HOW TO START A STARTUP PART 2 OF 2
Applying the principles: authorizing, paying for, and issuing initial stock of the company step by step
This articles tells you how to apply all of the theory and guiding principles discussed in Part 1 of 2 of How to Start a Startup and actually create the startup. Make sure to read part 1 first.
Table of Contents
Step 1. Decide on key matters
a. Startup entity type: C-Corp or LLC?
b. What the startup company will look like
c. Where the startup company will be incorporated
d. Texas startup angle
Step 2. File the Articles of Incorporation (or Certificate of Formation) with the Secretary of State
a. The startup company name
b. The startup company registered agent
c. The purpose of the startup corporation
d. Startup company stock
i. Type of Company Stock
ii. Number of Shares
iii. Share Price
e. Incorporator
Step 3. Hand the company over to the initial board
Step 4. Apply for an Employer Identification Number (EIN) from the IRS
Step 5. Get a corporate bank account
Step 6. Execute the Consent of the Initial Board of Directors
Step 7. Founders buy their shares of the company and execute collateral agreements
a. Founders purchase stock by executing a Stock Purchase Agreement
b. Pay for company shares
c. Pay the same price
d. Issue stock certificates
e. Founders file 83(b) Elections
Step 8. Execute Stockholder Consent and other Corporate Governance Matters
Step 9. Protect IP
Step 1. Decide on key startup matters
a. Startup entity type: C-Corp or LLC?
Answer: C-Corp.
C-Corps are easier to understand, better for employee stock options, better for investors. Life will be better.
Plus, investors will make the startup become a C-Corp later any way, so you might as well be one now instead of spending more money down the road later to fix it.
b. What the startup company will look like
- Who is going to own how much of the company
Answer: depends on you and your co-founders
- The initial board and what the roles will be in the company
Answer: depends on what you and co-founders want
- How founders will pay (exchange) for their stock in the company
Answer: Cash; IP
Paying for stock with services (past or future) will be more complicated and result in tax consequences.
c. Where the startup company will be incorporated
Delaware is the way to go.
Most companies are formed either in the home state of the founders or a state with known favorable corporate laws such as Delaware, Nevada, or Wyoming.
The state of incorporation is not necessarily where you are going to run your operations from. It just means where the company is incorporated. Investors down the road will like to see Delaware. Delaware has favorable corporate laws and people are familiar with them. You can incorporate in your home state now and save some cash, but you'll probably just have to re-incoporate in Delaware later (changing this down the road will even be more costly.)
As a startup lawyer I've had to deal with a number of companies in foreign states, but that is for asset protection in high risk multi-entity setups. Don't worry about that. Keep it simple and go for either your home state or Delaware.
d. Texs startup angle
You can also create the startup in Texas depending on your circumstances and particularly if cash is an issue. Depending on what you're doing with the company and the type of business being transacted, if you start the company in Delaware, you will have to apply for registration in Texas as a foreign entity. This is not a big deal.
Step 2. File the Articles of Incorporation (or Certificate of Formation) with the Secretary of State
The startup is created when the Articles of Incorporation (sometimes called the Certificate of Formation or Charter depending on the state) is filed and approved with the Secretary of State of the state where you want to incorporate. Include this information:
a. The startup company name
Make sure that it does not conflict with other names in the state. You can search here: https://delecorp.delaware.gov/tin/EntitySearch.jsp
You may also need to make sure that there are no trademark issues.
My experience has shown that many entrepreneurs put way too much time and effort into the name. There are bigger issues at hand. Yes, the name is important, but don't get bogged down on this point. Remember to execute with ruthless efficiency.
b. The startup company registered agent
The registered agent setup is a service that you hire--generally about $110-$150 a year. You can find a service here: http://corp.delaware.gov/agents/agts.shtml
Why and what is this for? You are required to have an agent (a person or company) that is physically located in the state that accepts paperwork and documentation on behalf of the company (e.g. if you get sued.) This is called service of process.
No, you can't get around this.
c. The purpose of the startup corporation
This is simple: "To engage in any lawful business for which a company may be organized in this state."
d. Startup Company Stock
In order for stock to be properly issued to founders, it needs to be authorized as existing in the Articles of Incorporation. Get this part right. I've had to go back and fix this for companies. Like many things, it's just easier and cheaper to get the proper help and do it right the first time around.
i. Type of Company Stock
The initial stock issuance in a startup is going to be for founders of the company. This is sometimes referred to as founders' stock.
Founders' stock is no different than other common stock.
There are different types or classes of stock: common and preferred stock.
Common stock is the basic unit of ownership that founders, consultants, employees, etc. get. The common stock that the founders will receive is the same exact type of stock that will be used for employee compensation and other purposes.
Preferred stock is what investors get. Preferred stock investors receive special rights and preferences over common.
Don't worry about preferred stock right now.
ii. Number of Shares
The number of shares authorized is not terribly important (what matters more is the percentage breakdown of shares.) For a startup, a good number to authorize is 10,000,000 shares of common. The large number of 10,000,000 allows for plenty of room for future issuances and conversions.
When doing the initial issuance of stock to founders, each founder will receive a certain X% of the 10,000,000 shares. Not all shares will be issued to the founders. Some shares will be kept in reserve with the startup. These other shares will come into the picture later for equity compensation reasons and other purposes.
Founders should receive about 6,000,000 shares total subject to vesting out of the 10,000,000 authorized.
iii. Share Price
You have to set a minimum price per share. This is called par value.
