Startups represented by seedling growthStartup clients often rely on independent contractors and advisors during their early stages but do not have the cash to pay them, so they turn to equity compensation. Stock options are a great incentive tool, but founders should consider the following before issuing options to advisors or independent contractors:

  1. How Much?: Most founders grant early advisors and contractors options that cover anywhere from 0.10% to 1% of the company’s fully diluted stock on a case-by-case basis. Founders should consider (i) how important the advisor or contractor is to the success of the company, (ii) how much time the advisor will commit to the company, and (iii) the maturity level of the company and its future growth prospects. Advisors and contractors may talk to one another about their option grants, so be consistent and prepared to explain the rationale behind the grants.
  2. Vesting: Just like option grants to employees, advisor grants should be subject to a vesting schedule. Advisor grants typically vest on a monthly basis without a cliff over a period of 12-24 months, although shorter or longer vesting schedules may be appropriate. In certain scenarios, vesting schedules for independent contractors may be customized so that all or a significant portion of the grants do not vest until completion of the project for which the contractor was hired.
  3. Exercise Period: Vested Incentive Stock Options (ISOs), which can only be granted to employees, must be exercised within three (3) months after the employee’s termination. This is not the case for Non-Qualified Stock Options (NSOs) issued to contractors and advisors, but most equity incentive plans require both types of options to be exercised within the three (3) month period. Experienced advisors may negotiate to extend the exercise period because they do not have the cash to exercise the options or are not prepared to pay the tax associated with exercising the options. Depending on the relationship with the advisor, it may be in the company’s best interests to extend the exercise period, especially with advisors who may be able to help the company in the future through their expertise or connections.
  4. Intellectual Property: All advisors should sign some form of confidentiality and invention assignment agreement. Although many advisors or contractors may resist, such agreements can be tailored to address the advisor’s concerns while still protecting the company ownership of its intellectual property, which is key to the company’s future success and ability to obtain venture financing.
Copyright: / 123RF Stock Photo
Copyright: / 123RF Stock Photo

When negotiating the terms of their investment in a startup, angel investors should consider requiring the following covenants from founders.   These covenants help preserve the value of the angel’s investment  by protecting the company from potentially adverse actions of the founders.

  • Vesting of Equity: The founders’ equity should be subject to forfeiture in decreasing percentages over several years (commonly referred to as “vesting”).  Vesting prevents a founder who leaves the startup after working for only a short period of time from retaining all the equity in the startup originally granted to him or her. Note, however, that if founders receive equity that is subject to vesting (often referred to as “restricted stock”), they should consider making an election under Section 83(b) of the Internal Revenue Code within 30 days after issuance in order to avoid adverse tax consequences once the equity vests.
  • Repurchase Rights:  The startup should have the right to repurchase a founder’s vested equity upon certain “triggering events.”  Triggering events may include: (i) death, (ii) disability, (iii) bankruptcy, (iv) taking action materially adverse to the startup’s interest, or (v) becoming disassociated or expelled from the startup.  Depending upon the particular triggering event, the purchase price is often the fair market value of the equity determined by an independent appraiser, which amount is often paid out over several years.
  • Restrictive Covenants:  Departing founders should be prohibited from (i) divulging or using the startup’s confidential information, (ii) competing with the startup (whether by starting his or her own company or working for an existing competitor), or (iii) soliciting the startup’s employees, contractors, or customers away from the startup.  These types of restrictions are usually found in standard company documents such as a Stockholders’ Agreement or Operating Agreement, or in a separate written agreement between the startup and the founder directly.
  • Assignment of Inventions:  Founders (as well as employees, developers, and other contractors of a startup) should be bound by a written agreement that assigns to the startup all intellectual property created in connection with the services performed for the startup.  Absent a written agreement, the individual or entity providing the services will generally have ownership rights in such intellectual property, and this can cause problems for a startup when it seeks to assert ownership rights, raise capital or sell to a third party.

The initial months of a startup can be a whirlwind for the founders – i.e., making final decisions regarding the team, picking the correct entity structure, agreeing upon the appropriate buy-sell terms, and leasing the right office space.  30 days can fly by in the blink of an eye.  Depending upon the terms regarding the stock owned by the founders, the failure to make an election under Section 83(b) of the Internal Revenue Code (an “83(b) election”) during such 30 day period can lead to disastrous tax consequences for the founders.

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Copyright: yupiramos / 123RF Stock Photo

Founders often purchase or are granted “restricted stock” in connection with forming their company, with the underlying restricted stock agreement providing that such stock is subject to forfeiture or repurchase by the company, with such stock becoming no longer subject to forfeiture or repurchase by the company over a period of years (often referred to as the “vesting” of restricted stock).  Such restrictions are intended to prevent a founder that leaves the company after a short period of time from retaining some or all of his or her equity in the company.

Stock that is subject to vesting over time will generally be taxed when such stock is no longer subject to a substantial risk of forfeiture.  Therefore, when the stock “vests,” the founder will be taxed on the difference, if any, between the fair market value of the stock as of the vesting date and the original purchase price for such stock.  Every startup hopes that its stock rapidly increases in value, and in such scenario, a founder could have significant tax implications when his or her stock becomes vested.

That is where the 83(b) election comes in.  If an 83(b) election is properly made, the founder will incur tax on all of the restricted stock in the calendar year when the stock is received.  This allows the founder to incur and pay the tax when the value of the stock is low (or at least lower than when such stock will vest).  The risk to the founder in making the election is that he or she ends up leaving the company (voluntarily or involuntarily) before the stock fully vests and loses all or a portion of his or her stock, but already paid the tax (if any) applicable to the receipt of all such stock.

In order to make a timely and effective 83(b) election, a founder must file the election with the IRS office with which the founder files his or her tax return prior to the date of receiving the stock or within 30 days thereafter. The election should be sent via certified mail, return receipt requested, and is effective upon mailing.  Mailing an election on the 31st day after receiving such stock or thereafter will not be effective. A copy of the election should be attached to founder’s federal income tax return, and the founder should also provide the company with a copy.  A sample election form may be found at the IRS website.