Chapter 1:
Incorporating a Business 

There are a few baby steps every new business must take before it can run. This list will help you launch and prepare your company for moving to the next stage like incorporating a business and issuing equity. Since these are foundational elements, it is in your company’s best interest to ensure they are firmly in place before moving on to the next phase. 
Estimated Read Time : 26 Minutes

Company Structure: Incorporating a Business

The Business Plan

The importance of creating a business plan cannot be overstated. It is vital to your business sustainability that you dive into the details. While each business plan is unique, they all contain these core components:

Executive Summary

This summarizes the entire business plan by introducing the market need you have identified, how you plan to address it, who your key managers are, and what conclusions are most important for purposes of sound decision-making

Mission Statement

This is your vision and your purpose

Company Synopsis

This is about your products or services, your competitive advantage, operations, distribution, and core competencies

Market Analysis

This discusses your marketplace, the competition, and how you fit in

Management

This describes your management team, their experience and backgrounds

SWOT Analysis

This describes your management team, their experience and backgrounds

Financial Assessment

This includes a cash flow statement to help you clarify current and future needs so you can anticipate how cash flow could affect growth; revenue projections, income statements, profit projections, budget and balance sheets are all critical components

Strategy

This describes how you plan to leverage opportunities, minimize threats, and market your product or service

Action Steps

This states your goals and objectives and what steps you will take to achieve them

Choosing a Name:
Building Your Brand Value 

Many people often associate brand with a particular company, a logo, or trademark. Coca Cola and Apple are two compelling examples.

What you need to know about brand is that it is more than that. Much more. Brand is a company’s reputation. It is what people think or feel when they hear the name of a company. It is about the value and benefits that a company stands for.

Accordingly, choosing a company name requires careful consideration. Deciding what feelings or key characteristics of your business you want to reinforce will help steer you in the right direction.

Another consideration is to aim for something short. The more concise the name, the more effective it usually will be. Again, think Apple. Think Virgin, Google, Skype, Facebook and Twitter.

Shorter names are not only more memorable, but will make practical aspects of your branding easier when printing stickers or claiming a twitter handle.


Remember: you are creating a brand, not a name. So getting it right from the very beginning is a crucial part of your overall marketing strategy.

Once you have chosen a name, you need to make sure it is not already being used. It is imperative to check the name availability at both the state and local levels. Here are a few easy steps you need to take:

  • Search the U.S. Patent and Trademark Office (USPTO) database for the name you want to use
  • Search the online business records of the Secretary of State in the state you are incorporating in for name availability
  • Search the internet
  • Search domain registries
When you have a name that is available, you can file a Statement of Trademark with your state’s Secretary of State office. Filing with the USPTO at the federal level can also be done, but it does cost more time and money. You may want to postpone federal registration until a later time to ensure that the name is right for your business. It will also allow your company more time to gain traction prior to absorbing the extra costs.

Obtain a Domain

Once you have determined that your name is available, you should immediately register it with a domain service like GoDaddy. This will serve as a placeholder for your website and prevent others from using the same name.

Apply Online for an EIN

You will need to secure an Employer Identification Number (EIN) in order to open a business bank account and transact business in general. You can apply online at irs.gov and obtain one immediately.

Secure Required Business Licenses

You may need one, more than one, or none for the time being. Licenses are usually required by state and local government. If you are working outside of your home, you will at a minimum need to apply for a local business license with the city or town in which your business is located. Depending on the type and location of your business, you might also be required to register with the state for sales tax, unemployment, and other certifications.

You can check for license requirements with your state’s Secretary of State office, as well as with the Small Business Administration (SBA) at sba.gov. The SBA offers small businesses a rich online library of resources that is free. You can easily check their site for links to individual states’ licensing requirements.

Procure Insurance

What kind of insurance coverage you will need is determined largely by the type of business you are starting. Workers’ comp is required once you have your first employee. Property insurance is often a condition in standard commercial leases if you are renting space. Once you incorporate, you will want to consider E&O (Errors and Omissions) and D&O (Directors and Officers) coverages, depending on the type of business you are in. Liability insurance in general should be discussed with your insurance agent. Group health insurance should also be open to consideration as it could help to reduce the cost of your insurance premiums.

