It's Never Too Early for Tax Advice/The 83(b) Election (Mistake #6)

While this 6th installment of the Ten Legal Mistakes Made by Start Ups examines the "83(b) Election," the underlying theme is the need to engage an accountant who understands your tax profile and a lawyer who understands the accountant.

Myth #6:  "I don't need to be concerned with tax issues because this is just a start up."

I constantly hear founders state that they can wait on tax advice, and for that matter legal advice, until they can "afford it."  To that, my response is that as a founder you cannot afford to wait.  One significant example relates to the common mistake founders make in failing to make the 83(b) election as it relates to restricted stock.   

If the start up engaged an experienced business lawyer, the founders would have received advice regarding the importance of granting restricted stock (i.e., stock that is subject to forfeiture) that vests upon certain dates or milestones. Under Section 83 of the Internal Revenue Code, a founder can make an election resulting in the acceleration of the taxable event to the date of the grant rather than the date the stock actually vests.  This is commonly referred to as the 83(b) Election.   

What is the advantage of the 83(b) Election?  It allows the founder to pay ordinary income tax on the fair market value of the stock as of the grant date rather than the vesting date.  The assumption being that stock in a start up company will have substantially less value than at the later vesting date when presumably the value of the company has increased, and with it the fair market value of the shares.  The 83(b) Election means the founder will likely pay very little tax on the granted restricted stock.  If, after the stock vests, the company and thus the shares have appreciated, the founder will pay capital gains tax on any eventual sale of the shares.

What if I fail to make the 83(b) Election?  The failure of the founder to make a timely 83(b) Election means that when the stock vests, the founder will have to pay tax as of the vesting date.  While the founder may be pleased that the company is doing well and its valuation has dramatically increased from the start-up days, the founder will be very unhappy to learn of a tax liability based on the value of the shares at the time of vesting at tax rates applicable for ordinary income.

When must the 83(b) Election be made?  The election must be made within 30 days of the grant of the shares by filing notice with the IRS

Lesson:  An 83(b) Election is just one significant pitfall that start ups/founders should be aware of -- demonstrating why mistake number six made by start ups is not just the failure to make the 83(b) Election, but the broader mistake of failing to engage a good accountant and a business lawyer to address important tax matters facing all start-ups.  

Ten Legal Mistakes Made By Start-Ups: Giving Away the Store (#5)

For the 5th installment of my posts regarding the Ten Legal Mistakes Made By Start-Ups, I am addressing the willingness of founders to give away too much equity in exchange for services to be provided to the company.

Myth #5:  "Equity Has Very Little Value in a Start-Up so it is Cheaper to Give Equity than to Pay Cash to Consultants/Employees/Service Providers."

I completely understand that start-ups often face the quandary of needing certain expertise or services and not having the financial resources to pay for them.  And so, start-ups invariably turn to the only currency they believe they have, namely equity in the business.  I am not suggesting that offering equity instead of money is a mistake, but rather it is the nature of the offer where many founders go array.

First, founders need to consider the monetary value of what they are willing to offer.  In simple terms, you need to understand the value of what you are receiving compared to the value of the non-cash offer you will make.  So, before making an offer, determine how much it would cost the company to just purchase the services or pay the consultant/employee.  Then try to get a sense of the value of what you are offering, which means understanding what the potential value of your business could be the coming years.  Use these metrics as the jumping off point to determine what to offer in non-cash compensation.  Of course, the other party is taking risk by accepting equity (or a similar interest) instead of money and that might be a reason to sweeten the non-cash terms a bit, but remember the value of your business will also presumably increase and with it the value of the interest granted to the third party.

Second, consider the nature of the non-cash compensation:

    (a) Stock/Membership Interests:  If you grant stock in a corporation or membership interest percentage in an LLC you are giving not only financial but also ownership rights in the company.  Do you really want this person to be an owner, even if it is a minoirty interest?

    (b)  Economic Interests Only:

            (i) LLC:  In LLC, like a corporation, you can have different classes of interests.  One alternative, then, is to create a class of interests that only have economic rights and no voting rights.  The person gets the upside but has no say in the operations.

