Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

Davis Wright Tremaine, iMedExchange, Clarity Health and Faultline Ventures invite you to attend the innovateHealth’s inaugural “Capital Meets Innovation” Summit on May 12, 2009. This program will highlight successful strategies being used by health care entrepreneurs from the Pacific Northwest to access capital and build their businesses during “droughts” in the traditional funding markets. The Summit will also feature an opportunity to introduce investors from across the country to the next generation of technology-enabled health care services companies. For more information, CLICK HERE.

About innovateHealth: innovateHealth is a fast-growing group of health care technology and services stakeholders focused on driving innovation in the health care industry and building awareness of the health care services and technology cluster in the Pacific Northwest. innovateHealth both connects our members within the region and connects our cluster to the larger national and global markets. The group's first two events were standing room only.
 

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Founders often ask how they can keep a co-founder who leaves the company shortly after formation from taking his founders’ stock with him. The remaining founders typically feel that the departing founder should not be able to share in the company’s future upside value. Similarly, investors typically want to prevent a founder from leaving with his stock shortly after making an investment.

Like employee stock options, founder stock can be subject to vesting based on service to the company. This is accomplished by the founder granting the company an option to repurchase his stock for the nominal price paid by the founder if he leaves the company before the stock vests. The stock “vests” periodically when a partner is released from the repurchase option. This is often referred to as “reverse vesting.” Note, investors sometimes give vesting credit for time a founder spent building the company’s value by exempting a portion of the founder’s stock (e.g., 25%) from the repurchase option.

For example, three founders could each agree on a repurchase option with quarterly vesting over two years with respect to their founders’ stock for which they paid $0.001 per share. In this example, 12.5% of the stock held by each founder would be released from the repurchase option quarterly such that at the end of two years all of the stock held by each founder would be free of the repurchase option and a founder would be free to leave the company with such stock.

When using a repurchase option, a founder should seek tax advice as to whether to file an 83(b) election with the IRS. Such an election enables the founder to include in income at the time of original issuance the value of the stock that is subject to repurchase. 

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It is fairly common in connection with a financing that an investor will require a founder to agree to place a certain number of the founder's fully vested and owned founders shares under an at-cost repurchase restriction, which at-cost repurchase right lapses over a new vesting period.  

The question that this raises from a federal income tax perspective is whether the founder should or needs to file a Section 83(b) election upon the imposition of the new vesting conditions.  The IRS answered this question in Revenue Ruling 2007-49.

"In Situation 1, in connection with the new investment, the substantially vested shares of Corporation X stock owned by A are subjected to a restriction causing them to be “substantially nonvested”. Because the substantially vested shares of Corporation X stock are already owned by A for purposes of § 83, there is no “transfer” under § 83. Thus, the imposition of new restrictions on the substantially vested shares has no effect for purposes of § 83."

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S corporations may only have one class of stock.  However, "[d]ifferences in voting rights among shares of stock of a corporation are disregarded in determining whether a corporation has more than one class of stock."   Thus, an S corporation "may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors."

See Treasury Regulation 1.1361-1.

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 Preferred Stock is stock which is "preferred" over common stock in any number of different ways.  For example:

• preferred stock may be entitled to dividends before common stock;
• preferred stock may have special voting rights (protective provisions; the right to block a subsequent financing or sale transaction);
• preferred stock may have the right to be paid first a certain fixed or formulaic amount of money before the common stock on a liquidation or merger of the company into another company;
• preferred stock may be redeemable at the option of the holder after a certain period of time; or
• preferred stock may have a purchase price protection mechanism built into it--such that if the company issues additional stock in the future at a price per share lower than the price per share of the preferred stock, the preferred stock's purchase price will in effect be reduced on the subsequent stock sale.

Preferred stock may have any one or more of these characteristics.  In addition, preferred stock holders may desire contractual rights in addition to the rights specified above--such as:

• a voting agreement with the other stockholders, ensuring the preferred stockholders representation on the company's board of directors;
• registration rights;
• the right to receive financial statements or other information on a regular basis;
• preemptive rights on future stock financings;
• rights of first refusal on sales of founder stock;
• co-sale rights on founder stock;
• drag along rights; and
• others.

Companies issue prefer stock for any number of reasons, but most typically, because their investors demand it.  For an example of a Series A Convertible Preferred Term Sheet, see the National Venture Capital Association's model legal forms page.