Develop Website & Register on Social Media

If you’re on a budget, use a website builder like Squarespace or Launchrock to immediately begin acquiring customers. At a minimum, the landing page verifies your credibility. One of the staples of a legitimate website in today’s marketplace is social branding. This means that your landing page should include links to the principal social media sites including Facebook, Twitter, and LinkedIn. This will require that you register your company’s profile with those providers, in addition to any others that are relevant to your business.

Company Structure:
Incorporating a Business

If you are ready to start approaching investors or customers, then you will need to think about incorporating a business immediately in order to reduce your liability exposure, minimize costs, and demonstrate your credibility.

When incorporating a business, whether as a C-corporation, a Limited Liability Company (LLC), or any variation thereof, the new entity is treated legally and financially as a separate person. This is often referred to as the “corporate veil,” and it protects your personal assets from any liabilities that the company incurs.

Additionally, incorporating a business will offer you tax benefits. The caveat here is that you need to ensure that the type of entity you choose is appropriate for your type of business and future needs. Tax planning is definitely one of the more critical considerations when incorporating so it is strongly recommended that you consult with a qualified business attorney or accountant before diving into incorporating a business

For example, if you are a high tech startup with intellectual property and are planning to raise financing in future funding rounds, a C-corp might be a better choice than an LLC. On the other hand, if you are an environmental consulting firm with industry clients, but no need to raise funding or no intellectual property, an LLC with subchapter S selection will minimize your tax burden and give you more flexibility.

Where Should You Think About Incorporating A Business? 

Incorporating your business has never been easier. Whether it is registering online directly with a state’s business division or opting for the quick and easy access of do-it-yourself (DIY) incorporation documents on DIY legal sites, the temptation for many startups is to use one of these inexpensive options to minimize business costs.

There are, however, multiple risks of choosing a business entity that winds up being inappropriate for your business. Deciding which entity looks appealing without the guidance of an experienced business attorney could expose you to higher liability and costs.

If you are planning on incorporating a business yourself, you need to carefully choose where to incorporate. It is a common misconception that Delaware is the best choice. For some companies, Delaware is the right venue in which to incorporate a business, while for others incorporating in the company’s home state is the right choice.

 Why Delaware When Incorporating A Business?

Tiny Delaware is home to big business, including 50 percent of all publicly-traded companies in the United States, and nearly 65 percent of all Fortune 500 companies. Banks find Delaware attractive because of its high cap on the amount of interest they can charge borrowers.

Companies that plan to seek venture capital (VC) financing know that VCs tend to favor Delaware corporations. Even with states like Nevada and Wyoming, and Florida beginning to flex sizable pro-corporation muscle, Delaware remains the clear favorite.

There are two principal reasons why most tech startups incorporate in Delaware: (1) they are incorporating a business as a C-corp, and (2) they expect high growth.

Before taking any steps towards incorporating a business, it is in your best interest to get legal guidance. Many people incorrectly assume that Delaware is the best state in which to incorporate when often there are better options.

Approximately one-half of all states have adopted the Model Business Corporation Act (MPCA), making corporate law governing both public and private uniform throughout much of the county. While Delaware remains a notable exception, the trend is leaning towards more states adopting the Act, leaving little variation between most states.

As a general rule, if you are a tech company that’s expecting rapid growth, Delaware may be the best choice. In addition to their state law being highly developed and favorable toward corporations, there tends to be a fairly universal knowledge of Delaware corporate law among lawyers across the country.

Delaware does offer C-corps the greatest flexibility in terms of structuring boards of directors, stock issuance and preference, and voting rights when incorporating a business. It also provides the broadest privacy protections. For instance, it does not require director or officer names to be revealed on formation documents.

Other Benefits of Incorporating a Business in Delaware Include:

  • Chancery Courts that specialize in business and corporate law
  • No jury trials
  • Management-friendly laws that allow directors to reserve substantial power
  • No corporate tax on out-of-state Delaware corporations (although franchise taxes are required)
  • No inheritance tax on non-resident shareholders
  • No tax on shares held by non-residents
  • Only a majority of the outstanding stock is required for merger as approval
For these reasons, many investors prefer companies that have are incorporating a business in Delaware as C-corps. However, even if you are a high tech startup with no reason or plans to go public, you should seek legal advice from a home state attorney to explore your in-state options.

Why Not Delaware When Incorporating a Business

If you are a small, early stage startup that has no intention of seeking venture capital or institutional financing, and you are not planning on an Initial Public Offering (IPO), then incorporating in the company’s home state is probably the best option.

