How to Properly Distribute Shares in a Corporation
If you don’t have the time to read the entire article, at least remember this: the number of issued shares may not exceed the number of authorized shares.
This comprehensive guide explores legal aspects of entering the US market from the founders’ perspective: from the corporate entity form and opening a bank account to immigration and personal tax considerations of founders.
Chances are that if you are reading this, you have researched other startup guides on the internet. What sets this startup guide apart from others is that we do not tell you how to do your job or solely focus on getting your business noticed. This legal guide for startup founders goes beyond basic advice and guides you throughout the entire process. You will find yourself repeatedly referring back to this document when addressing specific issues or even when negotiating with investors. To save you time, we included a plethora of valuable links, overviews, and well-organized detailed sections.
Of course, seek advice from your lawyer if legal issues arise, but know that with an understanding of the common pitfalls and a solid understanding of the process, many legal issues can be avoided. We want you to be prepared, knowledgeable, and confident at each stage of the process.
You can sometimes get by without a legal entity, but if you must have one, the choice boils down to a limited liability company (LLC) or corporation (C-Corp).
How to choose between them? Here’s the rule. If you’re planning to raise funds from outside investors, including participating in an accelerator program, you’re going to need a C-Corp. Professional investors won’t invest in an LLC due to the nuances of the U.S. tax system, which we explain further below.
LLCs are subject to so-called “pass-through taxation,” meaning the company itself isn’t the subject of taxation, but taxes on the company’s income are paid independently by its owners. If an investor acquires a stake in an LLC, he can be required to pay taxes on any increase in the value of his stake – even if the company’s profits were not distributed.
A C-Corp’s income is subject to double taxation because, unlike an LLC, a C-Corp is a separate entity for taxation purposes and is required to pay income tax. If the C-Corp declares and pays any dividends to its stockholders, those dividend recipients will be taxed on their personal income at their individual tax rate. This indicates that an LLC is almost always a more cost-effective option than a C-Corp when it comes to taxes. To avoid worrying about paying taxes on the company's retained earnings in their personal tax returns, investors tend to favor C-Corps as investment recipients. This is done to shift the tax obligations to the C-Corp’s founders and accountants, keeping taxes predictable for investors.
In terms of corporate governance, since LLCs are not required by law to hold annual meetings of their members, they are not required to pay the expenses associated with sending out annual meeting notices, creating agendas, holding meetings, voting procedures, producing accurate meeting minutes, and sending stockholder notices. Almost all of these expenses are necessary for a C-Corp.
The management style for an LLC is completely up to the members unless the manager-managed type of operational control is chosen. C-Corps, on the other hand, are governed by their board of directors, who are chosen by the stockholders. The directors, in turn, appoint the CEO, CTO, Secretary, and other officers of the C-Corp.
The table below describes the major differences between LLCs and C-Corps.
To summarize, there is no definitive answer to the question as to what corporate form is better because it depends on the objectives you have set for your business. But there’s a simple rule of thumb: an LLC is a better option for companies that are generating revenue and don’t plan on fundraising. If you don’t need investments, or you’re simply setting up an operating or holding company, an LLC will do just fine.
Once you’ve figured out which corporate form best suits your needs, you should decide on the company’s state of registration. If you are a U.S. citizen, the choice is quite simple: you should opt for the state where you live or work to avoid any complications related to foreign qualification of businesses, “nexus” for taxation purposes, and dozens of other challenges. If you are a non-US resident, things might get pretty complex, since you are now exposed to 50 states with different laws, tax regimes, and a whole range of traps and pitfalls.
Nevertheless, certain states have gained enormous popularity over the past several years. While Delaware remains the jurisdiction of choice for business formation and California has the famous Silicon Valley companies to its name, in recent years Nevada, Wyoming, Florida, and Texas have become increasingly popular among startup founders and investors.
Despite the hype around certain states, there are important considerations when deciding on your state of registration, including state corporate law, franchise tax and other state taxes, level of bureaucracy in terms of corporate operations (e.g. filing amendments to the corporate documents), obligation to have a physical business address in the state of formation, ease and promptness of the formation process, and level of transparency of information about the company’s beneficiaries. The table below compares some of those criteria among several states.
* For the ease of reference, we will refer to the states in the above table by their short names throughout this guide, namely DE (Delaware), WY (Wyoming), NV (Nevada), CA (California), and FL (Florida).
However, most companies are registered in Delaware due to the state’s well-developed corporate law favorable, tax treatment, and relative anonymity. Furthermore, if you plan to raise funds for your C-Corp, it is more likely that your seed investors will strongly advise you to incorporate in Delaware. The reason behind this favoritism is quite simple – if your company proceeds with an IPO, Delaware law will shield investors via its corporate law.
Having your corporation registered in Delaware doesn’t restrict you from doing business in other states. At the same time, if your company has a physical presence (office, staff) or conducts significant commercial operations (sales) in another state, you’ll most likely need to qualify to do business in the other state as well as maintain a registered agent and an office there.
You should keep one very important detail in mind. If you plan to get a long-term U.S. visa and move to America to do business there, consider a state’s business environment when choosing where you plan to settle.
Incorporation of a new business mostly seems like a complicated and overwhelming process due to the paperwork involved and the tedious steps to complete. It is essential that your business has all documentation drafted correctly to prevent serious legal issues down the line. This includes during the period of the pre-investment due diligence process.
If you are planning to form an LLC or C-Corp in the U.S., our U.S. Startup Package provides an all-inclusive solution to launching your business in the United States.
However, you can still incorporate a new entity without an attorney. In this case, it’s most convenient to use the services of a registered agent, who:
In the table below you can find several registered agents who may be of help in establishing your company in the United States.
Strictly speaking, founders aren’t required to hire an attorney to incorporate the company, since the attorneys themselves retain agents as contractors.
