The Case of the Late Co-Founder

January 13th, 2009

This situation comes up for me all the time and it is really hard to manage in a way that makes everyone happy.

The scenario is that founders A and B start a company and split the initial shares.  Time passes, business happens.  The company may or may not take on investors or issue equity to employees, but the business grows one way or another to the point that even by the most conservative valuation methodology- free cash on the balance sheet- the company can no longer justify the super-duper-low stock price the founders paid.

Person C them comes into the picture.  C is an extremely high-powered executive who can bring tremendous value.  A and B want to treat C as effectively a co-founder and give her a share of equity equal to theirs.  The challenge is that since the company now has real value, C’s share of it can be expensive.

A, B and C come to me and say “please do your legal magic and make this all work out right”.  Sadly, there is no magic here, just a bunch of unhappy compromises.  There are three main intertwined issues: how much the stock costs, when to pay for it and what the tax consequences will be.  Here’s my shot at acknowledging them and pointing out the options in 500 words or less.

What the Stock Costs
This is simple on its face.  Per share value = company valuation / number of shares.  The valuation number is the toughest variable to work out, and the methodology we use depends in part on IRS rules.

When to Pay For the Stock
Wherever possible, we want to buy the stock early.  Owning stock outright starts the capital gains clock ticking and that can make a big difference when the company is sold (the SEC’s Rule 144 holding period starts at the same time).  Owning a stock option does not count toward the capital gains period until the option is exercised.

What are the Tax Issues to Dodge?
The two big ones are capital gains rules, which require the stock to be held for one year before it is sold, and Section 409A, which imposes a penalty on stock or options issued as “deferred compensation” (i.e. basically any equity issued now and paid for later) if the stock or options are issued at a price deemed below fair market value (more on 409A here).

And here are the preferred ways to handle this situation, with their attendant drawbacks.

Buy the Stock
This is the cleanest option.  Buying the stock outright avoids 409A issues completely and starts the capital gains clock.  In my experience, though, most people do the math and decide that a year or two of sweat equity is one level of risk, but cash is something else entirely.  Most people opt not to take this option, especially when the price is in the 5, 6 or 7 figure range.

Stock Options
This used to be everyone’s favorite way to handle this situation, and it may still be the best.  If the company has real value, co-founder C could have a huge bill to get her stock.  Options let her defer payment of the price until she knows the company is going to be worth something (esp. the night before the company is sold).

409A throws up one roadblock here.  To avoid the 20% penalties, the company will need a valuation of its stock.  This is often manageable, though no one likes paying ~$10,000 for the valuation.

The bigger drawback is that she will probably lose her shot at capital gains treatment.  She would need to exercise a year before the company is sold to get into capital gains land, and if the exercise price is high that may not be feasible.

Historically, more of my clients have elected this option than any other.  No one likes paying taxes, but at least this option limits the risks (assuming the 409A issue is handled well).

Promissory Note
Back in the dot-com days this was popular.  Executive buys the stock and gives the company a promissory note for the purchase price, intending that the company would either forgive repayment or Executive would repay it from sale of the stock in a merger or IPO.  When the companies hit the wall, however, bankruptcy trustees seized on these notes as collectible debt and a number of very unhappy conversations followed (“you mean I got almost no salary, my stock is worthless *and* I need to pay you $200,000?!?”).

A promissory note would work for C’s purposes, but it carries a lot of risk.  It is a promise to pay the company and if things don’t go as expected C can find herself not merely uncompensated for her time spent with the company, but actually owing money to it.  Once in a while a situation arises where this arrangement can make sense, but it is rare.

Is That It?
That’s what A, B and C always ask me when we talk through the possibilities.  Unfortunately the answer is yes.  We use the most favorable valuation we can justify to bring the price down (assuming we have any flexibility there), but in the end the whole purchase price must be paid.  C can pay up front or she can pay later, but there is no way to do what clients really want- which is to sneak C in at the original founder price.

The lesson?  There are two, I think.  (1) get in as early as possible; and (2) get your stock documented right when you arrive before the deal gets any worse.

Reblog this post [with Zemanta]
Tags: , , , ,
  • Comments Off on The Case of the Late Co-Founder

Why Deferred Salaries Don’t Work for Startup Founders

September 4th, 2008

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one’s mind around.  The argument goes something like this:

“I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point.”

My humble suggestion is always the same- don’t think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your “deferred” salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company’s accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be “extra cash” available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company’s bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don’t see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don’t realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no “advisory” options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

Tags: , , ,

Slow Steps Into the Digital Age at the IRS

February 20th, 2008

For those who have never filed form 1099 before, one copy (red) goes to the IRS and another (black) goes to the independent contractor who provided services to a business. Apparently the reason for this is that the IRS’s computers scan the filings, and they can only read forms printed with red ink.

One can’t download the fileable form, because the shade of red must be very specific and a normal color printer can’t be trusted to get it right. One must have the forms mailed out or buy them from an office supply store.

About.com tells me that the Social Security Administration updated its systems to accept black copies of form W-2, but the IRS has changed its systems twice without adding this magical ability.

The IRS does allow 1099s to be filed electronically. This is a great step forward- it fairly leapfrogs the whole download/print/mail correct-color routine.

*However*, while thousands of businesses everywhere have figured out how to create online forms viewable and editable in any web browser, AND have worked out a way to let consumers create accounts online in minutes (if not seconds), the IRS is not quite there.

So in order to conveniently file my 1099s online, I must first mail in a form to the IRS, receive a Transmitter Control Code back by mail, and then download and install the IRS’s special form-creation software.

Identity theft and fraud are certainly big concerns so I can understand the need to verify identity before setting up accounts. Putting documents in the mail is not a remedy here though (the IRS should ask Network Solutions about Stephen Michael Cohen and Sex.com on this point).

The IRS has a huge job managing millions of accounts. They are certainly correct to be careful, and kudos to them for getting on the e-filing program. My wish, though, is that after Microsoft takes over Yahoo and drives away key employees, that the IRS will see an opportunity to pick up some Internet expertise. Yahoo has great e-commerce software. Get some of the engineers behind it working on IRS e-file programs for all kinds of filing.

Tags: ,