There are a few baby steps every new business must take before it can run. This eBook will help you launch and prepare your company to move to the next stage in development. It is crucial that your business establish these foundational elements before moving on to the next phase.
The importance of creating a business plan cannot be overstated. It is vital to your company's sustainability, so let's dive into the details - while each business plan is unique, they should all contain these core components:
This summarizes the entire business plan by identifying the market need, how you plan to address it, who your key managers are, and your financial projections.
Your mission statement is your bridge between today and the future. What does your business offer? Why are those offerings important in today's market? Why should customers choose you over the competition? These are critical questions to ask yourself when shaping your mission statement.
This is about your products or services, your competitive advantage, operations, distribution, and core competencies. An investor should be able to read your synopsis and easily gain a firm grasp of your business and strategy.
The Market Analysis is a thorough assessment of the market within your industry. In this section, you will discuss market dynamics such as volume and value, buying patterns, the competition, and how you fit in.
This is your chance to brag on your team. Tell your potential investors who will be managing your company and where they come from. Highlight their experience and establish a clear picture of how they will contribute to the success of your company.
A SWOT analysis identifies your company's internal Strengths andWeaknesses, and its external Opportunities and Threats. This tool helps you determine what your company does well now, as well as construct a successful strategy for the future.
The financial assessment section of your business plan should be composed of four financial statements: the income statement, the cash flow projection, the balance sheet, and the statement of shareholders' equity.You should also include a brief explanation and analysis of these four statements.
This is where you will discuss how you plan to leverage business opportunities, minimize threats, and market your product or service.
This is where you will outline your objectives and what concrete actions you will take to achieve them.
Choosing a Name: Building Your Brand Value
Consumers often associate a "brand" with a particular company, logo, or trademark. Coca Cola and Apple, for example, are easily recognized by their logos.
However, is important to recognize that a brand is a more than just a name or design; it is a company’s reputation. It is what people think or feel when they hear the name, or see the logo. It is about the value that the company provides to the consumer.
Accordingly, choosing a company name requires careful consideration.
Our first recommendation is to keep your name short. The more concise the name, the easier it is for the consumer to recall. Take Google, Skype, Facebook or Twitter, for example. These are well known brands that are all limited to one word, with less than three syllables.
Shorter names are not only more memorable, but will make practical aspects of your branding easier for marketing purposes, such as branding merchandise or claiming a twitter handle.
Remember: you are creating a brand, not just a name. So getting it right from the very beginning is a crucial part of your overall marketing strategy.
Once you have chosen a name, you need to ensure it is not already in use. It is imperative to check your name's availability at both the state and federal levels. Here's how:
Search the Secretary of State's online business records for the state in which you are incorporated
Search the internet
Search domain registries
When you have confirmed the availability of your name, you should file a trademark application. You can do this at both the federal and state level. Lloyd & Mousilli can help you determine i
Obtain a Domain
Once you have determined that your name is available, you should immediately register it with a domain service like GoDaddy. This will serve as a placeholder for your website and prevent others from using the same name.
Apply Online for an EIN
You will need to secure an Employer Identification Number (EIN) in order to open a business bank account.
An EIN is a 9-digit number used to identify a corporation for tax and banking purposes. Most banks will not open a business account in the corporation’s name without an EIN.
Business licenses are usually required by state and local government. If you are working outside of your home, you will at a minimum need to apply for a local business license with your city or town. Depending on your location and industry, you might also be required to register with the state for sales tax, unemployment, and other certifications.
You can check for license requirements with the Secretary of State, as well as with the Small Business Administration (SBA) at sba.gov. The SBA has a free online library of information and resources, including a list of each state's individual licensing requirements.
The type of insurance coverage you will need is determined largely by the type of business you are operating. Workers’ compensation is required at the time you hire your first employee, and property insurance is often a condition in standard commercial leases. Once you incorporate, you will want to consider E&O (Errors and Omissions) and D&O (Directors and Officers) coverages, depending on your industry. Liability insurance should be discussed with your insurance agent, and you should consider group health insurance to reduce the cost of your insurance premiums.
