Founding a company is an exciting moment in an entrepreneur’s career. But even on Day 1, there are steps entrepreneurs should take to avoid major financial and diligence issues in the future. In this series of posts, we’ll cover some basics that often trip up founders to help guide you through those early steps.
Entrepreneurs often assume they own their company de facto (i.e., by virtue of the fact that they formed it, without any other required action)- a proposition that seems so logical and fundamental, it’s hard to believe its not true.
Later in their company’s lifecycle (typically, when there’s pressure on due diligence because the founders either consult an attorney knowledgeable in the space or there’s an interested incubator, accelerator or angel investor), many founders are surprised to learn that after forming their company, they must take another critical step to become shareholders in the company they founded – purchasing their company’s stock.
This often overlooked step works to the founder’s benefit, when it’s done correctly. In fact, we often tell founders that the ability to purchase their company’s stock on Day 1 is one of the core economic upsides to founding a business in the first place. While this seems backwards (why should you have to buy stock in a company founded by you- isn’t that the investor’s role?), it makes sense considering the price the founders pay for that stock, as long as the stock is purchased at or near the time of formation of the company. Because at formation of the company, there’s typically no assets or value associated with the company other than the nominal par value of the stock, allowing a founder to purchase their shares at a fraction of a penny per share (whatever the par value is set to).
Of course, there’s nuances and unique circumstances to each company formation that need to be discussed with your lawyer and financial advisor. Sometimes, there is real value associated with the stock, even on Day 1 (for example, if the company is a spinout with assets). And there are other steps that a prudent founder or founding team may need to take at inception along with the purchase of their stock (e.g., consider imposing vesting restrictions on the stock and filing an 83(b) election).
But first things first, make sure you purchase your stock on Day 1, before that hockey stick growth you’re projecting becomes a reality…
Fox Rothschild’s Emerging Company Resource Center includes formation document checklists developed by our nationally recognized emerging companies attorneys; information on relevant intellectual property issues (trademarks, patents, licenses); data room portals for investor due diligence; and other resources for emerging companies. We encourage our entrepreneurs to reach out to us with questions as they grow their company with these resources.