Fundraising

This section of the Blog will discuss some of the basic aspects of equity fundraising.  Many companies will need to raise money in order to fund business operations.  Fundraising can be done in a wide variety of ways – this Blog addresses only some of them.

ISOs vs. NQs

In a nutshell, the difference between an incentive stock option and a non-qualified stock option is the way in which they are taxed.  The exercise of an incentive stock option is not generally a taxable event, whereas the exercise of a nonqualified stock option is (and it is taxed at the ordinary income rate). 

The are complex rules that govern incentive stock options, so you will need the help of an expert tax advisor to work through the issues.  Here are two of the broader rules:

• An incentive stock option may only be issued to an employee of a company. 
• The underlying stock of an incentive stock option must be held for one year after the option is exercised and two years after the initial grant of the option in order for the sale of such stock to qualify for long term capital gains tax treatment.

It is emphasized here that these are only the general rules governing Incentive Stock Options.  Other rules beyond this general description are applicable and must be followed.  Consult your tax advisor regarding these rules.

Rule 409A

Rule 409A of the Internal Revenue Code is intended to prevent Enron-era abuses with respect to the valuation of stock options.  The general rule of thumb is that the excercise price of stock options must be equal to the fair market value of the company’s stock at the time of grant.  This, of course, is tricky business for private companies to comply with, since by nature there is no relevant market against which the company can be valued (for public company’s you can easily obtain their valuation in open market).  There is a specific list of factors that boards of directors must consider in determining the valuation of the company at the time such stock options are issued, and the board needs to take care that it carefully considers all such factors in determining fair market value. 

The penalties for not complying with 409A are pretty harsh - immediate regonition of ordinary income plus a potential 20% penalty.   Get a lawyer and/or an accountant on board if you are wading into this tricky territory.

83(b) Elections and Restricted Stock

Employee compensation is always an issue for start up companies, who are typically not immediately generating positive cash flow but still need talent to help run the business.  Thier are a number of ways to do this.  One way is for the company to grant what’s known as “restricted stock”, which is stock which “vests” over a period of time.  Prior to the stock vesting, it can be forfeited back to the company upon termination of employment.   Typically, the grant of unvested stock is not a taxable event, since the employee did not really receive anything of value.  The date on which the stock vests would normally be the date the employee would be liable for taxes on the grant of stock. 

This, however, can be quite a tax hit to the employee.  Say, for example, that on the date the restricted stock is granted to the employee, the company is worth $1 and assume the stock vests over a 1 year term.  If the value of the company increases over than one year term from $1 to $1000, the employee will take an ordinary income tax hit on the equity grant that is 1000x higher than the tax she would have paid on the initial grant date (which would have been zero if she paid fair market value of the stock – see below).  To satisfy this tax hit, the employee has to come out of pocket.  If you add some more zeroes to the ends of these number, you can be talking about some serious tax liability. 

Fortunately, this result is avoidable by making what is known as a Rule 83(b) election under the Internal Revenue Code.    If the employee makes this election, ordinary income is recognized when the initial grant is made – which is typically zero since the purchase of the stock is made at the company’s fair market value (since at inception, the fair market value is relatively low).  Thus, when the restricted stock vests, no income tax is due, and the only future taxable event occurs when the stock is later sold by the employee.   The election needs to be made timely – that is, within 30 days of the initial date of grant.  Great care should be taken that these rules are followed meticulously.

Employee Compensation – The Issue of Stock Options

I have not had a more common question from clients than whether or not they can issue “penny warrants” to their employees, friends, family, etc.  The answer is that unless your company is only worth a penny, no.  Issuing any kind of equity at a price below the fair market value results in significant adverse tax consequences to the recipient.  With respect to employee compensation, issuing stock options at an exercise price below the then fair market value of the stock can trigger significant adverse tax consequences under Rule 409A of the Internal Revenue Code (including a potential immediate tax liability and 20% tax penalty to the employee).  More on valuation and employee compensation is contained in other sections of this Blog.

Assignments of Property to the New Company

Folks rarely start businesses with no assets to contribute to the business at all.  If you’ve created a design that you’ve copyrighted, purchased some start up equipment, before you incorporated your business, you need to get those assets to the company.  Typically this is done by was a contribution agreement or an assignment agreement under which the owner of the assets contributes the property to the corporation in exchange for stock of the corporation.  This can sometimes be a tricky endeavor, and you need to be aware of a few things including the following:

• Valuation – certain property, such as intellectual property, is tough to assign a value to.  This can affect the total valuation of the company and can affect the per share price at which equity and options may be issued (if the per share price is too low, adverse tax consequences can result). 
• Taxation – in order to the contribution to be a tax free contribution for the founder, Section 351 of the Internal Revenue Code must be complied with.  In a nutshell, in order for a founder’s contribution of assets to a corporation to be tax free under Section 351, the founder must only receive stock in exchange for the intellectual property, and the founders, after the contribution, must own at least 80% of the company immediately following the contribution and exchange for stock. 

