For early-stage founders that are focused on getting their businesses started, legal formalities often are not a top priority. Two founders may believe that their verbal agreement to split their new Delaware C-corporation 50/50 is good enough to establish their ownership, however this is still a stock issuance that must be properly documented. Although it may not seem overly complicated at the outset, ignoring the requirements to formally allocate stock to founders can lead to many problems down the line. After deciding how much stock to allocate to each founder, the following legal steps will be necessary:
Board Consent for Stock Issuance: The Board of Directors should formally consent to the issuance of founders’ shares, which can usually be done by the Board of Directors executing a Written Consent (rather than by a vote at a board meeting) for most startups. Although Board Resolutions won’t need to be submitted to any government authorities, they are legally binding decisions of the company and should be kept among company records. This is a fairly simple document that a business attorney should be able to draft quickly.
Stock Purchase Agreements: Although there are a few ways to issue equity to founders, most startups issue stock to founders at a very low price at the time of formation, when the actual value of the company is close to zero. Founders should contact a business attorney as soon as possible after incorporation to finalize these issuances under Stock Purchase Agreements. Otherwise, if founders fail to properly execute stock issuances and the company increases in value, then a simple purchase becomes cost prohibitive at the current fair market value. Although founders could just purchase the shares anytime at a lower price than the actual value, the difference between the price paid and the fair market value will be considered compensation for tax purposes. Alternative methods to acquire stock after the company’s formation can also carry significant tax disadvantages.
Founders that plan to raise funding should consider establishing a vesting schedule in their Stock Purchase Agreement. Rather than instantly granting a founder the ownership of stock in the company, that ownership vests over time under a vesting schedule and the company has the right to buy back any unvested shares if a founder leaves the company before their shares are fully vested. Many investors will expect to see vesting schedules in place for equity awarded to founders and key personnel in order to incentivize a long-term commitment and to prevent free-riding from any founders that leave the company early on. Without a vesting schedule imposed on founders from the beginning, it would enable a co-founder to leave at any time while keeping substantial ownership of the company and unfairly benefitting from the company’s later successes. Note that, within 30 days of receiving founders’ stock subject to vesting, you should consult with your tax professional about filing an 83(b) election with the IRS to save money in taxes later.
Confidential Information and Invention Assignment Agreements (CIIAAs): While executing Stock Purchase Agreements, it is common to execute CIIAAs at the same time. These agreements are critical to protect a company’s confidential information from exposure and to secure the company’s intellectual property rights to founders’ inventions for the company (subject to certain restrictions in some states, like California). These agreements assign or transfer the ownership of any relevant intellectual property to the company. These agreements should carve out exceptions for prior inventions that are not included, but you should make sure that the company owns the intellectual property necessary for the business. CIIAAs may also contain non-solicitation and/or non-competition clauses (again, subject to restrictions in some states). Startups generally require all employees to sign CIIAAs as well.
Securities Filings: Federal securities laws require every sale of securities (even if to just one person) to either be registered with the SEC or conducted under an exemption from registration. Most early startup stock issuances are conducted under exemptions from SEC registration, however there are still certain filings required. Many states also have their own securities filing requirements in addition to federal requirements. Securities laws are complex and carry harsh penalties for non-compliance, so you should consult a business attorney about these matters.
Capitalization Table: With clean purchase agreements and documentation in place, you can create a Capitalization Table for your reference and to easily provide potential investors.
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