Startup Law 101 Series – Distinctive legal aspects of starting a startup business with a founder team

Introduction

Startups with founding teams require a different type of company formation than a small business. This is because it differs in many key ways from a traditional small business. These differences are highlighted in this article so founders can avoid making mistakes when setting up their company.

Attributes for a Typical Startup Business

Startups are a type small business. Their founders aim to make long-term and substantial profits, just like any other small business. Maybe some of those empty “concept businesses” from the bubble era didn’t intend to create long-term value, but that era has passed. Startups today must either create value in a sustainable marketplace or they will fail just like every other business. However, a startup that is more than a single effort can be quite different from a small business. Why? It’s not because the enterprise has any other goal than building long-term and sustainable value, but because of the way its founders see their short-term goals.

A startup founder team will choose a business model that allows them to exit quickly (typically within 3-5 years), and if they are successful, an extremely high return. The team will want stock incentives, which are usually forfeitable until they earn sweat equity. The team will often want to contribute very little to the venture. It will often possess valuable IP that the team has created in concept and will likely bring to the prototype stage. Because team members often give services to the venture, it can run into tax problems. To compensate a small group of initial employees or consultants, it will use equity incentives. They typically defer or skip their salary. It will also seek out outside funding, including from family members and friends but more often angel investors and VCs. As the venture is likely to fail, it will be a make-or-break affair over the next few decades. The founding team must always have a near-term exit strategy in mind with the hope of a positive outcome.

This blueprint is different from a traditional small business. It was often founded by founders who made substantial initial capital contributions without putting much emphasis on intellectual property rights. Their goal is to make immediate operating profits and have no expectation of an extraordinary return on their investment.

These attributes make it different for startups to form a company from a small business. Sometimes, a small business setup is simple. Startup setups are more complicated. This is because it has more legal consequences. It affects the choice of entity and the structural choices made during the setup.

Startups Need a Corporate, As Opposed to an LLC.

A LLC is an easy and low-maintenance option for small business owners. This is a great option for people who want to manage their business either by consensus or with the guidance of a managing member.

What happens to this simplicity when an LLC is tailored to meet the unique needs of a startup company? If members are given restricted units with vesting-style provisions Employees are given the option to purchase membership units. What happens when a preferred group of membership units are defined and issued to investors. The simplicity is lost. The LLC can accomplish almost everything that a corporation can, but why adapt a partnership-style legal structure to achieve goals for which the corporate form is best suited? It is almost impossible to do this, so the corporate structure is best for most founders deploying their startup.

There are two other clinkers: an LLC doesn’t allow you to receive tax-advantaged treatment under federal tax laws. This means that there is no comparable incentive stock option. VCs won’t invest in LLCs due to the negative tax impact on their LP investors.

For special cases, LLCs can be used to start up ventures. Some founders choose to set up an LLC structure in order to enjoy the tax-pass-through benefits in cases where this tax treatment is appropriate for their investors. An investor who is key to the venture may want special tax allocations. This can be possible through an LLC, but not through a corporation. Sometimes, the venture is well-capitalized when it starts. A founder who contributes valuable talents but has no cash would be subject to a prohibitive tax on their equity. In such cases, a profits-only interest will be granted to the founder. This will solve his tax problem and give him a rough equivalent ownership through a share of the operating profits.

Despite such extraordinary cases, the corporate structure is still overwhelmingly preferred by startups. It is strong, flexible, and well-suited for dealing with the unique issues startups face. Let me now address some of these issues.

Restricted Stock Grants for Small Businesses – These are rare for startups with founding teams

Unrestricted stock grants allow the recipient to purchase stock once and keep it for life, subject to a buyback at fair market value. This is the norm in a small business. In fact, thetechportal flipkart acquires AR startup it is the greatest privilege for entrepreneurs. Although it may not be much, you will definitely own it.

However, unrestricted grants may be problematic for startups. For example, if three founders form a startup, they can each walk away with their equity interests and continue to work hard to make it successful over several years.

A conventional small business is not likely to be exposed to this risk as a startup. A co-owner in a small business will usually have contributed significant capital to the company. For “working the business”, they will often also receive salaries. The ability to borrow current money from such businesses could be a significant part of their value. The chances of a walk-away owner gaining a substantial windfall are greatly diminished. In fact, such an owner could be very prejudiced by not being part of the business’s internal affairs. This person will be a minority shareholder outside the corporation. Insiders will have access to his capital contribution and can manipulate profit distributions and other company affairs pretty much as they please.

Startups are different in that each founder contributes primarily through sweat equity. Founders must earn their stock. A founder who gets a large share of stock and walks away with it is considered to have gotten a substantial amount.

This is why restricted stock is necessary for startups. Restricted stock allows founders to receive their grants and retain their stock. However, they could lose all or part their equity interest if they do not remain as service providers with the startup.

The Risk Of Forfeiture Is The Defining Ellement of Restricted Stock

Restricted stock can be purchased at a cost from the recipient if they cease to have a service relationship.

The repurchase rights apply to x% of founder stock at the date of grant. X is a number that was negotiated between the founders. It can be 100% if the founder does not have any stock immediately, or 80 percent if 20% is immediately vested. The remaining percentage will be deemed immediately vested (i.e. it is not subject to forfeiture risk).

In a typical case, x equals 100 percent. This repurchase right expires gradually over time as the founder works for the company. As time passes, the founder’s right to repurchase stock becomes less and less valuable and the stock gradually vests. A company might grant a restricted stock grant to its founder, with pro-rata vesting every month for a period of four years. The company’s repurchase rights apply initially to all founder stock, and then lapse as to 1/48th with each month of continued service by the founder. The founder can be terminated from his service and the company has the right to purchase back all unvested shares of the founder at cost. This is the amount paid by the founder.

At cost is exactly that. You pay $1,000 for one million shares of restricted shares you received as founders. The company usually has the option to purchase your entire interest back for $1,000 if you leave the startup as soon as you have made the purchase. This may not be important at the beginning.

Let’s say half of your shares were repurchased. This could be two years later, when the shares may be worth $1.00 each. The company can then buy up to 500,000 shares worth $500,000 from you for $500, if your service contract with the company is terminated. In such cases, your interest will be forfeited if the shares are repurchased at cost.

This forfeiture risk is what differentiates a restricted stock buy-back from one at fair market value. The latter is most commonly used in small-business contexts.

Limited Stock Can Be Mix and Match to Meet Startup Needs

With respect to founder grants, restricted stock does not have to be done in a vacuum.

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