It’s a common situation for a start-up: you have a terrific idea for a new venture and you have assembled a team of rock stars who will work together as the founding team to further develop the idea. As you think about the initial ownership (equity) of the venture, you should keep these five suggestions in mind:
- Understand contributions, commitments and control. If intellectual property will be contributed to the venture, be sure that each contribution is correctly documented so that there is no controversy later about who owns what. The founding team should have honest conversations (that may be awkward) about any contributions they are making to the venture, their level of commitment to the venture, and who will control the venture.
- Subject all equity to vesting. Initial equity grants (usually shares of common stock issued by a corporation) typically vest over a period of time (commonly four years). While founding team members often express wild enthusiasm for and commitment to each other and the new venture early on, it’s pretty common for at least one founding team member to depart. Sometimes that founder elects on his or her own to pursue another opportunity, and sometimes that founder is encouraged to seek another opportunity. In either case, if that founder’s equity is not subject to vesting, then the founder will usually be able to retain all of his or her equity after departure. This means that the departed founder will benefit from the increasing value of your venture without sharing in all of the pain and effort that goes with developing a successful enterprise.
- Think carefully about how equity is allocated, then grant it. That founding team member may be your best friend from college, but if he or she is going to make a small contribution, don’t allocate too much equity to him or her. You will doubtless need it down the road as you fill out your team, and if equity is not allocated in rough proportion to actual contributions, ill will between members of the team can develop. At the same time, once you decide to grant equity, document it carefully. Promising to grant equity later can lead to a dispute about what was promised, and it can create big tax problems.
- Restrict the transfer of equity. The transfer of equity by the founders should be restricted, usually with a right of first refusal giving the company the right to match any offer to purchase a founder’s equity. The right of first refusal should prevent one of your co-founders from transferring his or her equity to someone you don’t want as an owner – such as a competitor, or a former co-worker whom you never got along with. In some circumstances, the company should also have an option to repurchase vested equity from a departing founder, usually at fair market value, so that the departing founder only shares in the value that has been created before he or she departs.
- Comply with the tax rules. If a start-up equity grant will vest over time, it’s almost always best to file an election with the Internal Revenue Service under Internal Revenue Code Section 83(b). If your company is issuing nonqualified stock options, be sure to comply with the valuation requirements in Internal Revenue Code Section 409A, usually by obtaining a formal appraisal of the company. You’ll need some professional help to deal with Sections 83(b) and 409A, but the requirements are generally not hard to meet. Failing to comply, however, can result in a nasty tax surprise, and can make it more difficult to finance or sell your company later.
There is lots to do as you get your new venture up and running. Keeping these suggestions in mind involves a little extra effort in the beginning, but will pay dividends later.