            (ii)  SARS/Phantom Stock:  Stock Appreciation Rights (SARS) and Phantom Stock are methods of offering economic rights without granting any ownership (voting rights).

Third, make sure whatever you grant is subject to vesting based on milestones.  For example, if the person will be designing a webpage and then maintaining it, restrict the vesting of the interests based on milestones like acceptance and final uploading of the website, and then annual grants for website services.

Fourth, include a clawback, giving the company the right to clawback the grants upon certain triggering events (like breach of a material performance goal).

Fifth, try to get a Buyout Option/Shotgun Clause, giving the company the right to repurchase the interests for a consideration based on a triggering event and a defined mechanism of valuation (hint, this is for another posting, but don't just say "fair market value").  

The Take Away:  Just because you are a cash-strapped start-up, do not undervalue your business by giving away the store in the form of a large percentage of equity.


Disclaimer:  This site is for discussion purposes only and does not constitute legal advice.  You are urged to seek the advice of an experienced attorney with respect to any legal matters.

Ten Legal Mistakes Made by Start-Ups: Employment Issues (#4)

For the 4th installment regarding the Ten Legal Mistakes Made By Start-Ups, the next important issue relates to hiring employees or engaging consultants.

Myth #4:  "I don't need any form of agreement with employees as they are be hired at will and can be terminated at any time."

You are correct that under New York law, absent an agreement to the contrary, an employee is deemed to be "at will" and therefore can be terminated at any time.  I am not suggesting an agreement is needed for a general officer worker; however, with respect to certain employees/consultants the reason for, at the least, a simple letter agreement is to protect your business assets.

1.   Intellectual Property Rights:  If the employee or consultant will be providing assistance with respect to, for instance, the development of your goods or services, contributing to marketing plans or development of marketing ideas, helping with website design or content, or contributing anything that could constitute intellectual property, then there should be a an invention assignment/work for hire clause giving the business the rights in intellectual property contributed by the employee/consutlant. 

2. Prior Employment/Existing Restrictive Obligations: 

    (a) Again, if the employee/consultant will be involved in the development of your goods/services or content, require a representation and warranty  that the person will not  use or incorporate any intellectual property rights owned or developed for third parties/prior employers in the course of their work for your company.

    (b) Ask if they have a non-compete or any other restrictive agreement to make sure they are not violating obligations to third parties, and include a representation and warranty that the employee is not in violation of any existing agreements.

3.  Indemnification:  include an indemnification clause giving you the right to assert a claim against the employee/consultant for losses arising from any intentional misconduct, omission or gross negligence or for violating any obligations they have to 3rd parties.

4. Confidentiality/Non-Solicitation provisions:  there should be a confidentiality clause preventing an employee/consultant from not only disclosing but also using your confidential/proprietary business information to solicit customers after separation -- and include a right to seek an injunction (in addition to monetary damages).

5. What about a Non-compete?:  Under New York law, a covenant not to compete must be reasonable in time and geographic area, meaning it (a) is not greater than is required for the protection of the legitimate interest of the employer, (b) does not impose undue hardship on the employee, and (3) is not injurious to the public. Courts weigh the employer's business interests against the employee's ability to make a living. The enforceability of a non-compete is a discussion for a separate post, but understand that, in the absence of use of confidential information/trade secrets of the former employer or significant compensation, courts are chary to enforce non-competes.  The decision whether to require a non-compete and then drafting the provision should be made in consulation with a lawyer.

6.  Miscellaneous provisions:

    (a) Use of Email/Technology:  in this day it is helpful to restrict the use of and access to company email  and other technology to business-related matters.

    (b) Return of Equipment:  require the return of all equipment at the conclusion of the employment.

    (c) Venue for Disputes/Service of Process:  I like to include a choice of venue (place) for any dispute so you don't end up in an inconvenient forum in the event of an issue; and it is helpful to allow for service by mail as an alternative form of service of process because it is easier and cheaper than trying to effect personal service.

Therefore, when hiring an employee or engaging a consultant, consider whether even a simple letter agreement should be executed to protect your business.

Ten Legal Mistakes Made By Start-Ups: Failing to Protect Intellectual Property

For the 3rd installment of my posts regarding the Ten Legal Mistakes Made By Start-Ups, I highlight the issue of the need to protect intellectual property.