Social Media & Website Development
If you’re on a budget, consider using a website builder like Squarespace or Launchrock to immediately begin acquiring customers. At a minimum, the landing page verifies your credibility. One of the staples of a legitimate website in today’s marketplace is social branding. This means that your landing page should include links to your principal social media sites like Facebook, Twitter, and LinkedIn. This will require you to register your company’s profile with these platforms, in addition to any others that are relevant to your business.
Choosing your Company Structure
If you are ready to start approaching investors or customers, then you will need to think about incorporating a business immediately in order to reduce your liability exposure, minimize costs, and demonstrate your credibility.
When incorporating a business, whether as a C-corporation, a Limited Liability Company (LLC), or any variation thereof, the new entity is treated legally and financially as a separate person. This is often referred to as the “corporate veil,” and it protects your personal assets from any liabilities that the company incurs.
Additionally, incorporating a business will offer you tax benefits. The caveat here is that you need to ensure that the type of entity you choose is appropriate for your business and future needs. Tax planning is definitely a critical consideration when incorporating; it is strongly recommended that you consult with a qualified business attorney or accountant before diving into the incorporation process.
For example, if you are a high tech startup with intellectual property and are planning to raise capital in future financing rounds, a C-corp might be a better choice than an LLC. On the other hand, if you are an environmental consulting firm with industry clients, but you don't need to raise capital or own intellectual property, you may consider an LLC with subchapter S selection. This will minimize your tax burden and give you more flexibility.
Where should you incorporate?
Incorporating has seemingly never been easier. Whether you are registering directly with a state’s business division online or opting for templatized corporate documents on DIY legal sites, there are some tempting quick and inexpensive options for startup founders.
However, without sufficient information, a founder may discover too late that they have chosen an entity type that is less than ideal for their business. Deciding which entity looks the most appealing without the guidance of an experienced business attorney could expose you to higher costs and liability.
If you are planning on incorporating your business yourself, you should carefully consider which state makes the most sense for your business. It is well-known in the business world that Delaware is a popular state to incorporate in. However, it may not be the best option for every company.
When is Delaware the right choice?
Delaware is home to 50 percent of all publicly-traded companies in the United States, and nearly 65 percent of all Fortune 500 companies. In short, Delaware is no stranger to big business. Banks tend to favor Delaware because of its high cap on the amount of interest they can charge borrowers, and Venture Capitalists (VCs) are attracted to the state's tax benefits.
There are two principal reasons why most tech startups incorporate in Delaware: (1) they are incorporating a business as a C-corp, and (2) they expect high growth.
Before taking any steps towards incorporating a business, it is in your best interest to seek legal guidance. Many people incorrectly assume that Delaware is the best state in which to incorporate when often there are better options.
Approximately one-half of all states have adopted the Model Business Corporation Act (MPCA), making corporate law governing both public and private business uniform throughout much of the county. While Delaware remains a notable exception, more and more states appear to be adopting the Act, leaving little variation between most states.
As a general rule, if you are a tech company that expects rapid growth, Delaware may be the best choice. Since Delaware's state laws highly favor corporations, corporate lawyers across the country are generally familiar with the state's laws.
Delaware offers C-corps the greatest flexibility in terms of structuring the company's board of directors, stock issuance and preference, and voting rights. It also provides the broadest privacy protections. For instance, it does not require director or officer names to be disclosed on formation documents.
Other benefits of incorporating in Delaware:
Chancery Courts that specialize in business and corporate law
No jury trials
Management-friendly laws that allow directors to reserve substantial power
No corporate tax on out-of-state Delaware corporations (although franchise taxes are required)
No inheritance tax on non-resident shareholders
No tax on shares held by non-residents
For these reasons, many investors prefer Delaware C-corps. However, even if you are a tech startup with no plans to go public, you should seek legal advice from a home state attorney to explore your options.
When is a different state a better fit?
If you are a small, early stage startup with no intentions of seeking venture capital or institutional financing, and you do not have plans for an Initial Public Offering (IPO), then incorporating in the company’s home state could make the most sense.