However, it is important to understand that once your company is incorporated, you are only halfway through the setup process. By the time you receive your Certificate of Incorporation, you should be prepared to enact a set of crucial documents that will serve as the cornerstone for your company’s future operations.
Due to the legal ramifications that go hand in hand with these documents, enlisting the aid of a corporate attorney that can guide you through the legal complexities may be your best route. For example, your future investor(s) will expect that documents evidencing the acquisition of the company’s shares by its founders have been properly drafted and executed, and that the relations between shareholders and employees have been legally and factually established with the corresponding transfer of intellectual property (“IP”) rights. In every startup scenario, it is imperative to establish a solid legal foundation to avoid troubles in the future.
In particular, the gold standard for the initial set of documents is:
A document that establishes and confirms the existence of the company in a particular state, it indicates the number of company’s authorized shares, and the name and address of its registered agent.
A set of rules and regulations enacted by the company to provide an organizational framework for its operation and management.
A document that confirms the appointment of the company’s initial directors or members.
A document that sets out the general organizational matters necessary for the start of the company’s operations, including initial distribution of shares, appointment of corporate officers, determination of the term of the fiscal year, powers of directors and officers, etc.
Typically, an Excel document that outlines ownership of the company’s shareholders, including the number and class of shares as well as the ownership percentage. Sometimes it also includes the types of investment vehicles used by the company during its financing rounds, names of investors, and classes of shares.
A document signed by and between your company and its initial shareholders constituting the transfer of shares and stating the number and class of shares to be acquired, the per-share price and total purchase price, along with some other terms.
NB! A single record in a Cap Table that indicates someone has a particular number of shares is not sufficient.
A document confirming the transfer of IP related to the project from founders and key employees to the company. Protects the company in case of termination of relationship with certain founders and employees or corporate conflicts between founders, since all IP related to the project will remain the exclusive property of the company.
A pro-company services agreement will not only help you establish relationships with your employees and contractors, but also secure the company’s right to all intellectual property related to the project produced by your employee or contractor during the term of your arrangement.
As soon as you have all these documents signed by the appropriate parties, you will be ready to move toward the next steps of setting up your business. These steps are described in further detail in the following sections.
The next steps following the company’s incorporation are obtaining a tax number, opening a bank account, setting up your mailing facilities in the U.S., and, sometimes, getting insurance.
A tax number (Employer Identification Number or EIN) for a company in the U.S. can be easily obtained online in a matter of minutes, provided that one of the company’s officers has a Social Security Number or Individual Taxpayer Identification Number. To obtain a tax number, follow the instructions on the EIN Assistant website.
If no SSN/ITIN is available, the tax number can be obtained by fax, mail, or over the phone. The process is described in detail on the IRS website. In short, the most common way to obtain an EIN is to mail a filled-out SS-4 form to the IRS with a return request to be forwarded to your business address either in or outside the U.S. You do not have to file your EIN application by yourself, instead you may opt for hiring your attorney or registered agent to obtain an EIN on behalf of your company.
Standard IRS processing times are somewhere between 7-20 business days, depending on the overall workload of the IRS itself. For example, during the busiest tax period in April-May, processing times can increase up to 35 business days.
Once you’ve received your EIN, you can open an account at a U.S. bank. For that you’ll need to gather the required documents about the company and its key shareholders. The primary documents and information requested by banks in the U.S. are the company’s articles of association, EIN, and basic information about your business and its controlling persons, including names, addresses, and IDs of the company’s officers, directors, and shareholders with an ownership percentage exceeding 25%.
Most banks require your physical presence, but there are also some that can open an account remotely, such as Mercury. However, you should note that Mercury does not provide its services to residents of certain countries, so make sure that your country of residence (not citizenship!) is not on the list.
Even though most states do not require you to have an address within the state of your company’s registration, even for online businesses it is extremely useful to have at least a virtual mailbox with a built-in mail forwarding feature to accept letters and parcels addressed not only to the company, but also to the founders individually.
The key point of confusion here is the difference between a registered address and a mailing address. This is usually expressed in the question, “Why on earth should I have two separate addresses and which one will be used as the company’s business address?”
The answer is simple – your registered address is not your address per se but rather the address of your registered agent that will be used for the official correspondence from state and federal authorities and courts. The company’s mailing address is designated for day-to-day operations: communications with partners and contractors, opening and maintaining the bank account, receiving certain security-related letters, such as Google Play Market code for developers, etc. If the address you provide to your counterparties and authorities is the company’s registered address, be sure to either purchase mail scanning and forwarding service from your registered agent or understand the risk of not being able to retrieve any mail sent to your registered address aside from official correspondence.
For example, our U.S. Startup Package includes a mailing address in New York for 1 year. Nevertheless, if you are going through your incorporation journey alone, you may find the following mail forwarding service providers useful:
As soon as you have these details sorted out, you will be fully ready to move to the next step on the ladder to success.
In most U.S. states, companies are prohibited from operating under a different name in the absence of formal notification from the state. A business entity must register their “fictitious name” or a “doing business as” (d/b/a) name with the state or individual counties prior to doing business under it.
For example, conducting business under a name that differs from the official name of the company as reflected in the Certificate of Incorporation, at the level of individual counties in the State of Delaware, where such activities take place, will be subject to an administrative fine not exceeding $100, imprisonment of the official representatives of the company for up to 3 months, or both of these measures simultaneously.
Another way to legally use the alternative name is to change the official name of the company with the state. Such change can be made by filing an application with the Secretary of State and paying a processing fee for the application.
The most important aspect of choosing an entity name is to understand that a wrong choice could lead to the need to use the other name later on and to incur the costs that follow this decision. Note that it will also affect other aspects of the company’s operations, such as trademark registration, which is discussed below.
Delaware corporate law has an archaic feature: the Certificate of Incorporation must indicate the number of the company’s authorized shares. This number represents the maximum number of shares the corporation is authorized to issue to its shareholders.
