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Buy-Sell Agreements: Why Every Business Needs One

A buy-sell agreement is a necessity for any co-owned startup business. Most entrepreneurs don’t spend a lot of time thinking about their eventual departure from their recently formed startup, but a set of rules detailing the terms and procedures of the inevitable parting can obviate countless headaches in the future.

 

What is a Buy-Sell Agreement?

Buy-sell agreements define and govern the rules of transferring corporate stock[1] in the event a shareholder decides to transfer, gift, or otherwise relinquish her shares. The agreement generally defines and controls 1) who is eligible to purchase the shares, 2) which events trigger a right to purchase the shares, and 3) the terms and conditions of the purchase.

Buy-sell agreements can include a wide array of common provisions depending on what the company and shareholders are trying to accomplish. These agreements typically answer questions such as: Is a shareholder’s family entitled to her shares upon the shareholder’s death? Does the family acquire all the rights of the deceased shareholder? Can a company repurchase the stock of a shareholder who was recently convicted of a serious felony against the shareholder’s wishes? How is the purchase price decided? Are there limits on when or to whom shareholders can sell their stock? The purpose of a buy-sell agreement is to provide answers to these questions, and many more. Having a clear set of stated rules can prevent a wide array of different kinds of disputes between co-owners in the event of a potential sale.

 

Common Provisions

Right of First Refusal – A right of first refusal is a popular provision in buy-sell agreements and requires a selling shareholder to offer her stock to either the corporation or remaining shareholders before she sells to a third-party. The terms of the sale to the corporation or shareholders often must match or exceed the established arrangement with the third-party.

Example – Sara wants to sell her shares and finds a buyer in Billy, a third-party, who agrees to buy all her shares for a total of $1,000. A right of first refusal gives the company and/or remaining shareholders the right to purchase Sara’s shares in lieu of Billy, but only at a price of $1,000 or greater. Sara is allowed to sell her shares to Billy only if the corporation and the shareholders do not exercise their right to purchase her shares.

Analysis – A right of first refusal allows the company to “keep it in the family.” It obviates the risk an outsider might bring to the company. Many closely held companies implement rights of first refusal to prevent unwanted third-parties from becoming a shareholder.

This right also assures the seller a fair price for her stock. If the company does not want a third-party to become a shareholder, it must match the price offered to the seller, effectively the fair market value.

 

Right of First Offer – A right of first offer acts in a manner similar to a right of first refusal, but instead allows the seller to offer her shares to the corporation BEFORE finalizing terms with an outside party.

Example – Sally decides to sell her shares and offers to sell them to the company for a total of $1,000. If the corporation declines her offer, Sally is then free to sell her shares to any third-party for a price greater than or equal to $1,000.

Analysis – A right of first offer, as opposed to a right of first refusal, is more advantageous to the seller. Rights of first refusal tend to dampen the value of a seller’s stock because potential buyers understand their offer will likely be negated when the company decides to purchase the seller’s shares. As a result, many potential buyers refuse to put forth the due diligence required in researching the purchase. Potential buyers in a right of first offer, on the other hand, know they will not face the same barrier and are more willing to invest the time and effort required before such a purchase. Consequently, sellers attract more interest when they are restricted only with a right of first offer, as opposed to a right of first refusal.

 

Option – An option to repurchase gives the company and/or other shareholders the right to repurchase the stock from another shareholder upon certain triggering events. The declaration of bankruptcy, filing for divorce, conviction of a felony, and termination of an employee-shareholder are all examples of events that might trigger an option to repurchase the stock of the respective shareholder. Because options, unlike rights of first refusal or rights of first offer, do not inherently include an offering price, the buy-sell agreement should establish a method of valuation for the stock.

Example – Fred was convicted of murder and sentenced to twenty years in prison. Such a felony was listed as a triggering event in the buy-sell agreement. The company now has the option to repurchase Fred’s 100 shares, regardless of any possible objections from him. The buy-sell agreement specifies that, in the event of an option to repurchase, the company will pay the selling shareholder $50 per share. If the corporation decides to exercise its option, it must pay Fred $5,000 for his 100 shares.

Analysis – Options give the corporation a way to mitigate potential harm caused by certain “triggering events.” Fred is unlikely to add value (and can potentially contribute a significant amount of harm) to the company from prison during the next twenty years. The option gives the company a way to divest from Fred and put his shares to better use elsewhere.

 

Drag-Along – A drag-along gives a company the right to require its shareholders to participate in the sale of the company.

Example – Matt is the majority shareholder (80%) of a company and would like to sell his shares. Abe wants to purchase the company, but he is only interested in purchasing the entire company. He is not interested in acquiring only 80%. Mitchell, the minority shareholder (20%), has no desire to sell his shares. The drag-along provision forces Mitchell to sell his shares to Abe along with Matt.

Analysis – Drag-along provisions prevent holdouts. Companies often have many shareholders, and not every shareholder is always eager to sell. Without a drag-along, a single shareholder could potentially block the sale of a company initiated by a majority of the other shareholders.