If you are incorporating a business in Delaware, but will be doing business in another state, you will still need to register in the other state as a foreign business entity. In addition, you will be required to file periodic reports in Delaware, as well as other states you do business in. Moreover, Delaware requires that you regularly submit franchise taxes, even if you are already paying those taxes to the state(s) in which you are already doing business.
A perk of incorporating in Delaware is that it takes very little time to complete the incorporation - typically just under a month. However, many (if not most) other states enable you to incorporate online with the Secretary of State’s Office in just a few minutes – and often for a lower fee than Delaware.
Many companies do not require C-corp status. Filing as an LLC with subchapter S selection or another type of entity that’s not a C-Corp – especially when there’s no expectation of going public – is usually best done in the state where the company is conducting business.
Operating in certain industries may mean that you must incorporate in your home state. One of the fastest growing unique industries, for example, is the cannabis industry. As of December 2015, 23 states and the District of Columbia currently have laws declaring marijuana legal in one form or another.
Colorado, Washington, Oregon, Alaska, and the District of Columbia have all legalized both recreational and medical marijuana. A number of other states have either decriminalized marijuana, or are allowing possession of derivative products. For example, Georgia Governor Nathan Deal recently signed a law legalizing the possession of up to 20 ounces of cannabis oil.
With another eight states expecting to legalize marijuana to one extent or another within the next couple of election cycles, everyone from lighting manufacturers, to irrigation companies, to Wall Street venture capitalists are trying to keep up with the best course of action when incorporating.
For some, incorporating will be limited to only those states in which they are qualified to do or own a cannabis-related business; for others, equity ownership might be impossible, but other structuring mechanisms are available.
Generally, where you are incorporating a business is not going to affect the decisions of most people, with the exception of perhaps investment bankers and investors who are considering a fast growing C-corp that is planning on a future IPO, high tech or otherwise. Once again, consulting a knowledgeable business attorney will be your most worthwhile investment.
Determining the right type of entity
Selecting the right business structure is one of the most important choices you will make. It will impact virtually every aspect of your business including regulatory compliance, employment obligations, tax and legal liabilities, and your ability to attract investors.
There are three principal types of corporations: C-corporation, S-corporation, and Limited Liability Company (LLC). Knowing your business needs and goals will dictate which structure will best serve your interests and accommodate your growth.
Important questions to ask before incorporating
Tax Liability: How can you promote your company’s growth, while minimizing your tax burden?
Formation Costs: What are the costs of incorporating in more than one state, including maintaining a registered agent?
Costs: What are the costs associated with administrative compliance including filing annual reports, fees, and related taxes (e.g., Delaware’s franchise taxes)
C-corporations are generally most popular with companies that are planning to participate in equity or debt financing, raise funding through multiple financing rounds, and that aim to go public. If you are considering venture capital, then a C-corporation would best suit you since VCs are unable to invest in S-corporations and are generally hesitant to invest in LLCs.
S-corporations are favorable for startups that will not be seeking equity or debt financing through venture capital funds, do not plan to go public, and do not foresee having more than 100 members. The chief advantage of an S-corp is that it provides tax benefits on distributions. Distributions are excess profits, which are the sums remaining after salary and payroll expenses (e.g., FICA) are deducted. At this point, the remaining profits are characterized as dividends and can be distributed to the owners at a lower tax rate than ordinary income.
LLCs are most attractive to companies with objectives similar to S-corps, except that they have more flexibility. For instance, like an S-corp they are pass-through entities, so the owners do not get hit with double taxation since income from the entity is paid only by individual members, not the entity itself. Unlike S-corps, an LLC can have more than 100 members, can be owned by or own another entity, can have more than one class of stock, and can be owned by non-residents. They are also less expensive than S-corps to form and maintain. S-corps require more administrative attention, especially with respect to compliance with strict IRS regulations and oversight.