The gold standard is 10,000,000 shares of the company’s common stock having par value of $0.00001 per share. Do not be fooled by Quora and Reddit commenters who write that such a number of shares will expose you to franchise tax of several tens of thousands of dollars. Familiarity with navigating the Delaware franchise tax payment portal is a must to avoid unnecessary taxes and legal issues.
Founders have been known to distribute either all authorized shares at once or even more than the actual number of authorized shares among themselves. While the distribution of shares after issuing the maximum number of authorized shares is generally voidable, distribution of all shares among founders at the very beginning may cause similar headaches. The result of these actions could lead the company to have no shares for further distribution to future investors or in reserve for the purposes of an employee stock option plan (“ESOP”).
The erroneous perception that ownership in the company is based on the authorized shares and not the issued shares can cause many problems. In reality, the actual ownership is always calculated based on the issued shares. So, if the company has 10 million authorized shares, but only one shareholder with 6 million shares, that shareholder is the 100% owner of the company. Keeping this simple principle in mind will go a long way in saving founders much trouble down the line.
If there is more than one shareholder, the principle remains the same, with one exception: for the purposes of calculating shareholders’ ownership percentages, the shares reserved for the ESOP are usually included, even if they are unissued. You can see a typical capitalization table of a pre-seed startup below.
Now let’s assume that the number of issued shares matched the number of authorized shares, and you have an angel investor or advisor who wants to receive shares of the company’s common stock. In such scenario you will have two ways out: repurchase founders’ shares or issue additional shares of common stock.
In the first scenario, you will have to execute a stock repurchase agreement and have it approved by the board of directors. Please note that in case your original stock purchase agreement contained vesting provisions, you will first have to accelerate the vesting of your shares either partially or in full by obtaining a resolution of the board and only then continue to the execution of the stock repurchase agreement.
If you choose the second scenario, you will have to file a certificate of amendment of your Certificate of Incorporation with the Secretary of State of the state of your company’s incorporation. Such certificates must be accompanied by the corresponding resolutions of the company’s shareholders and board of directors. In Delaware, filing of such amendment will cost you at least $294, leaving aside attorney’s fees for the drafting of all the necessary documents.
As you can see, both of these options are costly and involve extra paperwork. Therefore, you should think ahead and distribute a reasonable number of shares early in the process. A common rule of thumb is to distribute 6,000,000 shares among the founders and leave the rest for the ESOP and early investors taking common stock. This way, you won’t need to incur additional costs to amend your Certificate of Incorporation to authorize new shares of stock or go through the stock repurchase process.
To stay active, every company needs to file and pay its taxes, submit annual reports, maintain its internal documents in good order and try to avoid common mistakes. This section considers these aspects in more detail. For taxes, please refer to section VII.
You may be required to obtain certain additional documents, such as a Certificate of Incumbency or Certificate of Good Standing (Certificate of Status).
A Certificate of Incumbency is a document issued by the company itself (both corporations and LLCs) that lists the names of its current directors, officers, shareholders, and other information at the discretion of the company, such as the company address, signing authority, and other information.
A Certificate of Good Standing is a document issued by the state that indicates an entity is active, has fulfilled its tax and reporting obligations with the state, and is authorized to do business:
Price: $50 per certificate (short-form) or $175 per form (long-form).
Price: free (online version) or $10 for a paper version.
Price: $5 or $15 for inperson orders.
Price: $50 (expedited processing is available for an additional fee).
Price: $8.75 for corporations and $5 for LLCs.
All states require companies to retain a registered agent at all times. Failure to pay fees may lead to the resignation of your registered agent. In general, if your registered agent resigns and within 30 days you fail to obtain and designate a new registered agent, your company may be declared forfeited.
In the heat of negotiations with investors or in a rush to solve things faster, many founders forget about one very important step – formal corporate decisions. Even though Delaware law and the laws of other states provide for avoiding formal meetings with the board of directors or shareholders by obtaining a written consent of the directors/shareholders, many startup founders do not see the importance of formalizing their company’s decisions.
In the absence of formal approvals, many corporate actions, including distribution of shares, appointment of directors, approvals of SAFEs, ESOPs, and others may be considered void or voidable.
As we said before, it’s easy to lose track of formalities when things are moving at a high speed, but forgetting about your cap table may lead to a recordkeeping problem that is very difficult to rectify.
If you don’t keep your cap table updated, you may accidentally issue more shares than your company is authorized to issue, lose track of convertible securities that you’ve given to investors, and encounter other difficult problems.
A simple Excel file might suffice at the beginning, but when you are sensing that you’re moving toward a higher number of investors, shareholders, or option holders, you may find the following services of use:
At the beginning of every endeavor, it always seems that you and your cofounders are on the same page and have a common interest and investment in your goal. However, history shows that no matter how strong the partnership is, there is always a chance of a conflict, or, at worst, a breakup. No matter how impossible it seems, it is at least prudent to entertain this possibility.
Here are a few suggestions to consider before forming a company to prepare yourself and, more importantly, your company for such an unfortunate turn of events:
Understand that there are unlimited reasons why a conflict could arise at any point in the startup process. This could be due to differing views of the company’s future, a personal misunderstanding regarding major decisions, or outside influences. This is why we advise that you spend time considering and planning for the ‘what ifs’ of your company’s formation from a personal and legal perspective.
Almost every startup needs capital for its growth and development. There are various instruments for fundraising: the classic ones, such as direct equity investments or debt (ordinary loans); hybrid instruments such as SAFEs (Simple Agreement for Future Equity) and KISSes (Keep It Simple Security) that are being used with increasing frequency by U.S. investors; and more innovative emerging forms of financing that include the issuance of tokens (e.g. Simple Agreement for Future Tokens or Token Warrant Agreements).
