Founders often run into similar questions and curiosities. Below is a log of frequently asked questions addressed by our lawyers, many of whom have been in your shoes.
- Why should a company form a corporate entity?
The main advantages to forming a corporate entity are:
- Limited liability protection
- The ability to issue equity (which helps compensate founders, incentivize employees and solicit investment)
- The means to centralize and protect all of an entity’s Intellectual Property (IP) and assets.
For more information on forming corporate entities see Why, How and When Should You Incorporate?.
- What are the common corporate entity choices for a startup?
There are various corporate structures to consider, such as a C corporation, S corporation or limited liability company. The most common entity choice for a startup looking to raise venture capital (VC) financing is a C corporation, typically incorporated in Delaware. For more on corporate entities for startups see Why, How and When Should You Incorporate?, What Form Should a Company Take? “C” Corporation, “S” Corporation or LLC?, Incorporation in 6 Steps and Forming a Limited Liability Company in 5 Steps.
- Which type of corporation should a startup choose?
Founders typically elect to incorporate as a C corporation, but some startups may also elect to form an S corporation if those startups intend to have no more than one class of stock and no more than 100 stockholders, all of whom must be US individuals. The main difference between C and S corporations is US federal tax treatment: C corporations face taxation at the corporate level and again at the stockholder level, while S corporations are generally only taxed at the stockholder level. For more on choosing an incorporation type see Incorporation in 6 Steps.
- What is involved when a startup incorporates as a Delaware C corporation?
A startup incorporating as a Delaware C corporation is required to prepare basic incorporation and founder documents and pay filing fees (and yearly taxes going forward) in the state of Delaware, and additional fees in any other jurisdiction where the company will qualify to do business (which will include the state where the corporation is physically based unless the corporation is physically based in Delaware). For more on Delaware C corporations see Why, How and When Should You Incorporate?, What Form Should a Company Take? “C” Corporation, “S” Corporation or LLC?, Why Incorporate In Delaware, Where Should You “Qualify to Do Business” and Incorporation in 6 Steps.
- When should a startup incorporate?
The decision as to when a startup should incorporate is ultimately a cost-benefit analysis based on when the advantages of incorporating outweigh the associated administrative work and costs. For more on the timing of incorporation see Why, How and When Should You Incorporate?
- In which state should a startup incorporate?
For most startups, especially those that will eventually seek (VC) financing, the answer is usually to incorporate in Delaware. Four reasons Delaware is the preferred location for incorporation are:
- Delaware has well-established corporation law.
- Advisors know Delaware law.
- VCs prefer Delaware Law.
- Delaware is efficient.
For more on the benefits of Delaware as an incorporation venue see Why Incorporate in Delaware.
- For a startup, what are the key incorporation documents and what are the purposes of the documents?
The two key incorporation documents for a startup are 1) the certificate of incorporation and 2) the bylaws. A corporation is considered to exist when its certificate of incorporation has been filed with the secretary of state. For a new company, the certificate is generally very brief because very few items must be covered to make the certificate effective. The bylaws set forth the general governance provisions for the company. For more on incorporation documents see Incorporation in 6 Steps.
- When are annual reports due for a Delaware corporation?
Every year, Delaware corporations must file reports and pay franchise taxes by March 1 in order to remain in good standing with the Delaware Secretary of State. For more on annual report filing deadlines see Filing Delaware Annual Reports and Paying Franchise Taxes: Tips and Resources.
- In which state should a startup form an LLC?
For business, legal and tax reasons, Delaware is the most common state of formation for startups. The laws of the state of formation will govern a company, including laws related to mergers, duties of managers and officers, members’ rights, filing requirements and fees, and franchise taxes owed to the state. A company must qualify to do business as a foreign LLC in every state in which that company intends to operate, except for the company’s state of formation. For more on forming an LLC see Forming a Limited Liability Company in 5 Steps.
- What are the key LLC formation documents and what are their purposes?
The two key LLC formation documents are 1) the certificate of formation and 2) the operating agreement. An LLC is considered to exist when the LLC’s certificate of formation has been filed with the secretary of state. For a new company, the certificate is generally brief because very few items must be covered to make it effective. The operating agreement sets forth the ownership structure and general governance provisions for the company. For more on forming an LLC see Forming a Limited Liability Company in 5 Steps.
- Where should a startup qualify to do business?