A Snapshot of the Critical Differences Between Each Entity Type
Limited liability for owners
Unlimited number of shareholders / members
Income of entity taxed separately from owners / shareholders
Income of entity not taxed – passes through to individual owners / shareholders
Foreign ownership is allowed
Entity can be owned by or own other entities
More than one class of stock / ownership interest is permissible
Shareholders / members can deduct business losses on individual tax returns
These guidelines can equip you with the knowledge you need to make the right decision regarding your company's corporate structure. However, engaging with an experienced corporate attorney will assure you of that decision, and possibly save you from costly mistakes. Using this information as a basis for selection after discussing your specific business needs with a lawyer is always recommended since every company's circumstances are unique.
Compensation: How To Properly Pay Employees
In order to adequately assess how best to compensate your employees, you will need to gauge your appetite for risk and understand your business needs. A realistic appraisal of these essential business components will govern your staffing strategies.
For example, a consulting startup is going to have fundamentally different staffing needs as compared to a tech startup. How you structure compensation will depend largely on these considerations.
A small consulting firm, for instance, may simply need an administrator to assist with general housekeeping, like organizing files, scheduling appointments, and interacting with clients. Similarly, a marketing start-up might need an entry level graphic designer. Employees in these types of positions will typically expect a regular paycheck.
On the other hand, a high tech startup will usually have a need for more sophisticated staff. Inventors, software experts, biotech professionals, and engineers might be the only personnel who can contribute to any meaningful growth and sustainability.
When it comes to deciding how to compensate your employees, there are options that can give you the flexibility you need to meet the needs of both the company and valuable staff.
Wage and hour compliance is governed by the Fair Labor Standards Act (FLSA). For FLSA purposes, employees are generally classified as exempt or nonexempt, depending on their salary and the type of work they do.
Exempt employees typically fall under one of the specified FLSA categories. The most common are white-collar professionals, and they are exempt from overtime requirements. This option is appealing to employers since they are not required to pay overtime or keep track of their time. However, since it is an exception, the employer bears the burden of proving the legitimacy of this classification.
One more thing to keep in mind is that exempt employees who are paid salaries or commissions are entitled to receive earnings that must equal $7.25 an hour, or higher where the state law provides for a greater rate. For instance, an employer is prohibited from paying an employee a salary of $250 per week since the minimum wage requirement would place a salary based on a 40-hour week at $290 dollars.
Nonexempt employees are those who are paid by the hour. Since they are nonexempt, employers are legally required to pay them not only the minimum wage, but also overtime. The federal minimum wage is $7.25. However, 25 states have minimum wage rates that are higher than the federal minimum wage. When state minimum wages are greater than the federal rate, then the FLSA obligates the employer to pay nonexempt employees the higher of the two rates. Conversely, some states have minimum wage rates below the federal standard. In this scenario, employers must pay employees the federal rate of $7.25 per hour. Additionally, the FLSA requires employers to pay nonexempt employees one and a half times the employee’s hourly wage for overtime. Overtime is any amount above 40 hours per week.
There are numerous other FLSA and state law wage and employment requirements. For instance, the FLSA obligates employers to provide employees with breaks. Furthermore, while an employer might wish to offer comp time (time off) to an employee in lieu of paying overtime, this is prohibited with respect to nonexempt employees.
While the FLSA will remain uniform, state law will vary. Consulting a knowledgeable attorney in this area is highly recommended.
Founders of early startups sometimes offer key employees who can help grow their business equity in lieu of or as a supplement to wages. This is a popular choice of compensation for bootstrapped tech startups.
This choice tends to take the form of stock options, which are used to incentivize employees who can benefit from the increasing value of the stock’s price. The value is theoretical at the outset since a young company usually does not have a valuation: there are no customers, purchase orders, or assets. For companies that are planning on going public and have a promising future, this can be a very appealing option to an employee.
The typical equity grant for early hires is about 1-2 percent of the company’s outstanding shares. Outstanding shares are the number of shares that a company is legally permitted to issue pursuant to its incorporation documents; issued shares are the actual number of shares that the company has issued.
Stock options make the most economical sense for more sophisticated startups with a relatively developed staff (senior management, rank-and-file, etc.). Since creating an options program is time intensive and requires highly specialized legal expertise, they are quite costly to implement. Therefore, creating a stock options program for just one employee does not usually justify the cost, but if you are planning to develop a highly skilled staff, then offering options could be the right choice.