Drag-alongs also benefit minority shareholders. With a drag-along provision in place, otherwise powerless minority shareholders do not have to worry about other “holdout” shareholders blocking a valuable transaction.

 

Tag-Along – A tag-along gives shareholders the right to include their stock in the sale of another shareholder’s stock. The shareholder exercising his tag-along right is often entitled to the same terms and conditions agreed to between the initial seller and third-party.

Example – Samantha, who currently owns 80% of a company, wants to sell all her shares to Iris for $100/share. Tiffany, who currently owns 20% of the company, does not want to be involved in the company without Samantha. Tiffany can exercise her tag-along right and force Samantha and Iris to include her shares in their transaction with the same terms and conditions. Because Tiffany’s shares are now tagging-along with Samantha’s shares in the transaction, Iris can no longer only purchase Samantha’s 80%. She must either purchase both Samantha’s and Tiffany’s shares, which would give her 100% of the company, or purchase nothing. If she decides to proceed with the purchase, she must also pay Tiffany $100/share.

Analysis – Tag-alongs are often in the best interest of minority shareholders. If a majority shareholder decides to sell his shares, it is often because he received a favorable price. A tag-along prevents the minority shareholder from getting stuck with the third-party purchaser. Instead, she can exercise her tag-along right and sell her shares at the same favorable price received by the majority shareholder.

 

Rights of first refusal, rights of first offer, options, drag-alongs, and tag-alongs are just a few of the common provisions found in buy-sell agreements, yet each wields tremendous sway in determining whom a corporation’s shareholders will be and how much power and interest those shareholders will have. Every entrepreneur should take great care in structuring a buy-sell agreement. The time and effort that goes into it may not seem worthwhile at the time, but it could prove priceless down the road.

[1] This article refers to shareholders and stock within the corporate structure, but the same principles apply to any co-owned company (e.g., members and units within an LLC as well as partners and interest within a partnership).

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Re-allocating Equity in Your Startup

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

Founders often have to revisit their equity division once they begin operating their company and see the actual value that each is providing.

We have previously written about considerations for founders in splitting initial equity in their startup.  No matter how thoughtful founders are in dividing their initial equity, it is common for founders to realize after a period of time operating their company that their initial equity allowances do not accurately reflect the actual contributions or value from each team member.  Founders often believe they can simply create their own document redefining their split of equity %’s.  In the case of an LLC, founders often try to simply amend the cap table exhibit to their Operating Agreement.  While these steps are better than nothing, reallocating equity %’s involves transferring shares (for a corporation) or units (for an LLC) and therefore could trigger some tax and securities issues.  Additionally, it is important to generate clear documents, signed by all involved parties, in order to avoid later disputes over the number of shares/units held by individuals (especially when those shares/units hold more value).   Just as importantly, maintaining a clean and clear cap table is really important for early stage startups.  Investors will typically want to see clear documents showing the issuance from the company to each shareholder of shares that correlate to the numbers of shares indicated on the cap table.   This post provides a few specific methods for properly reallocating equity in an early-stage startup.  The specific approach will spend on the specific governance documents and circumstances for your startup, so please consult your attorney.  This post assumes a few important things:

  • the company is pre-financing and it can issue equity at a nominal valuation (in the case of a corporation, at or near par value of $.0001 or $.00001).
  • all stockholders are remaining involved with the company, in other words, no one is terminating an employment or contractor arrangement with the company.
  • the company’s board of directors (for a corporation) or board of managers (for a manager-managed LLC) are remaining the same.
  • the company has implemented standard vesting procedures for all founders (to learn more about vesting, see this primer on vesting.)

Calculating the Adjustment

The first step in reallocating equity is to figure out how much stock (for corporations) or units (for LLC’s).  Presumably, you have determined your new desired %’s.  You might think about your desired outcome in terms of %’s, but in order to get there, you need to think about the number of shares or units held by each individual.  For example, assume three individuals (Founders A, B, and C) currently own respectively 40%, 40%, 20% of the issued equity in a company, reflected by having been issued 2M, 2M, and 1M shares respectively.  They’ve decided to reallocate equity so that the three founders will own 30%, 30%, 40% of the issued equity respectively.

There are a variety of ways to achieve this outcome.

1) Issuing More Shares/Units to the Founders Desiring to Increase Their %.

For example, the company could simply issue Founder C more shares so that Founder C holds 40% of the new total.  In the above example, this would mean issuing Founder C 1,666,667 shares so that Founder A and B would still each own 2,000,000 shares and Founder C would own 2,666,667 shares and the equity would be divided 30%, 30%, 40% respectively.

When issuing more shares to Founder C, if the startup is a corporation, it would ensure it does not exceed the number of authorized shares in its Certificate of Incorporation.

The following documents would typically be used to execute the above:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,666,667 shares/units to Founder C.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,666,667 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.

2)Repurchasing Unvested Shares/Units from Founders Desiring to Decrease Their %.

