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The key reason why Founders Need to Use Low-cost Stock in Capitalizing Their Startups

Founders will usually wish to use so-called cheap stock when they capitalize their startups.

Whenever you form a startup, you contribute cash or other assets for it in substitution for stock. You may also loan money on the entity. The number of debt to equity should be modest -- normally only 3 to a single (talk with your business lawyer or CPA). While capitalizing with debts are common for small corporations, it can be less so for startups, where straight equity capitalization will be the norm. That capitalization normally involves cheap stock.

Why do you use cheap stock?

Cheap stock is important because founders will often earn their equity as time passes since they perform services for that company. The internal revenue service may treat the need for that stock as taxable compensation. If you need to minimize tax, maintain your valuation on the stock low.

The concept would be to value your IP as low as possible and assign it on the company as well as modest cash contributions while pricing the shares themselves in a nominal price. If the company has modestly valued IP and nominal cash, it's not worth much and neither is its stock.

Founders may chafe at the idea of placing a low value on his or her IP. Not to worry. During funding, investors will see this strictly like a positioning move.

A typical model for startups is thus to authorize millions of shares of low-priced common stock, with many percentage used on founders, some restricted to an equity-incentive pool, and some available future investors. For instance, Millions of shares might be authorized, ones 4 million could possibly be issued to founders, Two million available a bonus pool, and 4 million available to investors. On this example, the founders might price the stock at a tenth of an penny ($.001) per share thereby contribute when using $4,000 for your 4 million shares issued for many years.

Large share numbers may give startups a psychological edge in recruiting. The greater shares, the greater the option grants. Which would you rather get, 1,000 or 100,000 options? Each might represent an identical curiosity about a company but the psychological question answers itself which sounds better. Startups set up their structures accordingly.

How does a cheap-stock strategy enjoy when it comes time for funding? Inside our example above, let's say that our startup with 10 million authorized shares will a Series An ideal stock round at its first funding. Feel that this startup amends its articles to authorize 4 million shares of preferred stock and that it raises $4 million, with: (1) the investors getting 4 million shares of preferred stock at $1.00 per share (convertible one-for-one into the 4 million shares of common available investors); (2) the founders still hold their original 4 million shares bought at $.001 per share; and (3) the rest of the 2 million shares either issued or reserved under an equity incentive policy for key service contributors.

The startup presently has a post-money valuation of $10 million (Ten million shares times $1.00 per share). Factoring inside the dilution that may result once all 10 million shares are issued, the founders now own 4 million out of Millions of shares, or 40% from the company. If the company all together is priced at $10 million, that 40% interest includes a paper price of $4 million. The founders paid only $4,000 to accumulate that interest, say, Yr earlier. Yet if all other formation issues were handled properly (like the filing of timely 83(b) elections), the founders will not likely normally risk incurring tax liabilities from the paper gain they have realized.

Was their interest worth $4 million at the time of company formation? Who knows? At that point, all numbers are nebulous. That is generally safe territory for using low valuations.

So what can founders accomplish through the use of cheap stock? If your startup fails, they lose only value of their labor. Whether or not this succeeds, they're able to ride through its pros and cons about the strength of capital investments manufactured by others via outside funding. They don't pay tax in the process. Any gain realized from your ultimate sale of their stock will probably be taxable only when they get tangible value in return and then probably at favorable long term capital gain rates.

Thus, cheap stock lets founders position themselves optimally from the tax and economic perspective to profit from the ultimate success they've already.

Cheap stock also benefits other key people besides founders. Options will not be issued at founder pricing but normally are issued at a significant discount from what investors ultimately pay. Provided that the startup is careful to avoid steps that cause a big upward valuation on the stock price noisy . stages, the discount model may be maintained and significant equity incentives agreed to key service contributors who are available in following your founders.

As a startup matures, the application of cheap stock is generally neither feasible nor desirable. Then, its use could possibly be unfair to existing shareholders and can also run afoul of an special Internal Revenue Code provision (409A) that imposes penalties if stock used for deferred compensation is just not valued correctly.

In the early stages, though, the cardinal rule is to use cheap stock. It's good dividends for many concerned. Don't neglect this fundamental facet of starting your startup.

One caveat: a company which is under-capitalized for your business it conducts might be in danger of having its "corporate veil" pierced. Use your small business lawyer to actually do your startup capitalization properly.

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