How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (4 page)

Each state has its own corporate laws and has a variety of structures, such as a C-Corp, a Limited Liability Company (LLC), and an S-Corp. The differences among them may seem arcane, but often have to do with taxes and the need to conform to certain business formalities, like conducting board meetings, as mentioned earlier. For example, LLCs have minimal filing and administrative requirements, which result in lower taxes for the company. Perhaps this is
why Facebook’s co-founder Eduardo Saverin originally formed Facebook as an LLC.

Unfortunately for Saverin, whose main role at the company was to help with business matters, this was a wrong decision. If he had thought far enough into the future, he might have been able to guess that Facebook would eventually need to raise outside capital, which means establishing Facebook as a C-Corp, preferably one in Delaware. Delaware C-Corps don’t just make it easier to obtain financing; they also are streamlined for setting up option plans, which allow a company to provide equity compensation to employees. Furthermore, the state of Delaware is home to many corporations specifically because it has a well-developed set of corporate laws, and the judges in that state also tend to act quickly on legal matters.

While some attorneys may quibble, I think a Delaware C-Corp is the best option for technology startups.

When forming one, the following are some things to consider:

• Establish each partner’s roles and responsibilities within the corporation. Here, again, is an opportunity to learn from Facebook’s mistakes. Saverin maintained control of the LLC, and when he had a dispute with Zuckerberg, he actually froze the corporation’s bank account. This heedless action almost killed Facebook, and Zuckerberg and his father had to put up $85,000 of their own capital to keep it afloat.
  
• Maintain control of your stock. Just look what happened to Craigslist. In 2004, one of Craigslist’s employees sold a 28.5% stake in the company to eBay, which turned out to be a terrible situation for Craigslist, because eBay eventually came out with its own classified service. Craigslist would never have been in this mess, however, if it had set stock resale restrictions. If Craigslist had given itself the right of first refusal—or, in other words, the option to buy shares of its own stock at the same price and terms that a third party is willing to pay—it could have avoided this horrible situation altogether.
  
• Assign all the intellectual property to the corporation. If you don’t, the entity has little value and investors may not be willing to make any commitments to it. Furthermore, if you have a cofounder and fail to assign all the corporation’s intellectual property to the entity itself, the cofounder could very well take her intellectual property and go elsewhere
  with it. Consider that when Facebook was created, Zuckerberg did not assign the intellectual property to the LLC. As a result, the entity had little value, except for some money in a bank account.
  

When forming a company, the founders are often optimistic and friendly—and with due cause. Hey, it’s an exciting time—full of huge amounts of potential. However, all this shared excitement can cloud your judgment. As much as possible, you need to realize that, over time, there are bound to be disputes between you and your cofounder. This very scenario cropped up fairly quickly in the case of Facebook, given Zuckerberg’s early clashes with Saverin. In some cases, these disputes can result in either you or your cofounder leaving the company. In light of this, you need to think about protecting your interests, which means negotiating hard with your co-founders. A key issue is making sure you allocate the equity in a way that motivates your team but is not too generous that it risks harming the venture.

The nonconfrontational approach to this issue is to split everything equally, but this may be the wrong way. For example, suppose one founder has quit his job to dedicate himself fully to the venture whereas the other founder is still working a nine-to-five job and can only commit time to the company after hours and on weekends. In this case, it would not be fair for the founders to split the equity evenly. Or suppose one founder is bringing existing code or customers or cash to the table. Would it make sense in this situation for each founder to be compensated equally? Probably not.

Equity-sharing discussions can be uncomfortable—and even contentious—but they may provide some insight into the real personalities of your cofounders. You may even realize that they may not be a good fit! As for Facebook, there was a difference in the equity split, with Zuckerberg getting a 65% share, Saverin getting a 30% share, and Dustin Moskovitz (who became involved in Facebook later in its development but is still considered one of its original cofounders) receiving a 5% share in the company.

Suppose you start a business with three other cofounders. Everyone works extremely hard, except one person: George. He rarely does any coding and when he does get involved, he usually complains. He’s actually become a liability to the venture. You and your other cofounders want to push him out
of the company. The problem is that he owns 25% of the company’s stock. In other words, he is, essentially, getting a free ride based on the efforts of everyone else. It’s unfair, right? Absolutely. However, fairness in this case does not matter to a judge. George paid for his stock and in return received 25% ownership. It’s that simple.

However, there is one way to deal with this type of situation—by using vested founders’ stock. Here’s how it works: Suppose your company has 1 million shares, and you and your other three cofounders have decided that each founder receives 250,000 of those shares. The price per share is 1¢, so each founder pays $2,500 to capitalize the venture. Then, in your company’s shareholder agreement, you include a vesting schedule that stipulates that a founder has to wait at least 1 year to vest—or obtain ownership—of the first 62,500 shares of his investment. The rest of his shares will vest, each month, for 3 more years.

Now let’s return to your hypothetical venture and, of course, George. You and your cofounders have been busting your butts and it has become readily apparent during that first year that you’ve been working together that George is just not working as hard as the rest of you. Because you and your cofounders were forward-thinking when you formed your company and decided to reimburse each cofounder for his work with vested founders’ stock, you can buy George out of his percentage of stock much more easily than if you had given him an outright share in the company.

Vested founders’ stock is a common business approach for Silicon Valley startups, and it works quite well for most parties involved—the Georges of the world notwithstanding. In fact, when a VC firm makes an investment in a company, the firm usually requires that the company begin using vested founders’ stock. If a venture already has a vesting program in place, it is unlikely that a VC firm will seek to undo this policy. The use of vested founders’ stock also shows the VC that the company’s founders are forward-thinking.

