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Louis Lehot is a leading corporate lawyer specializing in mergers and acquisitions, private equity and venture capital investments, and helping innovative companies go “garage to global.” He works with organizations in an array of industries including technology, healthcare, life sciences, and clean energy. 

Louis provides practical, commercial and strategic legal counsel to private and public companies involved in growth and liquidity events. He works on deals involving venture funding, mergers, acquisitions, spinoffs, strategic investments, and joint ventures. In addition, companies and investors seek Louis out for counsel in forming companies, financing, governing, and buying and selling businesses.

Mergers and acquisitions represent one of the most common and often the most beneficial exit strategies for startups. M&A plays a leading role in integrating innovation into markets over the longer-term. 

Tech entrepreneurs and startups are driven by much more than profit. These innovators are passionate about their inventions and want to see the products they develop in action, changing people’s lives and becoming mainstream in the long term—from new medicines to AI applications and apps that help manage your diet.

The term M&A is a broad one that means different things to different companies in different deals. An M&A transaction may refer to one company purchasing or absorbing another, a merger where two companies join together, an acquisition of major assets in a company, a tender offer to buy a company’s stock, or a hostile takeover. Companies large and small, public and private, need ongoing counsel to help them identify, structure and execute the deal that’s right for them, provide the legal framework that can optimally make it happen —and then make sure it happens successfully.

Louis Lehot represents buyers in creating acquisition programs, selling companies, purchasing assets, merging with other firms, and licensing. Louis’s clients range from bootstrapped startups to venture-backed emerging growth companies, to public companies, and the venture capital and private-equity financial sponsors that fund these entrepreneurs. His clients have included venture capital and private equity firms and corporate venturing groups that make investments in technology, healthcare, clean energy, and other innovative businesses.

The process of investing and acquiring startups can be wildly lucrative, but at the same time wildly risky. Parties on both sides of a deal need to find the right partner, the right deal, and importantly, the right legal counsel to ensure the best options are sought and that everyone does their part to ensure success.

Data drives the modern economy. By its very importance, it has become a target for hackers and bad actors. Whether it resides on third-party cloud servers or locally, the risks are significant and potentially disastrous. Data security, or lack thereof, poses a direct risk to consumer privacy, as it subverts the purpose for which personal information was disclosed and subjects the consumer to loss of privacy, financial harm, falling victim to scams, and other potential negative consequences.

Whether you are planning new data security policies or revising old ones, consider how to minimize your data liability. Though not practical for every situation, the best way to limit your data liability is not to collect the data in the first place (i.e., data minimization). As a simple example, in our data-driven world, users are frequently asked to provide personal information. Accessing a report might require giving out a name and an e-mail address or creating an account. That data might be useful to you for creating a mailing list, but the privacy implications are increasingly driving users to keep extra e-mail accounts as spam filters so that they can get the information they want without being bothered by newsletters.

IP protection. When an inventor, entrepreneur, or startup develops a novel technology, the first step in bringing it to market is legal counsel, to protect intellectual property and to explore deals that may fund its development and initial marketing. Among the issues legal counsel will advise on or oversee are:

Intellectual property protection. Entrepreneurs and companies developing technology must constantly be working to protect it. Protection includes filing for patents, trademarks, and copyrights, as well as working to avoid infringement, enforce rights, and defend against infringement should rivals claim they got the idea first.

M&As. Mergers and acquisitions are goals of most startups, a time to cash in on years of hard work, pay off now-happy investors, and set innovations permanently onto the market. Legal counsel oversees deal structuring, contracts and documentation, due diligence, regulatory compliance, and other essential legal details.

Litigation and dispute resolution. Unfortunately, the tech world is as competitive as it is innovative, and too often that winds up involving litigation. It can come from any direction, from patent trolls (companies that file patents only so they can sue future inventors) to competitors to investors. This is why tech companies hire legal professionals who are experts at IP law, infringement and pirating, contract breaches, and other relevant areas of law.

Lawyers serving clients in the Health Care and Energy industries help navigate and solve complex issues unique to these sectors. 

In the Healthcare industry, attorneys may assist clients with regulatory compliance, healthcare contracts, licensing, and addressing issues related to patient care and privacy. Healthcare lawyers may also be involved in matters such as healthcare litigation, medical malpractice defense, and advising on the implications of healthcare policies and regulations.

In the Energy industry, legal professionals may help clients with regulatory compliance, environmental law, project development, and negotiations with stakeholders. They specialize in areas such as renewable energy, oil and gas, and utilities, offering legal support on project financing, permits, and compliance with environmental regulations and industry standards.

An equity incentive pool is a tranche of shares of common stock that are set aside for stock options, restricted stock or other equity instruments to help a business recruit, retain, incentivize, and align key talent for long term value creation and success. Startup companies often use these shares in lieu of cash to compensate employees, directors, advisors, and consultants.

Why do I need an equity incentive pool?
Equity incentive pools reflect how much of your company you can retain. Each time a grant is made, you are making a statement about your company’s valuation.

Formed under the General Corporation Law of The State of Delaware, the corporation, known as a C Corporation, or stock or open corporation, is popular. Some 65% of Fortune 500 companies use this form as do more than 50% of all publicly traded companies. Delaware continues to be the foremost state for incorporating a business, as it has been since the early 1900s.

C corporations are taxed separately from their owners, under the U.S. federal income tax laws. In contrast, S corporations are not taxed separately. The C corporate form is beneficial to owners when the corporation wishes to lower taxes by reinvesting retained earnings. A disadvantage exists in those taxes can be assessed twice: at the corporate level and again at the shareholder level when a dividend is declared.

Advantages of incorporating in Delaware include the sophistication of the legislature and statutes governing corporations, the corresponding preference of investors for purposes of raising capital, the clear separation of rights and responsibilities between the parties involved, the absence of size limitation, and the judiciary that resolves disputes and interprets laws. Delaware’s Court of Chancery, consisting of a chancellor and four vice-chancellors, is thought to be more predictable than the courts of other states in that decisions are based on 200+ years of consistent case law and judicial procedure, the court has historically respected the good faith decisions of a Board of Directors over the desires of stockholders, and there are no jury trials in the Court of Chancery.

Traditional crowdfunding platforms, such as Kickstarter, Indiegogo and Patreon, operate on rewards-based systems whereby retail investors contribute cash in exchange for gifts, products, or discounts. Equity crowdfunding, on the other hand, is a method of investing into private companies in exchange for equity. It allows startups to raise funds from and pitch to a crowd of small, individual investors through internet-based platforms with built-in regulatory and legal compliance. While smaller, retail investors may not be able to make a significant impact on a stand-alone basis, when pooled with other like-minded investors, their financial contribution is magnified. Investing in one mission together with others of a similar mindset, the community can generate media and raise capital at a sufficient scale to accelerate growth. As a bonus, these platforms open doors for startups to connect with investors globally. Furthermore, equity crowd funders are not required to be accredited investors. Equity crowdfunding is thus considered less expensive and less time consuming than other ways of raising funds.

Formation

A capitalization table, often referred to as a “cap table,” provides a snapshot of a company’s securities holders at a specific moment.

The level of detail in a cap table can vary based on what information the company chooses to share and what the viewer needs. A basic cap table might display the total number of the company’s issued and outstanding securities, broken down by security type. A more detailed cap table could show the number of securities each stakeholder holds, their percentage of economic ownership, and their percentage of voting control.

Cap tables inform significant company decisions. Therefore, it’s vital for a company to keep its cap table accurate and updated. Companies use cap tables to decide how much equity to award to employees, how much equity to sell to investors, and determine which investors are required to approve major corporate actions. Investors use cap tables to understand their economic ownership and voting control in companies.

During fundraising, a company and its investors use a spreadsheet model, known as a pro forma cap table or “pro forma,” based on the company’s cap table, to forecast how new investments will impact ownership and voting rights. In mergers and acquisitions, a company will create a model, known as a “waterfall,” based on its cap table to determine how to distribute transaction proceeds to its stakeholders.

In the United States, securities offered to a company’s employees, consultants, or advisors, such as restricted stock or stock options, must be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption from registration. For this purpose, startups often use the federal exemption known as Rule 701 for securities offered to service providers. This rule provides a registration exemption for compensatory benefit plans, like the equity incentive plans or stock plans companies use to grant stock options.

The total value or amount of securities sold by a company during any consecutive 12-month period in reliance on Rule 701 cannot exceed the greatest of the following:

(i) $1,000,000;

(ii) 15% of the total assets of the company, as of the company’s most recent balance sheet date (which can’t be older than the company’s last fiscal year end); or

(iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the company’s most recent balance sheet date (which can’t be older than the company’s last fiscal year end).

If a company expects to sell more than $10 million of securities under a Rule 701-exempted benefit plan within any consecutive 12-month period, it must provide disclosures to its service providers who might buy the securities under the plan. These disclosures, which should be given a reasonable time before the sale date, include a summary of the plan’s material terms, risk factors, and financial statements.

A company has the flexibility to select any consecutive 12-month period for measuring Rule 701 compliance. This could be a fixed period or a rolling 12-month period. However, once chosen, the company must apply it consistently.

As a company starts making substantial grants under its equity incentive plan, it is important to regularly monitor and measure compliance with Rule 701. When the company approaches the $10 million within 12 months threshold, it should consult with knowledgeable securities counsel to begin preparing the required enhanced disclosures and planning for the distribution of this sensitive information, including confidentiality precautions. Failure to comply with Rule 701 requirements can lead to penalties and even the loss of the exemption. Rule 701 does not preempt state securities laws, so companies must also ensure compliance with applicable state blue sky laws.

Securities laws are a complex set of U.S. federal and state laws, regulations, and court cases that govern the offering and sale of financial instruments known as securities. Many other countries have their own securities laws which govern securities transactions within those countries. Examples of securities include common stock, preferred stock, SAFEs, convertible notes, bonds, options, warrants, certain digital assets, limited partnership interests, LLC units, and investment contracts.