The par value doesn't need to be a certain particular amount across all companies. It can be $0.001 or $0.0001. It depends on the circumstances. It can even be $0.00001.
If a founder is to get 5,000,000 shares, they would have to pay a minimum of $500 for their shares if par value is $0.0001.
If par value is $0.001, the founder would have to pay a minimum of $5,000. This $5,000 would go to fund the company.
Note: Early funding of a company is discussed in a separate article.
A major goal is to keep the value of common stock as low as possible for as long as possible. Common stock is what will be issued to employees for equity compensation purposes. Rules dictate that stock option grants need to be at their fair market value. Thus, it is best to keep the value of common stock low for incentive purposes and to not "artificially" inflate this value early on.
Authorize 10,000,000 shares of common stock at a low par value of $0.001 or $0.0001 or even $0.00001.
e. Company Incorporator
Give information about who is incorporating the startup; basically the person who is filing this information with the state.
Why? The incorporator is not necessarily going to be an owner of the startup. The incorporator will hand the reins of the startup to the board after documents have been filed with the state.
Step 3. Hand the startup company over to the initial board
After filing the Articles of Incorporation and the Secretary of State responds, the incorporator hands the company over to the initial board of directors.
The incorporator accomplishes this by executing a document called the "Action By Incorporator."
The initial board of directors discharges the incorporator of its duties and agrees to indemnify the incorporator for liabilies.
Step 4. Apply for an Employer Identification Number (EIN) from the IRS
This is similar to a social security number, but is for corporations. You can do that here: https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
Step 5. Get a corporate bank account
Don't combine personal funds with corporate funds. Get a corporate bank account.
Different banks have different procedures for this. Just go to a bank you know and trust and they will tell you what to do.
When you go to the bank the bank will give you a list of any documentation it requires for you to open a corporate account. This is generally your formation papers and the company EIN.
Step 6. Execute the Consent of the Initial Board of Directors
The Consent of the Board of Directors is in lieu of a formal meeting. This is what the consent is for:
- Electing the initial officers including CEO and secretary (this can be the same person)
- Authorizing the officers to issue stock to initial stockholders. Include the names of the stockholders, number of shares, and amount to be paid pursuant.
- Authorizing the officers to adopt the bylaws
Step 7. Founders buy their shares of the company and execute collateral agreements
a. Founders purchase stock by executing a Stock Purchase Agreement
Each founder purchases their stock from the company pursuant to a Stock Purchase Agreement.
This Stock Purchase Agreement spells out the terms of the stock and what is being purchased.
The Stock Purchase Agreement should be accompanied with a vesting schedule.
I'll explain that again because it's such an important concept. With a vesting schedule, you will receive all of the stock at the forefront, but the stock will be subject to repurchase by the startup if you choose to leave the company. Over time, more stock will "vest" to you, i.e., less and less stock will be subject to repurchase by the company. So if you choose to leave the company in year 2, the company will repurchase, say, 50% of your shares back from you. If you leave in year 3, the company will only be able to repurchase 25% back from you because by that time more stock will have vested to you.
Remember all of those principles we discussed above that helps protect you from your co-founders? That goes here.
This agreement includes provisions that detail:
- number of shares the founders are purchasing
- type of shares the founders are purchasing (common stock)
- how the founders are paying for their shares
- vesting terms and schedule
- share transfer restrictions including what happens if a founder dies
- IP assignment as part of the exchange of shares
b. Pay for company shares
Founders must pay for their stock in the company. Founder's stock is paid by cash, IP, and/or services.
c. Pay the same price
You and your co-founders need to pay the same price for the same type of shares (i.e., the same price per share.) If you don't, you may have to recognize income for tax purposes.
d. Issue stock certificates
You can do this via real paper or use an e-service such as https://esharesinc.com/
Unvested shares can be kept with the company or in escrow.
e. Founders file 83(b) Elections
An 83(b) election is a filing you make with the IRS that changes the recognition of income date to be the date of the purchase of shares. It must be done within 30 days of the stock purchase.
What does this mean?
You will have taxable income on the difference between the fair market value of the stock and the price you paid for it. Or in the case of services, you will be taxed on how you are compensated for your services (as always.)
When you are issued your shares at the beginning of the company, the value of these shares is extremely low as the company is not really worth anything.
With no 83(b) election: If you receive all of the stock subject to vesting at founding, and the stock value increases over time, you will have taxable income each time more shares vest. This makes sense theoretically. The company is growing, the value of the stock is increasing. This means that you will owe plenty of tax.
With 83(b) election: As mentioned, an 83(b) election changes the recognition of income date to be the date when you initially receive the shares instead of when the shares vest. At the company's start, the value of the shares will be minimal. This is advantageous to you.
Note: The 83(b) election timing is critical and must be made with the IRS within 30 days of the stock purchase.
Step 8. Execute Stockholder Consent and other Corporate Governance Matters
Execute stockholder consent. The stockholders elect the board of directors. The board of directors designate the officers of the company as necessary.
Step 9. Protect IP
Prior to incorporating you should already have agreements in place among all of the founders that whatever IP has been created will belong to the company. The next part is to make sure that IP created after the company has been created belongs to the company as well. This is an agreement between each individual involved with the company and the company itself. - Founders sign and execute Confidential Information and Inventions Assignment Agreement
Move on to Phase 2 and grow and operate your company. Now the real fun begins.