Myth #3:  "I can wait until later to address intellectual property issues as the costs are very expensive."

While it is understandable that start-ups are often strapped for funds and need to preserve financial resources, it can be a monumental mistake if you fail to protect your intellectual property rights from the outset.

First, if you have a product or service that itself, or any element thereof, may be patentable, you need to speak to a patent attorney to determine if a patent application is warranted in the US and/or any other country.  The risk is that if you wait too long you could lose your patent rights in the invention. A U.S. patent is invalid if no application is filed within one year of the first time the invention is offered for sale, sold, publicly used or publicly disclosed.  Determing when the clock begins to run requires the advice of a patent attorney, but understand that if you violate the rule, the patent is stautorily barred.  (Note, you should also consider whether you want to file a trademark application relating to your business name, products/services).

Second, make sure all employees/consultants sign an Invention Assignment Agreement.  Without an Invention Assignment Agreement, any person who worked on the development of the product or service can try to claim that they own rights to any ideas they contributed -- and you can imagine the claims the company will face if the business is successful.  The Invention Assignment Agreement is a clear acknowledgement that anything contributed by an employee/consultant is owned unconditionally by the company.

Third, and a related to the Invention Assignment Agreement, make sure that any intellectual property (which includes domain names, patents, trademarks, copyrights) contributed to the company by a shareholder/member are assigned to the company.      

Fourth, check to see if the domain you want is available and then purchase it.  You do not want to create marketing materials and begin promoting your business and then later find out someone else owns the domain name because the costs of rebranding or obtaining the name could be quite significant.

Fifth, as per my previous postings, do not just copy and paste your website policies from another website -- aside from the copyright issues, you need to make sure your policies are consistent with your product/service offering and your business policies.

There will be seven more installments of the Ten Legal Mistakes Made by Start-Ups so stayed tune.

Ten Legal Mistakes Made By Start-Ups: I Don't Need an Operating Agreement/Shareholder Agreement

Continuing with the theme of the my October 17 post regarding ten legal mistakes made by start-ups, here is mistake number 2:

Myth #2:  I Don't Need an Operating Agreement/Shareholder Agreement or I can just get one online.

If you have a partner in your business, even if it is your best friend since you were in kindergarten, it is a mistake to believe you do not need an Operating Agreement (for an LLC) or Shareholder Agreement/By Laws (for a Corporation). 

First, under New York law, an LLC is required to have an Operating Agreement.  In the absence of an Operating Agreement, the parties are bound by the default terms of the New York Limited Liability Company Law.  Among the default provisions, the LLC will be deemed to be member-managed, meaning any partner has a right to bind the LLC -- this can be a signficiant problem if you believe you were the only partner who was to have management rights.

Second, the Operating Agreement or Shareholder Agreement will delineate the rights of the members/shareholders thereby (hopefully) avoiding disputes.

Third, I have found that when a partner can point to a provision of an Operating Agreement/Shareholder Agreement the parties can rely on the written agreement to avoid the stress of a possible dispute.

Fourth, the Operating Agreement/Shareholder Agreement needs to be drafted by an experienced corporate/business lawyer who understands the intent of the partners with respect to management and financial matters.  Simply adopting an agreement found online or borrowed from a third party ignores the fact that a pro forma agreement will not capture the intention of the partners regarding key issues, including control, management of the business, financial rights, buy-sell/shotgun clause, and many other issues.

Fifth, the execution of an Operating Agreement/By Laws is an indicia of the intention of the partners to observe the formalities of the business organization, providing an important argument to any claim by a creditor to pierce the protection of the entity and assert claims against the partners individually ("pierce the corporate veil").

Next Installment:  Invention Assignment Agreements/Confidentiality Agreements

    

Ten Legal Mistakes Made by Start-Ups

The next several postings will focus on ten significant myths relating to start-ups -- while these are not the only legal mistakes fledgling businesses make, they are some of the common ones I have noticed in working with start-ups.  Note, the mistakes discussed in the next several posts are not presented in any particular order, and so today we start with an obvious but very common myth.

MISTAKE NO. 1:  "I don't need to incorporate as this is a no risk business."