A primary purpose of securities laws is to protect investors from being defrauded by issuers of securities. In the United States, the basic premise of federal securities laws is that issuers must register all offerings of securities with the Securities and Exchange Commission (SEC) unless there is an exemption from registration.

The registration process is the procedure companies undergo when they make an initial public offering (IPO) of their securities or “go public.” Registration requires a company to provide audited financial statements and detailed written disclosures about its business, its management, the securities being offered, and potential risks of investing in the company, to the SEC and potential investors. Once a company has gone public, it must regularly update this information, at least quarterly. The registration and reporting requirements are time-consuming and costly. As a result, only larger companies with sufficient resources and sophisticated internal controls and processes capable of managing the periodic reporting obligations choose this path.

All other companies, ranging from early-stage startups to pre-IPO firms, must find an exemption from registration when offering securities for sale to investors. These exemptions, detailed in the securities regulations, generally stipulate that certain types of securities offered to a limited number of qualified investors in specific ways do not require registration with the SEC.

When fundraising, startups typically use a “private placement exemption” to sell securities to “accredited investors.” These investors, as defined in the securities regulations, include individuals with a net worth exceeding $1 million (excluding the value of their primary residence) or an annual income over $200,000 individually, or $300,000 when combined with a spouse. Companies can offer and sell securities to non-accredited investors but must provide them with the same information as in a registered offering. Accordingly, startups are advised to sell securities only to accredited investors to avoid potential securities law violations and the expense of needing to prepare and maintain detailed disclosure documents.

Securities offered to a company’s employees, consultants, or advisors, such as restricted stock or stock options, must also be registered or qualify for an exemption from registration. For this purpose, startups often use the federal exemption known as Rule 701 for securities offered to service providers. This rule provides a registration exemption for compensatory benefit plans, like the equity incentive plans or stock plans companies use to grant stock options. As a company grows and begins to make significant grants under these benefit plans with a value exceeding certain dollar thresholds, Rule 701 requires the company to disclose information about itself, including risk factors and financial statements, to its service providers who hold securities under these plans.

In addition to federal securities law compliance, a company may also need to comply with state-level securities laws, known as “blue sky laws,” in each state where its investors reside, depending on the federal exemption the company uses and whether the federal exemption takes precedence over, or preempts, state securities laws.

If a company fails to comply with securities laws, affected investors gain a “right of rescission.” This right allows investors to sue the company, undo their securities purchase, and recover their money. Noncompliance can also lead to fines and, depending on the severity and type of violation, other civil and criminal penalties for the company and other responsible parties. Given the complexity of navigating securities laws, startups should work with knowledgeable securities counsel for even the earliest stages of financing and equity compensation.

Section 409A of the Internal Revenue Code, and the Section 409A Treasury regulations, are U.S. federal tax laws and regulations that effectively require companies to grant stock options with an exercise (or strike) price at or above the underlying shares’ fair market value as of the grant date. If an option is granted with an exercise price below fair market value, the option recipient may have to pay income taxes, interest, and penalties, potentially negating the option’s economic benefit. If the option recipient is an employee, the company must also withhold income and employment taxes on an underpriced option. Failure to do so could result in the company paying interest and penalties on the under-withheld amounts.

Obtaining a valuation from a qualified, independent appraiser and using the appraised value to set the option exercise price is a “safe harbor” valuation method under the Section 409A regulations. If a company doesn’t use a safe harbor method, it bears the burden to prove its value determination was reasonable if challenged by the U.S. Internal Revenue Service (IRS). This can be difficult and time-consuming, often involving extensive correspondence and accountants’ fees. A safe harbor valuation method provides a presumption of reasonableness, meaning the burden shifts to the IRS to prove that the valuation was “grossly unreasonable.”

A company’s 409A valuation report is valid for 12 months following the valuation date (which isn’t always the same as the report date) or until a material event affects the company’s value, whichever comes first. Therefore, expect to obtain a new 409A valuation at least annually, or more often if your company is fundraising or reaching other critical milestones during that period. Many startup lawyers view signing a term sheet for equity financing as an event that causes a 409A valuation to expire.

Obtaining a third-party 409A valuation is among the simplest safe harbors to qualify for and can serve as inexpensive insurance against avoidable tax issues. If a company doesn’t get a valuation report to set its option exercise price, it may end up spending more to address questions about potential tax consequences in the middle of a financing or M&A transaction than it would on the 409A valuation.

Valuation costs can vary based on the company’s stage, the number of stockholders, and the time frame for completing the valuation. Subscription valuation services, often bundled with cap table management software, are now available to help companies keep their valuation reports up to date.

The process of engaging a 409A valuation firm, providing necessary information, reviewing a draft report, and finalizing the valuation typically takes two to six weeks. The company will need to provide an updated cap table, financial statements and projections, and schedule a call between the appraiser and company management. Be aware of this timeline to avoid delays.

Some founders worry that a 409A valuation, especially one with a low fair market value, might negatively affect the valuation an investor or acquirer assigns to their company. However, this concern is unfounded. Sophisticated investors and acquirers value companies differently and for different purposes than valuation firms. They care more about whether a company has diligently obtained 409A valuation reports for its option grants than the specific value indicated in the reports. In fact, a lower 409A fair market value can make a company more attractive to employees and recruits. This is because the company can grant its stock options with a lower exercise price, leaving more room for an increase in the value of the shares. Experienced valuation firms understand this and will work with companies, within reasonable limits, to establish lower, yet still defensible, fair market values.

Many venture-backed startups incentivize employees by offering a portion of their compensation as equity. This allows employees to benefit from their contributions and share directly in the company’s growth. In early-stage companies, this equity compensation typically comes in the form of restricted stock or stock options.

For restricted stock, an employee must either pay for shares upfront or pay taxes on their value. As a company’s value increases, the upfront cost or tax on restricted stock can become prohibitive. At this point, companies often begin to grant stock options.

Stock options confer the right to buy company shares at a predetermined price, known as the exercise or strike price. They require no upfront cash, letting employees wait until the company’s future trajectory is clearer before purchasing shares. Stock options usually come with a vesting schedule, which means recipients must work for the company for a minimum period before they can exercise their options.

Under U.S. tax law, there are two types of stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs), each with different tax consequences. ISOs can only be issued to company employees by law. Tax and securities laws largely determine the features, drawbacks, and standardization of stock options in venture-backed startups. Section 409A of the U.S. tax code generally requires that a stock option’s exercise price be set at the fair market value of the underlying stock when the option is granted. Nowadays, companies typically establish their stock’s fair market value through an independent third-party valuation firm. This provides a tax safe harbor against the mispricing of stock options and related U.S. tax penalties. Federal and state securities laws generally require stock options to be granted pursuant to an equity incentive plan and only to employees and non-entity consultants of the company.

Stock options can be a valuable tool for startups to attract and retain talent. However, due to complex corporate laws and intricate tax and securities regulations surrounding equity compensation in the U.S. and worldwide, companies considering stock options should work with knowledgeable attorneys and tax advisors to ensure the correct setup and administration of their equity incentive plans.

 

  • Federal and state employment laws mandate that employees receive at least minimum wage in cash for hours worked. Payment in equity-only does not meet this requirement. Usually, a founder’s service to their company classifies them as an employee under these laws. While the federal Fair Labor Standards Act (FLSA) exempts executive employees who own at least 20% of the company and actively manage it from minimum wage requirements, not all states offer similar exemptions. For instance, in California, minimum wage requirements apply to founders just as they do to regular employees. As such, founders should consult with legal counsel in the states where they work to understand applicable wage laws. If state minimum wage laws apply, founders need to ensure they’re paying appropriate wages, regardless of their willingness to work for less, to avoid potential company liability.

 

Qualified Small Business Stock (QSBS) refers to stock that qualifies for tax benefits under Section 1202 of the U.S. Internal Revenue Code. This section allows the seller of QSBS to exclude up to 100% of capital gain on the shares from federal income tax. As of May 2024, any QSBS acquired after September 27, 2010, is eligible for this 100% exclusion. The exclusion is subject to limits of either $10 million or ten times the taxpayer’s adjusted basis in the QSBS, whichever is greater.

To qualify as QSBS:

  1. The stock must have been originally issued by a domestic C-corporation. The corporation’s gross assets must be $50 million or less at the time of and immediately following the stock issuance.
  2. The taxpayer must have acquired the stock at its original issue in exchange for money, property (excluding stock), or as compensation for services provided to the corporation.
  3. While the taxpayer owns the stock, at least 80% of the corporation’s assets (by value) must be used in the active conduct of one or more qualified trades or businesses defined in the Internal Revenue Code, which excludes most professional services.
  4. The corporation must qualify as an “eligible corporation” as defined in the Internal Revenue Code.
  5. With some exceptions, the corporation must not have conducted significant redemptions of its own stock for one year before and one year after issuing the stock to the taxpayer, and must not have redeemed stock from the taxpayer for two years before and two years after issuing the stock to the taxpayer.
  6. The taxpayer must not be a corporation.
  7. The taxpayer must hold the stock for a minimum of five years.

The benefits of QSBS can be substantial, especially for long-term stockholders with significant capital gains. Founders, early employees and investors in startup companies are often able to avail themselves of QSBS. With proactive tax and estate planning, there may be an opportunity for taxpayers to “stack” QSBS benefits. However, certain actions by a company, like poorly timed stock redemptions, can result in the loss of QSBS treatment. Therefore, it is crucial to involve tax and legal professionals to properly structure transactions and avoid the unintended loss of QSBS benefits.

 
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Note: The following information is relevant only for U.S. taxpayers. You should consult with a personal tax advisor about whether an 83(b) election is appropriate for your own tax situation.