Issuing digital tokens is becoming increasingly popular in the world of web3 startups. If you consider such an idea, check out our Web3 Startup Legal Guide and SAFT Legal Checklist.
To fully understand this part of the guide, you need to be familiar with common investment vocabulary. This section may also be useful to you later on when you just need to refresh your memory before negotiations with potential investors.
Shares that give all shareholders identical rights. In general, one share confers one vote and a proportional percentage of dividends.
Shares that give their holders rights and privileges above those conferred by common shares. These terms can be set out in the bylaws, particular stock purchase agreements, and the shareholders’ agreement.
The company’s valuation at which the investor acquires the shares, calculated before the investment is made or the next round of funding takes place.
The company’s valuation that factors in the investor’s investment.
Additional privileges in the payment waterfall for the investors in the event of the company’s liquidation.
Provisions that shield the investor from dilution by providing him the rights to participate in the subsequent round of financing or the ability to separately purchase additional shares to maintain his ownership percentage if the company’s valuation goes down.
A set of conditions that protect the investor and, consequently, restrict founders. These include the investor’s veto power to block certain transactions, information rights, etc.
The procedures that allow an investor to participate in certain transactions (such as a sale of shares by other shareholders) at the terms offered to the sellers or outside purchasers. These types of rights are generally granted in a shareholders’ agreement at later stages of the company’s development (Series A and later).
The conditions governing the vesting (obtainment of rights to the shares either during a certain time or dependent on other factors, such as the duration of employment, certain achievements, etc.) of founders’ shares.
The rights available to current investors in future financing rounds.
The investor’s rights authorizing access to certain company information (such as balance sheets, annual reports, etc.) or participation in board meetings.
The issuance of shares is one of the main forms of fundraising for startups in seed financings and later (seed stages also often feature the use of convertible loans). As discussed above, shares entitle their holders to various rights. In practice, when fundraising from outside investors, a startup will usually issue preferred shares.
The number and types of privileges that can be granted are limited only by the imagination of the corporation’s investors and board of directors. Just remember that anti-dilution protection, ROFR, tag-along, drag-along, and preemptive rights are your leverage instruments when dealing with investors. Professional investors have started to become much friendlier toward founders and try to offer fair terms, but this doesn’t mean that you should lower your guard during negotiations.
All agreements that you will need to enter into in order to sell your company’s shares (whether common or preferred) will contain a list of representations and warranties and will differ in length and complexity depending on the attorney who drafted the documents. Below is a brief overview of common representations and warranties that you will find in such agreements and the reasoning behind them.
Authority; Enforceability; Compliance with Laws. Both parties entering into the agreement need written assurance that they are duly incorporated, validly existing, and are in good standing with the state of their incorporation. If your investor is an individual, the corresponding representation is that he has legal ability to enter into the agreement (not disabled, a minor, or precluded from entering into the agreement by some previous commitment). The representation regarding compliance with laws serves a similar purpose: both parties confirm that they conduct their business and are entering into the agreement in compliance with applicable laws (including any corporate formalities, previous agreements, securities laws, etc.).
Intellectual Property. Representations regarding intellectual property can be found in almost every agreement dealing with investments, as most investors require it. A company that doesn’t own its intellectual property is a wild card for investors, even if you are the only owner and inventor. Generally, this representation will require a confirmation from the startup that it owns all intellectual property necessary for the operation of its business, for example, by requesting an Intellectual Property Assignment Agreement.
Under U.S. law, all companies that want to issue securities to investors must register them with the Securities and Exchange Commission (SEC). But there are a few exemptions available under the Securities Act of 1933 for private sales of securities. The most commonly used exemptions are governed by Regulation D and Regulation S.
These exemptions require that certain conditions are met in order for them to be applicable to a particular transaction. Such conditions include restrictions on the amount of funds to be raised during any 12-month period, with a gap between such periods of at least six months ($1 million with no limit on the type of investors or $5 million as long as the number of non-accredited investors does not exceed 35 persons), and SEC notification. Non-accredited investors (also commonly called “retail investors”) are generally any investors other than institutional investors and high-net-worth individuals.
Under the terms of a convertible loan (note), the investor gives the company a loan that can subsequently be converted into the company’s shares or must be repaid with interest. Usually, the decision rests with the lender and may be predicated on a whole range of events, such as the next equity round, dissolution of the company, maturity date, or other circumstances.
The documentation for convertible loans is pretty standard. If you want to raise funds from an angel investor, you can use one of the freely available templates, and then you’ll just have to agree upon the key terms, which include:
It’s also worth paying attention to the terms relating to the definition of “qualified financing,” maturity date, and liquidation preferences.
These instruments represent the next step in the evolution of convertible loans. The SAFE agreement was developed by Y Combinator, the top startup accelerator in the United States. Another well-known accelerator, 500 Startups, uses the KISS agreement.
The main feature of the SAFE, and what distinguishes it from a convertible loan, is that the company doesn’t have to repay the funds to the investor if the next round of financing doesn’t come through. The logic is simple: if the company was unable to fundraise for the next round, then it is unlikely to be able to repay the loan. There are a few different versions of the SAFE – it would be easiest to look over their terms by referring to the primary source, where you can also download the templates and explanatory guide.
According to the terms of the KISS, the investor is also prevented from demanding repayment of the investment amount, but can still insist on the forced conversion of that same amount into a new class of shares upon the maturity date (18 months). The KISS also gives investors more rights in terms of accessing the startup’s financial information.
Discussing the sale of tokens as a form of financing is rather difficult, since all tokens are different and the phenomenon itself prompts mixed feelings with experts and novices alike. But it’s not an instrument that can be ignored either.
One of the most recognized forms of issuance is the SAFT (Simple Agreement for Future Tokens). You can read a clear explanation of how it works and what to consider during negotiations in our breakdown of the SAFT here.