While new businesses often have limited financial resources, it is a mistake to believe that since the start-up may not have any assets there is not need to "waste" money on incorporating.  You may even see comments on the Internet or hear stories of businesses that waited to incorporate, implying that business incorporation is a concept pushed by lawyers seeking fees.  The fact is that without a proper business entity not only are the assets of your business exposed, but your personal assets are exposed to any obligations incurred or liabilities arising in connection with your business.

Okay, but your response is that my business is simple, it's not borrowing money, there are no employees, no leases, no contracts, no products or services that could cause any harm, and thus there is no risk.  Wrong, there is always risk any time you offer goods or services for sale/licensing or distribution.  Some of the risks are obvious, like selling goods that turn out to cause an injury or offering a service that a customer complains failed or lead to some harm; and some are less obvious, like selling goods or services that turn out are infringing intellectual property rights of a third party or the business fails and business creditors are seeking payment.  Without a proper business structure-- whether a corporation, LLC, SCorp or Limited Partnership -- the business risk unnecessarily becomes a personal risk.   

Significantly, there are choices when incorporating your business, and these choices depend on several factors, including tax concerns.  It is important that you discuss your plans with a experienced business lawyer who will advise on the proper business organization to fit your new business.

Next Installment:                  

Shareholder Agreements: Define BuyOut Terms

In a prior posting, I noted the importance of setting forth clear terms for buying out another member (LLC) or shareholder (corporation).  For example, the buyout terms/shotgun clause can be set forth in the Operating Agreement of an LLC (or a separate agreement between certain members) or in a shareholder agreeement of a corporation.  The dispute between father and son of Amercian Chopper fame illustrates the need to clearly delineate the terms of any option.  (Paul Teutul v. Paul M. Teutel, 2010 NY Slip Op 09248 (2nd Dept. Dec 14, 2010))  

The father and son had an agreement that included an option for the Paul, Sr. to purchase the shares of Paul, Jr. "for fair market value, as determined by a procedure to be agreed to by the parties as soon as practicable."  Paul, Sr. sought to exercise the buyout option, which Paul, Jr. opposed enforcement of the option.   The Appellate Court ruled that while the reference in the clause to "the term of 'fair market value' in and of itself may be 'sufficiently precise' ... the plaintiff and the appellant went further and expressly agreed to later agree on a procedure for determining the shares' fair market value."  Significantly, the Court, quoting prior precedent, stated that for a closely held corporation (i.e.small prviately-held business) where ownership is held by a small group of shareholders and shares are not easily sold, the fair market value of the stock "'involves a certain degree of inexact valuation and subjectivity, making the procedure by which fair market value is determined of particular importance.'"

The Court reasoned that, as opposed to cases cited by Paul, Sr. where the parties had agreed on an (albeit flawed) procedure for determining fair market value of the stock, the clause here was simply an agreement "to later agree on a procedure for determining fair market value," and thus was not binding.

THE LESSON: The valuation of the stock/membership interests does not have to be determined at the time of drafting the option (buyout clause), but there must be clear terms as to the procedure for valuing the stock.  One alternative is to identify a 3rd party, like a CPA, as the person who will determine valuation and perhaps agree to share the expenses of the valuation.

Starting an Entity: Minimum Capitalization

I am often asked, what is the minimum amount of capital you have to legally put in a company at the beginning.  The simple answer is essentially zero, but the reality is that you need to consider several questions to determine how to sufficiently capitalize your business.

First, as always, you need to choose the appropriate business structure based on the nature of your business, tax considerations, and whether you have or intend to have additional partners.

Second, once you have chosen the appropriate entity, you actually need very little to form the entity:

  1.  Corporation:  New York, for example, has the state filing fee to form the entity, plus a tax on the shares, but that share tax is only $10.00 if the shares are either "no par" and total shares don't exceed 200, or a low par entity, with a total capitalization not exceeding $20,000.

 2. Limited Liability Company:  In New York, there is the filing fee, there is no fee on the any membership interests that may be issued, but there is a draconian publication cost, which varies depending on the county of formation.  

Third, although there is no minimum capitalization requirement, the reality is you will need funds to (a) form the entity, and (b) a sufficient amount to start and operate the business. 

