Many thanks to Libby Hadzima Perkins, Summer Associate currently attending UC Berkeley School of Law, for her assistance with this article.
You and your co-founders have begun exploring a new business idea. You plan to incorporate, build out a team and raise capital in the future. However, before incorporating you decide to divide ownership in the future company between the founders. You and your co-founders get together and draft a short founders’ agreement electing to divide the future company among the three founders by 40%, 40% and 20%. When the company incorporates several months later, you do not re-address the issue of ownership, as you feel you have already addressed it via the prior agreement.
This article offers a cautionary tale on the legal and business importance of addressing and documenting founder ownership interests upon incorporation.
Contracts are generally enforceable when entered into by consenting parties. So while the founders’ agreement may be enforceable with respect to ownership percentages once the company is incorporated, this relatively simple ownership agreement creates a host of other challenges for the newly-formed company.
Risk Management in a Downside Scenario
The founders have not addressed how they will deal with potential changes to the management structure. After all, a founder could leave or be terminated while still retaining a claim to his or her full stake in the company. In most circumstances, the founders should implement a vesting schedule. A founder who walks away before the end of the vesting period would only take with them the vested equity, leaving more equity available to help recruit a replacement. Vesting also helps to ensure that each founder is motivated to continue to build the business as well as to mitigate risk when founding teams do not work out as planned. For more information see our article Protecting Founder Equity.
Founders suffer economically from not receiving stock at incorporation. At the time of incorporation, a company’s equity is generally worth very little. Newly incorporated companies generally issue stock to founders at prices well below $0.01 per share. As time passes after incorporation, the stock generally becomes more valuable, especially once the company takes outside investment. Founders have several options for acquiring stock after incorporation but all have some downside. Founders can purchase stock at the current fair market value but now pay more for that stock. The company could also grant options to the founders though exercising those options could trigger negative tax consequences for founders. Options also do not carry voting rights, thereby limiting the founders’ ability to influence the company, and sooner or later the founders will have to pay the exercise price of these options. Finally, the company could also sell the stock at a discount to fair market value but the founders will pay income tax on the spread.
Failing to get stock at incorporation also gives founders less flexibility in a subsequent sale of their stock. The one-year holding period distinguishing short-term vs. long-term capital gains begins at the time stock is acquired. Therefore, founders would be taxed at the higher short-term capital gains rate if they have not held the stock for a year at the time they ultimately sell their shares.
Frequently a founding team member contributes intellectual property to a new venture. An overly simple founders’ agreement dividing up ownership may fail to assign or define what intellectual property a founder is contributing to the company. The result could be that a founder retains both a portion of the company as well as the intellectual property that the other founders assumed belonged to the company. Resolving this misunderstanding could be costly.
High-quality investors will expect that a company worthy of its investment has established a vesting schedule for its founders, has issued stock to its founders, and has assigned all relevant intellectual property to the company.
Therefore, it is best practice that a company formally issue and sell stock to its founders at the time of incorporation. Founders should enter into a restricted stock purchase agreement with the company that values the price of the shares at the time of purchase. Restricted stock purchase agreements should clearly describe vesting schedules and acceleration provisions, if any, around sensitive issues like change of control or termination. To learn more about vesting and acceleration terms see our article Founder Basics: Founder’s Stock, Vesting and Founder Departures. As part of the initial stock issuance, each founder should also irrevocably assign all intellectual property interests related to the company’s business to the company.
By clarifying the terms around founders’ ownership at the time of incorporation, founders avoid costly misunderstandings and ensure that all founders are economically aligned with the company’s success.