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Once the Delaware Division of Corporations accepts the certificate of incorporation, the incorporator adopts bylaws for the company, sets the size of the board of directors, and elects the initial board of directors.
Stock Plan Adoption
- The board adopts and the stockholders approve a stock plan.
- The corporation qualifies to do business in its home state (assuming it's not located in Delaware).
You might hear some people talk about the need to have a shareholder agreement. Startups following the standard process outlined above rarely need a separate shareholder agreement. Shareholder agreements are more commonly used by traditional small businesses, although some startup lawyers outside of major startup ecosystems use them as well.
It is important to make sure the company formation paperwork is done correctly. Unfortunately, it is practically impossible for most people to correctly complete the documents on their own, unassisted. This is true even when using forms or document generators provided by law firms for marketing purposes. Consequently, most startups use an attorney, software (such as Clerky), or both. Software helps take care of the clerical aspects of the paperwork, while attorneys are useful for legal advice.
Regardless of whether you are evaluating an attorney, software, or both, the most important criteria to consider are completeness and legal quality.
Completeness is relatively easy to evaluate. All experienced startup attorneys will be very familiar with the full set of steps above. With software, it is important to make sure the software will fully handle at least the full set of incorporation and post-incorporation setup steps. This is important because when software leaves the process hanging in the middle, it makes it more complicated to complete the company formation. The legal expense of doing so is almost always significantly greater than had the startup completed all of the first five steps together in the first place.
It's hard for non-lawyers to discern the quality of legal paperwork. Absent obvious mistakes, issues with legal quality often escape detection until a VC or acquirer performs legal due diligence. Most startups never make it that far, unfortunately, so they never find out whether their formation was done properly. Even when startups make it to a legal due diligence process, they usually don't publicize any issues that are discovered. All this makes it difficult to tell which lawyers and software produce high quality legal documents, and which do not. If you know fellow founders whose startups have raised or been acquired for a significant amount, one imperfect approach is to ask and see what lawyers or software they used without issue.
As part of the post-incorporation setup, directors and officers can optionally enter into indemnification agreements with the company. Despite what their name suggests, indemnification agreements don't usually add any indemnification, but rather clarify procedures for indemnification already provided in the certificate of incorporation and bylaws of the corporation. Some attorneys have directors and officers do this at formation. Others wait until the Series A financing, since VCs often join the board at that time and often have their own opinions about what should be in indemnification agreements. Regardless of when you choose to enter into indemnification agreements, any good startup attorney, as well as Clerky, can help you with them.
- the relative percentages of the company each founder should own,
- a rough sense of what percentage of the company will be owned by employees and consultants, and
- whether they want to informally set aside shares for the possibility of entering an accelerator program or adding additional co-founders.
Using the standard 10,000,000 authorized shares, an example of a typical allocation would be:
- 8,000,000 shares divided among the founders
1,000,000 shares to be reserved for issuance under a stock plan for employees and consultants2
- 1,000,000 shares informally set aside for accelerators or additional co-founders
The corporation can always amend its certificate of incorporation to authorize more shares. This requires additional time and legal expense, so founders typically try to allocate shares at formation in a way that minimizes the chance a subsequent amendment will be required.
When startups issue stock to founders, they usually subject some or all of the shares to vesting. This means that even though the founders own their shares, the corporation can repurchase some shares if the founder ever stops providing services to the corporation.3 The number of shares the corporation can repurchase is limited to the number of shares that have not yet vested.
When common stock is subject to vesting, it is referred to as restricted stock by startup attorneys. Restricted stock typically vests over time on a schedule known as a vesting schedule. The date when vesting begins is known as the vesting commencement date.
The most popular vesting schedule, by far, is frequently referred to as 4-year vesting with a 1-year cliff. Under this vesting schedule, 1/4th of the shares subject to vesting will vest on the 1-year anniversary of the vesting commencement date (this is the 1-year cliff). After that, 1/48th of the total shares originally subject to vesting will vest every month.4 By the end of 4 years, all of the stock will have vested.