The lesson here is to be careful at the outset when you are performing these inital maneuvers. A little caution at the start can save a lot of time and headache down the road.

“S” Corporations

Subchapter “S” corporations, like LLCs, are pass through entities for taxation purposes; that is, profits and losses pass directly to each shareholder and are not held at the entity level.  Corporate governance of an “S” corporation is the same as for a “C” corporation – you’re basic corporate formality such as regular board and shareholder meetings apply for “S” corporations.  You get subchapter “S” status for your corporation by filing a Form 2553 with the IRS after you form the corporation with your relevant state.  It’s a very simple process. 

There are some fairly significant limitations that make “S” corporations suboptimal for most business beyond very closely held companies with very few shareholders.  You cannot have more than 100 shareholders in an “S” corporation, and none of the shareholders can be institutions (such as investment funds).  You also cannot have more than one class of stock, which is also a significant drawback for fundraising purposes.  Thus, unless you are sure that your company will not need to raise funds and will be only owned by a few people, an “S” corporation is probably not the route to go (particularly given the LLC option).

Basic Aspects of Limited Liability Companies

Limited liability companies are probably the most flexible of the corporate entities discussed in this blog.  Limited liability companies are a form of “pass through” entity, which means that the entity itself does not pay taxes and that all profits and losses pass directly to each member of the company.  Losses also pass through directly to each of the members of the LLC in proportion to their percentage share of the LLC.  This is great because the LLC avoids the dreaded “double tax” treatment that applies to “C” corporations.  However, there are complicated tax rules that apply to LLC’s and you’ll need to keep your accountant on the horn so that you comply fully with all of these rules and don’t blow the pass through status of your entity. 

There are some other drawbacks to LLCs as well.  The first is that venture capital funds have a strong preference against investing in LLCs, and so if you company gets to this stage, you will likely have to convert to a “C” corporation (which in itself is not a very complicated maneuver and can be done rather quickly).  From the point of view of compensating employees with equity in the company, you generally cannot grant incentive stock options to employees of an LLC (see the discussion on incentive stock options in the “C” corporation section).

Basic Aspects of “C” Corporations

“C” Corporations are by far the most prevalent form of corporate entity around.  Virtually all large corporations are organized as “C” corporations.  Here are some of the key tax attributes of a “C” corporation:

• Profits are taxed (and losses are taken) at the entity level – that is, if you form ABC Corp. as a “C” corporation, ABC Corp. itself files a tax return and is taxed on profits.  
• When ABC Corp. makes distributions to its shareholders, the shareholders also pay taxes on these distributions at the ordinary income tax rate.  This is the oft-maligned “double-tax” – both ABC Corp. and the shareholders pay taxes on corporate profits. 

Most start up companies will want to choose a “pass through” entity, such as an “S” corp or an LLC in order to avoid the double layer of taxation.  Each of these entities are discussed in this blog.  However, it should be kept in mind that most venture capital investors highly prefer investing in “C” corporations, because there is much more settled law around them and because there is standard way in which to create preferred stock in a “C” corporation, which most venture capital investors insist on investing in.  Therefore, the choice of corporate entity depends in part on your company’s anticipated need for fundraising down the road. This choice can be deferred in a sense by starting your company out as pass through entity and then changing to a “C” corporation.  This is something you will need to discuss with your lawyer and accountant.

There are additional benefits to a “C” corporation.  You can have an unlimited number of shareholders in a “C” corporation.  You can also grant Incentive Stock Options (discussed elsewhere) to employees of a “C” corporation, allowing such employees to defer tax on such options until the underlying stock is sold (as opposed to when the options are exercised).   This is generally not an option for the other types of entities out there.

Choice of Corporate Entity

This section will discuss the various aspects of the different entities that you can choose to form in starting your business.  The main choices are (i) “C” corporations, (ii) “S” corporations, and (iii) limited liability companies. There are other variations of entities that another post will get into, specifically dealing with professional associations of doctors, lawyers, accountants, etc., but most businesses will be organized as corporations or limited liability companies for the reasons described below.