Starting your company is an exciting time. The temptation will be to sign all your legal documents as fast as possible so that you can get up and running. We highly suggest you avoid that temptation and take the time to thoroughly review and, if appropriate, negotiate your documents. With that in mind, in this post, we will cover how to read your founder documents and what to look for.
The Document Set
The documents you will likely be asked to sign are (1) a Proprietary Information and Invention Assignment Agreement (“PIIAA”) and (2) a Stock Purchase Agreement (“SPA”). Don’t be afraid of these documents. They are standard, and the company attorneys aren’t trying to pull anything on you. That being said, there are parts to be aware of and negotiate.
Proprietary Information and Invention Assignment Agreement
Why It’s Important
The PIIAA is the document in which you assign all intellectual property to the company you will develop or have developed relating to the company’s business. 99.9% of the time, this is non-negotiable. Intellectual property is uniformly the most valuable asset of an early startup. Investors abhor–and will frequently refuse to invest in–companies with muddled intellectual property ownership. An intellectual property lawsuit is a nightmare for everyone involved, and most startups simply don’t have the funds to finance one through trial.
What’s more, there’s usually no early resolution (settlement) of an IP lawsuit since the startup will need a judgment stating that it actually owns the IP. This means the startup will have to finance the lawsuit through trial, which is really expensive. The negative repercussions of this range from being unfundable (because you have to disclose to potential investors that you are in court over your most valuable asset) to expending all your bootstrapped capital on attorneys’ fees (because you can’t secure funding), with the net effect of not having any capital leftover to actually advance your company.
This is all a long way of saying that the PIIAA is very important, so expect to sign one.
What to Look Out for in a PIIAA
Now that you know why you have to sign it, here are a few things to note or look out for:
- You will have the opportunity to disclose and carve out any preexisting intellectual property that should not be assigned to the company. If that exists, be sure to fill out the form correctly.
- Are there negative covenants, e.g., a Non-Competition or Non-Solicitation clause? If so, were those part of the deal?
- Sometimes, Non-Competition clauses are unenforceable under state law. For example, Washington state has a law making Non-Competition clauses for employees unenforceable unless the employee makes $100,000 or more in annual cash compensation or the employee receives equity in the company connected with entering into the non-compete.
- If you are forced to accept a Non-Competition provision, make sure that it terminates if you are terminated without “Cause” or you leave with “Good Reason,” or if the company is sold (more on “Cause” and “Good Reason” below). You could also shorten the time period and narrowly define the “industry” you are prohibited from working in.
Stock Purchase Agreement
A stock purchase agreement typically lays out the following terms and conditions: (a) the price per share of the common stock that you will pay; (b) whether the shares are subject to vesting and the company’s rights to repurchase unvested shares; (c) restrictions on transfer, representations, and warranties, and market standoff provision; (d) whether the company can repurchase vested shares at fair market value, and (e) other possible provisions, such as as a non-competition and non-solicitation (if they aren’t contained in the PIIAA). Your agreement may be called a Restricted Stock Purchase Agreement or a Stock Purchase Agreement. “Restricted stock” refers to shares subject to vesting and the company’s right to repurchase unvested shares. Still, the title of the agreement is immaterial–, and companies (and law firms, for that matter) frequently mislabel them–so make sure you carefully read it to see if your shares are subject to vesting.
What To Look Out For In Your SPA
Here are a few things to note or look out for in your SPA.
Price Per Share
The first issue is the price per share. A company must issue its shares for no less than fair market value under Internal Revenue Service rules. If your founder shares are issued at the time of incorporation, they will likely be issued for a nominal price per share. This is typically the par value of $0.0001 per share, which you will need to pay to the company. This makes sense because the company’s valuation is justifiably close to zero when it is created. But if you are a co-founder that joins after the company has raised outside investment or created any significant value, then the company likely would not be justified in issuing your shares for only a nominal price per share. Be careful if you are faced with this situation because you may have a significant tax bill unless you pay cash for the shares upfront.
Vesting and Repurchase Rights
The second issue we will cover is vesting and repurchase rights.
The shares of common stock issued to founders are typically subject to vesting and the company’s right to repurchase unvested shares. A typical vesting schedule is 4 years with a 1-year cliff. This means 25% of the shares vest on the 1st anniversary of the founder’s service start date, and the remaining shares vest in smaller monthly installments over the next 3 years.