If you are incorporating a business in Delaware, but will be doing business in another state, you will still need to register in the other state or states as a foreign business entity. In addition, you will be required to file periodic reports in Delaware, as well as those states where you do business. Moreover, Delaware requires that you regularly submit franchise taxes, even if you are paying those taxes to the state(s) in which you are already doing business.

Some observers have noted that another advantage to incorporating a business in Delaware is that it takes very little time to complete the incorporation. However, many (if not most) other states enable you to incorporate online with the State Secretary of State’s Office in just a few minutes - and often for a lower fee than Delaware.

Many companies do not require C-corp status; in fact, incorporating a business as a C-corp for some companies could be detrimental to their overall financial interests. Filing as an LLC with subchapter S selection or some other type of entity that’s not a C-Corp - especially when there’s no expectation of going public - is often best done in the state where the company is conducting business. 

Unique Industries

On a more delicate note, there are some types of companies that require you incorporating a business in your home state. One of the fastest growing industries is the cannabis industry. For example, as of December 2015, 23 states and the District of Columbia currently have laws legalizing marijuana in one form or another.

Colorado, Washington, Oregon, Alaska, and the District of Columbia all legalized both recreational and medical marijuana. A number of other states have either decriminalized marijuana or are allowing possession of derivative products. For example, Georgia Governor Nathan Deal recently signed a law legalizing the possession of up to 20 ounces of cannabis oil. This is likely due to the influence of thought leaders such as Dr. Sanjay Gupta whose conversion from staunchly anti-marijuana to vehemently pro-medical wields tremendous influence.

With another eight states expecting to legalize, to one extent or another, all cannabis within the next couple of election cycles, everyone from lighting manufacturers to irrigation companies to Wall Street venture capitalists are trying to figure out the best route to incorporating these new industry entities.

For some, incorporating will be limited to only those states in which they are qualified to do or own a cannabis-related business; for others, equity ownership might be impossible, but other structuring mechanisms are available.

Generally, where you are incorporating a business is not going to affect the decisions of most people, with the exception of perhaps investment bankers and investors who are considering a fast growth C-corp that is planning on a future IPO, high tech or otherwise. Once again, consulting a knowledgeable business attorney is going to be one of your best investments.  

Determining The Right Type of Entity

Selecting the right business structure for your company is one of the most important choices you will make. It will impact almost the entire universe of your business including your regulatory compliance, employment obligations, tax and legal liabilities, and your ability to attract investors.

There are three principal types of corporations: C-corporation, S-corporation, and Limited Liability Company (LLC). Knowing your business needs and goals will dictate which structure will best serve your financial interests and accommodate your growth. 

Important Criteria to Evaluate When Incorporating a Business

  • Tax Liability: What opportunities do you need to promote your company’s growth, while minimizing your tax burden?
  • Formation Costs: What are the costs of incorporating in more than one state, including maintaining a registered agent? Compliance
  • Costs: What are the costs associated with administrative compliance including filing annual reports, annual fees, and related taxes (e.g., Delaware’s franchise taxes)
C-corporations are generally most popular with companies that are planning to participate in equity or debt financing, raise funding through multiple financing rounds, and aim to go public. If you are considering venture capital, then a C-corporation is going to be your choice since venture capitalists are unable to invest in S-corporations and generally refuse to invest in LLCs.

S-corporations find favor among those companies that will not be seeking equity or debt financing through venture capital funds, do not plan to go public, and do not foresee having more than 100 members. The chief advantage of an S-corp is that it provides tax benefits on distributions. Distributions are excess profits, which are the sums remaining after salary and payroll expenses (e.g., FICA) are deducted. At this point, the remaining profits are characterized as dividends and can be distributed to the owners at a lower tax rate than ordinary income.

LLCs are most attractive to companies with objectives similar to S-corp, except that they have more flexibility. For instance, like an S-corp they are pass-through entities, so the owners do not get hit with double taxation since income from the entity is paid only by individual members, not the entity. Unlike S-corps, an LLC can have more than 100 members, can be owned by or own another entity, can have more than one class of stock, and can be owned by non-residents. They are also less expensive than S-corps to form and maintain, since S-corps require more administrative attention, especially with respect to meticulously complying with IRS regulations that strictly govern S-corp oversight.

