Start-Up Legal Basics with Becki DeGraw of Wilson Sonsini on This Week in Startups with Jason Calacanis

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Key Takeaways

  • The Four Biggest Mistakes Founders Make
    • 1. Missing out on 83(b) tax elections
    • 2. Thinking they own the company when they don’t
    • 3. Waiting until funding before setting up the company structure
    • 4. Incorporating as an LLC first instead of as a corporation
  • An 83(b) tax form must be filed by a founder within 30 days of purchase of the stock
  • The Board of Directors issues approved stock and a founder must BUY stock to own the company
  • The switch from LLC to an INC is messy – there are lots of tax and legal issues
  • Re-upping founders means giving the founders another round of shares to keep their ownership share the same and to counter dilution
    • But some say it’s not fair to other shareholders

Intro

Becki DeGraw practices corporate and securities law in the San Francisco/SOMA office of Wilson Sonsini Goodrich & Rosati, where she serves as outside general counsel and advises technology and growth companies at all stages of development.


Mistake #1:  Missed 83(b) elections

  • When founders buy stock – restricted stock- the stock is subject to taxation unless an 83(b) election is made
  • If you don’t make an 83(b) election, the IRS will tax you on each date you vest compared with the fair market value of the stock on the date you bought it
    • Over time, the value of the stock usually rises and a founder will be taxed on the difference between what he or she paid and the current value – it adds up!
  • To obtain an 83(b), a founder must file within 30 days of purchase of the stock – an unnegotiable time frame
  • Once an 83(b) is filed, the founder’s tax is calculated based on the fair market value which, since it’s only been a month at most since purchase, is generally equal to the purchase price, therefore taxes = $0


Mistake #2: Founders Who Think They Own the Company But Don’t

  • Some founders think that because they incorporated the company, they own it – but that’s not enough
  • You have to appoint a Board of Directors who then appoint officers (CEO) who have the authority to act on behalf of the company
  • The Board of Directors issue approved stock and the founder then must BUY the stock


Mistake #3: Founders Who Wait Until Funding Before Setting Up the Company Structure

  • From a founder’s perspective, it’s not wise to wait, you’re going to pay a lot for your stock!
  • Suppose a founder gets $8 million in funding, now they have to reach out to a lawyer to get incorporated and issue some stock
    • Problem: Fees soar thanks to a term sheet that says the company is worth $8 million as does the price of the stock
  • Next, a 4019A valuation report from a 3rd party company is required to determine the value of the company

Mistake #4: Founders Who Start-Up as an LLC

  • It’s not disastrous to start as an LLC, but if founders want venture capital money, they’ll have to incorporate and that will be expensive
  • The switch from LLC to an INC is messy – there are lots of tax and legal issues
    • For example, you need to include stock options that you can’t have in an LLC
  • Founders need to hire specialized accountants familiar with flipping from LLC to a corporation

Recent Trends In Secondary Shares And Founder Re-Ups

  • Re-upping founders means giving the founder another round of shares to keep his ownership share the same and to counter delusion
    • But some say it’s not fair to other shareholders
    • The Board of Directors is the one to make the decision but it may or not be fair in light of their fiduciary duties
  • If the founder is really strong and still leading the company in a major way, re-upping makes sense
  • The first round of funding goes to grow the company – not in the founder’s pocket
  • The current economy is a founder-friendly market which has made secondary shares more common
This Week in Startups with Jason Calacanis : , , , , , ,
Notes By EWerbitsky

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