The second most popular vesting schedule is 4-year straight line vesting, which means that 1/48th of the total shares originally subject to vesting will vest every month. 4-year straight line vesting is the same thing as having 4-year vesting with a 1-month cliff.
The vesting commencement date is commonly set to the date the shares are issued to the founder. If a founder put substantial work into the startup prior to the stock issuance, it is not uncommon for the startup to give the founder some vesting credit. This refers to setting the vesting commencement date to an earlier date — often the date on which the founder started working on the startup full-time.
Vesting protects founders, investors, and employees. Consider two co-founders that have just begun work on a startup, and have decided to split the equity evenly. If one co-founder leaves after just a week and his or her stock is not subject to vesting, the remaining co-founder and other employees could go on working for years and still have the same level of ownership as the departed co-founder. By subjecting stock to vesting, startups avoid this kind of scenario.
If a solo founder does not already have vesting in place, investors will often require that a vesting schedule be put in place. Consequently, it is common for solo founders to impose standard vesting on their stock at formation, in order to reduce their chances of ending up with less favorable vesting terms.
For example, imagine a solo founder begins full-time work on their startup and does not subject their shares to vesting. Suppose that after months or years of work, the founder looks to raise money from an angel investor. The angel investor, seeing that the founder's shares are not subject to vesting, will probably require the founder to subject their shares to vesting, and may only allow for partial vesting credit (or none at all). Had the founder's shares been already subject to a normal vesting schedule, the investor might not have raised the topic at all.
The repurchase is typically for the original price that was paid for the shares. Though less common, some vesting provisions specify that the shares are subject to forfeiture back to the corporation (rather than repurchase by the corporation).
Though rare, some vesting schedules may vest over 4 years with a 1-year cliff, but vest quarterly or at some other interval after the cliff. Technically, these vesting schedules are 4-year vesting with a 1-year cliff. Nevertheless, the phrase 4-year vesting with a 1-year cliff is universally assumed to imply monthly vesting after the cliff.
When shares are subject to vesting, by default, the IRS treats it as a taxable event every time a portion of the shares vest. This means that whenever you have shares of stock vesting, the IRS considers as taxable income the difference between (1) the fair market value (FMV) of those shares at that time and (2) the price you paid for those shares.
For founders of successful startups, this can lead to a significant increase in taxes as the FMV of their stock increases. The taxable income is tied up in the form of illiquid stock, which makes it difficult for founders to be able to afford the tax increase. In addition, the process is likely to be a significant burden due to the number of times the FMV would need to be determined. For example, for 4-year straight-line vesting, the FMV would need to be determined 48 times.
Fortunately, the IRS allows recipients of restricted stock to elect alternative tax treatment through an 83(b) election. If you make an 83(b) election, you can disregard the vesting for tax purposes and consider the purchase of the stock to be the only taxable event. You would then recognize the difference between (1) the FMV of all the shares at the time you purchased the stock and (2) the price you paid for those shares as income for the current tax year. Founders typically purchase their shares at FMV, so if they make an 83(b) election, they typically do not have any taxable income from the purchase of the shares.
In order to make a valid 83(b) election, you must mail a signed 83(b) election form to the appropriate IRS office within 30 days of the stock issuance. It is critically important to make the 83(b) election on time, as there is no easy way to fix a missed deadline for 83(b) elections.5 The IRS permits both manual signatures and e-signatures on 83(b) election forms.
IRS regulations also require you to provide a copy of your 83(b) election form to the company. As a founder, providing a copy to the company can be as simple as emailing a copy to your co-founders (if any). It is considered a best practice to store copies of all 83(b) election forms in the company's records.
In addition to making a valid 83(b) election, it is important to get evidence that you've done so. VCs and potential acquirers will look for this evidence as part of the legal due diligence process, because missed 83(b) elections can cause startups a lot of problems down the line.
