February 18, 2011 2 Comments
Before transferring any knowledge, software code, IP, assets or money into a new business, the first thing you should do after signing the formation documents for the business is purchase your founders shares. Most good attorneys will advise you of this but in case yours does not, make sure this is Step One.
Why should purchasing your Founders Shares be Step One? This one is simple.
When you start a company, it has nothing of value – no assets, no IP, nothing that could be construed as placing a value on the business above zero. This is when you want to buy your founders shares because they are worthless (aka cheap).
As you can read about in our post Setting Par Value, assuming you are buying common stock, you will purchase these shares at par value. It is a relatively arbitrary number that as the linked article shows, you should set as arbitratily LOW as possible.
The reason to purchase your shares before transferring anything into the entity is that if you have transferred any assets, IP, signed any prior work products over to the business, or god forbid, already raised money for the business, you have created value in enetity that should result in it being worth more than all the shares times the par value. This is a problem. The challenge is that if you buy your shares at par, and down the road the IRS determines that you bought these for less than they were worth at the time, you could run into a meaningful tax issue. It could be determined that you were given the shares in exchange for transferring prior work product, IP, etc., and as a result you should have paid taxes for the value of these at the time they were transferred in return for the equity provided by the company (this would be an IRS determination, and one you want to avoid).
This is the same reason you should never raise money for a company until you have purchased your founders stock (and let a little time pass, a couple of weeks should do). If you take money at the same time or before you buy your shares, you have placed a clear value on the business, which makes it pretty hard to prove that you are paying the market value when you purchase your stock at par value (assuming par is set very low, as it should be) while the investors pay significantly more for their shares at the exact same time. The best case scenario at this point is that you raise money by selling preferred stock and you’ll need to do a 409A valuation analysis to place a value on the common stock to ensure you are paying the then fair market value for your shares. It should be noted that if you raise convertible debt you may be “safe” but it will depend on the convertible structure and the IRS’ determination. Trust us, you want to avoid leaving things to the determination of the IRS as much as possible.
So how big a deal is this? Aside from the tax issues for you personally, the company may have issues down the road for issuing “cheap stock”. We have seen issues around common stock valuations literally derail an acquisition process because the acquiring company auditors would not sign off on the issue even though it was a well bounded risk. A rare example but one where a seemingly innocuous decision had major ramifications later on.
So, back to Step One – Prepare your formation documents and purchase your founder shares at par. Do not sign documents to transfer IP, assets, etc. at the same time. Instead, wait a week or two to formally transfer anything over, raise capital, etc.. You can work on the project as much as you want, but just hold off on bringing this work across for a week or so. Again, a good corporate attorney will advise you of this right away, but in case you are not fortunate enough to have a good corporate attorney, we wanted to make sure you are prepared (look for a future post on selecting the right attorney….).