As we said before, most mistakes that startups make are a result of rushed decisions. First, investors and accelerators can pressure founders into agreements that do not reflect standard market practices (for example, adding anti-dilution provisions that in other circumstances would require significant negotiations, pressuring founders into issuing warrants without making additional capital contributions from the investor, or requiring entering into a shareholders’ agreement at the seed stage, etc.). We advise you to anticipate and to be on alert for such terms.
Acceding to such terms can lead to probing questions from future investors, incurring attorney’s fees, and sometimes to the termination of previous contracts. So take the time to actually read the agreements your company is entering into so you don’t give too much away to the investor or hinder the long-term growth of the company.
Do not forget that if you issue SAFEs or other investment instruments that require a transfer of preferred stock to investors, you have to check whether your Certificate of Incorporation allows your company to issue shares of preferred stock. Generally, such an option is not provided at the stage of incorporation, so, at the next financing round, you need to undertake a couple of steps. First, you must draft an amendment to the Certificate of Incorporation and have it approved by both the directors and shareholders of the company, and then file a copy of this amendment with the Secretary of State. In Delaware, the filing fee for this amendment is $194.
Failure to authorize the issuance of preferred stock in a timely manner may result in a breach of your obligations under your investment agreement. Consequently, it’s always better to double-check that all legal formalities are observed to maintain good relationships with your investors from the very beginning.
Almost every investor, especially at the seed and Series A stages, will require you to provide certain corporate documents to make sure that the legal facets of your business are crystal-clear.
There are several things of particular interest to investors, as indicated in the table below.
While preparing these documents for due diligence, you can easily get overwhelmed. This can be especially true if you didn’t spend the time previously to set up a logical and organized recordkeeping system. Here are some tips that might help you to keep your documents up to date and ready for due diligence:
All investors would agree that the “star quality” of the team is the lynchpin to accurately evaluating a project’s prospects. In order to recruit good talent, companies might promise a dynamic and “family-like” atmosphere with freshly baked cookies, or they could offer stock options or restricted stock units (RSU).
U.S. employment law is very flexible. Workers are classified as “at-will employees” – staff that the employer can fire at any time and for any reason other than unlawful discrimination and similar grounds.
U.S. federal law is virtually devoid of compulsory benefits for employees, such as minimum vacation days and paid maternity or paternity leave. However, such benefits can be mandated under state law.
When it comes to key employees, it is market practice to offer them an employment agreement that is effective for a certain term and provides the employee with certain guarantees. At the same time, for non-key staff like junior software developers, HR and SMM managers, it is common practice to use a contractor services agreement instead of an employment agreement.
If you have an international startup, using an employment agreement only makes sense for full-time employees located in the U.S. For others, a services agreement will do just fine while also keeping your costs down by saving on taxes and compliance and reducing the administrative burden of setting up formal payroll processes.
Below are the main differences between contractors and employees from the startup’s viewpoint:
Although it may seem reasonable for founders to leave their employees without any social security just because they work remotely or have a flexible schedule, this should not be considered common practice. Contractual freedom provides employers with the possibility to grant their contractors some of the benefits provided to employees, including certain anti-discrimination and retaliation protection, minimal compensation per reporting period, days off, and annual or other bonuses, either monetary or provided through services, products, or equity.
Workers who become your senior employees (for example, an experienced outside CEO or CFO) expect certain benefits. They normally require significant compensation (monetary or via equity) in case the startup succeeds during their tenure. The terms of such compensation can require much thought and negotiation prior to any legal agreement. Many experienced senior employees have been on this road before and have sued their previous employers. This is not a warning to steer clear of potential senior employees with an established history, but rather a reminder that agreements containing defined terms of compensation may at least spare you from future disagreements or litigation. For example, agreeing that compensation will be paid after the “next round of financing” is vague, so it makes sense to define the “next round” in terms of a minimal amount of money raised, its form, and approximate deadline.
A common stipulation included in employment agreements (especially with senior employees and rarely in services agreements) is the non-compete clause. This clause prohibits competition for the duration of employment with the company and for a few years thereafter. Startups should be cautious when drafting and negotiating this clause, since in the event of a dispute, a court can void any restrictions it finds unjustifiably broad in terms of time and place.
Virtually all VC investors require the existence of an option pool, meaning a number of shares reserved for the issuance of stock options and other instruments to employees and advisors. A company creates an option pool by adopting a formal employee stock option plan (ESOP), also called an employee equity incentive plan. Options can replace or accompany the salary or other compensation paid to workers in hopes of providing additional motivation for further engagement, especially if the startup has promising prospects.
To create an option plan, it’s not enough to include an “option pool” row in the cap table and enter the corresponding number of shares. You have to formally authorize an option plan describing the requirements for employees’ acquisition of options, the size of the pool, vesting structure, and other aspects.
The process of adopting an option plan is highly formalized, as the plan must be approved by the board of directors and the shareholders first. The following documents are necessary to fully implement the plan:
Please note that the exercise agreements should not be signed until the end of the vesting period or until the date of actual acquisition of shares under the option pool.
Startups usually reserve roughly 10-20% of their total shares for the option pool. For an example of an employee equity incentive plan, you may consult our free templates here.
An option gives an employee the right to acquire the company’s shares in the future at a certain price. The price is fixed at the moment the option is issued, and must generally correspond to the fair market value (“FMV”). An outside expert may have to be retained for the purposes of determining FMV.
There are two kinds of options: Incentive Stock Options (“ISO”) and Non-Qualified Stock Options (“NSO”). ISOs can only be issued to employees and are subject to more favorable taxation rules. NSOs can be issued to anyone, including outside advisors and consultants.
A Restricted Stock Unit (“RSU”) is the company’s obligation to issue shares or the equivalent amount of money to an employee in the future. RSU sales are not tied to the market price, so there’s no need to determine FMV. For this reason, RSUs can be more attractive for employees.