Another way to reallocate equity using the above example, is to repurchase unvested shares from Founders A and B.  Using the above example, the Company could repurchase 1.25M shares/units from each of Founders A and B, so that they would each own 750,000 shares/units and Founder C would still own 1,000,000, providing the desired 30/30/40 split.  Note that repurchased shares go into the Company’s treasury (ie., as authorized but unissued shares).  They effectively disappear into the ether, which allows Founder C’s % to increase even though she maintains the same number of shares/units.

The following documents would be used to execute the above:

  • A Board consent (signed by all directors in the case of a corporation or managers in the case of an LLC) authorizing the company to repurchase 1.25M shares/units from each of Founder A and B.
  • Repurchase Agreements between the Company and each of Founders A and B.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

3) Combination of #1 and #2 Above.

Another way to reallocate equity in the above example would be to repurchase 500,000 shares/units from each of Founders and and B and issue 1,000,000 new shares/units to Founder C.  This would keep the number of issued shares/units constant at 5,000,000.  This method might be preferable if the startup didn’t have enough authorized but unissued shares/units to issue Founder C without repurchasing some from Founders A and B (making method #1 impractical because it would require amending the Certificate of Incorporation for a corporation), Founders A and B didn’t have enough unvested equity to repurchase the necessary shares/units (making method #2 above impractical), or the startup otherwise wanted to maintain the existing number of issued shares/units.

To implement this approach, the Company would use the following documents:

  • Board consent (signed by all directors or managers) authorizing the issuance of 1,000,000 shares/units to Founder C and the company to repurchase 1.25M shares/units from each of Founder A and B.
  • A Restricted Stock/Unit Agreement between the Company and Founder C selling to Founder C 1,000,000 shares/units and implementing a vesting schedule (by way of granting Company a repurchase option in the shares/units that lapses over time).
  • Founder C would likely need to file an 83(b) election with the IRS within 30 days of signing the Restricted Stock/Unit Agreement.
  • Repurchase Agreements between the Company and each of Founders A and B where the Company repurchases from Founders A and B 500,000 shares/units each.  Note that most standard Restricted Stock Purchase Agreements require stock recipients to sign an “Assignment Separate From Certificate” preauthorizing the Company to repurchase unvested shares.  While this document is sufficient to reclaim unvested shares, in the situation of a willing seller, a separate document specifying how many shares are being repurchased and how many remain with the individual will typically be drafted.
  • Amended Restricted Stock/Unit Purchase Agreements between the Company and Founders A and B that amend the vesting schedule for Founder A and B’s remaining equity, as desired.  (Most vesting schedules will talk about some fraction of the totally number of shares/units held by the recipient vesting each month, so in the situation where the the totally number of units has decreased during the course of a vesting schedule, the fraction of shares eating each month may need to be revised).
  • If the Company is an LLC, there is typically a cap table attached as an exhibit to the Operating Agreement which would need to be amended.  Depending on the provisions of the Company’s Operating agreement, the above mentioned Board consent (which would be signed by all managers in the case of an LLC) should also authorize the amendment to this Operating Agreement exhibit.
  • If the Company has issued Stock/Unit Certificates or Notices of Issuances, those documents should be returned and/or amended accordingly.  Most startups will keep Certificates for unvested shares in escrow.

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LLC Formation: Why Filing Your Articles is Not Enough

While it might be simple to technically establish an LLC, several important documents are required to properly organize as a company with clear membership, governance, and IP ownership.

While merely filing Articles of Organization might be sufficient to establish an LLC, several important documents are required to properly organize as a company with clear membership, governance, and IP ownership.

Entrepreneurs are often attracted to organizing as a limited liability company (“LLC”) due to the perceived ease and cost-savings of formation.  In most states, one can (technically) establish an LLC by filing a single document and paying a small filing fee.  For example, in Michigan, one can establish an LLC by filing the Articles of Organization and paying a $50 fee.  While filing the Articles of Organization may technically establish an LLC, more is needed in order to properly organize an LLC.  This post examines the additional steps needed to properly organize a multi-member LLC.

Information Contained in Articles of Organization

The Articles of Organization are a simple one-page document that provide the following:

  • the name of the company;
  • the duration of the company, if other than perpetual (this is typically left blank for tech startups);
  • the name of the registered agent and address of the registered office;
  • the name of the “organizer” of the LLC.

Most states do not require any documentation other than the Articles of Organization (or that state’s equivalent publicly-filed document) in order to establish an LLC.

Information NOT Contained in Articles of Organization

Importantly, the Articles of Organization do not provide any of the following information:

  • who holds equity in the company;
  • how much equity any single person holds in the company;
  • who makes what decisions on behalf of the company;
  • what happens if a member leaves the company; and
  • who owns the IP created by members of the company.

At the most basic level, the absence of information about who is part of the company is particularly troubling.  If a founder does nothing more than file the Articles of Organization to set up a company, there is no conclusive document indicating who is part of the company.  Without more, individuals could point to vague oral or email statements to claim that they are entitled to some equity interest in the company.

