If you’re starting a business with another person or a group of people, you’ll be sharing ideas, divvying up equity, and investing money together.  For startups, resolving questions of equity, ownership and control is critical to the company’s growth and success.  A founders’ (or shareholders’) agreement can be an effective and efficient way to address these issues from the beginning and help protect the company from disputes and conflicts later.

A founders’ (or shareholders’) agreement defines the relationship between key people in the startup, usually the founders and first shareholders.  The agreement can do a variety of things, but often includes: 1) allocating each founder’s equity stake; 2) defining each founder’s responsibilities in the company: 3) establishing transfer restrictions on founder shares; 4) setting vesting schedules and/or acceleration provisions; and 5) explaining what happens to a founder’s interest in the company if the founder leaves voluntarily or is fired.

The process of creating a founders’ agreement can be very helpful to a startup , as it allows the founders to brainstorm potential problems and set policies to prevent those problems from arising.

Once you have a founders’ agreement in place, you may find that it helps your startup to stay focused on its growth and investment plan.  Also, investors like to see founders’ agreements as such agreements demonstrate that founders have considered and resolved critical questions for the startup.

As an employee, founder or an investor in a startup, you may receive restricted stock that will vest at a later date. Upon receipt, you have the option of making an 83(b) election with the IRS. But what is an 83(b) election? Why should you consider making one, and what’s the process for doing so? The following paragraphs contain information about the basics of an 83(b) election and why it may be beneficial to file one.

What is it:

An 83(b) election is a optional provision that directs the IRS to tax the stock at the time of the grant, when it may be worth very little or when payment is made. The relatively low worth of the stock at the time of the grant (versus at the time that it vests) helps the grantee minimize his or her potential tax liability when he or she opts for an 83(b) election.

Why should you do it:

For a startup, the stock is likely to be worth much less at the time it’s granted than at the time it vests. Ideally, making an 83(b) election will result in paying less taxes because you’ll be taxed on the stock at the time of the grant instead of when it vests, when it hopefully holds a higher value.

When you should do it:

An individual must file the letter of election with the IRS either prior to the date of the stock purchase or within 30 days after the purchase date. There is no exception to the 30-day rule.
The following circumstances would be advantageous for an 83(b) election:
• If the amount of income reported at grant is small;
• If the stock has moderate to high growth prospects; and
• If the risk of stock forfeiture is very low.
However, under these circumstances apply, you might reconsider making an 83(b) election:
• If there is a moderate to high risk of stock forfeiture; or
• If there’s a heavy tax burden at the time of the grant in addition to low to moderate growth prospects.

How you should do it:

Within 30 days of the purchase date, you must send a letter to the IRS stating your intent to make the election. You must include the following items in the letter:
- Your name, address, and taxpayer identification number.
- A description of each property for which you are making the choice.
- The date or dates on which the property was transferred and the tax year for which you are making the choice.
- The nature of any restrictions on the property.
- The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice.
- Any amount that you paid for the property.
- A statement that you have provided copies to the appropriate persons.

You must send your letter to the IRS where you file your tax returns; you can find the address for the office you need on the IRS website. You should also make copies of your 83(b) election documents because in addition to filing with the IRS within 30 days of the grant, you also have to file it with your personal income tax return. Finally, send a copy of the election to the company that granted you the stock for them to keep in their records.

Startups frequently need to value their companies in order to issue stock options or other equity interests in the company, but in the early stages, this can be difficult. Here are some tips that new startups can use to value their ventures:

Know the basics
A business owner should know the latest income statement and the contents of the balance sheet. Keeping detailed records of the business’s costs and earnings provides a foundation for determining the value of the startup and for making projections about the startup’s future. In addition to keeping records of the financial details of the company, the startup should keep a written business plan that enumerates the company’s goals, both tactical and strategic. This list can be used to track milestones and quantify the startup’s achievements, which can also be used to make projections for the startup’s future and to place a value on the business.

Compare your startup to similar businesses
Comparing a startup to similar businesses or competitors is one of the easiest ways to determine both the comparative marketshare as well as the value of the company, which is necessary when discussing external investment or IPO. A similar business would be one that is in the same industry and geographical region as the startup. Sites such as BizBuySell.com and BizQuest.com can be used to find out the selling price of businesses in the same industry as the startup. Talking to accountants, lawyers, or other professionals who deal frequently with startups can also help you value similar companies and, therefore, your own. Finally, learning how much a similar company was worth when it became profitable can give you a sense of how much the startup may be worth when it becomes profitable.