Startups usually incentivize their key employees with options, while larger companies tend to offer RSUs.
NB! Both options and RSUs should be included in the company’s capitalization when calculating the stake of the investor under virtually all investment vehicles: warrants, SAFEs, Convertible Notes, KISSes, etc.
The issuance of options and RSUs is always predicated on vesting, where the shares become the employee’s property but are contingent upon the occurrence of certain conditions. These conditions could include the simple passage of time or the achievement of certain indicators. The classic vesting schedule is “4-year vesting with a 1-year cliff,” under which the employee receives 25% of the total promised number of shares after the first year of employment, and then 1/48 of the shares every month for the next three years of employment.
It’s worth repeating that all intellectual property that your employees or service providers create must belong to the company. This is something you need to be very specific about in agreements with your team, as overlooking this can seriously hinder your company’s ability to protect its assets. We would like to draw your attention to “work made for hire” clauses in order for you to avoid disputes similar to the Khalid v. Citrix Sys., Inc case.
If and when you have to say goodbye to your employees, don’t forget about certain formalities:
Trademarks serve as an indicator of the source of goods or services. Unlike the rest of the world, their registration isn’t required in the U.S., where exclusive rights to a trademark result from its commercial use.
Registration confers certain privileges, such as constructive notice to market participants of your ownership of the trademark (the right to use the ® symbol) and additional rights in the event of litigation.
You can draft an application for a simple trademark without an attorney using the TEAS form. Applicants with a permanent residence outside the U.S. must hire a U.S.-licensed attorney who will submit the application and will further communicate with the U.S. Patent and Trademark Office (USPTO) should any issues arise.
Before choosing a name for your product, make sure that it’s available for use. You can do this free of charge by searching the USPTO Trademark Database. Similarities with other trademarks in the database can suspend or completely restrict the registration process, so go through the database carefully. The USPTO provides the Trademark Electronic Search System (TESS) to assist in searching all registered trademarks and trademark applications in the database. To minimize the risks of your trademark registration being refused, you should conduct at least a simple “knockout” search of the trademark database for marks identical to the one you wish to register.
You can register words, designs, and even smells and sounds as trademarks.
The registration process has several stages. The duration may vary from 9 months to several years depending on the circumstances. Here are the main stages of the trademark registration process for a mark that is already being used commercially a the time of filing:
Most applications, however, run into issues, which the USPTO identifies in a letter called an “office action.” To ensure your mark progresses to registration, you must remedy all the issues identified in the office action within 6 months of receiving it.
If you already used the trademark in commerce with your goods and services, be ready to provide evidence of such use (called the “specimen”). The specimen must show how your mark is used in commerce. For example, if you have an e-commerce business, your specimen can be a screenshot of your online storefront where the mark appears.
If your trademark is currently not in use, but you intend to begin use within 3 years of filing your application, you can file an intent-to-use application, which will allow you to reserve rights in the trademark provided you submit a specimen in the 3-year window.
Once your mark is registered, you can use the ® symbol next to your mark wherever it appears. Registration serves as constructive notice to the market that you are the owner of the mark and provides important rights in case someone infringes your mark.
To preserve your registration, you will need to file a declaration of use with the USPTO between the 5th and 6th year after registration. Then, you will need to renew your registration in the 10th year after registration and every 10 years after that.
If you have missed these deadlines, you can file a declaration of use for an additional fee in the 6 months that follow. If you don’t do this, your registration will be canceled.
The USPTO sends reminders about these deadlines through the email addresses provided at the time of application. You can also located the relevant information about your mark at the Trademark Status & Document Retrieval (TSDR) site by entering your registration number and checking any deadlines listed in the folder entitled “MAINTENANCE.”
Here is the schedule of the fees you can encounter during the application and maintenance process:
You can find the complete USPTO fee schedule on the USPTO website.
Copyrights protect works recorded on tangible media and arise immediately at the time of their creation by their authors. For tech startups, the most relevant copyright-protected item is the source code written by their employees. The registration of copyrights isn’t mandatory in the U.S., but it does confer rights similar to those granted by a trademark registration.
Copyright registration is mainly essential for the purposes of copyright infringement litigation. To sue someone for infringement of your copyright, you first need to apply to the Copyright Office for its registration. Registration doesn’t mean that the lawsuit you file will be a definite success, but it does provide the court with a basic level of proof of the validity of your copyright. Copyright registration creates a presumption of copyright ownership, which gives you a stronger position in court: by having it you don’t need to prove that you are the actual copyright owner, but rather the other party bears the burden of proof that you are not.
Moreover, as with a trademark registration, a copyright registration serves as constructive notice of copyright ownership. Thus, copyright registration reduces the number of copyright infringements because the information on whether a work is protected by copyright is made available to the public. Second, registration may result in financial benefit to the owner since anyone wishing to license the copyright can contact the owner.
In general, some registration applications must be completed online (applications for published and unpublished photographs, newsletters, newspapers, etc.), others may be done using paper forms (literary works, visual arts works, sound recordings, etc.), and some must be completed on paper (vessel designs, mask works, etc.). Online copyright applications are submitted through the Electronic Copyright Office (“eCO”). Each application contains three essential elements:
The average processing time for all copyright applications is 3.6 months, but the process takes longer for applications submitted on paper. The Copyright Office encourages applicants to use eCO to submit their copyright claims. When an online application doesn’t require any correspondence with the applicant, the processing time is reduced to 1-2.5 months.
Note that if correspondence is needed to complete the processing of the application, registration may take up to 7.5 months. See the actual registration processing times here.
Patents are issued for inventions (such as processes or machines) that are new, useful, and non-obvious, as well as for industrial designs.
Startup founders and their investors often inquire about the applicable national boundaries placed on their patent or if they can obtain a patent on the startup’s invention.