If the founder stops working for the company, then the company may repurchase the unvested shares for, typically, the lower of (i) the price per share paid by the founder or (ii) the fair market value on the date of repurchase. This is a strong incentive mechanism for a co-founder to continue pulling his or her weight to grow the company. A co-founder should not view vesting negatively, though, because he or she will want other co-founders to be bound by the same terms. This way, all founders are bound together to grow the company.
Generally, this right to repurchase is deemed automatically exercised by the company within a certain time period after you leave. If you would like, you can try to negotiate to reverse this presumption and/or shorten the time period.
The alternative is the company granting all co-founders’ shares upfront and not subject to any vesting. In this case, anyone co-founder could leave and keep all of his or her shares, which is very unfair for the remaining co-founders who will be working hard to grow the company. This also gives the remaining co-founders no mechanism to recapture the departing co-founder’s shares. This is informally known as “walking off the job” and leaves the company with what is known as “dead equity.” If there is a significant chunk of this dead equity, the company could become unfundable. Investors will pay close attention to this.
Vested Share Repurchase Right
Additionally, some stock purchase agreements contain a “vested share repurchase right.” A vested share repurchase right gives the company the right to repurchase not only unvested but also vested shares, too, in certain circumstances. These circumstances include a founder leaving the company or materially breaching an agreement with the company. In this case, the shares must be purchased for fair market value when the company repurchases them–not the low initial purchase price.
This provision should also not be looked at negatively. It is a way for the company to avoid the “dead equity” mentioned above. You should be aware of it and prepared for the company to exercise it in the event you leave the company, even if all your shares have vested.
Non-Competition and Non-Solicitation Provisions
Next, be sure to review your SPA, whether it be a restricted SPA or just a SPA, for Non-Solicitation and Non-Competition clauses like in the PIIAA, using the same analysis as above.
Single and Double Trigger Acceleration, “Cause”, and “Good Reason”
Double and Single Trigger Acceleration
Next, be sure to review the document to see if there is a “Single Trigger” or “Double Trigger” acceleration. Most documents nowadays come standard with double trigger acceleration. What this means is your shares will immediately vest in full if the company is acquired AND you are terminated without “Cause,” or you leave for “Good Reason” within twelve months of the acquisition.
Instead, you could negotiate a “single trigger” acceleration. This could mean your shares will vest in full if the company is acquired OR you are terminated without “Cause,” or you leave for “Good Reason.”
“Cause” and “Good Reason”
In any event, either of these accelerations is critical to your compensation and will ensure you are properly compensated in the event of acquisition and/or there is a dispute with the company over your departure
The definitions of “Cause” and “Good Reason” are critical to whether your single or double trigger acceleration benefits will trigger. In your review and negotiations, try to negotiate a narrow definition of “Cause.” You don’t want the company to terminate for some vague, unsubstantiated reason and have your shares not vest in full.
On the other hand, try to negotiate a broad definition of “Good Reason,” so you have more latitude to leave and still have your shares vest in full.
File Your 83(b) Election with the IRS
Section 83(b) of The Internal Revenue Code gives taxpayers receiving equity compensation the option to pay taxes before they vest. If your shares are subject to vesting, this is your most important deadline, and you only have 30 days to file this election from the date you execute your SPA. It should be attached to the back of your SPA.
If you miss the 83(b) election filing deadline, you will have put yourself in a grave tax situation. Not making the election timely results in the following:
1) When your shares vest, you will owe taxes on the difference between the value of the shares at the time of vesting and what you paid for them.
2) This is a disaster because you probably paid virtually nothing for your shares, and they will go up in value. Plus, this tax hit occurs every vesting period. So as your shares go up in value, you will owe more and more taxes as the shares vest.
For this reason, you have to own your 83(b) filing. File it yourself. Do not expect the company or company counsel to do it for you. Neither generally will for liability reasons.
Conclusion
Don’t be afraid to negotiate these documents. They’re going to live on forever, and a little upfront effort and negotiation have the potential to spare you a lot of headaches and make you a lot of money in the future. Always consult with an attorney, and if you have any questions, please contact James Graves or Danny Neuman.
By: James Graves and Danny Neuman
Disclaimer: this post is for informational and educational purposes only. It is not intended to provide any legal advice.