The 83(b) election is a U.S. federal tax filing commonly utilized by startup founders and early employees when they acquire stock subject to a vesting schedule. Filing an 83(b) election with the Internal Revenue Service (IRS) allows a stockholder to pay all income taxes on their shares in the year of acquisition, based on a presumably low fair market value of the shares, rather than as the shares vest over time, based on a presumably higher fair market value at the time of vesting. Electing to pay this tax once upfront usually results in savings. However, the 83(b) election may not be advantageous in all situations, such as when the fair market value of the shares is likely to decline from the purchase date. Unfortunately, a stockholder cannot adopt a wait-and-see approach with the 83(b) election. It must be filed within 30 calendar days after the purchase or transfer date to be effective, and it cannot be submitted online.

The 83(b) election is applicable when acquiring actual shares of stock subject to vesting. You don’t need to consider an 83(b) election when receiving a stock option, even if the option is subject to vesting, unless the option is “early exercised” (i.e., the underlying stock option shares are purchased while they are still subject to vesting). 83(b) elections are also generally not applicable to restricted stock units (RSUs), which are different from the shares of restricted stock that startup founders and early employees typically deal with.

Don’t procrastinate on the 83(b) election. Filing an 83(b) election requires mailing it to the IRS, and the postmark date determines if your filing was on time. If you’re acquiring stock that is subject to vesting, complete the 83(b) election paperwork and mail it to the IRS as soon as possible to avoid a last-minute rush to the post office.

Keeping proof of a timely 83(b) election filing is vital. Send the 83(b) election via certified mail, select the option for “return receipt requested,” and include an extra copy of the completed 83(b) election form along with a self-addressed stamped envelope. The IRS will mark the copy as “received” and return it to you. Once you receive it, keep this IRS-stamped copy and share the proof of filing with the company that sold or granted you the shares.

Consider keeping additional evidence of filing, like photographs of the completed 83(b) election form and mailing envelope, screenshots of any tracking history, and the certified mail return receipt. These can be useful as proof of filing if the IRS doesn’t return a stamped copy or if the mail gets lost or delayed.

Startup investors and acquirers are keenly aware of, and aim to avoid, the potential personal and business consequences of missed 83(b) elections. These consequences can include unexpectedly high taxes for founders and penalties for companies that fail to withhold employee income taxes on vesting shares. Lawyers representing these parties will require proof of timely 83(b) elections from anyone who has acquired startup stock subject to vesting. Missing 83(b) elections can lead to lower financing valuations, decreased acquisition prices, increased indemnities, deal delays, and higher transaction costs due to the legal effort needed to address 83(b) election issues. There is no perfect remedy for a missed 83(b) election filing.

Filing an 83(b) election on time and maintaining good records of the filing will save you and your company time, money, and hassle.

Vesting acceleration is the concept of speeding up the vesting of a person’s equity under specific conditions. Two main types are “single-trigger acceleration” and “double-trigger acceleration.”
Single-trigger acceleration allows a portion of a person’s unvested equity to vest when a single condition, or trigger, is met. A common trigger is the company’s acquisition. In this case, a person with “100% single-trigger acceleration” would have all their unvested shares vest if the company is acquired.

Double-trigger acceleration requires two conditions to be met. Typically, these are the company’s acquisition (first trigger) and the termination of the person’s employment (second trigger). So, a person with “100% double-trigger acceleration” would have all their unvested shares vest only if the company is acquired and their employment is terminated post-acquisition.

While there can be countless variations in acceleration amounts, the number of triggers, and what constitutes a trigger, unusual arrangements are generally not worth considering. Traditional single-trigger and double-trigger acceleration provisions can already deter investors as they may render a company less attractive to potential buyers. With single-trigger acceleration, employees may not be incentivized to remain with a company post-acquisition. Although double-trigger acceleration offers a more balanced approach, potential buyers may still feel constrained by the obligation to accelerate an employee’s share vesting if they decide to terminate that employee following an acquisition. Considering this potential deterrent, vesting acceleration is usually limited and reserved for a startup’s key employees.

Stock vesting is a legal and risk management tool by which a person gradually earns the right to keep their equity in a company. Equity typically “vests” over a set time period, known as a “vesting schedule,” or upon meeting other contractually defined criteria. The company is entitled by contract to buy back or reclaim unearned or “unvested” stock.

Implementing stock vesting with all service providers—founders, directors, employees, consultants, and advisors—is strongly recommended. Investors often use stock vesting to motivate company founders to stay and build value post-investment. Startup founders use it to ensure co-founders’ commitment and reward them for their efforts in building the company. Companies use it to retain dedicated employees and incentivize long-term goal achievement.

Historical practice and labor market competition have resulted in a standardized vesting schedule for startup employees. This typically spans four years, with 25% of equity vesting at a one-year cliff and the rest vesting monthly in equal amounts thereafter. Advisors usually have a two-year vesting schedule, with a three- or six-month cliff becoming increasingly common, and the remainder vesting monthly in equal amounts. Consultant vesting schedules are often based on deliverables and performance and can vary significantly. For efficiency, startups should apply standard vesting schedules consistently, but they can be adjusted to suit specific needs and circumstances.

The importance of stock vesting can be demonstrated with a hypothetical four-person founding team, each holding 25% of the company’s stock. Without a vesting schedule, a founder could leave at any time, retaining all their shares without further contributing to the company’s growth. If one founder leaves after six months, they would still retain 25% of the company’s stock, reaping all of the potential benefits with none of the work. This is unfair to the remaining founders and new hires who would continue to build the company. However, if a typical four-year vesting schedule with a one-year cliff had been applied, a founder leaving after six months would keep no shares, while the other three founders’ ownership would increase to 33% each. If any of them leave later, they would only retain the shares they’ve earned through their continuing work and tenure with the company.

Delaware corporate law requires that corporations have both a registered office and a registered agent within the state. The registered agent and office address must be listed in the corporation’s certificate of incorporation, and this information is public. The registered agent is expected to be available during regular business hours to accept service of process and other communications for the corporation.

If the corporation is required to register to do business or pay taxes in other states, those states may also require the corporation to appoint an agent who resides in that state to accept service of process on behalf of the corporation.
Several reputable companies offer registered agent services, typically for an annual fee, across many jurisdictions. Most startups hire one of these companies as their registered agent and registered office in Delaware because the startup may not otherwise have an office or personnel in Delaware.

Startups may also find it convenient to appoint the same company as a registered agent in their headquarters state and other states where they operate. This approach not only protects the privacy of the startup’s employees, who may not want to act as individual registered agents because their information becomes public, but also eliminates the need to update registered agent or office information with the state due to staff changes or office relocations. Moreover, it generally frees the startup from the responsibilities of setting up and maintaining offices and ensuring an agent’s availability in multiple locations.

“Fully diluted capitalization” refers to the total number of a company’s outstanding shares, options, warrants, and other convertible securities. This total is calculated as if all these securities were fully exercised or converted into the most basic unit of shares. For a Delaware corporation, this basic unit is usually the company’s common stock. The fully diluted capitalization is then expressed on an “as-converted to common stock” basis. Besides options and warrants, convertible securities can include convertible promissory notes, SAFEs, and convertible preferred stock.

The definition of fully diluted capitalization can change depending on the context. For instance, in startup fundraising, shares of common stock that are reserved but unissued under a company’s option pool are usually included in the fully diluted capitalization for price calculations, even though these shares are not outstanding or held by anyone. However, during a company’s sale or liquidation, these shares would be excluded from the fully diluted capitalization calculation used to allocate proceeds, as no one has a claim to these shares.

Understanding fully diluted capitalization and its components is crucial for founders and investors to comprehend their ownership and the potential impacts of transactions.

When forming a new Delaware corporation, deciding the number of shares to authorize in the Certificate of Incorporation is important. The authorized shares are the maximum number of shares a corporation is permitted to issue under its Certificate of Incorporation. While this number can be changed later, doing so requires additional filings with the state. Depending on the company’s stage, it may also require further approvals from both the board of directors and stockholders.

In a typical startup situation, assuming the company has no significant assets, it’s recommended to authorize 10,000,000 to 15,000,000 shares of common stock in the Certificate of Incorporation. From these authorized shares, 10,000,000 shares would be allocated among the corporation’s founders and a potential option pool. Shares in an option pool are reserved for future issuances to employees or other service providers. The initial size of an option pool usually ranges between 10% to 20% of the company’s original allocated shares. So, for example, a company might distribute 8,000,000 to 9,000,000 shares among its founders, reserving the remaining 1,000,000 to 2,000,000 shares (out of 10,000,000) for its option pool.

Founders should determine the size of the option pool based on their hiring plans between incorporation and the company’s first round of venture capital equity financing. With each round of equity financing, the lead investor typically requests an increase in the option pool to cover option grants for another 12 to 18 months of hiring.

Extra authorized shares simply exist as “dry powder” and are not issued or reserved unless needed later. The company can use these shares to add a late-joining co-founder or increase the option pool if more hiring is needed than initially anticipated.

If the company will start with significant assets (around $650,000 or more), then minimizing state franchise taxes may be a consideration during its early stages. Authorizing fewer shares might be desirable in such cases, but this should be weighed against the preferable optics of the founders and employees holding a normalized number of shares, and the costs of amending the Certificate of Incorporation or instituting a stock split later to increase the number of authorized shares.

If you have any questions or doubts about how many authorized shares are the best choice for your situation, you should consult with legal and tax professionals before incorporating.

Incorporating a corporation in Delaware involves preparing several formation documents. These outline the company’s structure, management, and operations. Importantly, a Certificate of Incorporation must be filed with the Delaware Secretary of State. The following offers a summary of the documents typically included in a Delaware corporation’s incorporation package. Upon forming the corporation, management should consult with legal and tax professionals to ensure appropriate corporate upkeep.