If a company transacts business in states other than the state of incorporation or formation, the company must consider whether it needs to qualify to do business in such other states. Whether a company’s activities constitute transacting business in a particular state will depend on the specific nature of the activities and the laws and regulations of that state. After a company determines the additional states in which the company should qualify, the company must pay a registration fee, annual taxes, and any associated filing fees for each such state to become and remain qualified to do business in such states. For more on qualifying to do business in various states see Where Should You “Qualify to Do Business”?
- Does the term “founder” have any legal significance?
No, the term “founder” has no legal meaning. No rule or law mandates who can be called a founder. What matters more than the title of founder is who will serve as officers and directors of the company, how the equity will be allocated, and what vesting will apply to stock options. For more on the meaning of “founder” see What’s in a Name — What Does Being a Founder Mean?
- What is a startup’s typical board composition at incorporation?
For most startups, at the time of incorporation the board of directors is merely composed of the founders or a subset of the founders. During this early stage, the directors sign a written consent in order to handle most acts that require board approval. However, live or tele-meetings allow for more careful deliberation and discussion than written consents, especially for complicated matters, in particular matters that may implicate a director’s fiduciary duty of loyalty to the company (e.g., a transaction between the company and another entity a director controls). For more on effective early-stage board management see How to Run an Effective Board Meeting.
- What is a capitalization table?
A capitalization (cap) table is a record of the ownership of a company and will include a list of both the owners and the type of security the owners’ possess. For more on cap tables see What You Need to Know about Capitalization Tables.
- What is a capitalization table used for?
A cap table is useful for determining voting (e.g., who needs to approve a new investment under the charter) and economic rights (e.g., distribution of dividends). Companies can also use a cap table to help make decisions about granting new securities. For example, a company can use a cap table to determine the extent to which the founders will be diluted if a venture capital firm invests $X at a $Y valuation or to determine how much to expand the option pool to provide adequate equity incentives for new hires. For more on cap tables see What You Need to Know about Capitalization Tables.
- What should a capitalization table include?
A cap table should include a summary of current ownership by type of security and class, as well as details listing individual holders, type of security, date of grant, exercise price (if applicable) and vesting period (if applicable). For more on what should be included in a cap table see What You Need to Know about Capitalization Tables.
- What does issued and outstanding shares mean?
When a corporation issues shares in exchange for payment, the person or entity that purchased the shares becomes a stockholder. The corporation then notes in its stock ledger that these shares are owned, and the shares are referred to as issued and outstanding. For more on what issued and outstanding shares means see Issued and Outstanding Shares Versus Fully Diluted Shares.
- How is a company’s fully diluted capitalization calculated?
A corporation’s fully diluted capitalization is calculated assuming that:
- All convertible preferred stock, warrants and options the corporation has granted are actually converted to common stock or exercised by the holder and become issued and outstanding shares of common stock.
- All shares reserved for future awards are granted as options or other equity awards and are exercised by the holder and become issued and outstanding shares of common stock.
For more on what fully diluted capitalization means see Issued and Outstanding Shares Versus Fully Diluted Shares.
- Why is it important to secure legal rights to Intellectual Property?
Securing IP is critical for the viability of a startup and one of the areas on which institutional investors will focus their diligence. Generally, investors will not invest in a company, and buyers will not acquire a company, unless the company owns or licenses all the necessary IP to run the business. Even if an acquirer or investor remains interested in a company without secured IP, the company’s valuation will be significantly lower as a result. For more on securing IP see Top 5 Mistakes Founders Should Avoid.
- Is it ok to delay the creation of a legal entity?
Delaying the creation of a legal entity can pose potential issues for the founder(s) and the company down the road. By delaying the creation of a legal entity, the company risks not appropriately securing the ownership of IP that should be owned by the company (or that founders thought was owned by the company). As questions about the province of a company’s IP come up, original founders or inventors may no longer be with the company or could be difficult to track down. For more on creating a legal entity see Top 5 Mistakes Founders Should Avoid.
- Is it ok to delay the decision as to the founders’ equity allocation?
One of the most important decisions founders make when starting a company is how to divide up the initial equity pie among company founders. For startups, waiting too long to make the equity-split decision can be a critical mistake, decisions should be made as early as possible. When a startup’s value is close to zero, the decision about how to divide up the pie is a lot easier (and much more tax efficient) than after the company has gained some initial traction, or right before the company raises funding at a (paper) valuation that could be in the millions of dollars. For more on dividing up initial equity see Top 5 Mistakes Founders Should Avoid.
- What does it mean when shares vest?