A Snapshot of the Critical Differences Between Each Type of Entity:

Features C-Corp LLC S-Corp
Limited liability for owners Yes Yes Yes
Unlimited number of shareholders / members Yes Yes Limited
Income of entity taxed separately from owners / shareholders Yes No No
Income of entity not taxed - passes through to individual owners / shareholders No Yes Yes
Foreign ownership is allowed Yes Yes No
Entity can be owned by or own other entities Yes Yes No
More than one class of stock / ownership interest is permissible Yes Yes No
Shareholders / members can deduct business losses on individual tax returns No Yes Yes
These guidelines can arm you with the knowledge you need to make the right decision when deciding on which corporate structure will best fit your company. However, engaging an experienced corporate attorney will assure you of that decision, or possibly even save you from a costly mistake. Using this information as a basis for selection after discussing your specific business needs with a lawyer is always recommended since the circumstances of each company are as unique as fingerprints.

Compensation:
How To Properly Pay Employees

In order to adequately assess how best to compensate your employees, you will need to gauge your appetite for risk and understand your business needs. A realistic appraisal of these essential business components will govern your staffing strategies.

For example, a consulting startup is going to have fundamentally different staffing needs as compared to a tech startup. How you structure compensation will depend largely on these considerations.

A small consulting firm, for instance, may simply need an administrator to assist with general housekeeping, such as organizing files, scheduling appointments, and interacting to a limited extent with clients. Similarly, a marketing start-up might need an entry level graphic designer. Employees in these types of positions will typically expect a regular paycheck.

On the other hand, a high tech startup will usually have a need for more sophisticated staff. Inventors, software experts, biotech professionals, and engineers might be the only personnel who can contribute to any meaningful growth of the company, let alone business sustainability.

When it comes to deciding how to compensate your employees, there are options that can give you the flexibility you need to meet the needs of both the company and valuable staff.

Wages

Wage and hour compliance is governed by the Fair Labor Standards Act (FLSA). For FLSA purposes, employees are generally classified as exempt or nonexempt, depending on their salary and the type of work they do.

Exempt employees typically fall under one of the specified FLSA categories. The most common are white-collar professionals, and they are exempt from overtime requirements. This option is appealing to employers since employers are not required to pay overtime or keep track of their time. However, since it is an exception, the burden of proving the legitimacy of this classification is on the employer.

One more thing you will want to keep in mind is that exempt employees who are paid salaries or commissions are entitled to receive earnings that must equal $7.25 an hour, or higher where the state law provides for a greater rate. For instance, an employer is prohibited from paying an employee a salary of $250 per week since the minimum wage requirement would place a salary based on a 40-hour week at $290 dollars.

Nonexempt employees are those who are paid by the hour. Since they are nonexempt, employers are legally required to pay them not only the minimum wage, but also overtime. The federal minimum wage is $7.25. However, 25 states have minimum wage rates that are higher than the federal minimum wage. When state minimum wages are greater than the federal rate, then the FLSA obligates the employer to pay nonexempt employees the higher of the two rates. Conversely, some states have minimum wage rates below the federal standard. In this scenario, employers must pay employees the federal rate of $7.25 per hour. Additionally, the FLSA requires employers to pay nonexempt employees one and a half times the employee’s hourly wage for overtime. Overtime is any amount above 40 hours per week.

There are numerous other FLSA and state law wage and employment requirements. For instance, the FLSA obligates employers to provide employees with breaks. Furthermore, while an employer might wish to offer comp time (time off) to an employee in lieu of paying overtime, this is prohibited with respect to nonexempt employees.

While the FLSA will remain uniform, state law will vary. Consulting a knowledgeable attorney in this area is highly recommended. 

Equity Grants

Founders of early startups sometimes offer key employees who can help grow their business equity in lieu of or as a supplement to wages. This is a popular choice of compensation for bootstrapped tech startups.

This choice tends to take the form of stock options, which are used to incentivize employees who can benefit from the increasing value of the stock’s price. The value is theoretical at the outset since a young company usually does not have a valuation: there are no customers, purchase orders, or assets. For companies that are planning on going public and have a promising future, this can be a very appealing option to an employee.

The typical equity grant for early hires is about 1-2 percent of the company’s outstanding shares. Outstanding shares are the number of shares that a company is legally permitted to issue pursuant to its incorporation documents; issued shares are the actual number of shares that the company has issued.

