By Claire Kalia (Founding Managing Partner, Kalia Law Group)
Equity issues are critical to most startups because equity determines central questions such as ownership, control and compensation.
At the early stages of a company, it’s especially important to make sure that equity is issued in a way that meets the company’s current needs and future plans.
Here are some tips for smart things to do (and things to avoid doing) with your company’s equity.
Tip 1: Vest founder shares, including yours.
You wouldn’t let anyone walk away with half your company, would you? If you don’t impose vesting on founder shares, you take the risk that your co-founder will disappear tomorrow and take half, or a third, of the company with them.
No matter how much you trust and love your co-founder, if you don’t impose vesting on founder shares you’re exposing your company to an unacceptable amount of risk. And even if you don’t think the risk is a big deal, investors will.
Vesting of founder shares is something potential investors really want to see, and they may insist upon it. They know how often founder break up and part ways, and they won’t want to invest in a venture that doesn’t protect the company in the event that a founder jumps ship.
Tip 2: When it comes to splitting the company, equal is not always equitable.
Do you and your co-founder have a 50-50 (or 33-33-33) equity split? If so, it’s probably for two reasons: one, it’s simpler, and two, you may believe, as most people do, that equal splits are generally the fairest. However, equal equity splits are not always the best thing for a company because they often favor one founder, which can lead to disputes later.
The rule of thumb is, the equity split should as closely as possible approximate each founder’s relative contributions, both past and anticipated, to the venture. This includes cash contributions, time contributions, other contributions including IP, business contacts and physical assets, and each individual’s opportunity costs.
If you haven’t already, sit down now with your co-founder and discuss each of your past and future contributions and try to come to an agreement about a fair equity breakdown.
Equity battles are one of the most common reasons for startups to fail, and for that reason, investors will scrutinize the equity split of a company they are considering.
So even though it may be tough to work out a breakdown that represents the contribution from each individual, it’s an important investment in the future stability and success of your company.
Tip 3: Get your stock option plan right.
Startups are usually rich in equity and poor in cash, which is why stock options are a popular compensation tool for startups. If you are planning to use stock options, take lots of care. Stock plans that are not set up correctly raise serious securities, employment and corporate law issues, and those issues just get harder to fix as time goes on.
I’ve seen many an acquisition delayed and sometimes even de-railed after the buyer discovered that a startup’s stock plan was not properly adopted in early stages and now employees and ex-employees are walking around with dodgy options or stock. Don’t go there.
Adopting your stock plan properly now will help avoid lots of trouble later.
Tip 4: Don’t forget to file an 83(b) election.
Ask a founder of a successful startup what they would do differently if they could do it over, and many will say that they wish they had remembered to file an 83(b) election. What exactly is an 83(b) election?
It’s basically a choice to ‘pre-pay’ all of your taxes on your restricted stock now, instead of later when the stock vests. Why would you do this? Because right now your stock is probably worth very little, so the taxes that you’ll pay now are minimal.
If you don’t file that election, you will owe tax when the stock vests on the difference between what you paid and the fair market value on the vest date.
If the stock has increased significantly in value, your tax bill could be huge.
You only have 30 days after receiving restricted stock to make your 83(b) election so you may want to consider now whether you plan to make the election.
Tip 5: Create a founders’ agreement.
A founders’ agreement is like a prenup: it’s a contract between individuals setting forth their agreement on critical issues in their relationship. Like a prenup, a founders’ agreement is designed to reduce the possibility of messy disputes between the parties later. Even if you and your co-founder are head over heels about each other, it’s a good idea to set down in writing your agreement about important issues relating to the venture.
You can put anything you want in a founders’ agreement, but some of the most common issues are: equity splits and vesting of founders’ stock, transfer restrictions on founders’ stock, non-solicitation and confidentiality obligations, voting, and tag-along rights.
Founders often find the exercise of writing a founders’ agreement helpful because it helps to crystallize founders’ plans for the venture. Also, writing a founders’ agreement may uncover differences in opinion that were not otherwise apparent, which gives founders the opportunity to proactively address those issues.
Who knows? You and your co-founder may even find that after writing your founders’ agreement you are more in love than ever.
Editor’s note: Got a question for our guest blogger? Leave a message in the comments below.
About the guest blogger: About our guest blogger: Claire Kalia is a startup attorney and the managing partner of Kalia Law Group. Claire advises startups on issues including formation, employment, compensation and benefits, tax, and intellectual property. Before founding Kalia Law Group, Claire worked at Orrick, Herrington and Sutcliffe in Menlo Park, where she advised some of Silicon Valley’s most successful and well-known companies.