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Founder Equity: Strategies and Pitfalls

April 28, 2011

Who owns your company anyway? For a startup or a company taking on key employees and investors, getting the capital structure right is critically important.

Disputes about ownership can be costly and messy. One famous example is Facebook, which was sued by co-founder Eduardo Saverin and by the Winklevoss twins over ownership rights. More recently, a man named Paul Ceglia has produced emails that he claims show that he should own half of Facebook. Ownership disputes can be expensive and can jeopardize future fundraising.

Here are five important strategies for creating an ownership structure that achieves your objectives and avoids unpleasant surprises:

Strategy #1: Create Clear Documentation

Your documentation should clearly show who owns how many shares. Stock certificates should be issued and copies kept in a safe place. Avoid ambiguous emails and other communications promising ownership. If the company takes a loan, document it with a promissory note so that it is clear that it’s debt, not equity. If an owner leaves, it is important to have the rights to buy back his or her equity and to complete that purchase.

Strategy #2: Use Vesting

What happens if a founder or employee leaves early? They keep their shares unless those shares are subject to vesting requirements or some other buyout agreement. Vesting incentivizes people to stay with the company and avoids a windfall to those who leave early.

Strategy #3: Equity Compensation

Stock options can be used to provide equity incentives subject to vesting and conditions. Stock options grants do not result in actual shares until the options are exercised. The employee is not taxed until exercise or until the shares are ultimately sold (depending on the type of stock option).

Strategy #4: Avoid “Cheap Stock”

Many companies have a money partner and a sweat-equity partner. The money partner pays for its shares and the founder/entrepreneur/CEO receives his or her shares for free or minimal cost. Problems arise if the IRS values all shares based on what the money investor paid and treats the founder’s shares as taxable income at that same value. Proper planning can help a found avoid an unpleasant tax bill with no cash income to pay it. The IRS has a special procedure called an 83(b) election which allows a stockholder to take the income while the value of unvested shares is low, rather than later when the value may be much higher.

Strategy #5: Maintain Flexibility

Companies want to preserve the ability to take in future investors. Founders may also want to preserve rights to participate in future rounds of financing.

We invite you to meet with a Varnum attorney to plan the capital structure that best meets your objectives.

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