Stock options make the most economical sense for more sophisticated startups with a relatively developed staff (senior management, rank-and-file, etc.). Since creating an options program is time intensive and requires highly specialized legal expertise, they are quite costly to implement. Therefore, creating a stock options program for just one employee does not usually justify the cost, but if you are planning to develop a highly skilled staff, then offering options could be the right choice.

Caveat: Compensating employees only with stock or stock options is generally not considered wages for purposes of minimum wage calculation. Accordingly, this type of arrangement can easily violate minimum wage laws. While there might be ways to structure this type of compensation package, they are very narrowly construed and require robust legal skill. If you are thinking about this option as compensation, engaging an experienced attorney is essential in order to avoid fines or legal action, or both, that could impair your company’s brand and value.

Cash & Equity

When stock is used as a component of compensation, it is vital for the startup to accurately value shares. Failure to do so can result in sharp penalties, as well as damage to the company’s reputation and value. Also, it is crucial to understand that the company will still be legally required to submit payroll taxes based on sweat equity.

Similarly, correctly characterizing your employees as exempt or nonexempt is crucial to ensuring legal compliance. As noted earlier, mischaracterizing an employee as exempt can result in steep consequences. In addition to interest, fines and penalties, a company will also be required to account for and pay any overtime to employees who were incorrectly characterized as exempt.

In some instances, the company’s executive officers can be subject to criminal penalties, including imprisonment. Therefore, even if a startup believes that an employee is exempt, it is prudent to still maintain good records reflecting the employee’s time. There is an enormous variety of inexpensive employee time tracking and management software that is easily available. This is an essential compliance tool, so make sure you integrate it into your management from the outset.

Using equity compensation can be useful, but also costly since it demands professional administration, usually by an accountant or an attorney. If stock is given in lieu of wages or sold for less than its fair market value, the employee can incur unintended tax consequences.

Federal and state securities, tax, and labor laws - among others - will govern stock option plans, so it is paramount to a company to ensure full and accurate compliance. Often even the most diligent startups learn at some point that their administration of a stock option program was flawed, exposing them to fines, penalties and restitution.

Another potential negative consequence of an incorrectly administered stock option plan is that it can derail a potential acquisition. It is is not unusual for non-compliant stock option programs to be discovered by VCs during a due diligence examination in connection with a financing round.

All of these more common pitfalls can be avoided be engaging legal counsel or an accountant with expertise in establishing a compliant stock option program.

Issuing Stock Certificates

There is a lot of confusion about the necessity of issuing physical stock certificates. The reason for paper stock certificates is to ensure accurate, indisputable evidence of shareholder ownership. While most companies still issue traditional paper stock certificates, the truth is that they are not necessary.

In fact, public traded companies have been using the Direct Registration System (DRS), ditching physical certificates several decades ago. DRS allows investors to elect having their securities registered directly on an issuer’s books. At the heart of the system is ensuring shareholder access to their securities information.

Privately held companies can also use DRS and issue e-certificates. However, before doing so, it’s advisable to check the laws of the state of incorporation since state corporate law varies. For example, California has very specific notice requirements; and while Delaware enables companies to issue e-certificates, it is not requirement.

Startups wanting to issue e-certificates need to incorporate relevant provisions into their operating agreement or bylaws, and ensure general compliance with state corporate law. If your company has already incorporated, but didn’t include provisions to address the issuance of e-certificates, then you need a board resolution to issue uncertificated shares. Additionally, you’ll need to amend your bylaws to reflect the change.

In smaller companies, corporate formalities might be easily overlooked, so it is vital to your compliance to enlist competent legal counsel to help you navigate through the requirements. Also, engaging an attorney can save you money in the long term since there can be tax and other regulatory implications - whether you’re going paperless or relying on physical certificates.

DRS can certainly save a lot of time and money, but you really should consult a lawyer to help you evaluate what makes the most sense for your business model. You can also take a look at the Security and Exchange Commission’s (SEC) information sheet available at www.sec.gov that describes advantages and disadvantages of each type of registration from the investor’s perspective.

Who Makes The Decisions For Your Company

Startups that start out small will usually have an informal, more flexible management style. Being inclusive with a small group is logistically easier since for one thing, you can fit everyone in the same room. Decision making can accommodate each person’s input, building important camaraderie.

However, as small companies experience increased growth, it can become challenging to include everyone’s opinion and feedback. On a practical level, it will usually be inefficient since it will take more time and effort to coordinate scheduling; meetings will take longer; and formal rules of order can be counterproductive.

