incorporation

Think About Equity from the Start

When incorporating a start-up company, founders are typically concerned with growing their company and bringing in capital to execute their vision. To properly set the company up for growth, the company needs to have a sound policy for allocating equity. There is not just one correct way for all start-ups to allocate their stock. Rather, there are many considerations that founders must address. The path to a sound corporate equity structure starts from the very beginning. Even before incorporation, meet with your co-founders and discuss these issues to ensure you start the right way.

Dividing Stock Among Founders

After determining the amount of stock your company will authorize, which is the total amount of issuable stock, you will decide how much stock each founder will receive. The number of stock issued to each co-founder should be catered to each co-founders’ involvement and relationship with the company. If one of the co-founders has a passive role in the company’s business operations, it may not make sense to issue them the same amount as someone more involved. Although this may be a difficult discussion to have with your co-founders, it ensures that the ownership of the company rests with the members closest to it.

Executing Stock Purchases and Investments

After determining the appropriate amount of stock each founder should receive, founders will need to execute some form of a stock purchase agreement. This agreement will dictate the terms of each founders’ ownership in the company. The value of each share at an early-stage company will likely be very low, so the purchase price will be small, but it is integral to enter into this agreement.

In these agreements, companies should consider whether they want to include provisions like right of first refusal, IP rights, limitations on transfer, vesting schedules, and other language that will solidify the boundaries of a given shareholders’ interest. A right of first refusal provision will give your company the initial right to buy stock from an existing stockholder that is planning to sell their interest before they can sell it to any other buyer. IP rights provisions will dictate what intellectual property will belong to the company after a stock purchase. Limitations on transfer can include many different provisions that essentially prevent the purchaser from selling their stock unless certain conditions are met. Vesting schedules are discussed below.

Vesting Schedules and Other Restrictions

Founders should determine whether to implement a vesting schedule into their issued stock. A vesting schedule is a time-based restriction to issued stock, typically applied to founders’ and employees’ stock. It incentivizes critical members of the company to stay for the long-term by preventing the member access to all their issued stock until they have been at the company for a certain amount of time.

Founders may feel like a vesting schedule is an unnecessary restriction on their interest in the company but there are a few reasons that implementing a vesting schedule is a good idea. First, potential investors love, and often request vesting schedules. From the investor’s perspective, a vesting schedule provides some assurance that the company’s key members are in it for the long haul. Second, a vesting schedule also provides an assurance to co-founders. It may seem unlikely that any of your fellow founders would abandon the company, but it is helpful to provide an extra incentive to make sure.

Option Pools for Future Use

It is also important to decide how many of the corporation’s authorized stock will be available to issue and how many will be saved for later issuance. As your company grows, you may want to offer employees some type of equity package as compensation. To do so, you would want to set up an option pool that you can eventually pull from. Typically, an option pool should make up about 10-20% of total authorized stock, with the remaining stock allocated among founders, advisors, and investors. It is crucial to decide on an option pool early on because it will dictate your corporation’s total available stock.

Compensate Advisors with Equity

Start-up companies usually benefit from hiring advisors or consultants that are not typical employees but have some sort of expertise that brings value to the company. Allocating equity to advisors is a practical consideration because the start-up may not have enough money to pay a typical compensation and it can be attractive to investors. Since advisors will usually not be involved with the management of the company, they will not be issued a large portion of the company’s stock. When deciding to bring on advisors, consider the value that they are adding and how much time they will be dedicating towards the company, and allocate stock accordingly.

Use a Capitalization Table

A capitalization table, or cap table, is a document (usually on a spreadsheet) that provides a layout of the company’s ownership distribution. After tackling the equity issues raised in this article, it is important to keep an updated cap table that documents how your company has allocated its stock and to whom they allocated it to. Therefore, the table will include all the stockholders, how much they own, what type of stock they own, how much stock the company has issued and how many are still available for issue.

There are several different software platforms that you can use to store your equity documents and produce a cap table for you. Carta and Pulley are two examples of commonly used platforms. The best way to make sure your cap table is properly constructed and regularly updated is to hire a law firm to manage this platform for you. Hiring a law firm administrator is especially helpful for start-ups engaging in multiple financing rounds because expressing the specific terms of each financing instrument can be difficult.

Lloyd & Mousilli is Here to Help

You should consider hiring Lloyd & Mousilli to successfully implement your company’s equity allocation plan. Our firm has helped form hundreds of startup companies, and we have the experience and expertise necessary to set your company up for past, present, and future equity allocation.