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Early stage companies frequently want to bring on key hires and incentivize them with equity, but do not know what type of equity award is the best from a tax perspective to both the employee and the company.  There are in general two types of equity awards most commonly used (assuming that the company is operating in the corporate form and not as a limited liability company):

• stock options; and
• stock awards or stock grants.

In general, for a private company with limited cash reserves, and whose key hires also desire to preserve their cash (and not pay it to the IRS), stock options are usually going to be a preferable alternative to stock grants (unless the current value of the stock is so low that the immediate tax impact is nominal).  

The reason?  Stock grants will be taxable either (1) upon grant, if fully vested, or if a Section 83(b) election is made (in which case the taxes must be paid immediately upon grant, and will have to be withheld from the employee--i.e., the employee will have to write a check to the company for the taxes), or (2) upon vesting, when the value may be considerably higher than the value on the date of grant (and the taxes must then be paid at that time, and the employee will have to write a check to the company at that time for the taxes).  

The primary benefit of a stock option as opposed to a stock grant is that if the stock option is priced at fair market value on the date of grant, the receipt of the option is not taxable to the optionee, and the option will not be taxable at all until exercise--the timing of which the optionee controls (as opposed to a vesting date for a restricted stock award).

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The Obama Administration is proposing that venture funds above a certain size be required to register with the SEC. 

"All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed a certain threshold should be required to register with the SEC." 

See  FinancialStability.gov:

Currently, venture funds are generally not required to register with the SEC.  This proposed requirement that venture funds above a certain size will be required to register with the SEC may at the margins cause certain funds not to be formed, and slow down capital formation, capital flows to startup companies, and ultimately innovation.  Let us hope that the size requirement will be large enough not to have these effects.  We will keep you posted when we learn more.

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The American Recovery and Reinvestment Act changed COBRA.  Under the Act, certain persons who lose health care coverage as a result of an involuntary termination of employment are entitled to a subsidy of 65% of the employee's cost of COBRA coverage.  Before April 18 of this year, employers subject to COBRA must distribute revised notices to qualified beneficiaries who had a qualifying COBRA event between September 1, 2008 through December 31, 2009.  You can find out more information about this here.

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As if the venture capital industry did not have enough to worry about, with the Treasury's proposal to require venture funds above a certain size (not yet specified) to register with the SEC, it also appears that the effort to tax their "carried interest" as ordinary income will remain in the mix.  Representative Sander Levin, of Michigan, re-introduced legislation last Friday that would tax the carried interest of venture capital funds as ordinary income.

Excerpts from his press release (which can be found on the House Ways and Means Committee web site) are below:

 “Washington, DC – Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working  Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.  

Click here to view the legislation."

More:

"Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase."

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 Cybersecurity is and is going to be a significant issue in the years to come.  Some of the latest legislative action on this front is the proposed Cybersecurity Act of 2009, which would among other things:

• Establish the Office of the National Cybersecurity Advisor within the Executive Branch, who would report directly to the President and who would serve as the lead on all cyber matters coordinating with the intelligence agencies as well as civilian agencies. 
• Require the Commerce Secretary to "develop or coordinate and integrate a national licensing, certification, and periodic recertification program for cybersecurity professionals."
• Beginning 3 years after the date of enactment of the Act, make it "unlawful for any individual to engage in business in the United States, or to be employed in the United States, as a provider of cybersecurity services to any Federal agency or an information system or network designated by the President, or the President’s designee, as a critical infrastructure information system or network, who is not licensed and certified under the program."

The bill would also allow the President to "declare a cybersecurity emergency and order the limitation or shutdown of Internet traffic to and from any compromised Federal government or United States critical infrastructure information system or network."

For govtrack.us tracking information, see here.

To read Senator Rockefeller's press release, see here.  

Other news coverage at cnet, engadget, and Mother Jones.

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 If you didn't pay alternative minimum tax on your incentive stock option exercises prior to January 1, 2008, and you owe the IRS a bunch of money--don't worry about it.

The Internal Revenue Code now provides that any "underpayment of tax outstanding on the date of the enactment of this subsection which is attributable to the application of section 56(b)(3) for any taxable year ending before January 1, 2008, and any interest or penalty with respect to such underpayment which is outstanding on such date of enactment, is hereby abated."