Your State’s Default Governance Provisions May Not Be Appropriate

Most states have LLC statutes that provide default provisions for how LLC’s operate.  In the absence of additional documentation, such as an operating agreement signed by all members, these default provisions will control the operations of the LLC.  While it might be tempting to rely on these default provision rather than taking the time (and perhaps expense) to think through and establish company-specific provisions, founders should be wary of their state’s default provisions.  These default rules are unlikely to reflect exactly the way the founders intend to operate their company.  For example, in Michigan, section 450.4502 of the Michigan LLC Act provides that (unless otherwise specified in an operating agreement) each member is entitled to one vote in making company decisions.  In other words, even if interests in the LLC are divided 80/20 between two founders, they would each be entitled to one vote.

Additional Documents Needed for an LLC

The above deficiencies are why entrepreneurs should view LLC formation as requiring a suite of formation documents rather than the one-page Articles of Organization.  Specifically, a startup organizing as an LLC should use at least the following:

Operating Agreement – An Operating Agreement should be signed by all members of the Company.  Therefore, it confirms whether or not an individual is a member of the LLC, and how much equity that person holds.  The Operating Agreement should also specify at least: how decisions are made (e.g., what % of vote is required, and by whom, for the company to take certain actions); how membership interests can be transferred, if at all; and how profits/losses are allocated and/or distributed between members.  For most tech startups, it is common to create “Units” of membership interest (similar to stock in a corporation), which are established in the Operating Agreement.

Restricted Unit Agreements – If a startup seeks to impose “vesting” it is common to implement the vesting via a Restricted Unit Agreement entered into between the company and each individual member actively working with the company.  This prior post discusses the concept of vesting.  While the Operating Agreement may grant a member a certain percentage interest in the company, and the number of units that correspond to that percentage interest, a Restricted Unit Agreement will grant the company a repurchase option that lapses over time (i.e., the vesting schedule).  The Restricted Unit Agreement should be clear about specifying what action triggers the company’s repurchase option (for example, a termination of service, or a majority vote of the members of managers of the company).  Of course, whenever vesting is imposed (and the company’s repurchase option is less than the fair market value of the equity at the time of repurchase), holders of equity should pay attention to their 83(b) elections as discussed in this prior post.

Proprietary Information and Invention Agreement (“PIIA”) – PIIA’s should be signed by each individual member actively working with the company.  A PIIA assigns to the company rights in any intellectual property created by an individual during the course of their work for the company.  PIIA’s also include confidentiality obligations requiring the individual to maintain as confidential any of the company’s sensitive information.

IP Assignments –  If an individual (such as a founder) has been working on the startup prior to the company formation, then it is likely that individual holds intellectual property rights that need to be assigned to the company.  Because most PIIA’s are designed to cover intellectual property created during the course of an individual’s work for a company, they might not adequately cover pre-existing intellectual property.  Accordingly, IP assignments should also be used to cover any intellectual property created prior to company formation.

Proper Organization is Important Even for Startups Planning to Convert to a C-Corp

As discussed in this prior post on entity conversion, it is common for startups to initially organize as an LLC but later convert to a Delaware C-corp when they plan to raise capital from sophisticated investors.  For a startup contemplating this conversion, it might be tempting to forego the above organization documents, merely filing the Articles of Organization to establish the company as an LLC.  This is not wise, however.  Among other concerns, most state conversion statutes require a specified vote of the members in order to approve a conversion of an LLC into a Delaware C-corporation.  In MIchigan, for example, section 450.4708 of the Michigan LLC Act requires that all members approve a conversion unless the operating agreement provides otherwise.  Accordingly, absent an operating agreement, all members of the LLC would need to approve the conversion into a new corporate form.  However, absent an operating agreement, it is also difficult to conclusively know who is a part of the company (e.g., who the members are).  This lack of information would be ripe for an individual to later claim they were part of the LLC, but not included in the approval of the LLC to a C-corp.  Therefore, even when a startup is planning to convert from an LLC to a C-corp, they should first properly organize as an LLC so that the conversion process is clearly approved by a well-defined set of members under well-defined governance procedures.

Conclusion

With the above documents in place, it is now clear: which individuals are part of the company and how much they own; which members make what decisions on behalf of the company; that the company owns the intellectual property related to its business; and what happens if a member’s service for the company terminates.  None of this information would be clear if a startup merely files the Articles of Organization, and doesn’t take additional steps to properly organize itself.  Using the correct documents to properly organize will lessen the risk of potential disputes down the road, especially if the LLC later converts to a Delaware C-corp and seeks outside investment.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 5)

Walter Isaacson's bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

This is part 5 of our series on startup legal lessons presented in Walter Isaacson’s biography of Apple co-founder Steve Jobs.  This post address issues with stock options.  On pp. 365-366, Isaacson describes the haggling between Jobs and Apple over his stock options when he dropped the “interim” from his CEO title in 2000.  The issue of valuing the strike price of options emerged again in 2001 when Jobs received another grant of stock options.  These issues led to an SEC investigation in 2006-2007 related to potential irregularities in the stock option grants to Jobs.  Issues with valuing stock options are a common problem for startups.

This post will provide a general overview of stock options and then discuss the importance of accurately setting the exercise price due to 409A.