  1. Certificate of Incorporation – This is the foundational document for forming a Delaware corporation. When filed with the Delaware Secretary of State, it establishes the company as a separate legal entity. The document includes basic details such as the company’s name, registered agent and office in Delaware, purpose, duration, and stock structure. Delaware law requires that crucial rights and restrictions be contained in this document. Often referred to as a company’s “charter,” the Certificate of Incorporation serves as the constitution of a Delaware corporation.
  2. Bylaws – The Bylaws are second in importance only to the Certificate of Incorporation in a Delaware corporation. They function as a comprehensive rulebook for the company. They govern matters such as board of directors meetings and actions, stockholder meetings and actions, officer roles, and other procedures. They may also outline stock transfer restrictions and procedures. While the Bylaws are not filed with the Delaware Secretary of State, they still must be closely and formally observed.
  3. Action of Incorporator – The Incorporator is the person who signs and files the Certificate of Incorporation on behalf of the Delaware corporation. After the filing is complete, the Incorporator signs an Action of Incorporator document, to record the adoption of the company’s Bylaws, the appointment of the initial board of directors, and the transfer of management to the newly appointed board. A founder can serve as the Incorporator and also hold one or more roles (e.g., director, various officers, stockholder) as described below.
  4. Initial Unanimous Written Consent of the Board of Directors (Board Consent) – This document, often shortened to “board consent,” records the actions taken by the board of directors to establish the corporation. It usually includes the election of officers, the approval of stock issuances to the founders, and other significant formation matters. Major corporate actions must be authorized by the board of directors, either during a live meeting (which should then be documented in written meeting minutes) or through written consent. According to Delaware law, all actions taken via written consent must be unanimous, meaning each board member must sign the consent for it to be valid.
  5. Initial Written Consent of the Stockholders (Stockholder Consent) – This document, also known as a “stockholder consent,” records the actions taken by the stockholders to establish the corporation. Some corporate actions may require both board and stockholder approval. The initial stockholder consent typically approves a form of indemnification agreement for the corporation’s directors and officers, among other important matters.
  6. Indemnification Agreement – This agreement outlines the policies and procedures for how the corporation will indemnify its officers and directors if they are sued for actions taken on the company’s behalf in their roles as directors or officers.
  7. Restricted Stock Purchase Agreements (RSPAs) – The Restricted Stock Purchase Agreement (RSPA) is the agreement by which a corporation sells stock to its founders. Founders typically pay a nominal amount of cash and assign any intellectual property or business plan they’ve developed to the corporation in exchange for shares of common stock. The RSPA includes any vesting restrictions and acceleration provisions for the founders’ shares. If the founders’ shares are subject to vesting restrictions, the RSPA should include an 83(b) election form. This should be completed and mailed to the United States Internal Revenue Service (IRS) within 30 calendar days after the stock purchase. Upon executing the RSPA and paying for the shares, the founders become stockholders of the new company.
  8. Confidential Information and Invention Assignment Agreements (CIIAA) – The CIIAA, also known as PIIAA (Proprietary Information and Invention Assignment Agreement) or IP Assignment Agreement, among other names and acronyms, ensures that any intellectual property created by an employee during their employment is assigned to the company. This agreement should also include obligations to protect the company’s confidential information. It’s essential for founders, employees, and other service providers to sign a CIIAA or equivalent IP assignment and confidentiality agreement.
  9. Securities Law Filings – The sale and issuance of stock to founders and others during the corporation’s formation may necessitate state or federal securities law filings.
  10. Qualification Filings to Do Business as a Foreign Corporation – If a corporation intends to establish its headquarters or conduct most of its business in a state different from where it is incorporated, it may be required to qualify as a “foreign corporation” to operate in that state. For instance, Silicon Valley-based startups that are incorporated in Delaware must file and register as foreign corporations with the California Secretary of State and pay annual California franchise taxes.
  11. Federal Employer Identification Number and State Identification Numbers – After filing the Certificate of Incorporation and forming the corporation, the company should apply for a Federal Employer Identification Number (EIN) and necessary state identification numbers. The EIN is needed to open bank accounts and file tax returns. Currently, founders with a U.S. taxpayer identification or social security number can apply for a new EIN online through the IRS. If not, acquiring an EIN may require mailing a paper application, sending a fax, or making a phone call. An accounting professional can assist the corporation in understanding ongoing tax obligations.

For startups planning to seek venture capital financing in the United States, it’s often most beneficial to form a C-corporation in Delaware, regardless of the company’s headquarters location. The “C” in C-corporation refers to subchapter C of the United States Internal Revenue Code, the federal tax statute under which C-corporations are taxed.

Delaware is favored for incorporation because of its well-established, flexible corporate laws and a court system experienced in handling business issues. Additionally, its Secretary of State’s office is efficient, capable of processing business filings quickly and with fewer obstacles compared to many other jurisdictions.

C-corporations offer limited liability protection, flexibility in raising capital, the ability to issue multiple classes of stock, and relative ease in issuing equity-based compensation to employees.
Venture capital investors prefer to invest in Delaware C-corporations because they are familiar with the entity type and its legal and tax obligations. Many venture capital firms are even restricted from investing in non-corporations, such as LLCs, due to tax considerations.

Investors may require a company that is not organized as a Delaware C-corporation to convert into one as a prerequisite to their investment. To avoid potential transaction delays and additional legal fees, it’s advisable to establish and operate as a Delaware C-corporation from the outset.

If a company anticipates generating most of its revenue outside the United States, it might be tax-advantageous to establish the parent entity in a non-US jurisdiction, like the Cayman Islands, prior to forming any entity in the United States. However, the costs of maintaining an offshore entity and managing a complex organizational structure should also be taken into account.

If you’re uncertain whether a Delaware C-corporation is the right choice for your circumstances, you should consult with legal and tax professionals before incorporating.

Personnel

When expanding internationally, attracting and managing talent on a global scale can present numerous challenges. To build strong teams across borders, companies must take a thoughtful approach, considering the legal, social, and cultural differences that can come into play. Before entering any new market, it is important to understand the specific market dynamics and how to tailor your recruitment efforts so they are best aligned with local laws, expectations, and values.

Consider what benefits and opportunities will resonate most with candidates in each market. How can you customize and tailor your marketing and recruitment efforts so you are attracting top-level, high-performing talent? This is where local experts with specific experience in hiring and recruiting in that area can be very beneficial and help with a smooth process. Whether you are hiring locally, bringing in staff from the home office, or a combination, cultural integration will be critical here. There must be robust training programs that focus on bridging any cultural gaps between teams and fostering a collaborative, inclusive environment.

 Labor laws can vary widely depending on what countries and regions you are operating in, so ensuring compliance with foreign labor laws, contracts, hiring and firing processes, etc., should be at the top of your mind. Again, bringing in legal teams who can assist you in navigating the myriad of labor laws across the world can help you avoid serious risks and what can be costly legal issues.

Equity compensation – such as stock options or grants of restricted stock[1] – can be a valuable tool for startups trying to attract and retain top talent. To avoid costly penalties and potential hiccups during fundraising diligence, it is crucial to understand the rules governing the grant of equity compensation and follow proper governance protocols when making such grants.

Following the steps outlined below when granting equity compensation will help you avoid the common equity grant pitfalls discussed later in this post.

Step 1: Determine Grant Information. While the company is the sponsor of its equity incentive plan, the company’s board of directors, or a subcommittee thereof, is typically named as the “Plan Administrator” responsible for administering the plan. The Plan Administrator’s duties should be set forth in the equity plan, but, in general, the Plan Administrator will determine who will receive an equity award, the type of award (option, restricted stock, etc.), the size of the award, the vesting terms the award will be subject to, and the situations (if any) under which the award’s vesting may be accelerated.

Keeping track of these variables is important, so we suggest creating a chart like the sample below. It will come in handy when documenting the board’s approval of the grants (see Step 3 below).

Name; ResidenceJob TitleType of AwardSize of AwardExercise PriceGrant DateVesting Commencement DateVesting ScheduleAcceleration terms (if any)
John Doe Chicago, ILVP of SalesISO10,000$0.14October 1, 2024January 1, 2024ANo acceleration
Jane Smith Chicago, ILConsultantNSO8,000$0.14October 1, 2024June 30, 2024BNo acceleration
Vesting Schedule A: 4-year vesting schedule; 25% vests on the first anniversary of the Vesting Commencement Date; the remainder vests monthly on the last day of each month
Vesting Schedule B: 2-year vesting schedule; 12.5% vests on the last day of each calendar quarter

Step 2: Determine the Company’s Per-Share Price. Whether you’re granting options or restricted stock, you’ll need to determine the price per share of the company’s stock to set the exercise price of any options or to calculate the value of restricted stock granted to a recipient. To comply with the legal requirements governing incentive stock options (“ISOs”) and to ensure nonqualified stock options (“NSOs”) are exempt from the restrictions imposed on deferred compensation by Section 409A of the Internal Revenue Code, the exercise price of options should, in most cases, be set at no less than the fair market value (“FMV”) of a share of the company’s common stock on the option’s date of grant.

While there are various methods for determining FMV for this purpose, the most defensible method is for the company to engage a third-party, independent appraiser to complete a valuation of the company (a “409A Valuation”). Once a 409A Valuation has been completed, the Plan Administrator can use the per-share price of the company determined by the 409A Valuation to set the exercise price or value of the company’s equity grants.

Step 3: Approve the Valuation and Authorize the Awards. After the appraiser completes the 409A Valuation and the Plan Administrator has used it to (tentatively) set the exercise price (for option grants) or issue price (for restricted stock grants), the company’s governing body (typically the board of directors) should then: (a) approve the 409A Valuation, (b) confirm that no material events have occurred since the valuation date used by the 409A Valuation that could reasonably be viewed as materially affecting the FMV of the company’s stock, and (C) authorize the grant issuances. The board can accomplish this via action by written consent or by adopting board resolutions approving the equity grants during a meeting of the board. If the Plan Administrator has created a chart as recommended above, this can easily be attached as an exhibit to the written consent or included in the materials distributed to directors for an in‑person meeting.