Caveat: Compensating employees only with stock or stock options is generally not considered wages for purposes of minimum wage calculation. Accordingly, this type of arrangement can easily violate minimum wage laws. While there might be ways to structure this type of compensation package, they are very narrowly construed and require robust legal skill. If you are thinking about this option as compensation, engaging an experienced attorney is essential in order to avoid fines or legal action, or both, that could impair your company’s brand and value.
Cash & Equity
When stock is used as a component of compensation, it is vital for the startup to accurately value shares. Failure to do so can result in sharp penalties, as well as damage to the company’s reputation and value. Also, it is crucial to understand that the company will still be legally required to submit payroll taxes based on sweat equity.
Similarly, correctly characterizing your employees as exempt or nonexempt is crucial to ensuring legal compliance. As noted earlier, mischaracterizing an employee as exempt can result in steep consequences. In addition to interest, fines and penalties, a company will also be required to account for and pay any overtime to employees who were incorrectly characterized as exempt.
In some instances, the company’s executive officers can be subject to criminal penalties, including imprisonment. Therefore, even if a startup believes that an employee is exempt, it is prudent to still maintain accurate records reflecting the employee’s time. There is a large variety of inexpensive employee time tracking and management software available This is an essential compliance tool, so make sure you integrate it into your management from the outset.
Using equity compensation can be useful, but also costly since it demands professional administration, usually by an accountant or an attorney. If stock is given in lieu of wages or sold for less than its fair market value, the employee can incur unintended tax consequences.
Federal and state securities, tax, and labor laws – among others – will govern stock option plans, so it is paramount to a company to ensure full and accurate compliance. Often, even the most diligent startups learn at some point that their administration of a stock option program was flawed, exposing them to fines, penalties and restitution.
Another potential negative consequence of an incorrectly administered stock option plan is that it can derail a potential acquisition. It is is not unusual for non-compliant stock option programs to be discovered by VCs during a due diligence examination in connection with a financing round.
All of these more common pitfalls can be avoided be engaging legal counsel or an accountant with expertise in establishing a compliant stock option program.
Issuing Stock Certificates
There is a lot of confusion about the necessity of issuing physical stock certificates. The reason for paper stock certificates is to ensure accurate, indisputable evidence of shareholder ownership. While most companies still issue traditional paper stock certificates, the truth is that they are not necessary.
In fact, public traded companies have been using the Direct Registration System (DRS), ditching physical certificates several decades ago. DRS allows investors to elect having their securities registered directly on an issuer’s books. At the heart of the system is ensuring shareholder access to their securities information.
Privately held companies can also use DRS and issue e-certificates. However, before doing so, it’s advisable to check the laws of the state of incorporation since state corporate law varies. For example, California has very specific notice requirements; and while Delaware enables companies to issue e-certificates, it is not requirement.
Startups wishing to issue e-certificates need to incorporate relevant provisions into their operating agreement or bylaws, and ensure general compliance with state corporate law. If your company has already incorporated, but didn’t include provisions to address the issuance of e-certificates, then you need a board resolution to issue uncertificated shares. Additionally, you’ll need to amend your bylaws to reflect the change.
In smaller companies, corporate formalities might be easily overlooked, so it is vital to your compliance to enlist competent legal counsel to help you navigate through the requirements. Also, engaging with an attorney can save you money in the long term since there can be tax and other regulatory implications – whether you’re going paperless or relying on physical certificates.
DRS can certainly save a lot of time and money, but you should consult a lawyer to help evaluate what makes the most sense for your business model. You can also take a look at the Security and Exchange Commission’s (SEC) information sheet available at www.sec.gov that describes the advantages and disadvantages of each type of registration from the investor’s perspective.
The Designated Decision Maker
Smaller startups will usually have a more informal and flexible management style. Being inclusive with a small group is logistically easier; for starters, you can fit everyone in the same room. Decision making can include each person’s input, building important camaraderie.