Stock Option Basics

As described in “Consider Your Options” by Kaye Thomas, a stock option “is an agreement providing terms under which [one] can buy a specified number of shares of stock at a specified price.”  That specified price is the “exercise price” or the “strike price.”  For example, a company may grant an employee 10,000 stock options at an exercise price of $1/share.  The employee pays nothing and recognizes no taxable income on the grant of these options.  The employee can later choose to exercise the option by paying the exercise price.  For example, if after the stock options are fully vested, the company’s common stock has a fair market value of $5/share, the employee can “exercise” the options by purchasing 10,000 shares of common stock for $1,000 (10,000 shares at $1/share).

Benefits of Options

Stock options can serve as a tax efficient mechanism for giving employees equity exposure to a company.  Where as a restricted stock grant is taxed at the time of grant (assuming an 83(b) election has been made), stock options are typically not taxed at the time of grant.  This is helpful when the value of the company has increased such that the value of restricted common stock is no longer nominal and a recipient would have to pay a significant amount for restricted common stock (if purchasing outright) or in ordinary income tax (if not purchasing outright).

409A

While stock options can provide tax benefits, they can also present complexity and cost in determining the exercise price.  As you can tell from the above discussion, the exercise price is the price an individual will pay to exercise options and therefore has a significant economic impact on the option recipient.  Accordingly, a company may be incentivized to grant options at a lower exercise price in order to pass along more value to a recipient (or similarly to “backdate” the grant of options in order to grant them on a date when the company’s common stock had a lower value).  Under the current law, neither of these are advisable options.  The exercise price of a stock option must equal the fair market value of the underlying common stock on the date of the option grant.

This raises the question of how a company should value its common stock, especially at its early stages.  Company’s used to typically value common stock at 10% of the value of the preferred stock at the last financing.  That practice changed with the passage of 409A imposing significant regulatory hurdles and penalties for options granted at less than fair market value on the date of grant.  409A provides certain IRS-approved methods for startups to calculate the fair market value of option grants, thus shifting the burden to the IRS to show the fair market value was grossly unreasonable.

These approved methods include an independent appraisal (commonly called a 409A valuation), which is good for 12 months unless something impacts the company’s value (such as a financing).  These valuations cost anywhere from $2,500 to much more depending on the provider and the complexity of the company.  Another approved method is the illiquid startup appraisal, where the company has no imminent plans for an exit and a person with experience in valuations sets the value of the company.  See WSGR attorney Yokum Taku’s blog on setting the exercise price of stock options for more info.

Accordingly, startups should not take lightly the process of setting the exercise price of stock options.  At the early stages, when restricted stock can be issued at nominal value, restricted stock awards will typically be a simpler and more efficient way to pass along equity exposure to individuals.  As the company increases in value, options may become the preferred equity compensation vehicle, but startups should allocate resources to properly set the exercise price of the stock options and avoid any unnecessary problems under 409A.

As Apple found out, even prior to 409A, playing around with the exercise price of stock options can cause significant problems down the road.

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Startup Legal Lessons from the Biography of Steve Jobs (Part 2)

Walter Isaacson’s bestselling biography of Steve Jobs touches upon numerous legal issues common to startups.

With the movie “Jobs” opening in theaters this week, we are taking a look at the startup legal lessons raised in Walter Isaacson’s bestselling biography on Steve Jobs.  Not surprisingly, given the dynamic history of the company Jobs co-founded and led, the book touches upon numerous legal issues encountered by Apple.  These legal issues, as presented in Isaacson’s book, serve as a useful framework for addressing some of the common legal issues faced by startups and entrepreneurs today.  This is Part 2 of a multi-part series.

This post discusses the scenario of a departing founder.  As explained on page 61 of Isaacson’s biography, within two weeks of organizing Apple, co-founder Ron Wayne made the decision to leave the company.  He sold the entirety of his partnership interest to the other co-founders, Steve Jobs and Steve Wozniak.  Ron Wayne’s motivation to leave Apple was in part due to the personal liability he would take on as a partner in a general partnership (as discussed in Part 1 of this series, Apple was originally organized as a general partnership).

The departure of a startup founder, however, may not always go so smoothly.  It is extremely common for founders to leave startups.  All too often, these founder breakups can be fatal to a startup.  According to Harvard Business School Professor Noam Wasserman, roughly 65% of the failures of high-potential startups are due to “people problems.”

There are well-known mechanisms, however, that make it possible for a startup to survive a founder breakup.  These include:

IP Assignments

All individuals working for a startup should sign documents assigning to the company any intellectual property created by that individual arising from their work for the company.  This is typically accomplished through a Proprietary Information & Invention Assignment Agreement (commonly called a PIIA).  This document should be signed by an individual at the beginning of that individual’s relationship with the startup.  Proper IP assignment language should include the words “hereby assigns,” so that the language will act to automatically transfer IP rights from the individual to the company upon the individual creating that IP.

If the individual has created IP related to the startup’s business prior to entering a formal relationship with the startup (such as a founder who has been working on an idea prior to incorporation), then that individual should also assign to the company that individual’s IP rights already in existence.