Step 4: Execute Grant Agreements and Update Cap Table. After the board has authorized the awards, the Plan Administrator can start documenting the grants. Some companies choose to complete this task via a cap table management platform, while others prefer to collect signatures on their own form of “Option Award Agreement” or “Restricted Stock Award Agreement.” Either way, the company’s capitalization table should be updated following the issuance of all grants to be sure that (a) each award recipient appears as a stakeholder on the company’s cap table and (b) the size of the available equity pool is decreased accordingly.

Step 5: Complete Securities Filings. Some states, like California, require companies to make securities filings in connection with grants of equity compensation, while others do not. Consult your legal counsel to confirm what filings, if any, may need to be made.

Common Pitfalls:

When granting equity compensation to your employees and consultants, be wary of these common pitfalls:

  1. Inadequate Pool Size: Double-check the size of the available equity pool when determining grant sizes. If the equity pool is too small to accommodate the planned grants, the equity incentive plan will need to be amended. If you intend to issue ISOs, both the company’s board and its shareholders will need to approve the expansion of the equity pool. Depending on how much common stock a company is authorized to issue as equity compensation (and how much remains to be issued), an amendment to the company’s certificate of incorporation or articles of incorporation may also be required.
  1. “Stale” 409A Valuation: A 409A Valuation is generally valid for 12 months from the valuation date. However, if the company experiences certain material events during that period, the 409A Valuation can no longer be relied upon. Before issuing new equity awards, confirm that the 409A Valuation isn’t stale—either due to being more than 12 months old or because of the occurrence of material events. For more on this topic, please see our What is a 409A valuation? Guidepost.
  1. ISO $100K Rule: If you are issuing ISOs, consider the total value of each grant that will vest each year. If an ISO recipient will vest in more than $100,000 of ISOs (determined using the exercise price of the option) in a year, any options exceeding that amount will be treated as NSOs instead. For more on this topic, please see Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives.
  1. ISO 10% Owner Rule: When granting ISOs to recipients who hold 10% or more of the company’s equity, remember that the exercise price of those ISOs must be at least 110% of the FMV. In addition, unlike ISO awards for non-10% owners (who may hold ISOs for up to 10 years), ISOs awarded to a 10% owner cannot have a term of more than 5 years. For more on this topic, please see Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives.
  1. Appropriate Authorizations: Confirm who must approve each issuance of equity compensation. Sometimes, the company’s board of directors has the sole authority to approve each issuance. However, if a company has completed a preferred stock financing round, the preferred stock investors may also have certain approval rights—either by virtue of the protective provisions in the certificate or articles of incorporation or as a result of provisions in an investment document, like an investors’ rights agreement or a side letter. Determining who has the authority to issue equity compensation may become an issue (a) when granting awards to certain officers (CEO, CTO, etc.), (b) when deviating from the company’s “standard” vesting schedule, or (c) when an amendment to the certificate or articles of incorporation is required to accommodate an increase to the size of the equity incentive pool.
  1. Types of Awards: Carefully consider what type of equity award each recipient will receive (i.e., options (and, if so, ISO or NSO), restricted stock, etc.)—and be sure to confirm that the recipient is actually eligible to receive such award. For more information on various types of awards, please see our What are stock options? and What’s the difference between an ISO and an NSO Guideposts and Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives.

[1] Although this post discusses the procedures and pitfalls applicable to grants of corporate restricted stock and stock options, the guidance provided is generally applicable to membership interests in LLCs and other non-stock entities. There are, however, certain differences between grants issued by corporations and those issued by LLCs and other partnership-type entities. Before issuing equity incentives to employees of LLCs or similar entities, discuss any proposed grant with your legal counsel. 

Working for a startup can be a great resume and experience builder. Given the abundance of eager and available student labor, can your startup hire an unpaid intern?

For most startups, the practical answer is no. Although it is technically possible for a company to host an unpaid internship, there are strict conditions that must be met. The internship’s primary purpose must be the intern’s educational benefit, not the company’s economic gain. If you’re considering an unpaid intern to write business-critical code, design your company’s app alone, or implement your company’s marketing strategy, you may want to reconsider. If an internship is mainly for the company’s economic benefit, the intern must be compensated according to federal and state wage and hour laws.

If your company plans to offer an internship program, consult with a labor and employment lawyer to ensure that it meets applicable federal and state labor law requirements.

At-will employment means that an employer can alter or terminate an employment relationship at any time for any reason, provided the reason isn’t illegal, or even for no reason at all, without incurring liability to the impacted employee. Likewise, an employee can quit their job at any time for any reason or for no reason without incurring liability to the employer.

At-will employment is the standard rule in U.S. labor law. However, startups should note that this is not standard practice worldwide. Companies planning to hire outside the United States should seek advice from employment lawyers licensed in the countries where their workforces will be located to ensure compliance with local labor laws and practices.

Even in jurisdictions where at-will employment is the norm, companies should consult an employment lawyer if a policy change or employee termination could become complicated or contentious. Employers must comply with a maze of labor laws and regulations. These include rules related to worker classification (employees vs. independent contractors), wage and hour requirements, anti-harassment, discrimination, retaliation policies, non-competition, and job-protected leaves of absence, among others. A skilled employment lawyer can guide companies through this maze, help implement best practices and procedures, and mitigate employment-related risks.

In the United States, securities offered to a company’s employees, consultants, or advisors, such as restricted stock or stock options, must be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption from registration. For this purpose, startups often use the federal exemption known as Rule 701 for securities offered to service providers. This rule provides a registration exemption for compensatory benefit plans, like the equity incentive plans or stock plans companies use to grant stock options.

The total value or amount of securities sold by a company during any consecutive 12-month period in reliance on Rule 701 cannot exceed the greatest of the following:

(i) $1,000,000;

(ii) 15% of the total assets of the company, as of the company’s most recent balance sheet date (which can’t be older than the company’s last fiscal year end); or

(iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the company’s most recent balance sheet date (which can’t be older than the company’s last fiscal year end).

If a company expects to sell more than $10 million of securities under a Rule 701-exempted benefit plan within any consecutive 12-month period, it must provide disclosures to its service providers who might buy the securities under the plan. These disclosures, which should be given a reasonable time before the sale date, include a summary of the plan’s material terms, risk factors, and financial statements.

A company has the flexibility to select any consecutive 12-month period for measuring Rule 701 compliance. This could be a fixed period or a rolling 12-month period. However, once chosen, the company must apply it consistently.

As a company starts making substantial grants under its equity incentive plan, it is important to regularly monitor and measure compliance with Rule 701. When the company approaches the $10 million within 12 months threshold, it should consult with knowledgeable securities counsel to begin preparing the required enhanced disclosures and planning for the distribution of this sensitive information, including confidentiality precautions. Failure to comply with Rule 701 requirements can lead to penalties and even the loss of the exemption. Rule 701 does not preempt state securities laws, so companies must also ensure compliance with applicable state blue sky laws.

Many venture-backed startups incentivize employees by offering a portion of their compensation as equity. This allows employees to benefit from their contributions and share directly in the company’s growth. In early-stage companies, this equity compensation typically comes in the form of restricted stock or stock options.

For restricted stock, an employee must either pay for shares upfront or pay taxes on their value. As a company’s value increases, the upfront cost or tax on restricted stock can become prohibitive. At this point, companies often begin to grant stock options.

Stock options confer the right to buy company shares at a predetermined price, known as the exercise or strike price. They require no upfront cash, letting employees wait until the company’s future trajectory is clearer before purchasing shares. Stock options usually come with a vesting schedule, which means recipients must work for the company for a minimum period before they can exercise their options.

Under U.S. tax law, there are two types of stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs), each with different tax consequences. ISOs can only be issued to company employees by law. Tax and securities laws largely determine the features, drawbacks, and standardization of stock options in venture-backed startups. Section 409A of the U.S. tax code generally requires that a stock option’s exercise price be set at the fair market value of the underlying stock when the option is granted. Nowadays, companies typically establish their stock’s fair market value through an independent third-party valuation firm. This provides a tax safe harbor against the mispricing of stock options and related U.S. tax penalties. Federal and state securities laws generally require stock options to be granted pursuant to an equity incentive plan and only to employees and non-entity consultants of the company.

Stock options can be a valuable tool for startups to attract and retain talent. However, due to complex corporate laws and intricate tax and securities regulations surrounding equity compensation in the U.S. and worldwide, companies considering stock options should work with knowledgeable attorneys and tax advisors to ensure the correct setup and administration of their equity incentive plans.

 

 

 

Note: The following information is relevant only for U.S. taxpayers. You should consult with a personal tax advisor about whether an 83(b) election is appropriate for your own tax situation.

The 83(b) election is a U.S. federal tax filing commonly utilized by startup founders and early employees when they acquire stock subject to a vesting schedule. Filing an 83(b) election with the Internal Revenue Service (IRS) allows a stockholder to pay all income taxes on their shares in the year of acquisition, based on a presumably low fair market value of the shares, rather than as the shares vest over time, based on a presumably higher fair market value at the time of vesting. Electing to pay this tax once upfront usually results in savings. However, the 83(b) election may not be advantageous in all situations, such as when the fair market value of the shares is likely to decline from the purchase date. Unfortunately, a stockholder cannot adopt a wait-and-see approach with the 83(b) election. It must be filed within 30 calendar days after the purchase or transfer date to be effective, and it cannot be submitted online.

