Starting a Company? Make this Step One……

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….).

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2 Responses to Starting a Company? Make this Step One……

  1. Auntie Prener says:

    I am a little confused. Lets say 5 of us form a company and contribute $100 each for 1 million shares each – $0.0001 per share. Two weeks later, we contribute IP that is worth $50,000 plus $100,000 in cash. Wouldn’t the founders who contribute these assets be entitled to additional shares as consideration? If so, how many shares should we issue to the founders who contributed the cash and IP? And accordingly, what is the share price after the assets have been contributed?

    Wouldn’t it be easier to skip the first step and instead issue the initial 5 million shares in exchange for the cash and IP, which is collectively valued at $150,000 or $0.03 per share? You mentioned IRS issues in your article, but aren’t those issues equally relevant at the time the assets are contributed, whether or not we issue the super-cheap founders stock as a first step?

    Thanks!

    • CapGenius says:

      An interesting question given the person asking works for a business law firm. Not sure if you know the answer and are testing our response, or if this area of business law is not where you focus. The answer is that as a founder you actually do not want to ever want to assign value to the IP you are putting into the company in exchange for equity (note: this is a sale of the IP, not a contribution, which is an important distinction for tax purposes). The reason is that at the time of the sale of the IP to the business (the point where they pay you for this IP with stock), if you have assigned a value you are facing a taxable event for the sale of an asset which you likely had no cost basis in. More on this in a couple of paragraphs. Back to the scenario at hand first:

      So you start out and each of the five people invests (don’t call it a contribution unless you don’t intend to make it back!!) $100 to buy a 20% ownership in the company, which in this case is represented by each founder holding 1 million shares of stock. You now share ownership of something worth $500, and since you own 20% of that, and invested $100 to get it, the current value is equal to your invested capital. This is not “super cheap” founders stock because at the time of this transaction the company has effectively zero value, and there is no way to buy something that has no value on the cheap.

      The next part is tricker because it really depends on who “We” is in the question. If the “we” all five of the founders equally, or is the “we” a subset of these five people? For the sake of this answer we are assuming it is a subset of the five. We will cover each item (IP and cash) separately:
      (1) IP – First question – who says it is worth $50,000? Do all five founders agree this is the value they want to apply to the IP when it is transferred in? This is VERY important and for the sake of the answer we assume they have agreed on this value for the IP. In this case the owners of the IP (lets say it is two of the five founders, and that these two own the IP equally), are transferring an asset into the business worth $50,000. We would argue that if it comes in at the same time as the cash below, it should be valued the same.
      (2) Cash – We will assume that the same two founders who equally own the IP are investing the $100,000 and splitting that equally as well.

      A quick pause to note that the process of transferring IP as a founder and expecting to get additional value for it is out of the ordinary from what we normally see happening. The reason is a tax issue (usually). Generally this sort of IP was created by the founder (not purchased), so they put in time and energy to create it and make it worth something. If the company agrees that this is worth $50,000 and the person then transfers this into the company for stock, they will be given $50,000 in stock for an asset that has zero cost basis to them (no cost to create other than time and energy). This should trigger a taxable event where the founder would have to pay taxes on the $50,000 in stock they were issued for selling the IP to the company, with this income tied to the year of the transfer. So play that scenario out – founder transfers IP, gets $50,000 in stock in the start-up, pays taxes on the $50,000 (likely at full tax rate, not capital gains rate). If the company then fails, they get no value for the $50,000 in stock but paid taxes for it. While they can claim a loss on the $50,000 in stock, they are out cold hard cash from the taxes they paid.

      The more standard way for this to happen (IRS folks close your ears) would be for the founders to agree on how much of the company (%) the IP should be worth (similar to setting the value of the IP up front, and agreeing on the pre-money valuation that the company will be set at when the IP is transferred but the % approach avoids assigning a dollar value that the IRS might later come back and try to charge taxes (plus penalties and interest) on. Example for how we would typically see this done:

      Five founders – 20% ownership each
      Lets say the founders agree the IP is worth 20% of the company at formation (if you were assigning a $50,000 value you would be talking about a pre-money value of $200,000, but again DO NOT DO THIS!!).
      Quick math: 100% (total equity ownership) minus 20% for IP leaves 80%. This 80% is split equally amongst the five founders, so each would own 16%. The other 20% is split between the two founders who owned the IP, so they each get another 10%.
      Starting Cap Table:
      Founder #1 (Owned IP) = 26%
      Founder #2 (Owned IP) = 26%
      Founder #3 (No IP) = 16%
      Founder #4 (No IP) = 16%
      Founder #5 (No IP) = 16%

      Note: The $500 in initial capital would be paid in based on these ownership percentages instead of equally amongst the five founders.

      A few weeks after this is done, the founders who own the IP would CONTRIBUTE it to the company (some attorney might argue it is ok to do this at the same time). One question that arises is “what if they refuse to transfer the IP as promised”. Simple answer is that since nothing else has really been done in the business the other three founders would walk away, lose the $80 bucks they paid for their shares and thank their lucky stars that they learned the true colors of Founders #1 and/or #2 above before they really started to invest their time and energy to working together. In other words, there is really not much to gain for failing to see this through.

      OK, with that out of the way, lets move to the cash piece. First, and very importantly. Cash is cash. While you might choose to accept cash from some investors and not from others, once that determination is made, the cash that is invested on a particular date should likely (notwithstanding strategic investments, etc.) be valued the same. Given this line of reasoning, it does not matter that the $100,000 in cash is being invested by founders. In this example, if two of the founders are investing this cash the other three are no better off because this cash is coming from their co-founders (they may be much worse off but that topic is for another time). This $100,000 should be considered seed capital and should be valued as though it is the first outside capital being invested in the business – in our view it is the only fair way to do this if not all the founders are investing cash. One of the CapGenius contributors had this situation as a founder where another founder was putting capital into the business and he was not. They tried to argue for a “cheaper price” than the angel investors putting money in at the same time, and our CG friend pointed out that as a founder he was better off taking the money from someone willing to pay a higher price, and the only person who benefited from the lower value was the founder investing the capital (sorry, started down the rathole we promised to leave for another time).

      We cannot tell you what value to place on the company at the time of this investment as that is totally situation specific, but you should not think about it as being worth $.03 per share. You should think about this in terms of how much of the company this $100,000 will buy, which is all tied to a pre-money valuation.

      From a tax perspective, the $100,000 is easy to deal with – the two founders are investing $100,000 in cash and getting $100,000 worth of stock in return, so there is no taxable event and when they exit the investment they will receive capital gains treatment on this investment (assuming long-term holding period, etc).

      We hope this helped. More importantly we hope it makes sense (it did to us).

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