Restricted Stock Agreements Implementing Vesting

As discussed in this prior post, vesting refers to a company having the right to repurchase an individual’s equity if that individual’s service terminates.  The company’s repurchase option lapses over time.  Vesting is typically implemented through a Restricted Stock Purchase Agreement (for a corporation) or a Restricted Unit Agreement (for an LLC).

Departing Founder Example

Let’s pretend Departing Founder owns 25% of the common stock in a startup.  Departing Founder has a falling out with his or her co-founders.  Departing Founder has not signed any documents assigning IP to the startup and does not have a vesting schedule in place covering his or her common stock.  Upon Departing Founder leaving the startup, her or she will likely walk away with (at least) joint ownership of any IP to which Departing Founder contributed, and the full 25% of the company’s common stock.  The startup will not have any exclusive rights to the IP jointly-owned with Departing Founder.  In addition, 25% of the company will be dead weight, which will certainly be demoralizing to the remaining team members still working for the startup.  This startup is likely doomed unless it can work out an agreement with the Departing Founder to claw back the IP and equity.

Now let’s pretend the same situation exists with Departing Founder except that proper IP assignments and vesting schedules are in place.  Upon Departing Founder leaving, all IP will remain with the startup.  The Departing Founder walks away with no rights in the startup’s core IP.  Additionally, the startup will have the right to repurchase the unvested portion of Departing Founder’s 25% of the common stock.  For example, if vesting occurred over 4 years with a 1-year cliff, and Departing Founder left just after the 1-year mark, the startup would be able to automatically repurchase 3/4 of the common stock held by Departing Founder.  Departing Founder would remain a shareholder of the company, but only for the 6.25% of vested common stock (1/4 of Departing Founder’s 25% of the company).  The repurchased common stock would return to the company’s pool of authorized but unissued stock.  It would be available to incentivize the remaining workers, or more likely to attract the talent needed to replace Departing Founder.

Release and Termination

If possible, it is also wise to enter into a release and termination agreement with a departing founder.  While Ron Wayne is at peace with the fortune he would have had he not left the company, other departing founders might experience seller’s remorse and make claims against a company whose value skyrockets after a founder leaves.  Ideally, a startup and departing founder will  resolve any possibility that either startup or the departing founder could have any claim against the other in the future.

Returning now to the Apple situation, Ron Wayne desired to return all of his partnership equity to his co-founders.  This is likely an anomaly, though.  As discussed in our prior post in this series, most startup entities will provide limited liability to founders.  Accordingly, most departing founders will not have the threat of unlimited liability (present with a general partnership) to incentivize the departing founder to relinquish their shareholder or member status.  With the proper legal documentation — including IP assignments and equity vesting arrangements — startups can survive the departure of a founder.

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A Primer on Vesting

A "vesting schedule" does not refer to the days of the week when you must wear this.

A “vesting schedule” does not refer to the days of the week when you must wear this.

Fred Wilson recently wrote about the natural turnover on startup teams, with frequent references to the concept of “vesting.”  “Vesting” refers to a startup’s right to repurchase an individual’s equity if that individual’s service to the startup terminates.  This repurchase option lapses over time according to a “vesting schedule.” The following are some important points concerning vesting:

Vesting Schedule

Industry standard is to implement a four-year vesting schedule, with a one year “cliff.”  This means that the individual would need to work twelve months in order have the first 25% of his or her equity vest.  After the one year “cliff,” the equity vests on a monthly basis for the remaining 3 years.  The following is standard language implementing this vesting schedule from Orrick’s model Common Stock Purchase Agreement:

100% of the Shares shall initially be subject to the Repurchase Option. 25% of the total number of Shares shall be released from the Repurchase Option on the one year anniversary of the Effective Date, and an additional 1/48 of the total number of Shares shall be released from the Repurchase Option on the 15th day of each month thereafter, until all Shares are released from the Repurchase Option; provided, however, that such scheduled releases from the Repurchase Option shall immediately cease as of the Termination Date. Fractional shares shall be rounded to the nearest whole share.

The rationale behind the cliff is that there should be some minimal amount of service that each individual commits to a startup before they can walk away with any amount of equity.  The cliff can be adjusted, especially in the case of a founder who has devoted significant time to a startup prior to implementing a vesting schedule.  The rationale for equity vesting on a monthly basis after the cliff is to foster natural behavior from employees leaving the company when they desire to do so.  It would be counterproductive to have an individual who no longer desires to work for a startup continue working merely to achieve a future significant vesting milestone.

Repurchase Option

Many people mistakenly assume that with a typical startup vesting arrangement an individual is acquiring equity as it vests.  Actually, in the typical situation, an individual who owns restricted equity owns all of their equity.  For unvested equity, however, the company has an option to repurchase that equity if the individual discontinues service for the startup before that equity vests.  Typically, the startup can repurchase the equity at the same nominal price the individual paid for that equity.  Contrast this with a buy-out of an individual’s vested equity, which will typically require a calculation or agreement upon the fair market value of that equity at the time of the buy-back.