Vesting is when stock, which previously was subject to restrictions (commonly referred to, rather unimaginatively, as “restricted stock”), ceases to be subject to those restrictions. For more on vested shares see What does Acceleration of Vesting Mean?
- What is the difference between issuing stock outright and issuing stock subject to vesting?
Recipients of stock issued outright own these shares on the date of grant, with no risk of losing the shares in the future. By contrast, recipients of stock issued subject to vesting own some or all of the shares subject to forfeiture or repurchase if certain conditions are not met. For more on outright versus vesting stock options see Why is Vesting Important for Founders?
- Should founder shares be subject to vesting?
In most situations, applying vesting on founder shares at the time of issuance is in the best interest of both the founders and the company. For more on founder shares see Why is Vesting Important for Founders?
- Do investors look for stock to be issued subject to vesting?
Almost all venture capitalists (VCs) or other institutional investors want to invest in a company where the founders have “skin in the game” and, therefore, the investors prefer when founder shares are subject to vesting. In many venture capital investments, VCs invest in the founders just as much as the company idea. Investors want founders motivated to work for the company’s success and typically will not allow a scenario in which a founder can simply resign at any time and still retain all of his or her equity. For more on vesting founder shares see Why is Vesting Important for Founders?
- What is the length of a typical vesting schedule?
While the length of a vesting schedule can vary, three to five years is fairly standard, with a four-year vesting schedule being the most common. Four years may seem like a long time to founders, but sophisticated investors expect founders to have “skin in the game” for a long enough period to increase the likelihood of a successful return on investment. For more on vesting schedules see 5 Important Considerations for Founder Vesting Schedules.
- How frequently will shares vest?
The most common vesting frequencies — after any cliff vesting period— are monthly or quarterly, meaning that a portion of the granted shares vest every month or every quarter. The vesting frequency is often expressed as either a percentage or a fraction of the total shares granted. For more on vesting frequencies see 5 Important Considerations for Founder Vesting Schedules.
- What is a “cliff” and why does it matter?
A “cliff” is a time period from the vesting commencement date until the time the shares begin to vest. Once that “cliff” is reached a large chunk of shares becomes vested (essentially making up for the period in which the shares had not vested). Metaphorically, the shareholder climbs a cliff during the vesting period and until the shareholder reaches the top of the cliff no shares vest, but once the shareholder reaches the cliff, a large chunk of shares vest and the remaining shares then vest at a regular frequency. The most common cliff is a one-year cliff, which means that no shares vest until the first anniversary of the vesting commencement date, at which point one year’s worth of shares immediately become vested and the remaining shares vest over the period left in the vesting schedule. For more on cliff vesting periods see 5 Important Considerations for Founder Vesting Schedules.
- What is acceleration?
If certain events occur, acceleration provisions provide that a founder’s unvested restricted stock, will accelerate and become vested as a result of the triggering event. For more on acceleration see What does Acceleration of Vesting Mean?
- What are the common forms of acceleration?
The two most common forms of acceleration provisions are 1) single trigger and 2) double trigger. For both, the main triggering event is typically the sale or change of control of the company. Single-trigger acceleration provisions typically provide that upon a sale or change of control, all or some portion of the restricted stock will immediately become vested. By contrast, double-trigger acceleration provisions typically provide that upon a sale or change of control (i.e., the first trigger) no acceleration occurs and rather the restricted stock will only accelerate if the founder is then terminated without “cause” or leaves the company for “good reason” (these terms should be defined in the equity grant documentation) within some set time period (typically six months to one year following the sale or change of control) (i.e., the second trigger). For more on forms of acceleration see What does Acceleration of Vesting Mean?
- Which type of acceleration do investors want?
Startup investors usually buy into a company because the investors believe in the founders and the founders’ ability to make the company a success. Consequently, startup investors will be very leery of a single-trigger vesting structure which would allow the founders to walk away from the company and potentially leave it floundering following a sale or change of control. As a result, startup investors will often choose not to invest in companies with single-trigger vesting, or will require the change of single-trigger provisions to double-trigger as a condition to their investment. For more on investor-friendly acceleration types see What does Acceleration of Vesting Mean?
- Who is typically impacted by acceleration?
Acceleration provisions apply to founders or key employees of a company much more commonly than for rank-and-file employees who join the team later in the game. For more on who receives acceleration provisions see What does Acceleration of Vesting Mean?
- Is spending time on recordkeeping necessary?
