grant.

ISOs have certain special tax advantages to employees over NQOs, but those employee advantages come at a cost (and potentially a significant one) to the company.

What Are the Advantages to the Employee of an ISO?

  • No ordinary income tax on exercise
  • No employment tax on exercise
  • If two holding periods are met, long term capital gain on sale
  • If the holding periods are not met, if there was spread on exercise, you will have ordinary income equal to that amount on sale of the stock, and if there is gain beyond that, short term capital gain on that portion, but still no employment tax withholding.

Nonqualified stock options trigger income and employment tax withholding on exercise, if there is a spread on exercise. This is arguably a benefit of an NQO over an ISO because it is easier to calculate the income and employment taxes on an NQO exercise than the Alternative Minimum Tax (“AMT”) consequences of an ISO exercise.

The Costs to the Employer of an ISO

  • The loss of the deduction of the spread on exercise.
  • In contrast, with a nonqualified stock option, the company gets to deduct the spread on the exercise of an NQO. This can be a significant tax benefit to a profitable company.

The Qualifications and Limitations

If you decide you want to grant ISOs, you will need to know the various qualifications and limitations of ISOs.

Again, these qualifications and limitations are in exchange for the special tax advantages an ISO provides to employees over nonqualified stock options.

The ISO qualifications and limitations are:

  • ISOs can only be granted to employees. So independent contractors and members of the board of directors who aren’t otherwise employees can’t receive ISOs.
  • Only the first $100,000 that becomes exercisable during any 12 month period can qualify for ISO treatment.
  • ISOs to 10% or greater stockholders have to be priced at 110% of FMV and have no more than 5 year term.
  • The spread on the exercise of an ISO is not subject to ordinary income tax and employment tax withholding but the spread on exercise is an AMT adjustment.
  • The spread on the exercise of an ISO is not deductible to the company.
  • ISOs have to be granted pursuant to a plan that specifies the aggregated number of shares that may be issued under options and the employees or class of employees eligible to receive options, and which is approved by the shareholders within 12 months before or after the date the plan is adopted.
  • ISOs have to be granted within 10 years from the date the plan plan is adopted, or the date such plan is approved by the stockholders, whichever is earlier.
  • ISOs cannot be exercisable after the expiration of 10 years from the date such option is granted.
  • ISOs have to be granted with an option price not less than the fair market value of the stock at the time such option is granted.
  • ISOs cannot by their terms be transferable otherwise than by will or the laws of descent and distribution, and may be exercisable, during the optionee’s lifetime, only by the optionee.

The Full Benefit of ISOs is Rarely Realized

Probably the most important thing to know about ISOs is that most of the time the primary benefits of an ISO are not realized by the employee. Most employees don’t exercise their options until and in connection with a liquidity event—at which time they will not have satisfied the two holding periods. Nevertheless, even in that context, there are employment tax savings (although these might be relativity small, they still exist).

This blog does not constitute legal or tax advice.

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Tax Free Startup Company Stock

If you are not familiar, last December the Congress and the President made permanent one of the most significant tax breaks probably ever made available to founders and investors in startups. They created something that they could have rightfully called, “Tax Free Startup Company Stock.”

What am I talking about?

Well, last December the Congress and the President made permanent the 100% exclusion from tax on gain from the sale of qualified small business stock held for more than 5 years. Since September 27, 2010, when the 100% exclusion first went into effect at President Obama’s urging, it had always been set to expire every 6-12 months. Now it is here to stay.

This means that if you found a startup company, or you buy stock in a startup company, and that startup company is a C corporation engaged in a “qualified trade or business” (see definition quoted below) with less than $50 million in gross assets (both before and after you and others invest), you can completely avoid tax on up to $10M in gain on the sale of that company’s stock.

This doesn’t work if you form your new business as a LLC taxed as a partnership or an S corporation.

Section 1202 is a big deal, and one that you ought to carefully consider when selecting an entity form for your business, or what types of businesses to invest in.

