Common Startup Mistakes when FOUNDING a Company (Part 1) | Startup Legal Advisor, Michael Hool

Okay. On the founding side, there's a bunch of things we could talk about, but with founder equity, here's a typical scenario. Sit down, you got 3 founders, you're sitting at the table. You get 20%, I get 40%, and you get 40%. Let's go take on the world. And then, I don't know, some amount of time— this is a real— I'll give you a real-life example, okay? It was 2, 50/50. Let's take on the world. About 3 months into it, one of the 2 moves to Hawaii and stops working in the business. Well, he's got 50% of the company. And at that point, they had— it was actually a little bit longer than 3 months, but to make a long story short, they didn't think about what happens if and how do we get these shares back if this person who was expected to contribute sweat equity doesn't contribute the sweat equity for whatever reason. It could be a healthcare issue. It could be a lifestyle issue. They could just freak out and whatever. In this case, that's what happened. They just kind of went off and didn't do their part of the bargain. The company just is working on an investment right now at a $70 million valuation. This person that had 50% now has roughly 18%. It's a huge problem for the other founder. Because the other founder's busting his butt, working really hard, and the other guy's making millions and he's not doing anything. So you gotta think through— everybody's chummy right now when you're getting together. But you gotta think through what happens if that person isn't there and doing what they're supposed to do. A lot of times, like I said, it's not through choice. Things happen. But you want to have a mechanism in place to get those shares back so that you can use them to bring in the replacement co-founder or talent. So don't forget that. That's one that people forget all the time. They don't think about it. And there's— the way to do it is typically at the startup stage, everybody should be vesting. So if it's predicated on you performing services and your partner performing services, you're going to do this, I'm going to do that. You want to have a kind of a vesting schedule, right, so that your ownership vests over time. And that way, if you're ever not there, ready to perform, able to perform, the part that's not vested basically goes away. The part that is vested, you have a choice to make right now at the time we're thinking about this. Do we buy back that interest? Do we let that person keep the interest? But you need to think through so you can build in the mechanism now so that if that happens— The most common thing is you buy back the interest. You buy it back at a fair market value of what it is today. The reason for that is it's probably more— I don't know. It's just a problem psychologically for a founder who's working really hard and the other founder is not there working, receiving the benefit of of the upside that's being created. But you might say, hey, that's America and that's what we want. So as long as you did your time and worked really hard, that part that vested while you were there stays yours forever. It's kind of a, you know, you get to make the choice on how you want to set it up. So here's the other common mistake I see. And it happens with founders. Okay, we split it up among the founders. But then you start bringing in team members along the way. Someone's working on some software code, you get 5% of the company. Somebody's going to put together this marketing plan, you get 5% of the company. I've literally had times where I sit down and I add it up and it's 120%. And it's like, you guys, you don't have 120% to give. So who's going to give their shares back? And they're scratching their heads. It's like, well, I don't know. What should we do? You've got to think, when you're throwing around percentages, that's dangerous. I know everybody does it. When we talk about capitalization, that'll help solve that problem. You build a cap table that you keep it current and it always equals 100%. You can see the dilutive effect when somebody's getting an interest, how it dilutes everybody down. It's so critical to have that. Okay. Okay. The other thing is when you're granting equity interests and so forth, I think it's really important to just make sure you have somebody on the team. And if it's— if you don't have a team and it's you, but somebody's got to be really psycho about the documents. Somebody has to be focused. Making sure that stuff is documented and kept somewhere and you can find things when you want to find things. Again, when you're talking about granting equity, this is really hypercritical because I've seen things where I've read emails where people have granted 10% of the company by email. Then nobody can find it. One guy says it's this. This guy says that. Then the email surfaces a year and a half later. You just have to, like, this is one area that you have to slow down from all the fun, exciting, big stuff and say, wait a minute, somebody has to do the boring work of making sure this stuff is documented properly. Tax issues. There's a couple of— you start from the basic notion that when you receive anything for performing services, the IRS, the Internal Revenue Service, they want to tax that as compensation. So it can be a Tesla, it can be a dollar, it can be anything, property, a desk, a computer. The way it works is if you've provided services and you receive something in return and that's not cash, The IRS says the fair market value of what you receive should be taxed as compensation. And if you're— if that person is an employee, you should have withheld taxes from the fair market value of that. Well, there's no cash, so it creates an issue. Same thing is true when you're giving equity, okay. Equity is property. It's personal property under the law. So you just think about it in terms of a stock certificate. I'm going to give you X number of shares and you're going to do X, Y, and Z for the company. Well, the IRS says the fair market value of that stock is taxable as income. You as the company are required to withhold and pay into the government the appropriate withholding taxes. You need to think about that as the starting point. There's a couple mechanisms that are in place to help startups deal with that. The most common that you'll probably come across is something called an 83 election. And what that is, Section 83 of the tax code allows you to, at when the value of the property is really low or next to nothing in the startup phase, even if it's subject to vesting, let's say it vests over 4 years in every quarter, the way that would But absent making that election, if you just— the founder receives this— or let's say he's not a founder. He comes in 6 months later and he gets this equity that vests over 4 years. Every vesting, every time a portion of it vests, that portion that vests is taxable at fair market value. So you think about it, it's beneficial to have everything taxed today when the company's worth nothing. Then 2 years from now when you've struck gold and it's worth $30 million and you've got VCs chasing you around. 83 allows you to tell the government that notwithstanding the fact that this is subject to vesting, I want it to all be taxed today at zero value. Therefore, when the company goes up in value and those events occur, I've already I've already recognized gain on what it is that I've received and it was nothing. You have to make that election. The critical part of this is that election is due 30 days after the grant and there's no grace period. It's absolute. I've had many companies, and this is a real common thing among startup, in the startup legal community, where one of the things we have to try to cure are these issues of You know, you got 10 people that received equity and they didn't file their 83 elections. So now as it vests, companies ramping up, they're going to get hit with some pretty big taxes. So it's a complicated thing and there's some mechanisms that require you taking some risks and evaluating things that you can try to solve, but it's a challenge. The other thing is, you know, I'm not that old, but In the early days of my practice, this rule didn't apply. And that is when you grant, you could grant stock options. So like you could give employees options to buy and you could price those options at a penny or anything you wanted. So it was really kind of a nice way to give people equity essentially. give them a right to buy equity as they earn in, that is beneficial, right? Because the company is worth $5 a share, but you get the right to buy it for a penny. Well, the IRS got rid of that. And so now all grants must be at fair market value. They must be priced at fair market value. That's something to keep in mind because there's significant penalties for the recipient If that— there's a code section called Section 409 of the tax code that if that is not followed, there's significant penalties. And the recipient pays the penalties. So the other thing is when you're in an LLC, I know we're sort of pushing everybody that's in a high growth to corporate, but there are a lot of you that will bootstrap or you'll get strategic partners and you don't need to go the VC route. And there's various reasons you might stay an LLC. When you're making these grants to founders, employees, key people, the rules that I mentioned for tax incentive options and things that are applicable to corporations don't apply to LLCs. So you need to think through a strategy for getting them that equity without them paying taxes. And the most common way that we do it now is we grant profits interests. So there's a mechanism now where you can grant someone the profits interest. So when I grant you 5% of the company, the company might— that 5%, like just prior to me granting it to you, might have been worth $10,000. Right. Well, if I grant you a profits interest that says you're not entitled to the first $10,000 when the company is sold, you only get anything that's accrued after that, the IRS has blessed this as a profits interest and they will not tax it when you make the grant. So there's some things, there's some ways to do it with an LLC.