Posted on November 21, 2009 by Joseph M. Wallin

Common Mistakes In Starting A Company & How To Avoid Them

 I frequently meet with entrepreneurs after they have created their business entity and put some of the initial legal documentation in place.  I frequently see the following mistakes, which can be easily avoided and save time and money for entrepreneurs later.

  • Forming a Washington limited liability company and indicating in the Certificate of Formation that it is member managed.  This means that any member has the apparent authority to bind the company to contracts, even passive, non-actively involved investors.  You want to indicate, if you form a limited liability company, that the entity will be manager manged.  This signals to the world that the management is centralized and that all members do not have the apparent authority to bind the company. RCW 25.15.150.
    • Keep in mind that the Certificate of Formation on the Washington Secretary of State's web site, which you can find here, does not allow you to indicate whether the LLC will be manager or member managed.  It defaults you to member managed, which is typically not desirable. (The online application form, by the way, as opposed to the form, does include a prompt and a place to indicate manager or member  managed.)  I would recommend you use this example certificate of formation. 
  • Forming a Washington corporation using the Articles of Incorporation form from the Washington Secretary of State's web site.  If you do this, your corporation will have the following characteristics, which you generally want to avoid:
    • You will have cumulative voting.  RCW 23B.07.280.
    • You will have statutory preemptive rights.  RCW 23B.06.300.
    • You will not have the ability for the shareholders to act by less than unanimous written consent.  RCW 23B.07.040(ii).  
    • You will not have released the directors from personal liability to the maximum extent permitted by law.  RCW 23B.08.320 ("The articles of incorporation may contain provisions not inconsistent with law that eliminate or limit the personal liability of a director to the corporation or its shareholders for monetary damages for conduct as a director, provided that such provisions shall not eliminate or limit the liability of a director for acts or omissions that involve intentional misconduct by a director or a knowing violation of law by a director, for conduct violating RCW 23B.08.310, or for any transaction from which the director will personally receive a benefit in money, property, or services to which the director is not legally entitled.").
    • You will not have provided indemnification to directors to the maximum extent permitted by law.  RCW 23B.08.560.
  • If you intend for your corporation to have maximum flexibility to move forward to raise capital from third parties, you will want your Washington articles of incorporation to specifically state (i) no cumulative voting, (ii) no statutory preemptive rights, (iii) shareholders can act by less than unanimous written consent, and (iv) maximum protection for directors.
  • Not obtaining from the founders a clear assignment of intellectual property to the company.
  • Executing initial founder agreements which require unanimous consent of all of the parties to amend them, allowing one founder to veto the ability of the company to move forward.
  • Making equity arrangements with service providers without written documentation clearly defining the terms of the arrangement and services to be provided, over what time and what milestones are required.
  • Not imposing vesting on founders whose continued service is a condition to their receipt of their founder shares.
  • Attempting to form an S corporation and not having spouses in community property states execute the Form 2553 (a spouse in a community property state has to execute the S election form if the stock in the S corporation is community property, even if the stock is titled in the name of the other spouse; see the Instructions to Form 2553, and see Rev. Proc. 2004-35).

What to do if you are an entrepreneur and want to get off on the right foot?  Call and ask for an example form of Certificate of Formation or Articles of Incorporation and a free consultation.  You can reach me at 206-757-8184 or my partner Stuart Campbell at 206-757-8017.
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Posted on July 15, 2009 by Stuart Campbell

Liquidity for Employees - Facebook's Unique Solution

This week Facebook announced that an investor agreed to acquire up to $100 million of common stock from Facebook employees, which as I observed is a unique opportunity for private company employees. bloomberg.com/apps/news

Investors sometimes permit founders to achieve liquidity with respect to a portion of their equity holdings. This is typically accomplished either through the investor’s direct purchase from the founder of some of the founder’s common stock or by the company’s use of the funds invested by the investor to redeem a portion of the founder’s common stock. Facebook’s transaction is unique in that it extends this founder liquidity concept to employees, who typically have to wait for a company sale or public offering to achieve liquidity. Presumably Facebook’s board and management helped to negotiate this arrangement to reward long-time employees who have contributed to the company’s valuation growth over the past few years.

Such a transaction must comply with applicable securities laws and presumably includes an express acknowledgement by each selling employee that he or she realizes that the value of the shares being sold could rise and a release of all claims to any such future appreciation. While the Facebook transaction is very unique, given the state of the public markets such transactions may become more common.
 