To ease the mechanics of a startup exercising its repurchase option of unvested equity (which might take place after a falling out with the individual when the individual and company are not on speaking terms), it is common for both: (i) the startup to hold unvested equity in escrow, and (ii) for an individual, at the time of purchasing the restricted equity, to sign an assignment of unvested equity back to the company which the company will then sign if it executes its repurchase option at any time.

Triggering the Repurchase Option

It is important to think about what triggers a company’s right to repurchase an individual’s unvested equity.  Typically, a company’s repurchase option kicks in when an individual’s “service” with the company terminates.  Ideally, a company will have at-will relationships with all individuals and a clear governance structure such that an individual’s service can easily and clearly terminate.

Documents

Vesting is typically implemented through a Restricted Stock Purchase Agreement (for c-corps) or through a Restricted Unit Agreement (for LLC’s).  Orrick provides a model Common Stock Purchase Agreement with industry standard vesting language.

83(b) Elections

Remember that a standard vesting arrangement (where the company can repurchase an individual’s equity at the purchase price) means the equity is subject to a substantial risk of forfeiture such that an 83(b) election should be filed.  This prior post addresses 83(b) elections in detail.

As discussed previously on this blog, vesting is a critical part of setting up a healthy and productive environment for the startup team.  The combination of vesting schedules and at-will relationships is what allows a startup to alter its equity allocation if the initial equity distribution does not align with the actual contributions made by each team member.

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To 83(b) or Not to 83(b) (Part 2 of 2)

The tax implications of failing to file an 83(b) election when receiving restricted equity can sting.

The tax implications of failing to file an 83(b) election when receiving restricted equity can sting.

 

Let’s further examine the impact of failing to file an 83(b) election with a hypothetical.

A Hypothetical

Assume that the founder is granted 1,000,000 shares at a par value of $0.0001 in the startup on a four-year vesting plan and is subject to an income tax rate of 33%.

83(b).v2

As you can see, the tax savings from filing the 83(b) election are drastic.  Founders filing an 83(b) election, who pay for their equity with a nominal capital contribution, will actually recognize no ordinary income and therefore pay zero income tax at formation.  In addition, the founder making the 83(b) election will start the holding period upon receiving the restricted equity.  Accordingly, that founder will increase the likelihood of paying long term capital gains tax rates on an eventual sale of the equity.

In addition to the increased tax payments, failing to file the 83(b) election can also cause logistical problems.  Assuming a standard vesting schedule of 4 years, with a one-year cliff, once a founder stays in service to the startup for more than a year, the founder’s equity will be vesting on a monthly basis.  This will result in the founder recognizing ordinary income every month and therefore likely having to estimate the fair market value of that equity on a monthly basis.  This can all be avoided by properly filing the 83(b) election within 30 days of receiving restricted equity.

Also see Part 1 of 2 on 83(b) elections.

 

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To 83(b) or Not to 83(b) (Part 1 of 2)

Bees Picture

Failing to file an 83(b) election can be as painful as being stung by 83 bees.

Equity Compensation

Founders and early employees of a company often receive equity as compensation.  Like any other kind of compensation, these grants of equity are subject to taxes as ordinary income.  The tax liability for the founder or employee will be based on the fair market value of the equity received less any capital paid for that equity.  This is all straightforward when the equity is not subject to any restrictions.  The individual that receives the equity will recognize ordinary income in the year the equity was received.

What happens when the equity is subject to restrictions?  A common arrangement in startups is to have these initial grants of equity subject to time-based vesting restrictions.  This means that while the recipient owns the equity, the company can repurchase the equity if the recipient’s service to the company terminates.  As the recipient reaches certain time-based milestones, the company’s repurchase option will begin to lapse. Under these circumstances, the IRS does not recognize this equity as ordinary income until it actually vests.  This may seem advantageous—why pay taxes now when the IRS will let you pay them later?  However, this is not the case for the vast majority of entrepreneurs.

When to be Taxed

The problem with paying taxes on equity as it vests is that the tax liability will be based on the value of the equity at the time of vesting.  This means that if a startup is successful and grows in value, the amount owed in taxes will continue to grow over the lifetime of the vesting schedule. Compounding the problem is that the holder of the equity typically cannot sell it (due to the lack of a market and other restrictions placed on the equity).  Therefore, the holder is recognizing taxable income even though it is not actually receiving any monetary income from which it can actually pay the income taxes owed. If only there was a way to pay taxes on all of the equity at the point it was initially granted and worth only pennies.  Fortunately, the IRS has provided such an option for startups.

83(b) Election

Under 26 U.S.C. §83(b), a founder may elect to recognize equity as taxable ordinary income at the time of grant.  This “83(b) election” allows you to pay all taxes up front when the equity is worth very little as opposed to paying taxes over time when the equity vests and is growing in value.  Moreover, because most founders will pay for their founder’s equity in the form of a nominal capital contribution, there is actually no ordinary income recognized.  If you receive restricted equity in a growing startup, you should almost always make this 83(b) election.