However, as small companies experience increased growth, it can become challenging to include everyone’s opinion and feedback. On a practical level, it will usually be inefficient since it will take more time and effort to coordinate scheduling; meetings will take longer; and formal rules of order can be counterproductive.
At the same time, a new company is – by design or by default – creating a corporate culture. Its core values, actions, and beliefs will determine how a company engages with its employees and handles external transactions with vendors, colleagues, strategic partners and others.
Aside from the cultural aspects of decision making, a company’s legal formalities will dictate who ultimately has responsibility for the company’s overall management.
If you are a small startup incorporated as an LLC or S-corp, then the founders are the shareholders. They have the responsibility to ensure a company’s legal and regulatory compliance.
A small C-corp could have one person fill the role as the company’s sole shareholder, director, officer, and employee. A larger C-corp will have multiple shareholders who own the company and elect a board of directors (BOD). The BOD is charged with making business decisions and selecting corporate officers such as the CEO/president, secretary, and treasurer/CFO. They also issue stock and set the price per share.
In a large C-corp, it is the shareholders who must approve the company’s articles of incorporation, bylaws, and mergers and acquisitions.
Ownership: Creating an Option Pool & Issuing Equity
An option pool is a certain amount of stock that a company reserves for future issuance to advisors, consultants, directors, and employees. It is a very specific legal creature that requires great skill in drafting and executing since it is governed by the 1933 Securities Act.
Many startups – particularly in the tech industry – offer key hires options as part of their compensation package. Not only do options help bootstrapped startups fill in the compensation gaps where cash is in short supply, but they also tend to align the interests of the employee and company by instilling in the employee a sense of ownership and commitment to the overall success of the business.
Allocating approximately 10-15 percent of your authorized shares to an option pool is the norm. This means ensuring you have authorized an adequate supply of shares at the time of incorporation. Startups may feel anxious or shy about issuing millions of authorized shares, but it is crucial that a company optimizes its flexibility to accommodate for future growth. Reserving an ample supply for future investors and employees requires long-term planning.
If you are planning on multiple financing rounds and significant staff expansion, then you want to do a couple of things: (1) authorize enough shares when you incorporate, even if the number seems ridiculously high; (2) make sure to specify the lowest par value per share no matter how unrealistic it may seem; and (3) be judicious in the number of shares you distribute among early founders and to employees.
Issuing Equity To Founders And Early Team Members
Recent years have seen the rising popularity of restricted stock units (RSUs) offered as an alternative to more traditional stock options.
Stock options essentially give you the right to buy shares at a certain price (the strike price) after a vesting period – typically, after your one year anniversary date, with 25 percent transferred to you each year over a four year period. The key here is that you must purchase the options. Your hope is that by the time you’re eligible to buy the options, the stock has appreciated.
However, stock value could have eroded, deeming it worthless. That is where RSUs come in.
Restricted Stock Units (RSUs)
Restricted stock units (RSUs) are a relatively new financial tool. Similar to options, there’s a vesting period where the employee must satisfy certain conditions before the stock or its value is transferred (typically, there is a period of time and other conditions – e.g., work performance). Unlike stock options, there is no purchase involved. Instead, a certain number of units are allocated – or granted – to the employee, but there is no value or funding until after the employee has satisfied the vesting requirements.
After vesting, RSUs are transferrable if the employee accepts the grant. Therefore, these instruments always have value, in contrast to options that can decline in value by the time of vesting. The value of your RSUs is the closing market value of the stock price on the vesting date. That is also the point at which your tax liability is triggered, requiring you to pay withholding and income tax on the amount received.
Anyone receiving RSUs will most likely be required to file an 83(b) Election Form. The election must be filed with the IRS within 30 days of receiving or purchasing the RSUs. It effectively notifies the IRS that the RSU recipient is choosing to be taxed on their equity on the date the grant was made rather than on the vesting date. If an 83(b) Election Form is not filed, then the IRS will tax the recipient on the RSUs at the time they vest.