But, as you might imagine, Section 1202 does have a number of limitations and qualifications.

I received a question about some of those limitations this morning.

The Question Went Like This:

Joe, I thought I remembered a $1 million limitation on how much 1202 stock a company could issue in a given year but looking through your blog and a number of other sources it seems I’m confusing 1202 with some other tax benefit. Does this ring a bell? Is there a limit (other than the gross assets, active business and use of proceeds tests) I need to think about?

The Answer To This Queston Is:

There is no limit on how much 1202 stock a company can issue in a given year, except for the $50M gross assets limitation you mention above.

Section 1202(d) defines the term “qualified small business” as any domestic corporation which is a C corporation if:

“(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.”

Thus, while there is no express limitation on how many shares a company can issue that qualify as Section 1202 “qualified small business stock,” (see definition below) once the company has in excess of $50M in gross assets, it cannot issue qualified small business stock at all.

If you are recalling a $1 million limit of some kind, you are probably thinking of Section 1244. Section 1244 allows an ordinary as opposed to a capital loss on an investment in a C corporation, if you are one of the first $1 million invested.

Section 1244 is about losses. Section 1202 is about gains.

Section 1202 is a significant tax benefit to consider as you plan how to start and invest in companies.

*********Definitions below

“Qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—
(A) as of the date of issuance, such corporation is a qualified small business, and
(B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—
(i) in exchange for money or other property (not including stock), or
(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

“Qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, daccounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.

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Trademarks: When To File Outside the U.S.

By Ashley Long

If you are a startup company, your brand (your trademarks) may be one of your most important items of intellectual property. Protecting your brand through one or more federally registered trademarks is usually a really smart move. For not very much money, you can obtain federal rights allowing you to stop subsequent users from adopting your brand. If you simply use your brand, you obtain common law rights to it–but these common law rights provide limited protections.

A related question, once you have filed for your U.S. trademarks, is whether to file for protection outside the U.S.

When To File For Trademarks Outside the U.S.

If your brand is going reach beyond the U.S., and if you plan to expand your business operations abroad, then it is a good to at least consider foreign trademark filings.

Trademark rights are granted on a country-by-country basis.  As such, your use or registration of a trademark in the U.S. won’t give you trademark protection beyond our borders.

Let’s start with how the U.S. is different from other countries.  In the U.S., just using a brand in commerce will grant you some legal rights over the brand.  Many jurisdictions, however, are “first-to-file” countries.  That means whoever registers a trademark first – regardless of whether they’re using it – is the owner of the mark.  For example, both China and Japan are “first-to-file” countries.

Filing in all of the countries around the world can be an imposing proposition – both logistically and economically.  Here are some things to consider before commencing any foreign filings:

  • Will my brand have any presence in that country/region?
  • Am I willing to enforce my trademark rights if something goes wrong there?
  • Are the jurisdictions first-to-file or first-to-use countries?

If you’ve recently filed a trademark application in the U.S., you have a little breathing room before making any foreign filing decisions.  As long as you proceed with your foreign filings within 6 months of your U.S. filing date, your trademark rights in the foreign jurisdictions will be retroactive to the U.S. filing date.  This is important because it means that, even if a conflicting trademark was filed before yours, you are still first in line if your U.S. date predates the other filing.  (You can file after the 6 month priority deadline, you just won’t have the benefit of the U.S. filing date.)

Questions about foreign filings?  Please feel free to contact us for more information!

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Startup Compensation: Founders, Don’t Forget to Pay Yourselves (and Others)

By Dennis Kasimov and Joe Wallin

In the early days of a startup, it is common for founders to not pay themselves any cash compensation. This approach is sometimes also applied to other service providers, who receive just stock option compensation. Despite the prevalence of this practice in the early days, as things progress it can lead to situations that put the company and its founders in a tough spot.

Startup Compensation

Here are a couple of examples showing how things can go wrong.