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Incorporating a business is the process of forming of a new entity that is recognized as a separate “person” under the law. At the very early stages of your business, you will need to decide which entity is the best fit for your purposes. This is often overwhelming for founders and first time business folks. The three types of entities discussed in this article (C corporation, S corporation, and LLC) all partially shield the individual owners from certain types of personal liability. They each have varying benefits regarding fundraising and stock option grants. They also each result in different tax implications or benefits, and provide your company with greater credibility among investors, clients, and customers.

Some Legal Implications of Incorporating:

• Partial protection against personal liability: A corporation or limited liability company (LLC) partially shields individuals (stockholders, directors and officers) from business liabilities such as loans, accounts payable, and legal judgments. We use the word “partially” because some courts have decided against completely shielding individual owners from personal liability, depending on their behavior and knowledge of the matter. On the other hand, the assets of the corporation or LLC may be protected if an individual is involved in a personal lawsuit or bankruptcy.
  
• Transferable ownership: Owners of a corporation or LLC may easily transfer ownership interests to others, depending on state requirements and their own company agreements or bylaws.
  
• Conversion: Depending on the rules of the applicable state statutes, one type of business entity may be converted to another (for example, an LLC to a corporation) and may even be transferred to another state (i.e. from California to Delaware). Read a short Lloyd & Mousilli article on conversion if you’re considering starting with an LLC: LLC Now, Corporation Later?
  
• Taxation: Corporations are typically taxed at a lower rate than individuals. Corporations may also own shares in other corporations and resulting corporate dividends can be partially tax-free. If you have any doubts or want to explore tax questions, you should speak with a tax advisor. Our firm does not provide tax advice.
  
• Duration: Either an LLC or a corporation may continue indefinitely and beyond the lifetime of its owners.
  
• Raising capital: A corporation may raise funds by issuance of convertible debts and sale of stock. An LLC may raise funds by issuing membership interests.
  
• Employee incentives: A corporation may issue incentive stock options to employees as a form of compensation for their work and tenure. A similar structure may be created for an LLC, but it is typically more complicated and more expensive to manage and setup.
  
• Credit rating: A corporation acquires its own credit rating unassociated with the owner’s personal credit rating, even though the owner may be asked to provide some collateral or personal guarantee at times, especially early on after formation.

C Corporations

A C corporation is the standard corporation structure. An S corporation is a corporation that has elected special tax status with the IRS. Both of these corporate entity statuses share the following:

• They have shareholders, directors and officers.
• Both are required to follow the same internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder meetings, filing annual reports, and paying annual taxes and fees as required by state law.
• Articles of Incorporation are the same for both C and S corporations.
• Both C corporation and S corporation ownership is transferred by the selling of shares.

The advantages of C corporations are:

• Investors typically prefer this form of corporate structure when investing in accelerated growth tech companies due to multiple classes of stock available to C corporations, especially preferred stock. Preferred stock provides preferred returns and further protective provisions.  
• C corporations are also a more favorable setup for employee compensation. A company creating incentive (via stock options) to attract and keep talented employees often prefer C corporation status. C corporations may allow employees to defer tax status on the equity compensation until they sell that initial stock by offering incentive stock option plans, variations of which are possible, but more complicated, in an LLC. Tax-free and tax-deductible benefits are also available to employees in a C corporation (again, check with your accountant on all tax matters).
• C corporations allow the owners to take advantage of certain provisions in the tax code with respect to exclusion of a certain amount of capital gains and the deduction of certain losses. However, please check with your accountant with respect to these benefits.
• Non-US citizens or and non-residents are permitted to be shareholders / founders of a C corporation.
• Since ownership is unrestricted, C corporations are often the best choice for large companies that are or plan to be publicly traded.

The disadvantage of a C corporation is double taxation:

• FIRST at the corporate level on the corporation’s net income.
• SECOND to the shareholders when the profits are distributed, if corporate income is distributed to business owners as dividends.

When a corporation is originally chartered by the state, it exists as a C Corporation. It will remain a C corporation unless the company wishes to elect S corporation status.

S Corporations

The main difference between a C corporation and an S corporation is the taxation structure. S corporations only pay one level of taxation: at the shareholder level. To choose S corporation status, a tax lawyer or accountant may assist with filing IRS Form 2553 and ensuring all S corporation guidelines are met. Since S corporation election is not required at the time of incorporation as a C corporation, a company may wish to momentarily hold off on S corporation election in order to consult with an accountant or tax lawyer.

