by Page no: G112
Sessions
Legal Concepts
2018-09-20: by Megan Todd
Legal Concepts
Founder Institute companies will need to know all of the following items:
- Incorporation: the goal of incorporation is to protect owners by creating a separate legal ‘person’, the corporation. The corporation is the ‘person’ who is sued and can go bankrupt, while the real people behind the company – the shareholders who own the company – are fully protected. All FI companies are asked to incorporate. Besides protecting you, it also protects your future investors, who would never invest without incorporation.
- Preferred vs. common equity: the owners of the corporation are the shareholders, who hold shares in the corporation, otherwise known as ‘equity’. All companies start with common shares. Some companies will issue preferred equity to investors or others. These preferred shares get special rights that each company can define, e.g., they can get paid first in a potential sale of the company, potentially leaving the common shareholders with nothing.
- Officers and directors: the way shareholders avoid liability in a corporation is because although they own the shares, they don’t control what the corporation does. Shareholders elect a board of directors. The directors have ultimate control of the company, and also the most legal risk. The main way the directors exercise their control is by hiring or firing the CEO and other ‘officers’ of the company, such as the CFO and CTO. The CEO and other officers are the ones who control what the company does on a day-to-day basis. They are typically employees of the company. It is normal for early founders to be shareholders, directors, and officers in their company. In the future, the board may fire them as an officer. They would still be shareholders and could be directors unless they resign or are removed.
- Articles and bylaws: the articles and bylaws of your company are the rules your company operates by. These rules set such things as how shareholders choose the board, and what items get voted on by the directors or shareholders. Additional documents may also influence these rules, such as a unanimous shareholder’s agreement (‘we all agree to these additional rules’), or papers signed as part of a financing (‘as a condition of financing the company agrees to these additional rules’). These rules generally don’t matter much, until the time comes when, e.g., investors want to fire a founder, and a founder wants to stay on. Whether that happens or not will depend on what your rules say.
- Dilution: when a company raises money, it often does so by selling shares to investors. The company creates or issues new shares (with the approval of the board), and then sells those shares to investors, with the investors giving the company the money. When new shares are issued, all existing investors are ‘diluted’. Because more shares exist now, their (fixed number of) shares represent a smaller percentage of the company. If existing shareholders sell their shares to new investors, there is no dilution … and the money goes to the shareholders, not the company. Note that because of dilution it is never smart to promise somebody ‘1%’ of the company. Instead, promise them ‘10,000 shares’, and tell them how many shares exist today, so they can work out the percentages for themselves.
- Founder shares: when a company incorporates, the founders of the company will buy shares in the company. The price of these shares is often very cheap (e.g., 1,000,000 shares for $1,000), because a company that didn’t exist before can be worth only a few thousand dollars when it starts. As soon as the company starts to sell shares to investors, the share price will increase dramatically, e.g., to $1/share. If a new founder joins after you have raised investment, they will need to pay the same $1/share, and often can’t afford to acquire 1,000,000 shares as they could at the beginning. Even if you give them the shares, they would still owe tax on the value of the shares they were gifted. Because of this, later employees are normally compensated by options.
- Options: an option is a contract that gives someone the right, but not the obligation, to buy shares in a company (‘exercise the option’) at a specific price (the ‘exercise price’), during a certain period of time. The exercise price should always be equal or greater to the real share price when the option is written, or the recipient will owe tax on the difference. You should always list your options on your cap table: if the company is sold, the option holders will buy their shares, and the money given to shareholders will then also be split with option holders.
- Vesting: although founders and employees are expected to stay for many years when we let them buy founder shares or give them options, people may leave early. Vesting is a legal mechanism that forces people who leave the company early to give back some of their founder shares or options. With an option, the contract will normally say that unvested options can’t be exercised. With founder shares, a vesting clause will normally give the company the right to buy back unvested shares at the price the founder paid for them. Typically shares or options vest over four years, with a one-year ‘cliff’. This means that if you leave in less than a year, you lose everything; if you leave after one year you keep 25% and so on.
- 83(b) Election (for US companies only): if you receive founder shares in a US company, that vest over time, it may (depending on how you structured your founder share issuance) be important to file an 83(b) election within 30 days of receiving the shares. This is a letter you send the IRS stating that you want to be taxed on your shares now, rather than when they vest. If you do not do this, and the value of your shares goes up, you may have to pay tax each year as the shares vest, based on the value of the shares then. File the election as part of your incorporation, or make sure you don’t need one.
- Employment: each country or state has its own employment law, which will give employees rights, and which will force employers to pay taxes on the employee’s behalf. You can also have part-time contractors, who are exempt from employment law and pay their own taxes. Your local law will set out the conditions under which you can consider someone a contractor, and when you have to treat them as an employee. Note that it is important to have an employment or contractor contract with everyone who works for you, to make sure that you own all of their work, and any intellectual property they develop for you.
- Intellectual property: a corporation can own ideas or words via patents, trade secrets, copyright or trademarks. For instance, in a patent, you describe an idea to the patent office, and if it passes suitable tests, you can then have a ‘patent’ giving you the sole rights to that idea for 20 years (e.g., a chemical formula for a drug). You want to ensure that your contracts with employees give your corporation rights to the intellectual property they develop for you. Without a contract, they can claim the ‘IP’ for themselves or ask you for more money to transfer it over.