The 83(b) election is applicable when acquiring actual shares of stock subject to vesting. You don’t need to consider an 83(b) election when receiving a stock option, even if the option is subject to vesting, unless the option is “early exercised” (i.e., the underlying stock option shares are purchased while they are still subject to vesting). 83(b) elections are also generally not applicable to restricted stock units (RSUs), which are different from the shares of restricted stock that startup founders and early employees typically deal with.

Don’t procrastinate on the 83(b) election. Filing an 83(b) election requires mailing it to the IRS, and the postmark date determines if your filing was on time. If you’re acquiring stock that is subject to vesting, complete the 83(b) election paperwork and mail it to the IRS as soon as possible to avoid a last-minute rush to the post office.

Keeping proof of a timely 83(b) election filing is vital. Send the 83(b) election via certified mail, select the option for “return receipt requested,” and include an extra copy of the completed 83(b) election form along with a self-addressed stamped envelope. The IRS will mark the copy as “received” and return it to you. Once you receive it, keep this IRS-stamped copy and share the proof of filing with the company that sold or granted you the shares.

Consider keeping additional evidence of filing, like photographs of the completed 83(b) election form and mailing envelope, screenshots of any tracking history, and the certified mail return receipt. These can be useful as proof of filing if the IRS doesn’t return a stamped copy or if the mail gets lost or delayed.

Startup investors and acquirers are keenly aware of, and aim to avoid, the potential personal and business consequences of missed 83(b) elections. These consequences can include unexpectedly high taxes for founders and penalties for companies that fail to withhold employee income taxes on vesting shares. Lawyers representing these parties will require proof of timely 83(b) elections from anyone who has acquired startup stock subject to vesting. Missing 83(b) elections can lead to lower financing valuations, decreased acquisition prices, increased indemnities, deal delays, and higher transaction costs due to the legal effort needed to address 83(b) election issues. There is no perfect remedy for a missed 83(b) election filing.

Filing an 83(b) election on time and maintaining good records of the filing will save you and your company time, money, and hassle.

Last updated 

 

Vesting acceleration is the concept of speeding up the vesting of a person’s equity under specific conditions. Two main types are “single-trigger acceleration” and “double-trigger acceleration.”
Single-trigger acceleration allows a portion of a person’s unvested equity to vest when a single condition, or trigger, is met. A common trigger is the company’s acquisition. In this case, a person with “100% single-trigger acceleration” would have all their unvested shares vest if the company is acquired.

Double-trigger acceleration requires two conditions to be met. Typically, these are the company’s acquisition (first trigger) and the termination of the person’s employment (second trigger). So, a person with “100% double-trigger acceleration” would have all their unvested shares vest only if the company is acquired and their employment is terminated post-acquisition.

While there can be countless variations in acceleration amounts, the number of triggers, and what constitutes a trigger, unusual arrangements are generally not worth considering. Traditional single-trigger and double-trigger acceleration provisions can already deter investors as they may render a company less attractive to potential buyers. With single-trigger acceleration, employees may not be incentivized to remain with a company post-acquisition. Although double-trigger acceleration offers a more balanced approach, potential buyers may still feel constrained by the obligation to accelerate an employee’s share vesting if they decide to terminate that employee following an acquisition. Considering this potential deterrent, vesting acceleration is usually limited and reserved for a startup’s key employees.

 
 

Stock vesting is a legal and risk management tool by which a person gradually earns the right to keep their equity in a company. Equity typically “vests” over a set time period, known as a “vesting schedule,” or upon meeting other contractually defined criteria. The company is entitled by contract to buy back or reclaim unearned or “unvested” stock.

Implementing stock vesting with all service providers—founders, directors, employees, consultants, and advisors—is strongly recommended. Investors often use stock vesting to motivate company founders to stay and build value post-investment. Startup founders use it to ensure co-founders’ commitment and reward them for their efforts in building the company. Companies use it to retain dedicated employees and incentivize long-term goal achievement.

Historical practice and labor market competition have resulted in a standardized vesting schedule for startup employees. This typically spans four years, with 25% of equity vesting at a one-year cliff and the rest vesting monthly in equal amounts thereafter. Advisors usually have a two-year vesting schedule, with a three- or six-month cliff becoming increasingly common, and the remainder vesting monthly in equal amounts. Consultant vesting schedules are often based on deliverables and performance and can vary significantly. For efficiency, startups should apply standard vesting schedules consistently, but they can be adjusted to suit specific needs and circumstances.

The importance of stock vesting can be demonstrated with a hypothetical four-person founding team, each holding 25% of the company’s stock. Without a vesting schedule, a founder could leave at any time, retaining all their shares without further contributing to the company’s growth. If one founder leaves after six months, they would still retain 25% of the company’s stock, reaping all of the potential benefits with none of the work. This is unfair to the remaining founders and new hires who would continue to build the company. However, if a typical four-year vesting schedule with a one-year cliff had been applied, a founder leaving after six months would keep no shares, while the other three founders’ ownership would increase to 33% each. If any of them leave later, they would only retain the shares they’ve earned through their continuing work and tenure with the company.

 

Commercialization

Click-wrap consent refers to a manner in which software users agree to an end-user license agreement (EULA); for example, when downloading an app or browsing on a website. Software suppliers want to ensure that their EULA is enforceable against the end-user. In order to give a EULA the best chance at being enforceable against the end-user, a software supplier should adhere to the following guidelines:

  • Clear and Conspicuous Notice: The terms and conditions must be clearly visible to the consumer. They cannot be hidden or difficult to find.
  • Opportunity to Review Terms: Consumers should be given adequate time and opportunity to read and understand the terms before they accept them. There should be hyperlinks to the policies at or near the place where the use agrees to the policies.
  • Informed Consent: Ensure that the consumer is fully informed about what they are agreeing to. The “I agree” button or checkbox should only be activated when the user has clearly acknowledged the agreement. The user’s consent must be voluntary and based on a clear understanding of the terms they are accepting.
  • No Pre-Checked Boxes: Pre-checked boxes (where the consumer is automatically considered to have agreed to the terms unless they uncheck the box) are discouraged. The user should be required to take an active step to demonstrate consent (e.g., clicking “I agree” or checking a box themselves).
  • Unambiguous Agreement: The language used in the click-wrap agreement should clearly explain what the user is agreeing to, including that their action signifies acceptance of the terms. The user must know that they are agreeing to legal terms.
  • Record of Consent: The FTC recommends that businesses maintain a record of the user’s consent for future reference, particularly in the event of a dispute. This might include logs of when the user accepted the terms, what version of the agreement they agreed to, and any other relevant information.
  • No Forced Acceptance: The user should have the option to decline the agreement. If clicking “I do not agree” or not consenting at all prevents access to the service, this is usually acceptable, but users should not be tricked into accepting without their knowledge.

Service Level Agreements (SLAs) are agreements between a service provider and a client (usually found in a SaaS Agreement or Master Services Agreement) that outline the expected performance metrics and levels of service to be provided.

SLAs typically specify measurable performance targets for the services provided, such as:

Uptime: The percentage of time the service or system must be operational (e.g., 99.9% uptime).
Latency: The amount of time it takes for a service to respond to a request or perform a specific action after it has been initiated.
Support Responsiveness: The number of minutes, hours, or days before the provider’s customer service team will respond to and resolve a technical issue.
Often, SLAs include “service level credits” as a remedy if an SLA is breached, usually in the form of a refund of a percentage of the monthly subscription fee. If you are a provider offering an SLA and service level credits, you want to ensure that these service level credits are the customer’s exclusive remedy for missing SLAs, so that the customer cannot also seek breach of contract damages. If you are a customer, you of course do not want this to be the exclusive remedy and want the option to seek damages and/or terminate the agreement if the provider continually fails to meet SLAs.

Last updated March 11, 2025

One common way to increase sales and brand awareness for new software and other tech companies is to utilize resellers. Resellers will leverage their network to sell your product, and in exchange you will pay them a commission (usually in the form of a revenue share). However, some resellers offer more favorable terms than others and, if you are the provider, there are some common pitfalls to consider when contracting with a reseller:

Perpetual Revenue Shares: Typically, you want a defined limit on how long you will pay a revenue share to a reseller. Perhaps you pay 10% of the first year or two of any customer contract you enter with a referred customer. Maybe longer. However, if you agree to pay a revenue share for the lifetime of your relationship with a referral, this can be an issue as your business and relationship with that customer grows. Perhaps a 10K customer becomes a million-dollar customer 10 years down the line, and without a time limit on commissions, you could still owe a commission to your reseller.
Conflicting Sales Channels: Other issues arise when resellers refer you customers that you have a pre-existing relationship with or were referred to from other sources. In your contracts with resellers, you should be clear that you will only pay a referral on net new referrals, and if other resellers have made an introduction, or perhaps your sales team is already pitching a client, these won’t count for a commission.
Representations and Warranties: Lastly, when working with resellers, you want to be very clear about what representations resellers can and cannot make about your products. If your resellers are promising things that your software cannot do, this can result in customer relationship issues later on.
If you do decide to enter into a reseller and revenue share agreement, take care to avoid these pitfalls which can come at a cost to increased sales and brand awareness.

Last updated March 11, 2025

Going Global

Numerous considerations come into play when raising capital for international expansion. This includes understanding the different regulatory frameworks of each country or region, especially surrounding securities, tax, and reporting requirements. Failure to comply with local standards can lead to hefty fines or legal ramifications and might ultimately be a barrier to market entry. There are also international tax structures, such as transfer pricing and profit repatriation rules, that can impact investor returns. Therefore, companies should create a clear tax strategy that ensures compliance with international tax laws and helps to minimize the risk of tax inefficiencies or penalties.