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Posted on June 21, 2009 by Joseph M. Wallin

What Type of Equity Incentive Should I Grant My Employees?

Startups frequently have to answer this question:  What type of equity incentives should they grant their employees?  For C corporations and S corporations there are generally 4 possibilities:

  • nonqualified stock options (NQOs);
  • incentive stock options (ISOs);
  • restricted stock; and
  • phantom equity.

ISOs are stock options that qualify for the special tax benefits under section 422 of the Internal Revenue Code (no ordinary income tax on exercise—but watch out for AMT (alternative minimum tax)—and capital gain on sale if 2 holding periods are met).  Among other restrictions, ISOs (a) can only be granted to employees, pursuant to a shareholder approved plan; (b) must have a term not greater than 10 years (or 5 in certain circumstances); (c) must have an exercise price not less than fair market value as of the grant date (or greater in certain circumstances); and (d) not more than $100,000 in value can vest in any 1 year.  By restricted stock, I mean actual stock issuances, subject to repurchase rights at cost (or similar restrictions), which restrictions lapse over a vesting period.  And by phantom equity I mean a wide range of contractual arrangements (such as stock appreciation rights) that are not actual shares of stock, but are designed to approximate the rewards of stock ownership.

The type of equity award a company should grant its employees depends in part on the stage of the company.  For very early stage companies the tax consequences of restricted stock can be favorable (employee starts capital gains holding period) and bearable (meaning the tax owed upon grant, if there are no repurchase restrictions, or in connection with filing an election under Section 83(b), if there are restrictions, is not too painful).  However, once a company's value has gone up, such that issuing inexpensive stock from a tax standpoint is too expensive or too uncomfortable, I usually recommend companies use NQOs for the following reasons:

  • The potential benefits of ISOs (no tax on exercise (as opposed to ordinary income on the exercise of an NQO), and nothing but capital gain on sale) are rarely in fact realized.  Usually the holding periods to obtain these benefits aren't met, and the employee then has ordinary income when the stock is sold in a liquidity event;
  • The AMT consequences to an employee upon an ISO exercise are frequently more significant than expected (and being surprised that you owe more in tax than you expected is never good);
  • The company gets a tax deduction on the exercise of an NQO;
  • NQOs are less complex (you don't have to worry about AMT adjustments, the consequences of not meeting holding period requirements, etc.);
  • NQOs are more transparent from a tax reporting perspective because you calculate and have to make estimated tax payments up front at exercise (which reduces the likelihood of a surprise at tax return filing time);
  • Restricted stock is not as favorable because employees lose control over the timing of the incidence of the tax (if no Section 83(b) election is made at grant, restricted stock is taxable upon vesting (when the value may be significantly greater than at grant, meaning much more tax is owed than might have been initially expected), as opposed to an option which is taxable when the employee decides to exercise). Having some control over the timing of the incidence of the tax is important; and
  • Phantom stock or similar arrangements tend to be complicated and employees view them as inferior to actual stock options.

The table below summarizes some of the key federal income tax consequences of each of these types of awards. It is a high level summary only.  If you want more detail, please contact me.

Tax Consequences

NQO Priced at FMV at Grant

ISO Price at FMV at Grant

Stock Grant

At Grant

None (as long as priced at FMV)

None (as long as priced at FMV)

Taxable unless subject to vesting restrictions, or even if subject to vesting restrictions, taxable if the recipient elects to be taxed immediately by filing an 83(b) election within 30 days of receipt

At Vesting

None (as long as priced at FMV)

None (as long as priced at FMV)

Taxable if not already taxed; tax based on FMV of shares on vesting (income and employment taxes due at this time for employees)

Upon Exercise

Taxed as ordinary income (income and employment taxes due at this time)

No ordinary tax; AMT adjustment (watch out, can be very significant)

Not applicable

Upon Sale

Capital gain (short term or long term depending on time passed since exercise)

Capital gain if holding periods are met (2 years from grant; 1 year from exercise); otherwise, ordinary income)

Capital gain (short term or long term depending on time passed since the value of the shares was taken into income)

 

 

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Posted on April 12, 2009 by Joseph M. Wallin

Can An S Corporation Have Voting and Non-Voting Stock?

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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