If “cleanliness is next to godliness,” then poor recordkeeping in startup land is a mortal sin. Keeping organized when a business is on the line can seem like a luxury that a founder does not have time for, but it is critically important that the management of a startup make time to be organized. When startups go to raise money, an investor will want to perform extensive diligence on the company, including business, IP, capitalization and legal diligence. Startups can only respond efficiently and make a good impression with proper recordkeeping. For more on the importance of recordkeeping see Top 5 Mistakes Founders Should Avoid.
- Should a startup include stock transfer restrictions?
Privately held companies, particularly in pessimistic markets, cannot afford to deal with the distraction of employees or existing investors selling stock to third-party buyers (secondary stock sales). To guard against this risk, companies can and should set up their corporate governance documents at inception to provide that any secondary stock sale requires prior approval of the company. Companies should require prior approval for stock sales to help keep all stakeholders focused on growing the business and driving long-term shareholder value creation. For more on requiring prior approval for stock sales see How to Grow a Successful Startup in a Skeptical Market: 3 Considerations.
- Why would a non-US company choose to form a Delaware holding company structure?
A company incorporated outside the US may choose to form new Delaware holding company structures for several reasons, including:
- The United States remains one of the principal global sources of venture capital and other private financing.
- Some of the world’s premiere stock markets are located in the United States and an initial public offering (IPO) and stock exchange listing on NYSE or NASDAQ can lead to better access to capital and offer a potential path to liquidity.
- A trade sale to a US acquirer is often seen as an ideal potential “exit” and re-incorporating in the US can help facilitate a sale.
- US companies can sell their products to both US and non-US companies, more easily than non-US companies trying to do the same.
Companies that choose to operate through a US holding company can achieve each of the aforementioned objectives. Consequently, an increasing number of non-US companies — including companies that currently have minimal or no operations in the US — choose to form Delaware holding company structures, often in connection with private equity, venture capital or other private financing rounds. For more on non-US companies choosing to form a Delaware holding company see Doing the Delaware Flip: Why and How do Non-US Companies Re-Incorporate in the US?
- What are the key differences between common stock and preferred stock?
The two are very different forms of equity; preferred stock provides holders many beneficial rights and powers that are not otherwise available to common stockholders. The following are four key differences:
- Liquidation preference – non-participating and participating
- Voting rights – regarding board composition and protective provisions
- Additional features – including conversion rights, anti-dilution protection, registration rights, preemptive rights, right of first refusal, co-sale rights, covenants and drag-along rights
- What is an equity pool?
An Equity Pool is the number of shares a company sets aside, or reserves from which it can grant stock options or restricted stock. Companies often use these forms of incentive equity to compensate and incentivize employees, directors and consultants. For more information on equity pools see How to Decide the Size of a Startup’s Equity Pool.
- Why does the size of a company’s equity pool matter?
As a company will be using the Equity Pool for compensation and incentives, a company’s Equity Pool needs to be large enough to attract and retain talent. At the outset, an entrepreneur’s tendency might be to make the Equity Pool as large as possible to cover any and all compensation and incentive needs, but companies must be careful as the Equity Pool can have a dilutive impact on the ownership interests of founders and other early shareholders when the company decides to raise more money. For examples on how the size of the equity pool impacts a company see How to Decide the Size of a Startup’s Equity Pool.
- Should a Startup Grant Options or Restricted Stock?
A startup equity plan provides a company with the flexibility to issue both Options and Restricted Stock. But which is right?
It is usually the right call to grant Restricted Stock at formation and in the very early days that follow for the following reasons:
- With a restricted stock grant, an employee can choose to file an 83(b) Election and start the clock on long-term capital gains for these shares.
- In the very early stages of a company, the valuation of the startup’s common stock is likely very low and as a result, the cost of an employee making the 83(b) Election is de minimis. The employee must either purchase Restricted Stock at the current value or pay tax on the value of the shares, and due to the low share price, neither of these options poses a significant cost to the employee.
- Restricted Stock grants are not subject to Section 409A, so a company need not obtain a third-party 409A Valuation to support these grants.
- The shares can still be subject to vesting in reverse, so if the employee leaves, the company repurchases the shares at cost (so the dilution is the same as an option that an employee exercises upon leaving the company).
Restricted Stock won’t be as attractive once the valuation of the company has risen to the point that the cost of filing the 83(b) Election is more significant. As a rule of thumb, this inflection point would likely be after a startup’s first externally priced equity round or once a startup has more than a few employees. At this point, Option grants become the more common form of equity grant issued to employees.