The following is a list of five common legal mistakes I repeatedly see Startups make in issuing equity to founders and early investors:
- Issuing founder shares without vesting. Issuing shares without vesting permits a shareholder to walk away from the business at any time and keep all of their shares. Vesting protects the members of the founding team who take the venture forward. If people remain on the team and are productive, their shares will vest.
- Failing to make a timely Section 83 (b) election. If stock is subject to vesting, it’s subject to what the IRS calls a substantial risk of forfeiture. In such a case, the IRS doesn’t view the purchase as being closed until that risk goes away (i.e., when the stock vests). The IRS then calculates the difference between the price paid at the outset and the fair market value at that later date, then taxes this difference as ordinary income. An 83 (b) election allows the tax computation to be made based on the value at the time the shares are issued, which is often pennies per share.
- Violating securities laws. Any company selling stock or other securities must comply with both the federal and state securities laws by either registering the securities (rare for a start-up) or meeting all the requirements for an applicable exemption. In general, unless you are selling securities under one of the crowdfunding exemptions, only sell securities to accredited investors.
- Not entering into a Stockholder Agreement. Stockholder Agreements and operating agreements govern the relationship among a company’s owners, defining their mutual obligations, privileges, protections, and rights. These agreements create a mechanism for dealing with exits, control, and future disagreements. They can be complex, however, can protect against countless problems in the future.
- Granting anti-dilution rights. I still come across companies that grant full ratchet anti-dilution rights to early investors or founders, which gives them the right to maintain their percentage ownership interest in the company. Any sophisticated investor will require the termination of such rights before investing any capital. Never grant full ratchet anti-dilution rights.
The information contained in this article is strictly for educational purposes and is not intended to be legal or tax advice or to be relied upon by anyone without doing their own research, and consulting with legal and tax advisors.