Example 1: A minority co-founder (say, 10%), who has not been paid any cash compensation (and is not an exempt salaried employee – see below), is not working out and is let go. If this co-founder feels aggrieved, he or she might sue the company and the other founders personally for failing to pay the minimum wage. The minority co-founder may face an uphill battle to prove his/her claim, but this situation would be a thorn in the side of any startup, with the potential to grow into a costly lawsuit. You can avoid this entire scenario by simply paying the individual at least the minimum wage in cash.

Example 2: You classify a service provider as an independent contractor, and you do not pay them cash. Instead, you pay them in vesting equity. The person works for a while, but their work is unsatisfactory so you terminate them. Their equity is unvested, and so it all reverts to the company. This person may not only sue you for failure to compensate them (a hard claim to win on maybe, but if they make it you have to deal with it), but, to add insult to injury, they might also assert that they own the IP they created while working for you, because you didn’t pay them anything for it.

It is obviously in a startup’s best interest to steer clear of these issues. So, it is important you handle paying people correctly.

What are the Rules?

For founders acting as corporate officers, it is generally difficult to escape “employee” status and the minimum wage and overtime requirements. Under the federal income tax law, an officer of a corporation is defined as a “statutory employee” (see https://www.irs.gov/irm/part4/irm_04-023-005r.html) which may hint to a similar classification under the wage and hour laws. Admittedly, the federal Fair Labor Standards Act has an exception to the minimum wage for 20% or greater equity owners, but Washington state law does not have a similar provision (c’mon legislature!). Because Washington and Seattle minimum wage levels are higher than the federal standard, these are the applicable rules to Seattle-area based startups.

The risk with not paying your employee co-founders (and if they are an officer of the company, then they are likely an employee) at least the minimum wage is that they might sue you personally if things don’t work out. Washington state has an unlawful wage statute (RCW 49.52 (http://app.leg.wa.gov/RCW/default.aspx?cite=49.52.070)) that imposes personal liability “for twice the amount of the wages unlawfully rebated or withheld” on corporate directors, officers and investor representatives on the board. This is one reason investors usually want to know if a company has severance plans in place before they invest. Failure to pay severance when a company runs out of cash is another potential source of troubles for directors and officers of the company.

But wait, you might say, how can some famous CEOs pay themselves $1 a year, as Steve Jobs did at one point? Well, for one, Steve had millions of dollars in equity incentives and retirement benefits that more than made up for a lack of payment of minimum wage to him; this type of plan is not applicable in the early startup world.

Here is the startup rule: If you are the majority founder, you are probably not going to sue the company. So, you can probably not pay yourself in the very early days. But this situation will change as your company grows, particularly when you begin to solicit investment funding. Investors are going to want to have the assurance that there is zero potential of outstanding wage claims.

For Minority Co-Founders, The Problem Can Be Especially Acute

But what about your minority co-founders at the early stages? Do you pay them at least the minimum wage?

Maybe not. If they are independent contractors (and properly classified under the law as independent contractors), then the minimum wage doesn’t apply. Accordingly, for most cash strapped startups it is important to keep as many of their workers classified as contractors as possible.

But it is not always possible to classify a co-founder as an independent contractor. As mentioned above, if the co-founder is an officer of the company, contractor status may be unattainable. Worker classification is a highly fact specific inquiry and largely depends on how much control the company has over the individual.

Usually a startup has one or two dominant founders and one or two minority founders. The minority founders might not be receiving any cash compensation, and their stock compensation is probably subject to vesting. If the company has to cut a minority founder loose, that person might sue the company and the dominant founders for failure to pay the minimum wage, and under Washington law for double damages and attorneys’ fees.

So, What Should A Startup Do?

Here are some tips:

* Every worker, regardless of whether they are an employee or an independent contractor, should sign a confidentiality and proprietary rights assignment agreement, assigning all IP they create to the company. Think of your startup as a ski mountain. You don’t let anyone ski your mountain without a lift pass. Here, the “lift pass” is a solid IP assignment and confidentiality agreement.