The most important points to consider from this section are:
* There is no general rule of thumb due to the fact that patentability of software is still a hot topic discussed by the courts and the USPTO. Generally, if your software implements technical improvements to the computer system itself and you hire a competent patent attorney who can properly draft the patent application, you may be able to obtain a patent registration.
Obtaining a patent in the U.S. takes two to three years and costs several thousand dollars (at the very least), as the services of an attorney are essential. The application is submitted to the USPTO and, if approved, the patent holder gets a usage monopoly (the right to exclude others from making, using, offering for sale, selling or importing the patented invention) for 20 years for inventions and 15 years for industrial designs.
Patents obtained in the U.S. are legally protected only within the U.S., so if you plan to expand your business to other countries, you will have to obtain patent protection by applying in each of those countries. But keep in mind that you don’t have a lot of time to apply.
The Patent Cooperation Treaty (“PCT”) is an international treaty with 156 contracting states. The PCT allows applicants to submit one application simultaneously in the contracting states (allowing you to keep the same filling date for all of the chosen countries), obtain an international search report, and also provides a little more time for deciding on the countries in which you wish to obtain a patent. The granting of patents remains under the control of the national patent offices.
For a startup, it’s important to ensure that IP rights are transferred in favor of the company from all of its founders, contractors, employees, and domestic and foreign entities. This requires the execution of an agreement with the above-mentioned parties under which the rights to all of the IP are transferred to the company.
The must-have highlights of these agreements are provided in the table below.
The most important provision for services or employment agreements is the “work product” clause. Under this clause, a contractor irrevocably assigns to the company all rights to any work product developed by the contractor during the term of the arrangement, including any ideas, concepts, developments, etc. As a result, ownership of the intellectual property is transferred to the company, and the contractor retains no right to its further use.
Furthermore, it is necessary to obtain a license to any pre-existing IP that was produced by third parties and used by the employee during the course of creation of the work product. It is also vital to obtain representations from your employees that the work product was created solely by your employee, no third parties retain any IP rights in the work product, and that the work product is original and does not violate, infringe, or misappropriate any IP rights of any third parties.
Such measures can play a key role in a situation where a former employee uses the company’s IP to compete with it. It was precisely this scenario that unfolded in the case of a former Waymo engineer who stole the company’s files in order to create his own startup Otto, subsequently acquired by Uber. As a result of the lawsuit that followed, Uber admitted its fault and agreed to pay Waymo restitution in shares valued at roughly $250 million.
To avoid complications in the event that a company founder leaves, you should think ahead about consolidating all IP rights of founders in the company. To that end, when you first distribute shares to founders, make sure to transfer all intellectual property rights to your newly incorporated entity.
To do this, use a Proprietary Information and Invention Assignment Agreement. It will not only substantiate the transfer of pre-existing IP rights, but also allow to directly transfer every project-related intellectual property that will be created in the future to the company as a “work for hire.”
If you are planning to fundraise, your future investors will expect that all intellectual property related to the project belongs to the company that is the investment recipient. Investors do not want to invest into an asset-stripped the company.
For example, the GNU General Public License is a strict copyleft license. It obligates developers who use the code published under the GPL to transform their entire work into a GPL-licensed work too. This means that once you’ve implemented such code into your product, you will also be required to make the source code for this product openly available to anyone and allow him to modify and redistribute it under the GPL.
Open-source software is generally released on GitHub and other portals. What is important here is to always check the type of license that the software is being released under.
By following the hyperlink above, you can find general terms and conditions that govern the most popular copyleft licenses. Before implementing such software in your commercial products, make sure to find out exactly which license covers the code that you’re using and the specific terms that it imposes.
If you have an app for iOS or Android, when drafting the T&C you’ll need to consider the rules of the respective platforms: the App Store Review Guidelines and Google Play Developer Rules. For example, you won’t be able to submit an app to the App Store without a Data Universal Numbering System (D-U-N-S) number. Here is a special tip: regardless of what many sources online say, obtaining a D-U-N-S number is actually free. If you don’t have one already, you can easily do it yourself without external help by simply filing an application here.
If, while creating advertising materials for your applications, you want to use that helpful link “Download on the App Store,” you still have to review the relevant guideline to avoid any legal complications in the future. Your Social Media Manager (SMM) can easily forget about this. Here is one for Google Play as well.
This is also particularly relevant for applications that work with personal data, run quizzes, or use tokens. Apple, for example, just recently added cryptocurrency provisions to its rules (see Guideline 3.1.5 here).
If you’re selling SaaS products to corporate clients, you’ll need a standard contract. It’s worth recognizing from the start that you won’t always be able to impose your terms on such clients, so the contract should be appropriate. The basic framework can be taken from the Y Combinator template.
The U.S. has no comprehensive law on personal data analogous to Europe’s General Data Protection Regulation (“GDPR”). Nevertheless, there are certain federal and state laws on personal data.
The U.S. Electronic Communications Privacy Act prohibits the capture and unauthorized access to private communications, while the common law of the states allows individuals to sue in cases where their reasonable expectation of privacy has been violated.
If your client base includes EU citizens, you’re probably governed by the GDPR. In that case, you should familiarize yourself with the main provisions of the GDPR and the various instruments that are available for ensuring compliance with its requirements. This is especially applicable if you provide services related to social media and various social networks and platforms.
Failure to do so will expose your company to a penalty of at least $7,500, but it also grants the consumer the right to sue your company if it violates the privacy guidelines, even if there was no actual breach of the law. As an example, customers from California may sue your company in case there is no clearly visible footer or pop-up window on the website providing customers with an option to opt out of data sharing.
It can be a minor detail, the specifics of the services you provide, or data that you keep that need tweaking, but spending the time on these details upfront can save you some major headaches down the line.
Be advised that you should always indicate that all rights and title to your project remain the sole property of your company. It is useful to include a restrictive legend stating that the copy of your platform, app, website, etc., are licensed and not sold to users or provided for free.