Startup companies will choose an S corporation if the founders wish the benefit of a flow through tax treatment. In other words, a founder can include business losses on their personal tax returns as deductions, which may be particularly attractive during the early stages of a company. A startup can elect S corporation status before the financing stage and revoke S corporation status at the time of a financing. However, S corporation status prevents a startup from having entity (other corporations or LLCs) or non-US citizen/resident stockholders.

The disadvantages of S corporations, unlike C corporations, are:

• Limited ownership to 100 shareholders, who cannot be non-resident aliens, nor can S corporations be owned by other corporations.
• An S corporation cannot have multiple classes of stock.
• S corporations are not allowed to conduct certain types of business. Banks and insurance companies are not eligible for S corporation status.
• S corporations are less flexible than C corporations for employee fringe benefits.
• S corporations must report employee taxable compensation.

Limited Liability Companies

A limited liability company (LLC) blends elements of partnerships and corporate structures. An LLC is an unincorporated association that protects the liability of a company.

Startup companies often avoid LLCs because most technology startups seek to grant options to employees and consultants, and it’s very difficult to get professional investors interested in investing in an LLC. LLCs provide no standard or easy way to grant such options. A startup may convert from LLC status to a C corporation but, depending on the state, there may be statutory limitations or additional requirements in doing so. Consultancy and bootstrapped businesses, on the other hand, are often the best choices for LLC status.

Benefits of LLCs:

• Flexible management structure. Unlike corporations, LLCs are not required to comply with a formal management structure.
• Like the C corporation, LLCs have no ownership restrictions and members of an LLC may be non-US citizens and non-resident aliens.
• Flexible tax regime. An LLC can elect to be taxed as a sole proprietor, partnership, S corporation or C corporation. Using default tax classification, profits are taxed personally at the member level, not at the LLC level.
• LLCs can be set up with just one natural person (in some states) and thus partially separates the liability of a company from that member.
• LLCs can offer membership interests in the LLC to employees.

Disadvantages of LLCs:

• Investors may be wary of the LLC structure and prefer the traditional corporate structure of a C corporation or S corporation. This can make raising capital difficult for LLCs.
• Many states levy a franchise tax on LLCs, which is essentially the fee to pay for the privilege of the LLC status.
• Renewal fees may also be higher than a C corporation or S corporation.
• LLCs are not considered corporations for the purposes of civil procedure. Instead, LLCs are treated as partnerships by the courts. This affects diversity jurisdiction. Thus, if a member of an LLC is a citizen of the same state as a member of the opposing party, the LLC may not remove to federal court under jurisdiction (whereas the corporation can).
• The equity compensation process for employees is not straightforward and standard incentive stock options employed by C corporations are not typically available.

You should consult with the Lloyd & Mousilli team if you have any doubts about the appropriate entity type for your business.

Founders have been known to set up LLCs at the earliest stages of their ventures for obvious reasons, including:  

• LLCs tend to have flexible management structures and are often easier to maintain. Unlike corporations, LLCs are not required to comply with a formal management structure; and  
• LLCs tend to have flexible tax regimes. An LLC can elect to be taxed as a sole proprietor, partnership, or corporation. Using default tax classifications, profits are taxed personally at the member level, not at the LLC level.  

For more information, check out our article on What’s the Difference between a C Corp, S Corp, and LLC?

Potential Problems with Forming an LLC for your Startup

LLCs have some notable limitations and are not the best choice for accelerated growth startups for many reasons, including (but not limited to) the following:  

• The equity compensation process for employees is not as straightforward in LLCs  and standard incentive stock options employed by C corporations are typically not available. Moreover, if you have any inclination to pursue outside funding, you’ll be better off steering clear of creative, complex equity structures that fall outside the C corporation norm so that you avoid unnecessary scrutiny from potential investors and acquirers.  
• Investors may be wary of the LLC structure and prefer the traditional corporate structure of a C corporation. This can make raising capital very difficult for members of an LLC.  

Can’t I just convert my LLC to a C Corp later on?  

Not so fast! You may run into some problems if you try to convert your LLC into a C corporation at a later date:  

• Not all states permit the conversion from an LLC to a C corporation;  
• A conversion from an LLC to a C corporation may have surprising tax implications and you should make sure you hire an experienced accountant to advise you. If your IP development, employee acquisition, and customer engagement are well underway, the conversion costs can be costly and time consuming.  
• Even if a state permits the conversion to take place, make sure you hire an experienced startup lawyer to lead this charge on your behalf. Your Lloyd & Mousilli team is well positioned to represent you. Remember that potential investors and acquirers will run you through a thorough due diligence process, which will expose any corporate vulnerabilities and put the transaction at risk. Do things the right way to start!