* Every worker should also sign a document governing the terms of their service relationship. Are they an employee? If so, have them sign an at-will offer letter. If they can properly be classified as a contractor, have them sign a well drafted Independent Contractor Agreement.

* You need to pay your minority co-founders at least the minimum wage if they are an employee (e.g., an officer) of the company. Otherwise, you are accepting a risk of lawsuit. If you don’t have any cash to pay them the minimum wage, don’t make them an officer, and treat them as an independent contractor as long as you reasonably can (and pay them a small amount of cash to make an IP assignment binding). This can work well for someone working part-time on the weekends and evenings during the company’s early days.

* Be wary of informal and unspoken agreements among friends and family (“Dont worry, I won’t sue!”). This is business and the relationship can go south quickly. Moreover, an individual can never waive their right to minimum wage, even in writing.

* Use a payroll service so that you can rest assured that all taxes are deposited with the IRS and all employment tax returns are filed. See  http://startupclass.samaltman.com/courses/lec18/.

* You may attempt to qualify a founder/employee as a salaried executive exempt from the wage and hours laws. The requirements are detailed in WAC 296-128-510. This option will not eliminate the need to compensate the individual, but it may lower the required wages to as low as $155.00/week provided that the other requirements are met as well.

As you can see, this can be a complicated area of the law. Every company should seek a trusted legal advisor. One thing is clear though: do not sweep these issues under the rug during the early stages of your company.

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Tax Free Founder Stock

If you are thinking about starting an early stage tech company, one of the first things you will have to figure out is what type of legal entity to form.

Fortunately, there are only a few choices available to you. Your choices are basically only 1 of the following 3 possibilities:

  • an LLC taxed as a partnership for federal income tax purposes
  • a corporation that has made an election to be taxed as an S corporation for federal income tax purposes, or
  • a C corporation

Entity Choices

LLCs Taxed as Partnerships. An LLC taxed as a partnership is a state law limited liability company that has multiple members that has not made an election to be taxed as a corporation. An LLC taxed as a partnership does not pay federal income tax. Intead, it’s owners pay the income tax on the LLC’s income. The LLC files an information return with the IRS each year and sends each owner a Form K-1, so that the owners know what income they owe tax on. If the LLC incurs losses, sometimes the owners can deduct those losses on their tax returns.

S Corporation. S corporations are like LLCs in that they are pass through companies–meaning, an S corporation does not pay federal income tax; its owners pay the tax on the entity’s income. The entity files an information return with the IRS and sends each stockholder a Form K-1 each year so that the stockholders can pay the tax on the entity’s income. S corporations are only available if all of the stockholders are individuals (generally) and US citizens or lawful permanent residents (VC funds can’t be S corporation stockholders). Again, if the entity loses money, sometimes the stockholders can deduct those losses on their tax returns.

C Corporation. A C corporation pays its own taxes. Its stockholders do not pay tax on the entity’s income. If the C corporation pays dividends to its stockholders, the stockholders pay tax on the dividends. Thus, if a corporation is profitable, it will pay federal income taxes. Then when it pays dividends to its stockholders, the stockholders will pay tax on the dividends. This is sometimes referred to as the double tax problem.

The Importance of the Choice of Entity

Your choice of entity is important because it affects important immediate and downstream consequences, including:

  • How much money it will cost you and your co-founders to set up the company.
  • Whether the entity will be an entity that is easy to use to do important things like (i) grant stock options to advisors and service providers, and (ii) raise money from angels and venture capitalists.
  • How the founders will be taxed on the ultimate sale of the company, or their ultimate sale of their stock.

In general, LLCs taxed as partnerships are lousy choices for an early stage tech company that wants to follow the traditional path of granting stock options and raising money from Angels and VCs. Granting the equivalent of stock options in an LLC is complex and costly from a legal and accounting fees perspective.

That leaves you with the choice of S corporation or C corporation. Most angel investors do not want to invest in pass through companies and receive a Form K-1 from a company they invested in. This rules out S corporations.