Don’t forget external factors
When you’re using these formulas or comparing other companies to your own, don’t forget to take other factors into account such as the general outlook of the industry; customer trends and tastes; and the regulatory climate of the industry. In addition to all the other items mentioned above, these factors will play a role in helping you value your startup.

Once you’ve quantified the value of your start-up, you should prepare an executive summary containing your goals, your most recent earnings information, and your projections that you can present to potential investors. Be sure to keep the summary current in order to maintain preparedness for any potential investors.

Kaila Law Group has many clients who want to invest in their friends or family members’ businesses – either to support their venture, or with hopes of a return, or both.  We always remind our clients who are considering investing that there are a few tips that can help smooth the way to a successful business collaboration.

Tip 1: Try and stay objective. Better yet, hire someone to stay objective for you.

When it comes to business, it’s extremely important to stay objective – and when it comes to people we know personally it’s easy to let our personal feelings about them get in the way.  Before entering into a business relationship with anyone, it is important to consult a professional who understands and can explain to you any potential liabilities to which you may be exposing yourself.  You may be thinking to yourself “I’ve known Bill for years, and I trust him – why do I need to hire a lawyer?” It’s not that you each your own attorney – usually, both parties may consult the same lawyer. It is merely essential for each party to consult with someone who can determine what each wants and reduce it down to a legally effective agreement.

Here are some of the specific issues an attorney can address:

• Which entity (i.e. partnership, LLC, LLP) would best suit your business?
• How to limit your liability from debts incurred by the business.
• Defining clear roles for everyone involved – for example, determining whether investors have any managerial authority in the company.
• Defining the investment – is it a loan to be paid back? Is it an equity investment? Does it create a partnership-in-fact?
• How to avoid potential litigation should a conflict arise – an operating agreement drafted by an attorney can include procedures by which a business can internally resolve conflict without having to resort to potentially costly litigation.

Tip 2: Get it in writing

We know that you really trust your potential business partner, you’ve known him forever, he’s a good guy … no matter what, you should get the arrangement in writing, signed by all parties.  Again, that brother-in-law may be the most trustworthy guy you know, but people may gloss over details when moving forward with a business plan, or the details may be forgotten over time. An attorney experienced in business formation and start-ups can alert you to such issues, and ensure that each party is fully apprised of the agreement into which they are entering.

Tip 3: Make sure you understand exactly what you are getting in to.

Many people start business ventures with friends or family without fully understanding what is involved, both financially, and logistically, in investing in a business venture.   If you’re not sure what is really involved, consulting an expert can give you a much clearer sense of what the potential upsides and downsides are to the investment.  We usually recommend that people consult a business attorney and a CPA who can work together to limit the investor’s liability and protect against potential tax or legal pitfalls.  We sometimes put our clients in touch with financial advisors who can review clients’ financial plans and portfolios to determine whether the investment meets their financial goals.  This information will help you more clearly evaluate whether the investment makes sense to you, both financially and personally.

When personal and professional relationships are mixed, you need to take extra precautions to ensure that both you and your assets are protected. The fact that you know someone or that they are a family member has the potential to cloud your judgment. Consulting an objective third party who has experience in business formation and other matters is the best way to ensure that you proceed prudently and without exposing yourself to more risk than you intend.

What should you do if you are having trouble with a co-founder? Usually founders begin a venture with high hopes and a good working relationship, but just like in any relationship, there is always the chance that things may go awry. If you are finding yourself in that situation, here are a few things to keep in mind:

1) Dissent amongst founders is one of the most common reasons that startups fail, and it will send investors running for the hills. If you are having problems with a co-founder, the best thing for your company is to address the issue head-on, immediately.

2) If you want to get rid of a co-founder, make sure that you can. Check your founding documents, including founders’ agreements, equity documents and bylaws to make sure that you have the authority and the power to remove him or her. If you are not sure what this means, ask your attorney.

3) Get important people on board. Your other founders, advisors and major shareholders will need to know what is going on, and getting their agreement will smooth the process.

4) Be nice. Breakups aren’t easy, but you can make the transition smoother by being respectful, recognizing the founder’s contributions to the company, and offering to help them with recommendations or introducing them to people in your space. If your company can afford it, consider accelerating his or her vesting and/or offering severance. The startup space is small, and you never know when you may need this person again. It’s worth it to end things on good terms.