At the same time, a new company is - by design or by default - creating a corporate culture. Its core values, behavior, and beliefs will determine how a company engages with its employees and handles external transactions with vendors, colleagues, strategic partners and others.

Aside from the cultural aspects of decision making, a company’s legal formalities will dictate who ultimately has responsibility for the company’s overall management.

If you are a small startup incorporated as an LLC or S-corp, then the founders are the shareholders. They have the responsibility to ensure a company’s legal and regulatory compliance.

A small C-corp could have one person fill the role as the company’s sole shareholder, director, officer, and employee. A larger C-corp will have multiple shareholders who own the company and elect a board of directors (BOD). The BOD is charged with making business decisions and selecting corporate officers such as the CEO/president, secretary, and treasurer/CFO. They also issue stock and set the price per share.

In a large C-corp, it is the shareholders who must approve the company’s articles of incorporation, bylaws, and mergers and acquisitions.

Ownership:
Creating an Option Pool & Issuing Equity

An option pool is a certain amount of stock that a company reserves for future issuance to advisors, consultants, directors, and employees. It is a very specific legal creature that requires great skill in drafting and executing since it is governed by the 1933 Securities Act.

An option pool is a certain amount of stock that a company reserves for future issuance to advisors, consultants, directors, and employees. It is a very specific legal creature that requires great skill in drafting and executing since it is governed by the 1933 Securities Act.

Many startup - particularly in the tech industry - offer key hires options as part of their compensation package. Not only do options help bootstrapped startups fill in the compensation gaps where cash is in short supply; as importantly, they tend to align the interests of the employee and company by instilling in the employee a sense of ownership in and commitment to the overall success of the business.

Allocating approximately 10-15 percent of your authorized shares to an option pool is the norm. This means ensuring that at the time you incorporate, you have authorized an adequate supply of authorized shares. Startups can feel anxious or shy about issuing millions of authorized, but it is crucial that a company optimizes its flexibility to accommodate for future growth. Reserving an ample supply for future investors and employees requires long-range planning.

If you are planning on multiple financing rounds and significant staff expansion, then you want to do a couple of things: (1) authorize enough shares when you incorporate, even if the number seems ridiculously high; (2) make sure to specify the lowest par value per share no matter how unrealistic it may seem; and (3) by judicious in the number of shares you distribute among early founders and to employees.

Issuing Equity To Founders And Early Team Members

Recent years have seen the rising popularity of restricted stock units (RSUs) offered as an alternative to more traditional stock options.

Stock options essentially give you the right to buy shares at a certain price (the strike price) after a vesting period - typically, after your one year anniversary date, with 25 percent transferred to you each year over a four year period. The key here is that you must purchase the options. Your hope is that by the time you’re eligible to buy the options, the stock has appreciated.

However, stock value could have eroded making it worthless. That is where RSUs come in.
Recent years have seen the rising popularity of restricted stock units (RSUs) offered as an alternative to more traditional stock options.

Stock options essentially give you the right to buy shares at a certain price (the strike price) after a vesting period - typically, after your one year anniversary date, with 25 percent transferred to you each year over a four year period. The key here is that you must purchase the options. Your hope is that by the time you’re eligible to buy the options, the stock has appreciated.

However, stock value could have eroded making it worthless. That is where RSUs come in.

Restricted Stock Units

Restricted stock units (RSUs) are a relatively new financial creature. Similar to options, there’s a vesting period where the employee must satisfy certain conditions before the stock or its value is transferred (typically, there is a period of time and other conditions - e.g., work performance). Unlike stock options, there is no purchase involved. Instead, a certain number of units are allocated - or granted - to the employee, but there is no value or funding until after the employee has satisfied the vesting requirements.

After vesting, RSUs are transferrable if the employee accepts the grant. Therefore, these instruments always have a value, in contrast to options that can decline in value by the time of vesting. The value of your RSUs is the closing market value of the stock price on the vesting date. That is also the point at which your tax liability is triggered, requiring you to pay withholding and income tax on the amount received.

Anyone receiving RSUs will most likely be required to file an 83(b) Election Form. The election must be filed with the IRS within 30 days of receiving or purchasing the RSUs. It effectively notifies the IRS that the RSU recipient is choosing to be taxed on their equity on the date the grant was made rather than on the vesting date. If an 83(b) Election Form is not filed, then the IRS will tax the recipient on the RSUs at the time they vest.