Consequently, you must make it clear in your T&C that you provide users only with a conditional right to use your platform typically for non-commercial purposes for a limited period of time. Otherwise, one may try to sue you to prove that you’ve sold the whole platform at a price of a single user fee.
Do not forget that if you offer a product with significant involvement of your customer base through forums, personal accounts, and review options, people can abuse the functionality of the product and post offensive or explicit content on your platform. To keep your conscience clear, do not forget to add a specific provision to ensure that your customers, technical platforms such as the App Store or Google Play, and regulatory authorities know that you will try to do your best to timely revise and delete all offensive or explicit content through your own moderation or after thoroughly reviewing a complaint submitted by your customer.
A franchise tax is a tax charged by some U.S. states to certain business organizations such as corporations and partnerships. A franchise tax is not based on income. Rather, the typical franchise tax calculation is based on the net worth of capital held by the entity.
* If the Assumed Par Value Capital Method was used. For more information, see here.
** Only on assets located in Wyoming.
*** If an LLC makes more than $250,000, there is an additional fee payable by the 15th day of the 6th month of the current tax year. For more information, see here.
**** For tax years ending June 30, the due date is on or before the 1st day of the 4th month following the close of the tax year.
For federal income tax purposes, the IRS uses the following default classification:
LLCs using the partnership classification and single-member LLCs are considered to be pass-through entities. This means that the company itself is not subject to taxation at the federal level. The members will independently report the company’s income on their personal tax returns and pay taxes in proportion to their ownership in the LLC. LLCs that use the classification as a corporation will pay a federal income tax of 21%.
Unlike LLCs, for federal income tax purposes, a C-corporation will be recognized as a separate taxpaying entity with a current income tax rate of 21%.
Please note that this guide does not provide you with specific information regarding all of the IRS forms your company needs to file or information regarding all the taxes that your business may be required to pay. If needed, we recommend consulting a CPA that can provide assistance with your company’s specific tax obligations.
A sales tax is a tax imposed on retail sales of goods and services. If you sell physical goods, it will apply to you in most cases. However, this will become a much more interesting topic for discussion with your accountant if you sell digital products (SaaS).
The actual sales tax rates vary from state to state, with only some states recognizing SaaS as a taxable service. At the same time, it should be taken into account that in order for the obligation to pay sales tax to arise, there must be a nexus with a particular state. In most cases, such a nexus is established if sales in a particular state exceed $100,000. Below is a summary regarding the taxation of SaaS services in the most popular states:
Alabama, Alaska, Arkansas, California, Colorado, Florida, Georgia, Idaho, Illinois, Indiana, Kansas, Kentucky, Louisiana, Michigan, Nebraska, Nevada, New Jersey, North Carolina, Vermont, Oklahoma, Wisconsin, Wyoming.
Arizona, Connecticut, Hawaii, Iowa, Massachusetts, Minnesota, New York, Pennsylvania, South Carolina, South Dakota, Texas, Utah, Washington.
While you can certainly pay some taxes, such as the franchise tax, yourself, nothing tops having an experienced accountant who can analyze your particular situation and properly prepare and file your tax returns. Federal taxes are a nightmare on their own, but with the assistance of a CPA, you will be able to navigate these dark waters more easily and avoid common mistakes. So unless you are completely cash-strapped, budgeting a few thousand dollars a year for a qualified accountant is a wise choice.
Prior to 2016, single-member foreign-owned LLCs were not required to send informational reports to the IRS and or obtain an employer identification number (EIN). However, starting from 2017, such LLCs are required to obtain an EIN and annually file Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business) with the IRS along with Form 1120. For an LLC with a single member, “related parties” include the member himself, his close relatives, and companies owned directly or indirectly by such member. Therefore, even a transaction involving a contribution to an LLC from its sole member must be reflected in the relevant forms.
Be forewarned that if you don’t file these forms, the IRS will charge you a minimum penalty of $25,000.
Successful startups follow one of three paths:
The first path is not actually that common. Two random examples: Snapchat (didn’t become profitable but still conducted an IPO) and MailChimp (became profitable almost immediately and never raised outside funds).
The other two paths to success are the ones more travelled. In the parlance of investors, it’s called an “exit.” Here are examples of an exit:
In an asset deal, the startup’s founders usually move to the new, larger company in order to oversee work on the product. In such a case, the founders usually receive certain stock rights once at the new company in the form of restricted stock units , which are tied to the achievement of certain KPIs.
But what happens if you fail? Failure should be seen as just an opportunity to take a step back, reconsider your mistakes, and start over again with the sophistication gained from your experience.
But don’t forget that you still have an entity that you should shut down before moving on to the next endeavor if you do not plan to continue working on this particular project.
In Delaware, you have to follow 9 steps to dissolve a C-Corp. For your convenience, we’ve collected them in the form of a checklist:
What you definitely shouldn’t do is giving up your company and acting as it has never existed. If you close your eyes and forget that once upon a time you had an entity that is no longer operating, it does not make federal and state penalties go away, but rather helps them grow exponentially.
If you fail to properly dissolve your entity, you risk losing your good standing with federal and state authorities, banks, and partners. Furthermore, you will have to pay enormous fines of tens of thousands of dollars for not filing tax forms with the IRS, as well as fines and interest for non-payment of local state taxes.
As a result, in case you want to restore your business at any point in the future, it might be extremely hard to start all over again, especially to prove your legitimacy during the KYC and due diligence processes.
This is again a reminder to check out the previous section VII of this guide.
Congrats, you have made it through one of the most comprehensive legal guides for U.S. startups and are now equipped with knowledge and tools to navigate most of the formalities
If you have any further questions or just want to give us a high five, feel free to contact us on Twitter @buzkokrasnov or via email email@example.com. You can find all our related content and subscribe for updates at this page dedicated to U.S. startup founders.