Thus, you are left with a C corporation as the default best choice if you want to follow the traditional path.

But what if you desire to be able to take the losses from the company on your personal income tax return? Shouldn’t you form an S corporation then, and stay an S until you take money from investors?

The answer depends. But if you choose anything other than a C corporation you are potentially walking away from a very important tax benefit available to founders.

Tax Free Founder Stock

Under the federal income tax law, if you acquire stock in a C corporation with less than $50M in gross assets (both before and after you acquire your stock), and the corporation is engaged in a qualified trade or business (see definitions below) and observes some other rules–if you sell that stock after holding it for 5 years, up to $10M in gain can be completely excluded from federal income tax.

This exclusion doesn’t work if you form an S corporation or an LLC taxed as a partnership.

Below you will find the defined terms used in Section 1202 of the Internal Revenue Code. Don’t overlook this potentially very significant tax benefit when you decide on your choice of entity.

Keep this in mind when choosing what type of entity to form. If you qualify, you don’t to inadvertently miss this potential benefit.

Section 1202 Definitions

“Aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation.

“Eligible corporation” means any domestic corporation; except that such term shall not include—
(A) a DISC or former DISC,
(B) a corporation with respect to which an election under section 936 is in effect or which has a direct or indirect subsidiary with respect to which such an election is in effect,
(C) a regulated investment company, real estate investment trust, or REMIC, and
(D) a cooperative.

“Eligible gain” means any gain from the sale or exchange of qualified small business stock held for more than 5 years.

“Parent-subsidiary controlled group” means any controlled group of corporations as defined in section 1563(a)(1), except that—
(i) “more than 50 percent” shall be substituted for “at least 80 percent” each place it appears in section 1563(a)(1), and
(ii) section 1563(a)(4) shall not apply.

“Pass-thru entity” means—
(A) any partnership,
(B) any S corporation,
(C) any regulated investment company, and
(D) any common trust fund.

“Qualified small business” means any domestic corporation which is a C corporation if—
(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.

“Qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—
(A) as of the date of issuance, such corporation is a qualified small business, and
(B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—
(i) in exchange for money or other property (not including stock), or
(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

“Qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.

“Specialized small business investment company” means any eligible corporation (as defined in subsection (e)(4)) which is licensed to operate under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993).

This blog post does not constitute legal or tax advice. Always consult a legal or tax professional with your tax questions.

 

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Washington State Equity Crowdfunding News

Ashley Stewart (@ashannstew) recently wrote a great piece in the Puget Sound Business Journal on Washington State equity crowdfunding titled “Crowdfailure: Not a single company has been able to use Washington’s 2-year-old crowdfunding law.” She also wrote an accompanying blog post.

Washington State Equity Crowdfunding

The article tells the story of a company frustrated at its inability to make use of Washington’s equity crowdfunding law, and what might be done to fix it.

I know many people who think that equity crowdfunding is going to be a failure and that the whole concept is a bad mistake.

I don’t think we should give up yet. I think the concept has huge promise, but we need to continue to refine our laws and regulations until we get this right.

Here are my suggestions on how to make the Washington crowdfunding law more usable, more user friendly, and better.