Section 56(b)(3) is the provision which provides that the gain on the exercise of incentive stock options is an alternative minimum tax adjustment.  So, the Code now says, quite literally, that if you owe taxes attributable to the exercise of incentive stock options for a tax year ending before January 1, 2008, and interest and penalties on such taxes, you don't have to worry about it!

Taxpayers should be aware that the provision is only effective for ISO exercises prior to January 1, 2008, and does not extend into the future.

For more information, see:

• Wall Street Journal Smart Money Article
• This blog entry

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 "Section 409A"--Section 409A of the Internal Revenue Code requires the inclusion in income of deferred compensation paid pursuant to a deferred compensation plan that fails to meet certain requirements, or that is not operated in accordance with certain requirements.  

If a deferred compensation plan fails to meet the Code's requirements, or is not operated in accordance with the Code's requirements, then all compensation deferred under the plan for the taxable year and all preceding years must be included in gross income for the tax year to the extent not subject to a substantial risk of forfeiture or not previously included in gross income.

If compensation is required to be included in gross income under Section 409A, the tax imposed by 409A for the tax year is increased by interest and an amount equal to 20% of the compensation which is required to be included in gross income.

Compensatory stock options and compensatory warrants are subject to Section 409A, and under Section 409A all such options must be granted at fair market value on the date of grant.  If a compensatory option is granted at below fair market value, the amount that must be included in income is the spread between the fair market value and the exercise price upon vesting, plus 20% of that amount, plus interest.  

Non-compensatory warrants, such as those received in connection with making a loan, are not subject to Section 409A, although they raise other tax issues.

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Under Section 83(a) of the Internal Revenue Code, a taxpayer who receives property in connection with the performance of services must generally recognize as ordinary income the difference between the value of the property and the amount paid in exchange therefor at the first time the property is either transferable or not subject to a substantial risk of forfeiture. Section 83(b) allows a taxpayer who receives property in connection with the performance of services that is subject to such restrictions (e.g., nonvested property) to elect to recognize this income at the time of transfer.  The principal benefit of a Section 83(b) election is that the taxpayer can lock in appreciation which is generally taxable at capital gains rates upon later disposition.  

For example, suppose a startup company founder is issued founders' stock that is subject to a company repurchase at the stock's cost, but the repurchase right lapses over a service based lapsing period.  This founder has received stock, but because the stock is subject to a substantial risk of forfeiture (the at-cost repurchase right lapsing over the service based vesting period), the founder does not have to pay tax on his receipt of the stock until it vests.  However, the founder may prefer to make a Section 83(b) election to pay tax on the value of the stock today because its value is lower than it is expected to be when it vests--or because the founder paid full value for it today, so the Section 83(b) election costs him no additional tax today.  The making of the Section 83(b) election also starts the founder's capital gains holding period.

It is a common misconception, but a Section 83(b) election generally cannot be made with respect to the receipt of a private company stock option.  You must exercise the option first and acquire the stock before you can make a Section 83(b) election, and you would only make a Section 83(b) election in that instance if you exercised the option and acquired unvested stock (if the stock acquired on exercise of the stock option was vested, there would be no reason to make a Section 83(b) election).

Another common misconception is that Section 83 does not apply to restricted stock that is purchased at fair market value.  This is not true.  Section 83 applies even to stock that has been purchased at fair market value, if the stock is subject to a substantial risk of forfeiture and received in connection with the performance of services.  See this case, Alves v. Commissioner.

An 83(b) election has to be filed with the IRS within 30 days of receipt of the property, a copy has to be filed with the tax return of the person making the election, and a copy must be provided to the company.

Additional information about making the election can be found here.

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The alternative minimum tax (the AMT), is an alternative tax regime Congress originally enacted to prevent high income taxpayers from not paying any income tax at all.  The AMT is calculated by first calculating regular, ordinary taxable income, and then adding to that tax base items excluded from the regular tax base to determine alternative minimum taxable income (AMTI).  Then, after an exemption amount is applied, AMTI is subject to a flat tax--whichever tax is higher, the ordinary income tax, or the AMT, the taxpayer owes.

Most importantly to early stage startup companies is this--that the spread on the exercise of an incentive stock option is an AMT adjustment.  Meaning, that even if the option was granted at FMV, so that there is no income on grant, nor ordinary income on exercise--there is potentially a dramatic AMT impact on exercise.  Beware!

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