What is most important to understand here is that no matter which election is made, both options result in tax at the ordinary income tax rate. Also, the recipient will pay a long-term capital gains tax when the shares are sold. This means that making the proper 83(b) election is crucial to a sound long-term financial strategy.

One more note: unlike some other IRS provisions, the 83(b) Election is strictly enforced. There are no exceptions and no relief is available for late filings. A copy of the Election Form must also be filed with the company.

Stock Options

Stock options give an employee the right to buy a certain number of shares at a certain price (the strike price) at a certain time after they have earned the right to exercise (buy) your options. The employee earns the right to exercise their options (buy the company’s stock at the strike price) after the vesting period, which is typically four years, with a one year cliff. This means that if the employee leaves the company before the end of the first year, they get nothing; if they continue to be employed with the company after the first year, they get 25 percent after their first year anniversary and 25 percent each year until they are fully vested after four years.

Employees offered options are not obligated to purchase company stock; they simply have the option to buy or not. If the stock is valued above the strike price at the time of exercise, then the the employee can buy it, making a profit when it’s sold; conversely, stock valued below strike price at the time of exercise will be worthless. For example, if an options contract allows an employee to buy the stock at $10/share, and it is selling at $15/share on the day they can exercise their options (after the vesting period), they can buy it for $10/share, sell it for $15/share, and realize a $5/share gain on which they will pay taxes only when they sell. On the other hand, if the stock is valued at $9/share at the time they can exercise their options, then they are looking at worthless stock and are not obligated to buy.

Also, there are different types of stock options with varying tax consequences - e.g., incentive stock options (ISOs) and nonqualified options. Seeking professional guidance is always recommended.

One more important note about the strike price of options: the strike must be set at fair market value of the company at the time of the grant. Under IRS Rule 409A, options are legally considered deferred compensation. This subjects the options holder to tax consequences if certain rules are not closely adhered to.

Rule 409A legally obligates a company’s Board of Directors to set option strike prices at fair market value: if the strike is too low, then the IRS will treat the options as income and collect taxes as soon as they are issued. This, in turn, triggers the company’s legal withholding duties - all of which can be avoided simply by proving the fair market value of the strike price.

Enter the 409A valuation firm providing privately held companies with third party valuation verification. While this mechanism can greatly benefit options holders, it does add significant expense to a company’s operating budget, which is one powerful reason why the popularity of RSUs has accelerated in recent years.

Vesting

When you start a company with another co-founder or offer an employee options or RSUs, you want to ensure that they have a long term interest in helping the company succeed. If you give them options or RSUs without a vesting period, you run the risk of them exiting too early, leaving you without the value of their commitment, while they walk away with a potentially valuable piece of the company.

Vesting is a mechanism that deters an employee with options or RSUs from leaving a company too early: in order to receive the full value of their shares, the employee must remain with the company for a minimum period of time.

A common feature of vesting schedules is the vesting cliffs. Essentially, a vesting cliff is like a trial partnership. If an employee is granted a certain percentage of equity, it is stipulated that if they quit or get terminated at anytime during the cliff period, then the employee is prevented from collecting any equity.

The typical vesting period is four years with a one year cliff. That means that each year, the employee would earn 25 percent of their interest; after four years, they would be fully vested at 100 percent. However, to avoid them from realizing gains too early, there is a one year cliff period: If the employee exits the company before one year, they lose 100 percent of their equity. If they exit after one year, but before two years, they can collect 25 percent of their equity; 50 percent after two years; 75 percent after three years; and finally 100 percent at the end of four years when they become fully vested.

Occasionally, a company will want to speed up vesting to accommodate certain investors. Acceleration clauses are usually relevant to advisors who have successfully led a company to where it can be sold or go to IPO while the advisor is still sitting on the cliff. Since their contribution led to your success, it’s only fair to compensate them accordingly. Therefore, accelerating vesting and removing the cliff are commonly found in advisor stock option agreements and RSUs. 

Chapter One Checklist

Obtain EIN (the entity’s Tax ID number). 
Complete bylaws if a C-Corp or Operating Agreement if an LLC or S-Corp.
Open Checking and Credit accounts.
Procure Relevant Insurance. Property and General Liability Insurance, Coverage and E&O Insurance. 
Issue Stock. With Physical Certificates or Registered Online (the more common option). 
Secure a Domain Name and establish a Website. 
Ensure compliance with State and Local Law.