Suggested Improvements

  • Allow companies to use the law for smaller rounds ($250,000 or less) without having to hire an escrow agent and without have the DFI review and approve their Crowdfunding Form first. In other words, allow what they allow in Oregon: File the form, pay the fee, wait 7 days, and you can go ahead. This is one of the secrets of Oregon’s success. Oregon’s law went into effect after ours–and not through legislative action–the regulators just put a rule in place. Query whether we couldn’t just do that in Washington now. How about we adopt rules substantially similar to Oregon’s?
  • Don’t require public disclosure of executive officer and director compensation. It makes sense to require these disclosures to company shareholders for sure. But requiring disclosure of to the public at large doesn’t make sense. The public at large is not invested in these companies, and these are, after all, private companies. Either RCW 21.20.880(3) needs to be amended or the Washington State DFI needs to adopt a regulatory exemption like Oregon’s. 
  • Allow portal operators or similarly situated people to earn a success fee on the closing of an offering (such as 3-5%) without having to be registered broker-dealers. As of right now, not a single person in Washington State has started a crowdfunding portal. This could be because there is no money to be made in it. If you can’t charge a success fee without being a registered broker dealer, and registration and maintenance of that registration costs hundreds of thousands of dollars, it makes the business calculus hard. It is hard to see people taking the time and effort to create a portal without being able to make a reasonable fee for the work they do. I don’t think allowing a portal to make a fee of some percent without a broker-dealer registration should be off limits. Allowing market participants to make a reasonable fee will help this industry take off.
  • Allow the law to be used for real estate investments. Right now crowdfunding a real estate investment requires special approval of the DFI. This doesn’t make sense. Non-accredited investors ought to be able to pool their money to buy rental properties.
  • Allow the law to be used to sell convertible debt securities (such as convertible note, convertible equity instruments, and revenue loans). Right now the DFI’s rules disallow the sale of debt securities. Again, I don’t think this makes sense. Most early stage companies raise money in convertible debt offerings. Under the Washington State DFI’s current rules, the crowdfunding law can’t be used to sell debt securities.
  • Repeal the DFI’s rules on what preferences preferred stock must have. The DFI adopted minimum standards for preferred stock that are out of market. The most common form of early stage company preferred stock investment right now is the Series Seed round. But the Series Seed terms won’t meet the minimums the DFI laid out in its regulations for what rights, preferences and privileges preferred stock must have to be sold under the law. The current DFI rules push companies that want to issue preferred stock into a more complex, more expensive position than what angel and early stage VC funds demand in terms of deal terms.
  • Allow accredited investors to invest an unlimited amount. There is no reason to limit the amount accredited investors can invest. They are not limited in a Rule 506 offering.
  • Allow non-individuals to invest. Right now, only individuals can invest, but it would be better if an LLC could invest. That way, a company could take on one shareholder (the LLC), rather than potentially dozens of individual shareholders.

Summary

On Monday, May 16th, Title III equity crowdfunding is going to launch. It may turn out to be a lot more successful than people thought. I am optimistic, especially after having WeFunder Co-Founder Nick Tommarello on TheLawofStartups podcast (www.thelawofstartups.com). This isn’t the time to give up, but to improve what we have done to make it better.

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Secondary Sales and An Investor Covenant You Don’t Want To Miss

If you are investing in early stage companies, there are certain deal terms you want.

Most you probably know already: if it’s a round of convertible notes, you want a discount and a cap; if it’s a priced round, you want a liquidation preference. Etc.

But there is a new thing you need to add to your list of “must haves.”

You now want your investment documents to include a Section 4(a)(7) covenant.

What the heck is Section 4(a)(7)?

Section 4(a)(7) is a new federal securities law that basically says, it’s OK for you to sell your investment in a private company, as long as you don’t generally advertise the securities for sale, sell to another accredited investor, and the company cooperates with certain information requirements.

The new federal law trumps state law. So state law won’t hold you up.

Unlike the existing resale exemption most commonly used, there is no holding period required under this new law.

What is a Section 4(a)(7) covenant?

This new law is great—but you need the company’s assistance to access it, because the law requires the company to provide certain information to the purchaser.

So, get this covenant in your investment documents, and it may be easier for you to later sell your shares.

You can find draft covenants to include in your securities purchase agreements here. Thank you to Bill Carleton (@wac6) and Gary Kocher for collaborating in putting this together. 

And if you’re a founder or exec, don’t despair: Section 4(a)(7) will work for you, too. For a longer, in depth discussion of the new law, see this article in TechCrunch.

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The Beauty of Revenue Based Financing

For the most part, early stage company financings fall into two categories:

1.​Fixed price financings (e.g., a Series Seed or a Series A Preferred Stock financing); and

2.​Non-fixed price financings (e.g., convertible notes, or convertible equity).