What is most important to understand here is that no matter which election is made, both options result in tax at the ordinary income tax rate. Also, the recipient will pay a long-term capital gains tax when the shares are sold. This means that making the proper 83(b) election is crucial to a sound long-term financial strategy.
One last note: unlike some other IRS provisions, the 83(b) Election is strictly enforced. There are no exceptions and no relief is available for late filings. A copy of the Election Form must also be filed with the company.
Stock options give an employee the right to buy a certain number of shares at a certain price (the strike price) at a certain time after they have earned the right to exercise (buy) your options. The employee earns the right to exercise their options after the vesting period, which is typically four years, with a one year cliff. This means that if the employee leaves the company before the end of the first year, they get nothing; if they continue to be employed with the company after the first year, they get 25 percent, and 25 percent each year until they are fully vested after four years.
Employees who are offered options are not obligated to purchase company stock; they simply have the option to buy or not. If the stock is valued above the strike price at the time of exercise, then the the employee can buy it, making a profit when it’s sold; conversely, stock valued below strike price at the time of exercise will be worthless. For example, if an options contract allows an employee to buy the stock at $10/share, and it is selling at $15/share on the day they can exercise their options (after the vesting period), they can buy it for $10/share, sell it for $15/share, and realize a $5/share gain on which they will pay taxes only when they sell. On the other hand, if the stock is valued at $9/share at the time they can exercise their options, then they are looking at worthless stock and are not obligated to buy.
Also, there are different types of stock options with varying tax consequences – e.g., incentive stock options (ISOs) and nonqualified options. Seeking professional guidance is always recommended.
The strike must be set at fair market value of the company at the time of the grant. Under IRS Rule 409A, options are legally considered deferred compensation. This subjects the options holder to tax consequences if certain rules are not closely adhered to.
Rule 409A legally obligates a company’s Board of Directors to set option strike prices at fair market value: if the strike is too low, then the IRS will treat the options as income and collect taxes as soon as they are issued. This, in turn, triggers the company’s legal withholding duties – all of which can be avoided simply by proving the fair market value of the strike price.
When you start a company with another co-founder or offer an employee options or RSUs, you want to ensure that they have a long term interest in the success of the company. If you give them options or RSUs without a vesting period, you run the risk of them exiting too early, leaving you without the value of their commitment, while they walk away with a potentially valuable piece of the company.
Vesting is a mechanism that deters an employee with options or RSUs from leaving a company too early; in order to receive the full value of their shares, the employee must remain with the company for a minimum period of time.
Vesting cliffs are a common feature of vesting schedules. Essentially, a vesting cliff is like a trial partnership. If an employee is granted a certain percentage of equity, it is stipulated that if they quit or are terminated at anytime during the cliff period, then the employee is barred from collecting any equity.
The typical vesting period is four years with a one year cliff. That means that each year, the employee would earn 25 percent of their interest; after four years, they would be fully vested at 100 percent. However, to prevent them from realizing gains too early, there is a one year cliff period. If the employee exits the company before one year, they lose 100 percent of their equity. If they exit after one year, but before two years, they can collect 25 percent of their equity; 50 percent after two years; 75 percent after three years; and finally 100 percent at the end of four years when they become fully vested.
Occasionally, a company will want to speed up vesting to accommodate certain investors. Acceleration clauses are usually relevant to advisors who have successfully led a company to the point that it can be sold or go to IPO while the advisor is still sitting on the cliff. Since their contribution led to your success, it’s only fair to compensate them accordingly. Therefore, accelerating vesting and removing the cliff are commonly found in advisor stock option agreements and RSUs.
Chapter 1 Checklist
In summary, we covered how to…
Start Incorporating a Business
Obtain EIN (the entity’s Tax ID number)
Complete bylaws if a C-Corp or Operating Agreement if an LLC or S-Corp
Open Checking and Credit accounts
Procure Relevant Insurance. Property and General Liability Insurance, Coverage and E&O Insurance
Issue Stock. With Physical Certificates or Registered Online (the more common option)
Ensure Stock Options Comply with all Legal and Regulatory Requirements
File 83(b) Election Form within 30 Days of The Grant