There is also the issue of targeting the appropriate mix of venture capital, private equity, or institutional investors for cross-border expansion who are comfortable with the associated risks. When looking to local investors, companies should tailor their pitch so that it best resonates with their needs and preferences. It is important to highlight the market potential in the region and have a solid plan for market entry. International advisors are critical here to help navigate not only the regulatory and legal issues but also to assist with targeting investors and crafting pitches that will best resonate with local investors.

Last updated November 12, 2024

When a startup sets its sights on global expansion, there must be an emphasis on local compliance in each country and in each functional operation to avoid significant legal and financial risk. There are numerous regulatory and compliance concerns that must be addressed when moving into any new market, and the laws can vary widely between countries and regions.

Some of the most important areas of compliance include employment law and the local regulations surrounding labor, hiring and termination practices, employee benefits, and employer/employee contracts. Data protection and privacy laws also differ widely based on where you are doing business. Regulations such as GDPR in Europe can have costly consequences for violation, so ensuring you are in compliance across the board is key.

There are also regulations surrounding licensing and permitting within new markets, and of course, there are laws surrounding taxation and financial reporting or filing requirements that must be considered.

Working with legal advisors who focus their practice on bringing companies from garage to global will mean they anticipate issues and avoid accidents.

Last updated November 12, 2024

As companies look to international expansion, having a robust market entry strategy is a critical element to help avoid major roadblocks when moving into each new market. This starts by conducting detailed market research to understand elements such as the specific customer demographics of the region, cultural differences and sensitivities, customer needs, the competitive landscape, the economic environment, and growth potential within the market, as well as the legal and regulatory considerations involved in setting up business and compliance thereafter. It is also important to understand the political and social environment, as barriers to market entry come in all shapes and sizes.

Once thorough research has been conducted, an entry plan can be crafted, beginning with selecting the mode of entry to each market. Consider the best approach to entry based on the conditions of each market. This could be selling directly to customers, opening a new branch, forming a new subsidiary, entering into a distributor or reseller agreement, entering a strategic partnership or joint venture, acquiring an existing business, and any combination of the foregoing. Companies should also conduct operational planning, including establishing the necessary operational infrastructure, hiring key employees, site selection, and supply chain logistics.

From a legal perspective, the initial decision is what legal entity will be doing business in a country or jurisdiction with customers, suppliers, employees, contractors, and contractual counterparties. Sometimes, the choice of entity will evolve over time. Doing business in a country or jurisdiction will make a business liable to being compliant with the existing legislation and court system of that market, and each aspect of the business needs to be reevaluated. How can you maximize revenue? How can you minimize expenses? What taxes will be due to whom? What are the legal rules around employment or consulting relationships? How to do you protect your intellectual property? How do you mitigate risk? And so on…

Local resources and advisors who know the specific market you are attempting to access are invaluable when establishing your operational presence. Legal, tax, and accounting advisors are key.

Last updated November 12, 2024

When expanding globally, one of the most important areas for companies to consider is the cultural differences that exist between different regions and countries. Each culture is highly unique and brings its own traditions, viewpoints, and ways of doing things. This means companies should conduct thorough cultural awareness training to provide their teams with the knowledge of the appropriate business etiquette and customs they need to avoid costly misunderstandings.

Hiring local employees, as well as filling leadership roles locally, can be critical here. This helps to ensure you are adhering to cultural norms and employing those who understand the nuances of the language and communication style. By employing locally, you will also have a better grasp of the societal and legal norms of the area, including religious practices, holiday observances, differences in labor laws, etc.

There are also issues surrounding adapting your products or services as opposed to rolling out a standardized “one size fits all” version. You must, of course, keep the core of your products or services intact while also adapting as needed to adhere to any legal requirements or local preferences that exist.

Building strong relationships with local partners and working with legal counsel who are experienced in international markets are key to navigating the complexities that can exist when integrating into a new market and culture.

Last updated November 12, 2024

When expanding internationally, attracting and managing talent on a global scale can present numerous challenges. To build strong teams across borders, companies must take a thoughtful approach, considering the legal, social, and cultural differences that can come into play. Before entering any new market, it is important to understand the specific market dynamics and how to tailor your recruitment efforts so they are best aligned with local laws, expectations, and values.

Consider what benefits and opportunities will resonate most with candidates in each market. How can you customize and tailor your marketing and recruitment efforts so you are attracting top-level, high-performing talent? This is where local experts with specific experience in hiring and recruiting in that area can be very beneficial and help with a smooth process. Whether you are hiring locally, bringing in staff from the home office, or a combination, cultural integration will be critical here. There must be robust training programs that focus on bridging any cultural gaps between teams and fostering a collaborative, inclusive environment.

Labor laws can vary widely depending on what countries and regions you are operating in, so ensuring compliance with foreign labor laws, contracts, hiring and firing processes, etc., should be at the top of your mind. Again, bringing in legal teams who can assist you in navigating the myriad of labor laws across the world can help you avoid serious risks and what can be costly legal issues.

Last updated November 12, 2024

In a technology or other innovative business, a company’s most valuable asset is often its intellectual property. In assessing a company’s business and growth, ensuring IP protection in every market that the company is already or one day hopes to do business in is paramount. This means protecting patents, copyrights, trademarks, and trade secrets in the United States but also in countries where you will one day do business. The laws and regulations that provide the protections can differ widely from country to country, so it is critical to know and understand the laws of each market in which you are expanding. The more your business relies on innovation, the more vulnerable your business may be to IP infringement.

This means you will need to conduct significant due diligence to make sure you understand the specific IP protection laws that are in effect in each country where you are expanding. You will also need to conduct an analysis to ensure you will not be infringing on any existing IP rights in the countries you are targeting for expansion.

There are some avenues available to secure IP protections in several countries at once, including the following.

Patents

Patents are territorial, meaning you are only granted exclusivity in those countries where you have been granted a patent. The Patent Cooperation Treaty (PCT) is one way for companies looking to secure patent protection in several countries at once.

Trademarks

International trademark protection is not guaranteed if you have established protection in the United States. The Madrid System is a tool that allows companies to file for trademark protection in multiple countries.

Copyrights

It is important to check copyright law in each country you intend to operate and to ensure that they are part of the Berne Convention. If your country is a member of the Berne Convention and you have established copyright protection in your home country, that work should be protected in all other Berne member countries.

Trade Secrets

Trade secrets refer to all of the other forms of intellectual property that are not protected by a government filing. They are heavily linked to employment and contract law, so they are most sensitive to local variations in law and regulation that can vary from jurisdiction to jurisdiction.

Bringing on legal advisors who focus their practices on intellectual property protection globally early in the process is key, and you will need to keep them involved in each phase of growth to maximize outcomes and minimize leakage.

Last updated November 12, 2024

Fundraising

Numerous considerations come into play when raising capital for international expansion. This includes understanding the different regulatory frameworks of each country or region, especially surrounding securities, tax, and reporting requirements. Failure to comply with local standards can lead to hefty fines or legal ramifications and might ultimately be a barrier to market entry. There are also international tax structures, such as transfer pricing and profit repatriation rules, that can impact investor returns. Therefore, companies should create a clear tax strategy that ensures compliance with international tax laws and helps to minimize the risk of tax inefficiencies or penalties.

There is also the issue of targeting the appropriate mix of venture capital, private equity, or institutional investors for cross-border expansion who are comfortable with the associated risks. When looking to local investors, companies should tailor their pitch so that it best resonates with their needs and preferences. It is important to highlight the market potential in the region and have a solid plan for market entry. International advisors are critical here to help navigate not only the regulatory and legal issues but also to assist with targeting investors and crafting pitches that will best resonate with local investors.

Last updated November 12, 2024

In the early stages of a company raising capital may be essential, and two popular tools often used to structure early-stage venture capital styled investments are convertible notes and Simple Agreements for Future Equity (SAFEs). Both instruments can be used to raise seed funding before a formal valuation for the company is determined. While convertible notes and SAFEs are similar because they can both convert into equity interests of the company, there are key differences between the instruments that entrepreneurs and investors should understand. This article explains the key terms and highlights the differences between convertible notes and SAFEs. You should consider these points when deciding which option might be best suited to your fundraising or investment needs.

Key Terms Shared by Convertible Notes and SAFEs

Both convertible notes and SAFEs (collectively, “Convertible Instruments”) share the following features:

Conversion Events:
Qualified Financing. Convertible Instruments convert into equity if a “conversion event” occurs, usually when the company raises its next priced round of equity investment that meets a “qualified financing threshold.” A qualified financing threshold is a dollar amount of aggregate investment that the company must raise to cause automatic conversion of the Convertible Instruments. Qualified financing thresholds ensure that the company raises a meaningful amount of money in order to qualify as a conversion event. Upon conversion, the holder of the Convertible Instrument typically receives either a discount (described below), conversion at a valuation cap price (described below), or whichever conversion price is more advantageous to the investors as between the discount and the valuation cap price.
Liquidity Event. Convertible Instruments may also have conversion events that include the company undergoing a change of control (i.e., greater than 50% ownership change), a sale of the business transaction, or an IPO. For conversion events such as change of control, sale or IPO, the Convertible Instruments would either automatically convert at the valuation cap price or be treated “as-converted” and repaid a pre-negotiated amount with a premium. It is not unusual to see premiums of 150% or more of return on investment if the Convertible Instrument were paid off as part of a change of control transaction or sale of the business.
Discount: If the Convertible Instrument is converted and the “discount” is applied, then the holder of the Convertible Instrument would receive its equity shares at a discount as compared to the price per share paid by “new money” investors in the priced round. Customary discounts range from 10-25%. For instance, if the price per share for the company’s initial priced equity round was $1 per share and a 20% discount applied, the holders of the Convertible Instruments would receive their shares at $0.80 per share. If the Convertible Instrument includes a provision that the better of the discount and the valuation cap would apply, then the discount only applies if the priced equity round is raised at a valuation price that does not exceed the valuation cap.
Valuation Cap: If the Convertible Instrument is converted and the “valuation cap” is applied, then the holder of the Convertible Instrument would receive its equity shares at the valuation cap price, which is a predetermined maximum conversion price. This protects investors in the event the company achieves “hockey stick” growth metrics (i.e., the company’s value increases rapidly to a high valuation), by locking in today’s maximum price notwithstanding that the company raised its priced equity round at a valuation exceeding the valuation cap price. For instance, if a Convertible Instrument had a $10 million valuation cap, but the initial priced equity round is raised at a $20 million valuation, then the holder of the Convertible Instrument would receive twice as many shares as the investors investing directly in the priced-round (on a dollar-for-dollar basis). If the Convertible Instrument includes a provision that the better of the valuation cap and the discount would apply, then the valuation cap only applies if the priced equity round is raised at a valuation price that exceeds the valuation cap.
Key Differences Between Convertible Notes and SAFEs