The most important thing to know about filing an 83(b) election is that it must be done within 30 days of the date that you receive the restricted equity.  This is a firm deadline and the opportunity to make an 83(b) election will be lost after the 30 days expire.  The election should be mailed to the IRS Service Center where you would normally file your personal tax return.  You should then retain a copy of the election and make sure to include the election when you file your annual tax return.  While the IRS does not provide an official form for 83(b) elections, the text of a sample 83(b) election follows:

Section 83(b) Election

The undersigned taxpayer hereby elects, pursuant to § 83(b) of the Internal Revenue Code of 1986, as amended, to include in gross income as compensation for services the excess (if any) of the fair market value of the shares described below over the amount paid for those shares.

1. The name, taxpayer identification number, address of the undersigned, and the taxable year for which this election is being made are:

TAXPAYER’S NAME: _____________________________________________

TAXPAYER’S SOCIAL SECURITY NUMBER: __________________________

ADDRESS: ______________________________________________________

TAXABLE YEAR: Calendar Year 20__

2. The property which is the subject of this election is __________ shares of common stock of __________________________.

3. The property was transferred to the undersigned on [DATE].


4. The property is subject to the following restrictions: [Describe applicable restrictions here.]

5. The fair market value of the property at the time of transfer (determined without regard to any restriction other than a nonlapse restriction as defined in § 1.83-3(h) of the Income Tax Regulations) is: $_______ per share × ________ shares = $___________.

6. For the property transferred, the undersigned paid $______ per share x _________ shares = $______________.


7. The amount to include in gross income is $______________. [The result of the amount reported in Item 5 minus theamount reported in Item 6.]

The undersigned taxpayer will file this election with the Internal Revenue Service office with which taxpayer files his or her annual income tax return not later than 30 days after the date of transfer of the property. A copy of the election also will be furnished to the person for whom the services were performed. Additionally, the undersigned will include a copy of the election with his or her income tax return for the taxable year in which the property is transferred. The undersigned is the person performing the services in connection with which the property was transferred.

Dated: ______________

Taxpayer ______________

 

Also see Part 2 of 2 on 83(b) elections.

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Splitting the Pie

Photo Credit: DigiDi

Photo Credit: DigiDi

An early decision that can often trip up founders is how to divide the initial equity issued by the startup.  While there is no cookie cutter approach to this question, the following are some general principles founders should follow:
At formation, a startup is a long way from the finish line.

At formation, a startup is a long way from the finish line.
Photo Credit: Ben Shepherd

Future Effort– The vast majority of the equity awarded to founders should be based on the likely future effort needed to make the company a success.  Founders often over-value their contributions to the initial intellectual property upon which the founders are basing the company.  A general rule of thumb is that the founders’ equity granted in exchange for existing intellectual property being assigned into the company should be less than 10% (across all contributors), and often significantly less.

Aligning Interests & Properly Incentivizing – Don’t get too hung up on trying to precisely nail each founder’s value.  Instead, think about aligning each participant’s interests with those of the company.  To do this, you need to incentivize each participant to work their tails off to build a great company.  The right question is: how much equity is needed to properly incentivize exceptional effort from all involved?

Multi-stage Transaction – Founders should also recognize that taking a startup from concept to commercial success is a multi-stage transaction.  Investment rounds will often serve to correct any misalignments of interests between founders, the company, and investors.  For example, if a technical founder has 15% of the equity in a startup, but his or her role has become more important to the company than originally anticipated, investors will recognize the need for that founder to have a larger share of the company in order to be adequately incentivized.  The investors may require a reapportionment of the founders’ equity as a condition to investment.

Keep it Simple and Follow Established Models to Address Future Changes – Founders (especially student founders) are often concerned about the difficulty of allocating equity when the future time commitments of founders is up in the air.  Founders may be tempted to try to create an equity allocation that adjusts periodically based on the contributions of founders during that period of time.  This is unnecessary, can be unhealthy to team dynamics, and can cause tax complications.

Founders may be attempted to constantly adjust their equity to account for their changing contributions.

Founders may be attempted to constantly adjust their equity to account for their changing contributions.

Fortunately, there is an industry accepted model for aligning the interests of founders with the company and giving the company the flexibility to adjust its relationship with founders that are not living up to their end of the bargain.  This model includes:

  • establishing a “reverse vesting” schedule for each founder that grants the company a repurchase option in the founder’s unvested equity if the founder’s service to the company ends;
  • providing the company the ability to terminate a founder’s service at will (either through termination at will provisions in the employment offer letters or service contracts, or as a provision in the restricted equity agreement).

Accordingly, if a founder is not contributing the expected value to the startup, the startup can seek to adjust that founder’s equity split to something more appropriate.  If the founder acts unreasonably and is not willing to adjust his or her equity, the startup has the ability to terminate the founder’s service and stopping the founder’s stock from vesting.  This threat will either incentivize the founder to act reasonably and agree to an equity adjustment, or provides the company the ability to end its relationship with that founder without the founder leaving with equity that he or she did not truly earn.