In some cases, especially among technical startups, one or more of the company’s cofounders has already worked hard on the product before the other cofounders decide to jump onboard. Because of this unique situation, the company’s original cofounders may get credit for their early work by vesting a certain percentage of their stock, say, 5%, at the time of the company’s incorporation.

Sometimes companies with vested founders’ stock use a vesting schedule that accelerates when one of its founders is terminated without cause. In this type
of situation, the terminated founder typically walks away from the venture with all of his shares in the company. In theory, this arrangement seems to make sense. After all, if a founder didn’t do anything explicitly wrong in his work for the venture, it isn’t exactly fair for him to be fired and receive no compensation for the time and energy he invested in the company.

In reality, however, the case law for how to define
cause
is far from clear-cut, which means that even if you had due cause for terminating a founder, that founder would be able to claim that you didn’t have due cause and would walk away with a big chunk of your company. This doesn’t seem quite fair, either, now, does it? As a result, my suggestion is to avoid accelerated vesting schedules at all costs. However, if accelerated vesting is important to you and your cofounders, there is a better approach—partial acceleration. When your company uses partially accelerated vesting schedules, you maintain much more control over how many shares leave your company when one of your cofounders is forced out. For example, your company policy could be that founders who are terminated without cause are given an accelerated vesting schedule, but only for 6 months of that schedule.

Accelerated vesting is also used in change-of-control events, such as when your company is acquired by another firm. If you and your cofounders believe that a change of control over your company may be likely, you can incorporate into your shareholder agreement a single-trigger acceleration clause, which states that the forthcoming event will trigger the acceleration of 100% of your stock options. Keep in mind, however, that a single-trigger acceleration clause may make it nearly impossible to sell your company, because potential buyers will likely be put off by a stipulation that allows the founders to walk away from the sale with a huge payoff.

If you would like to provide for yourself in the event of a change of control but are wary of using a single-trigger acceleration clause for the reasons mentioned here, you might instead choose to include one or more of the following options in your shareholder agreement:

• Double-trigger clause: There must be a change of control and a termination without cause (often for a term of 12 months) for there to be 100% vesting.
  
• Compromise: At the time of the change of control, a partial amount of the shares will vest automatically, and then the rest are subject to a double trigger.
  
• Severance: The shares vest completely after the cofounders have been with the new company for a period of time, such as 1 to 2 years.
  

As most Americans would agree, taxes involve mind-numbing paperwork and onerous payments—and this is especially true for startups that don’t understand the Internal Revenue Service’s (IRS’s) core principles and choose to distribute vested founders’ stock. To avoid experiencing a big-time tax bite, read on.

Continuing with our example presented earlier in this section, “Use Vested Founders’ Stock,” let’s suppose that your company has been in business for 1 year, which means that 62,500 of your 250,000 shares have vested. However, instead of its initial price of 1¢ per share, your company’s stock value has increased to $1 per share because the venture has made a lot of progress. Thanks to you and your cofounders’ hard work, the IRS will now tax you on your gain. In your case, your gain is $62,500 ($1 for every share that is vested) less the initial $2,500 investment you paid (known as the
cost basis
), or $60,000. To make matters worse, the IRS continues to tax your vested founders’ stock as it vests over time.

Yes, you owe tax on this gain in share price, even though it is probably nearly impossible for you to sell your shares. The IRS does not really care if you don’t have the cash to pay your gains tax, either. It just sets up some type of payment program for you in the hopes that you eventually pay off the full taxed amount to the government.

This is an ugly situation for sure, but if you file an 83(b) election with the IRS, you can avoid the whole mess. How is this so? When you file an 83(b) election, you are—for tax purposes—treating your stock as though it was fully vested at the time your startup was formed. As a result, you pay taxes on the amount your stock was worth when you initially purchased it, rather than waiting to pay taxes on it until it appreciates down the line. Therefore, if you had filed an 83(b) election at the outset of your company’s formation after paying 1¢ per share to get your venture going, your gains tax would have been $0 when the price per share rose to $1 a year later.

By using the 83b election, you also start the clock ticking for long-term capital gains treatment. If you hold on to your stock for more than a year, your maximum tax rate on those shares is 15%. In other words, make sure you file an 83(b). Period. But remember, you must file an 83(b) election within 30 days after purchasing your company’s stock. There are no exceptions to this rule, and filing is as simple as sending a letter to the IRS. Don’t forget to use certified return receipt to make sure the IRS has received your paperwork. Your company should also keep a copy of the 83(b) so that you can include it with the following year’s tax return.

When a company is first started, its value is usually minimal, which makes it fairly easy for the founders to buy the company’s stock. If you recall from our previous example, each founder had to pay only $2,500 for 250,000 shares of stock, at a price of 1¢ per share. This is a fairly common situation.

Yet even a few thousand dollars can be tough for young founders to spare. Because of this, some founders offer to contribute their intellectual property, such as existing computer code or even a business plan, as payment for the shares. Although substituting intellectual property for cash might seem reasonable, it can cause huge headaches down the road. Not only is intellectual property difficult to value, but the contribution could result in adverse tax consequences for your company. There could even be difficulties in ensuring that the corporation actually owns the intellectual property. Therefore, to keep things clean, the best approach is for all parties to contribute cash. If a founder is serious about the venture, he will find a way to scrounge up a few thousand bucks.

In March 2012, Yahoo! filed a patent infringement suit against Facebook in an attempt to blunt the social network’s progress and delay its IPO. Interestingly, this was not the first time that Yahoo! had engaged in such legal practices. During Google’s IPO in 2004, Yahoo! launched a lawsuit against the search engine behemoth and was able to snag shares in the offering as a settlement. And Yahoo! is not the only major player in the tech world that is aggressive in going after the competition in the courtroom. At the time of this writing, operators big and small around the globe are embroiled in patent wars.