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Founders’ Equity: 7 Trouble Spots

April 21, 2010 - Author: Lee Schindler, Attorney at WilmerHale Law Firm

When launching a new start-up company, legal issues should not consume a large amount of money or time, two of the start-up’s most precious resources.  However, making a small investment up-front to get two things right can ensure you are protecting the value you create and avoid a lot of problems (including delays and more costs) in the future.  What are those two things?

1.  Capitalization, and

2.  Intellectual Property.

The consequences of getting either of these things wrong can be disastrous.  Today, we’ll look at the first issue: Capitalization.  Specifically, we’ll look at some things that can, and too often do, go wrong in the issuance of equity to founders when forming a new company.

(1) Allocation of Founders’ Shares

There are several issues related to founding a company that, while simple, can be quite counter-intuitive.  This is the first such issue: Splitting-up the company evenly (e.g., 4 founders each get 25%) can be poisonous for camaraderie and productivity.  Founders’ contributions will never be exactly equal (especially among 3 or more founders).  There’s nothing wrong with such inequality, but the split of equity should reflect the relative importance of the contributions being made and that are expected to be made into the future.  Otherwise, the most significant contributor will soon find herself: (1) resenting the other founders, (2) slacking off until she feels she’s getting her fair share and/or (3) asking for more of the company, upsetting the other founders.

(2) Promising an Ownership Percentage of the Company

When allocating ownership in a company, never promise someone that they will own X%.  Always talk in terms of the number of shares they will receive.  The risk is that the person may mistakenly believe that he is entitled to maintain his X% of the company indefinitely even as new people acquire securities in the company.  Trust me, this happens.  When new people acquire ownership, everyone gets diluted.  Hopefully, the new equity holders will bring more value to the company, so the value of everyone’s holdings can continue to grow.

(3) No Vesting

Perhaps the most counter-intuitive issue you’ll face when forming a company is the concept of vesting.  If you are launching a new company, why would you ever agree that part of the company that YOU just formed could later be taken away from you?  Three reasons: (1) You want to attract investors, and because investors are largely investing in you, they will demand that your shares be subject to vesting.  (2) You want the other founders to be subject to vesting, which incentivizes them to continue to add value to the company; you don’t want your co-founders to walk away with their shares while you stay behind to do all the work.  (3) You want to establish a precedent for your employees, who should all be subject to vesting.  It’s an easy sell if you can tell them, “I did this.  Your turn.”

(4) Acceleration of Vesting

It is understandable that new entrepreneurs usually expect that if they are fired from the company they created, without a good reason, they should keep all of their shares (i.e., their vesting should accelerate); or if their company is sold before they are fully vested, they expect to get a full cash out.  Unfortunately, many founders have learned the hard way that (1) the best way to keep everyone working hard and building value is for no one at the company to have vesting accelerate merely upon termination of employment and (2) the best way to sell a company for a large return is if there is little or no acceleration of vesting following a sale.  In the context of a sale, acceleration can reduce the value of the business in the eyes of the buyer (e.g., if the key employees will not have vesting incentives post-closing).  Nevertheless, some acceleration of vesting may be acceptable to investors and buyers, depending on the circumstances.  You may have heard of “double-trigger” (acceleration of vesting upon (1) termination without cause after (2) a sale of the company), for example.  In some situations, this can be a fair compromise to protect a founder while preserving the value of the company.

(5) Failure to File an 83(b) Election

Hopefully, you are convinced that it will generally make sense to subject the shares in your new company to vesting.  The next step is to make sure you don’t make a disastrous tax mistake.  When you buy those shares for fair market value, you have 30-days to make the biggest no-brainer tax election with the IRS.  An 83(b) election is an election to be taxed on the fair market value of the shares (less the amount you paid) at the time you acquire them.  Since the value of the shares in this new company should be nominal at the formation stage, you can likely afford to pay fair market value for the shares, in which case your 83(b) election means you pay $0 in tax.  Plus, your capital gains clock starts when you purchase your shares and there are no additional taxes until you dispose of the shares. Win-win-win!  If you fail, or choose not to file, an 83(b) election, you will need to pay tax on the fair market value of the shares (less your original purchase price) as the shares vest.  The amount of that tax is not only variable and unpredictable, if your company is successful, it can be quite high, and you may have no liquidity available to satisfy the tax if the company remains private.

(6) Securities Laws

For an attorney that is experienced with these issues, the issuance of founder’s shares is relatively easy to reconcile with state and federal securities laws.  Nevertheless, getting this wrong could create serious problems down the road.  A good business lawyer can easily help you navigate these waters.

(7) Managing Your Lawyers

As you can see, there are enough potential trip wires in forming a company, that an experienced business lawyer can be an essential advisor.  Forming a company with the right business lawyer should be a quick, efficient, educational and simple process.  Occasionally, however, founder negotiations will get “over-lawyered,” with each founder represented by separate counsel and unusual terms negotiated among the various parties.  That’s the wrong platform from which to launch a company.  For positioning with future employees, investors, lenders and acquirers, you want simple, standard legal documents.  Legal documents will not make your company grow, but they can inhibit its growth.

Lee Schindler is a business attorney with the WilmerHale Venture Group.  Based in the Waltham, Massachusetts office of WilmerHale, an international firm with over 1,000 attorneys, the Venture Group provides the legal guidance emerging companies need to go from start-up to venture capital financing, through IPO and beyond.

Mr. Schindler represents private and public companies in technology and life sciences. He advises clients with regard to formation, equity and compensation, seed financings, early- and late-stage venture capital financings, securities law compliance, mergers and acquisitions and public offerings.