Fixed price rounds are great when you can fix the valuation of a company, price the shares, and you are raising enough money to justify the legal costs involved. An example of when a fixed price round might not make sense: Suppose you are only trying to raise $200,000. A $200,000 round is probably not big enough to justify the legal fees and other expenses of a preferred stock financing (and if you are raising money from angels most won’t want common stock).

Convertible note or convertible equity (such as Y Combinator’s SAFE) financings are great for smaller rounds and for when you can’t settle on a valuation and fix the price per share. For example, in the $200,000 round example mentioned above, convertible debt or convertible equity would work great for that size round.

However, there is a new variant: Revenue Based Financing.

Revenue based financing is debt financing, but the repayment terms are determined by your company’s net receipts. For example: You might borrow $200,000 but your monthly payment would be 8% of the prior month’s net revenue until you have paid the lender some multiple of the initial loan amount (e.g., 2x).

Revenue based financing is nice because:

(1)​As an investor you can start receiving a return on your investment immediately. You do not have to wait some number of years until the company is sold.

(2)​As a company you frequently don’t have to give up equity in your company to raise the money. Non-dilutive financing is a beautiful thing!

There are certainly “knocks” on revenue financing:

(1)​You might say it is more expensive than a regular bank loan, and you might be right. But you might not be able to get a regular bank loan, or that might require a personal guarantee (some revenue based loans might not require a personal guarantees, e.g., Lighter Capital).  

(2)​Depending on the stage your business is at, revenue-based financing might not be the best financing choice available to you – e.g., your revenue is too unpredictable, or conversely, your revenue is so steady that a regular bank loan makes more sense.

(3)​You won’t be able to get any revenue based financing if you are pre-revenue (obviously).

(4)​It is debt, real debt, that must be repaid and “sits on top” of all equity.

Revenue based financing is something to keep in mind as you go about looking for different financing alternatives for your business.

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Incentive Stock Options: Post-Termination of Service Exercise Periods

The 90-day post termination of employment exercise period for stock options is under attack.

A lot of companies are moving away from 90 days. You can find a list of them in a GitHub repo maintained by Zach Holman. Zach also has written an impassioned post about this issue.

Why is the 90-day rule problematic? Because if you are fired, or quit, and you do not have the funds to exercise your stock options within 90 days of termination, you lose them.

Some people might ask the following technical question:

What if I have an ISO? Doesn’t it have to prohibit me from exercising beyond 3 months of my termination of employment or it is not an ISO?

This is a good question, for sure.

You can find the answer the plain language of the Internal Revenue Code. Section 422(a) says the following:

Section 421(a) shall apply with respect to the transfer of a share of stock to an individual pursuant to his exercise of an incentive stock option if—
(1) no disposition of such share is made by him within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share to him, and
(2) at all times during the period beginning on the date of the granting of the option and ending on the day 3 months before the date of such exercise, such individual was an employee of either the corporation granting such option, a parent or subsidiary corporation of such corporation, or a corporation or a parent or subsidiary corporation of such corporation issuing or assuming a stock option in a transaction to which section 424(a) applies.

In other words, you don’t qualify for the benefits of incentive stock options under the statute if you exercise beyond 3 months after termination of employment. But that doesn’t mean your stock option couldn’t have a 10 year exercise period–be styled as an ISO–and just tell you that if you exercise later than 3 months after your employment ends the option will be treated as a nonqualified stock option.

There is also a discussion of this at BenefitsLink.com.

One misconception relates to the 3-month period for exercise. Many employers understand, mistakenly, that the ISO rules require expiration of the ISO at the end of this period. The rule is not that strict. An option could be exercisable for more than 3 months after termination of service; it simply would not qualify for ISO status if it is exercised more than 3 months after termination of employment for a reason other than disability or death.

This blog post does not constitute legal or tax advice.

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