In order to get all possible evidence, most attorneys recommend mailing the 83(b) election form to the IRS via USPS certified mail with return receipt requested. You should then retain the certified mail receipt as well as the return receipt when it comes back to you. In addition, most attorneys recommend including a request for the IRS to acknowledge receipt of your 83(b) election. In order to do this, you should include a brief letter to the IRS, along with a copy of your 83(b) election and a self-addressed, stamped envelope. The IRS will then typically stamp the copy and send it back to you. Unfortunately, the IRS occasionally neglects to do this (or it gets lost in the mail), which is why it is important to retain the certified mail receipt and return receipt.
If you miss the deadline, you should speak with an attorney immediately to determine next steps. Unfortunately, the legal bill for addressing this matter will likely dwarf the cost of a standard corporate formation.
Founders of a new corporation may contribute cash to the corporation, to help the corporation start operating.
Some founders are tempted to simply increase the purchase price of their common stock, to get the desired amount of capital into the corporation when they pay for their shares. Most startup lawyers recommend against this approach because it can affect the FMV of the common stock. The value of equity compensation for employees and consultants is tied to the difference between the common stock FMV at the time of issuance, and the price at which the equity is eventually sold. Therefore, startups typically try to avoid prematurely causing an increase in the common stock FMV, to maximize the value of the equity compensation.
Instead, founders typically contribute cash to the corporation in the form of a simple loan. With a simple loan, the company would be obligated to repay the founder at a later time, along with nominal interest.
Alternatively, some founders structure the contribution as a seed investment in the form of a convertible note or safe. Founders should consider the impact a seed investment will have on control and relative economic outcomes, and any resulting side-effects on working relationships. Some future investors may seek to undo founder seed investments, if they feel the economics are too founder-friendly.
To issue equity to employees and consultants, most startups set up a stock plan. A stock plan is a company program used to issue stock options or restricted stock to employees and consultants. Stock plans must be set forth in a legal document that is adopted by the board and approved by the stockholders.6 Startups typically set up stock plans as part of the corporate formation process, even if they don't have any immediate plans to hire people, because it is easier and cheaper to do all the paperwork at once rather than over time.
There are three primary benefits to using plans:
- When a startup sets up and uses a stock plan properly, the startup and its employees and consultants can benefit from advantageous tax regulations.
Corporations must comply with securities regulations under federal and state laws whenever they issue any securities, such as stock or stock options. By default, a corporation will have to analyze securities regulations and potentially make filings each time it issues securities. With a stock plan though, corporations only need to make the analysis and any necessary filings once per relevant state, with respect to issuing stock or stock options to employees or consultants.
The name of a stock plan usually includes the year in which the stock plan was adopted. For example, if your startup adopted a stock plan in 2023, it would typically be named something like 2023 Stock Plan. This is done to distinguish stock plans from each other, since a corporation may adopt additional stock plans in the future (though, this is infrequent).7
When a corporation adopts a stock plan, it must specify the maximum number of shares that can be issued under that plan. The corporation can change this number later by amending the stock plan with approval of the board and stockholders. The corporation must reserve that maximum number of shares for issuance under the plan, and must have enough shares available for issuance in order to do so. The reserved shares are often collectively referred to as an option pool or stock option pool.
The following are also terms commonly used to refer to stock plans:
- Stock option plans
- Employee stock option plans (ESOPs)
- Equity incentive plans
The term stock plan, as used in the context of startups, does not typically refer to:
- Employee stock ownership plans (ESOPs)
- Employee stock purchase plans (ESPPs)
These other types of plans have a very specific meaning, and are not commonly used by startups. Note that employee stock option plans and employee stock ownership plans share the same acronym, confusingly.
Stockholder approval is required to enable favorable tax and securities laws and regulations. Some investors may negotiate for their specific approval to be required, in addition to general requirement of stockholder consent.
One common reason a corporation would adopt more than one stock plan is because there are favorable tax regulations that only apply to stock options issued within 10 years of the adoption of the stock plan the options are issued under. When this 10-year mark is reached, corporations often adopt a new stock plan in order to ensure its stock options continue to receive favorable tax treatment.