Fourth, if you plan on issuing shares or membership interests to 3rd parties within a relatively short time after formation, you may need to consider whether the low-priced shares/interests issued to yourself will have a negative impact on the valuation of the company in the eyes of potential investors.

Therefore, it is necessary for you to review your business plans with both an experienced business lawyer and your accountant.

Business Valuation: Partner Buy Out

When you enter into a business with a partner, it often makes sense to include a buyout clause in the partnership agreement (for a partnership)/operating agreement (for an LLC)/shareholder agreement (for a corporation)/joint venture agreement in the event that one of the partners is interested in selling (or buying) its interests.  Any buyout clause should include not only the mechanisms for exercising the buyout, but the methodology for setting a value for the business.  Sometimes the business partners feel it is too early to agree on a valuation method when starting a business or are concerned that defining the method at early on will lock them in if they try to raise capital or sell the business in the future.  On the other hand, if the partners choose not to include a buyout clause, they may find themselves arguing over the valuation if there is an opportunity to buyout all or some of the partners.

In the context of a buyout, whether your governing document has a buyout clause or not, at some point  valuation of the company itself becomes the issue.  The method of valuation of the business is the heart of the matter, and there are differing methods that can be used (Asset-based Methods, Income Capitalization, Discounted Projected Future Earnings, Sales Multiples, Earnings Multiples and others).  If the valuation method is not be defined ahead of time in a buyout clause, then  the parties will need to agree on a method at the time of the buyout (which can lead to time-consuming negotations or even a deadlock).  

The buyout clause (if one exists), or a future buyout agreement, can include the obligation to retain an accounting firm, investment bank, or a professional who is experienced in valuing similar business, to conduct the valuation. The partners should decide in advance how much they are willing to spend on the valuation/appraisal, how the costs will be shared and whether the determination be accepted as final.

The key to avoiding buyout disputes is to address the valuation issue in the Operating Agreement, Shareholder Agreeement, Partnership or Joint Venture Agreement rather than negotiating it when a buyout opportunity arises.  However, if the partners have decided not to define the valuation method ahead of time, they should at least agree on the retention of an independent third party to make the determination. 

The S Corp: Pros and Cons

Your are about to start a business, and you heard that an SCorp is a business structure used by many small businesses.  However, you are not certain if it is the right structure for your business.  Below is a simple list of the Pros and Cons of an SCorp:

PROS:

1.  Provides the protection afforded shareholders of a corporation:  An S Corp is actually formed as a corporation and is governed by the state corporate law statute (in New York:  The Business Corporation Law).  To become an S Corp, the owner makes an election to be taxed in accordance with Subchapter S of the Internal Revenue Code.

2.  S Corps avoid Double Taxation:  A corporation is taxed at the corporate level/entity level on its profits and then shareholders are taxed on any distributions (dividends) received from the corporation -- resulting in double taxation.  An S Corp election means that there is no entity level/corporation tax, and instead shareholders are only taxed on the distributions thereby avoiding double taxation.

The ability to avoid double taxation is what makes the S Corp a popular choice for small businesses.

CONS:  

1.  Ownership restrictions:  Limited to 100 shareholders, all of whom must be individuals, and none of which can be foreigners (i.e., shareholders must be US citizens or residents).

2.  In contrast to the Limited Liability Company, there are more corporate formalities that must be observed (thereby increasing the cost of the maintenance as compared to an LLC).

3.  Can only have one class of stock:  so less flexible than a regular corporation ("C" Corp) or an LLC if want to vary the rights of shareholders; and

4.  Unlike a "C" Corp and an LLC, profits and losses must allocated to shareholders based on their share in the business.

IMPORTANT:  Like a "C" Corp, FICA is imposed only with respect to employee wages and not on distributions to shareholders. However, the IRS and state tax authorities see as a red flag an attempt to categorize wages as a distribution to shareholder where the shareholder-employees has not been deemed to have been reasonably compensated (paid wages) for the services performed withing the company.  Simply stated, a shareholder-employee cannot try to reduce FICA obligations by shifting what should be wages to a distribution on shares.     

The above does not constitute legal advice, and therefore if you are starting a business, make sure you discuss the proper structure with an attorney and an accountant.