It takes more than just a unique idea and hard work to launch a new business. Turning a concept into an entrepreneurial endeavor has many legal and financial implications that should be approached strategically to start a company on solid ground. In this two-part series, I aim to provide a basic overview of these legal and financial considerations from my perspective as a corporate lawyer.
In the first part of this series, I touched on common legal implications of starting a new business, including protecting intellectual property, choosing partners, and naming your business. You can read more about that here. In this post, I focus on common financial issues from a legal perspective, including equity, raising capital, and separating your new business from your personal finances.
Grant Equity Appropriately
Use caution when granting equity or promising someone a percentage of the business. It is easy to tell someone that you will give her 1 percent or 5 percent of the business, for example, for helping you accomplish some of your business goals. When it comes to legally granting that equity in the business, however, you need to establish what that means exactly, and how and when the percentages are determined. Typically, a founder will not intend for these equity grants to be “evergreen” percentages, meaning that the grants would not be diluted by future capital raises or equity issuances. A best practice would be to grant a certain number of shares or units, which would equate to a percentage of the company on the date of grant, and thus the percentages would be dilutable pro rata with all other equity holders. These considerations can make a big difference in how much equity a founder gives away and how much she retains.
Create Vesting Stipulations
Make sure that the initial equity grants to co-founders and employees are subject to vesting — either time-based or performance-based. Although you may think you and your co-founder are destined to build the business together for eternity, the reality is that business partnerships do not always work out. You will want to build in stipulations to ensure that the business can take back a portion of a co-founder’s equity if that co-founder is no longer working for or providing services to the business. Having additional equity available to grant to future partners can be critical to bring in the right people that will help you launch and grow the business.
File 83(b) Elections
If the business issues stock to founders or employees subject to vesting, then the founders and/or employees should consider making 83(b) elections with the Internal Revenue Service within 30 days following the date of the grant, particularly if the stock is granted before it has much value. Filing this election with the Internal Revenue Service can mean a substantial tax savings to founders and employees when they sell their stock in a successful exit.
An 83(b) election (named as such because it stems from Section 83(b) of the Internal Revenue Code) allows a person to pay current tax at ordinary income rates on the current value of the shares (which presumably would be very low) and start that person’s capital gains holding period before the stock has vested. That way, future appreciation in the stock is taxable at lower capital gains rates and only upon a disposition, when there is liquidity to satisfy the tax. Without an 83(b) election, the recipient of the shares would pay tax at ordinary income rates on the value of the shares when they are no longer “subject to a substantial risk of forfeiture” (i.e., when they vest). By this point, the stock could be worth significantly more, and the recipient would have to pay much more tax even if she does not receive cash to pay it. However, there are tradeoffs to making an 83(b) election, particularly that the founder or employee pays tax on stock that may otherwise never vest or come into the money. It is important to consult with your accountant and your lawyer early on in the process to devise a strategy.
Separate Business From Personal
Once the company is formed, begin to take actions in the name of the company rather than in the name(s) of the founder(s). One of the reasons for forming an entity is to limit personal liability, so you should ensure that there is clear separation between the assets of the business and the assets of the founder. Agreements should be signed in the name of the company using a company signature block, and not simply the name of the founder. It is important to obtain a tax identification number for the company and open a bank account for the business. The assets of the business should not be commingled with the personal assets of the founders.
Raise Capital Strategically
Anyone who has gone through fundraising will tell you that it is a very arduous and time-consuming process that takes away from the founders’ abilities to run the business. Before you rush to raise capital, however, make sure you have planned to raise the right amount of capital at the right time. Raising too much capital too soon at a low valuation can be very dilutive to the founders. Not raising enough money early on can make it difficult to launch your product or service, and may leave you struggling to find investors at a critical time for the company. Many entrepreneurs find that they wished that they had raised more capital than they initially thought they needed when it was available, as invariably there are delays and unforeseen roadblocks that arise during a company’s path to cash flow positive. It is also important to remember that raising money by selling equity (including convertible debt) in your business, no matter how much or how little, is a securities offering that must comply with federal and state securities laws.
Select Venture Capital Partners Wisely
Choosing the right venture capital partners should be based on more than just the valuation and the percentage of the company that you will be selling. There are many nuances in the terms that venture capitalists will present to you, and many different ways that they may be compensated for their investment in your company. Just because a venture capital firm offers you the highest valuation does not mean that its money is the least expensive. Take time to fully understand the terms that are presented to you — such as participating preferred equity, accumulating dividends, redemption rights, anti-dilution protection, and protective provisions. Further, one or more investors will most likely take a seat on the board of directors of your company, which means they will be involved with your business on a regular basis. Carefully evaluate to what degree they have the experience and contacts necessary to add value to your business beyond simply writing a check. Finally, consider whether you like the investors on a personal level.
The importance of these technical details that surround the launch of a company cannot be stressed enough, and can be daunting for an entrepreneur with an already full plate. Set your business up for early success by hiring a lawyer or law firm experienced with startups and venture capital investing. A strong legal team is an invaluable resource that will help guide you through the legal challenges you face when starting your own business.
Pamela Zimlin is a member of the DailyWorth Connect Program. Read more about the program here.
This article is made available by Pamela Zimlin and Royer Cooper Cohen Braunfeld LLC (“RCCB”) for informational purposes only, not to provide you with specific legal advice. By reading this article, you understand that there is no attorney client relationship between you and RCCB. The content of this article should not be used as a substitute for obtaining competent legal advice from a licensed professional attorney.