In the early days of starting a business, you might be tempted to gloss over ownership structure, equity stakes, and other seemingly boring details. After all, you might think, as long as you keep taxes low, paperwork uncomplicated, and partners motivated, better to deal with the big stuff first. But these decisions can have a significant cost down the road, particularly for entrepreneurs who seek outside investors.
Last fall, when Rama Katkar and Kristin Kranias quit their jobs to start their first venture, Hipiti.com, an online shopping aggregator in San Francisco, they planned ahead to raise capital. Katkar knew from her four years doing private equity deals to be mindful of the concerns of would-be investors. “You don’t want to increase the number of obstacles between you and funding,” she says.
One such obstacle can be your business’s structure. Most entrepreneurs incorporate as a limited liability company or an S corporation for their simplicity in filing taxes and lower tax rates. “In these structures, profits and losses from an active business entity pass through directly to the owner’s personal returns,” says Steve Bortnicker, a Certified Public Accountant in Chappaqua, N.Y. “You can even carry back or carry forward the losses if you can’t use them all in your current return.” In the startup phase, when business losses are more likely than gains, the ability to use losses to trim your personal tax bill by offsetting income from wages, interest, and dividends can obviously be important for founders.
But venture capital firms generally won’t invest in these so-called pass-through entities. They prefer C corporations, which allow different classes of stock for passive and active investors. They also want to protect their investors—which can include tax-exempt institutions or foreign entities—from having to file U.S. tax returns. “Most venture firms are unwilling or unable to invest in any other type of entity because of their fund structure,” says Katkar.
Where you incorporate can also throw a wrench in your fundraising effort. The vast majority of U.S. investors are familiar with Delaware C corps and uninterested in spending time getting up to speed on so-called governing laws in states where they are not already actively investing. While it is possible to modify where your business is domiciled down the road, it can be expensive, not to mention complicated.
How founders distribute equity among themselves is also material to investors. “If founder shares are granted on day one and partners part ways early, you may find yourself dealing with a partner that is not only checked out but in a position to impact the decisions that matter in your business,” says Katkar. Founders who have the ability to walk away with significant equity before crucial milestones are reached limit the company’s ability to offer incentives to recruit new talent.
Nail down who owns what when. To protect everyone involved from costly buyouts and contentious interactions in the aftermath of a startup separation, establish a founders’ vesting schedule that governs the length of time a founder must work in the business to realize an ownership stake. A three- to five-year vesting period for founders’ shares is fairly standard; many schedules also include a so-called cliff period that keeps equity from starting to vest until six months after operations commence.
How frequently shares vest is another important detail to hammer out. Annual vesting cycles can create bizarre incentives for founders to stay in the business longer than they want to (or should) be there. Instead, opt for a monthly vesting schedule that compensates founders more frequently for their time spent and encourages them to leave when it is best for them and the business.
For those who set up a vesting period for stock, know that it is important for each founder to file an 83(b) election with the IRS within 30 days of purchasing restricted stock. An 83(b) eliminates the negative tax consequence by recognizing the founder’s income at the time of the initial stock purchase when the fair market value is low and income on the transaction is next to nothing; without one, each time stock vests partners will face a taxable event in which income will be calculated as the difference between fair market value of the stock and the issuing price.
Finally, investors will also want to know that you have set enough stock aside to keep employees motivated in expanding the business. Granting restricted stock and options can be a complicated tax matter. When starting out, it’s perfectly acceptable to keep your equity structure simple. Just know that for companies with growth potential, investors want to see that you have the ability to set 20 percent of equity aside to attract top talent.
Structuring your business with investors in mind does not have to cost a fortune. “If you have a friend that started a company in a similar sector, ask to read their documents; seek input from lawyer friends to help you understand the data you uncover,” suggests Katkar. Taking the time to get up to speed on standard practices will save you money in the long run. Before you etch anything in stone, you will want to work with a seasoned lawyer and tax professional.