Interest Rate: Convertible notes accrue interest on the principal amount invested while outstanding. Customary interest rates for convertible notes range from 5% to 12% but can vary based upon current market conditions and the applicable federal minimum interest rate. Upon conversion of the note, the accrued interest is capitalized and added to the principal amount invested. SAFEs do not accrue interest, which is beneficial to the company to only be required to convert the principal amount invested to equity.
Maturity Date: Convertible notes have a fixed maturity date, at which point the note must be repaid. While investors can demand repayment at maturity, if the company lacks the ability to repay, in the startup company context, the parties usually agree to extend the maturity date to give the company additional time to perform. Typical convertible note maturity dates range from 12-36 months. SAFEs do not have maturity dates, which benefits the company by providing more flexibility on timing for achieving a conversion event.
Debt Obligation: A convertible note is a recognized debt instrument and gives investors the right to call an event of default if the note is not repaid at maturity. Investors also receive the benefit of common law lender’s rights, which includes priority treatment in a liquidation or dissolution prior to equity holders receiving any remaining proceeds. Holders of SAFEs are less secure than holders of convertible notes since SAFEs do not have an unconditional repayment obligation.
Socialization. Since convertible notes are debt and have been around longer than SAFEs, it may be easier to explain a convertible note investment to “friends and family” investors, whereas SAFEs are more familiar to professional investors and VCs. SAFEs may require more time and effort to explain to retail investors.
Conclusion

Convertible Instruments serve as powerful tools for startups and investors to navigate early-stage fundraising needs and to efficiently raise pre-seed and seed rounds. While convertible notes offer investors the security of debt, SAFEs present a more company-friendly approach. Understanding the nuances of both instruments can help startups and investors choose the best financing method based on their circumstances.

Last updated November 12, 2024

An accredited investor is an individual or entity that meets certain wealth, income, or asset thresholds or holds specific professional certifications, as defined under Regulation D of the Securities Act of 1933. These qualifications are meant to ensure that investors have sufficient knowledge or wealth to evaluate and bear the risks associated with unregistered securities offerings. The Securities and Exchange Commission (SEC) periodically updates these requirements to reflect changing market conditions.

Under Rule 501 of Regulation D, individuals generally qualify as accredited investors if they meet any of the following:

Net Worth: a person whose net worth, alone or with a spouse or spousal equivalent, exceeds $1 million at the time of the purchase, excluding the value of their primary residence.
Income: a person whose income exceeds $200,000 individually or $300,000 with a spouse or spousal equivalent in each of the two most recent years, with a reasonable expectation of the same income level in the current year.
Executive Role: a director, executive officer, or general partner of the company offering the securities.
Professional Certifications: a person who holds certain professional certifications, designations, or credentials recognized by the SEC. To qualify, the certifications must be in good standing and issued by an accredited institution recognized by the SEC.
Family Office: certain persons who are a “family client” of certain family offices with over $5 million in assets under management.
Knowledgeable Employees: certain employees of private investment funds that are involved in the fund’s investment activities.
In certain circumstances, entities such as businesses or charitable organizations can also qualify as accredited investors. Generally, to qualify, the entity must either have $5 million or more in assets or be made up entirely of accredited investors.

For more detailed and up-to-date information on accredited investor requirements, consult Rule 501 of Regulation D on the SEC’s website.

Last updated November 12, 2024

When raising capital under Rule 506 of Regulation D, companies often weigh the pros and cons of filing a Form D with the SEC versus navigating state-by-state “Blue Sky” securities filings. Filing a Form D offers a significant advantage, particularly by granting “covered security” status under the National Securities Markets Improvement Act (NSMIA). This means that, rather than complying with the complex registration and qualification processes in multiple states, a company can simply file a notice and pay a fee in each state where the securities are offered. This streamlined process makes a Form D filing an appealing choice for companies raising capital across multiple states, as it simplifies compliance and reduces administrative burden.

However, filing a Form D does come with some downsides. For one, it requires public disclosure of certain information, such as the fact the company is raising capital, the amount of capital being raised, and the names of key executives, which may attract unwanted attention. Additionally, even though failing to file a Form D does not automatically strip the offering of its federal “covered security” status, some state regulators may still view the filing as necessary to bypass state-level registration requirements. This can create some uncertainty when dealing with state regulators.

In contrast, companies that choose to rely on state-by-state Blue Sky filings without filing a Form D (by using a Section 4(a)(2) exemption, for example) do not have the “covered security” status of the NSMIA, meaning they must navigate each state’s unique securities laws individually. This approach may be viable for small, local offerings but can quickly become expensive and time-consuming in a multi-state offering. Despite the information publicly disclosed in a Form D, many issuers find the streamlined process of relying on Rule 506 and avoiding extensive state regulations outweighs the potential downsides.

Last updated November 12, 2024

When a company raises capital by selling securities under Regulation D of the Securities Act of 1933, it must file a Form D with the Securities and Exchange Commission (SEC). The Form D filing serves as a notice that informs the SEC of the securities offering and is required to comply with federal regulations. Form D allows companies to raise capital without registering their securities so long as they qualify for an exemption under Regulation D.

Although filing a Form D makes certain details about a company public, the disclosure is relatively limited. The required information includes:

Names and addresses of your company’s executive officers and directors.
Type and amount of securities being offered.
The total amount of money the company is aiming to raise, the amount sold, and the gross proceeds paid to the company’s directors, officers, and promoters.
Identity of brokers, dealers, and finders used to solicit investors in the offering and the amount of sales commissions and finders’ fees paid to those persons.
Form D does not require a company to disclose its valuation, cap table, or the names of its investors. Additionally, a Form D filing does not impose any ongoing reporting, compliance, or corporate governance obligations, aside from the possibility of needing to amend the filing in the future.

Filing a Form D is a legal requirement if a company is selling securities under Regulation D and must be filed electronically through the SEC’s EDGAR system within 15 days of the first sale of securities. While some companies may choose to delay filing to control the release of sensitive information, such delays can lead to penalties and may jeopardize a company’s ability to rely on Regulation D for future funding rounds. To avoid any legal or strategic missteps, it’s essential to consult your legal team to ensure your filing strategy complies with securities regulations while supporting your business goals.

Last updated November 12, 2024

Securities laws are a complex set of U.S. federal and state laws, regulations, and court cases that govern the offering and sale of financial instruments known as securities. Many other countries have their own securities laws which govern securities transactions within those countries. Examples of securities include common stock, preferred stock, SAFEs, convertible notes, bonds, options, warrants, certain digital assets, limited partnership interests, LLC units, and investment contracts.

A primary purpose of securities laws is to protect investors from being defrauded by issuers of securities. In the United States, the basic premise of federal securities laws is that issuers must register all offerings of securities with the Securities and Exchange Commission (SEC) unless there is an exemption from registration.

The registration process is the procedure companies undergo when they make an initial public offering (IPO) of their securities or “go public.” Registration requires a company to provide audited financial statements and detailed written disclosures about its business, its management, the securities being offered, and potential risks of investing in the company, to the SEC and potential investors. Once a company has gone public, it must regularly update this information, at least quarterly. The registration and reporting requirements are time-consuming and costly. As a result, only larger companies with sufficient resources and sophisticated internal controls and processes capable of managing the periodic reporting obligations choose this path.

All other companies, ranging from early-stage startups to pre-IPO firms, must find an exemption from registration when offering securities for sale to investors. These exemptions, detailed in the securities regulations, generally stipulate that certain types of securities offered to a limited number of qualified investors in specific ways do not require registration with the SEC.

When fundraising, startups typically use a “private placement exemption” to sell securities to “accredited investors.” These investors, as defined in the securities regulations, include individuals with a net worth exceeding $1 million (excluding the value of their primary residence) or an annual income over $200,000 individually, or $300,000 when combined with a spouse. Companies can offer and sell securities to non-accredited investors but must provide them with the same information as in a registered offering. Accordingly, startups are advised to sell securities only to accredited investors to avoid potential securities law violations and the expense of needing to prepare and maintain detailed disclosure documents.

Securities offered to a company’s employees, consultants, or advisors, such as restricted stock or stock options, must also be registered or qualify for an exemption from registration. For this purpose, startups often use the federal exemption known as Rule 701 for securities offered to service providers. This rule provides a registration exemption for compensatory benefit plans, like the equity incentive plans or stock plans companies use to grant stock options. As a company grows and begins to make significant grants under these benefit plans with a value exceeding certain dollar thresholds, Rule 701 requires the company to disclose information about itself, including risk factors and financial statements, to its service providers who hold securities under these plans.

In addition to federal securities law compliance, a company may also need to comply with state-level securities laws, known as “blue sky laws,” in each state where its investors reside, depending on the federal exemption the company uses and whether the federal exemption takes precedence over, or preempts, state securities laws.

If a company fails to comply with securities laws, affected investors gain a “right of rescission.” This right allows investors to sue the company, undo their securities purchase, and recover their money. Noncompliance can also lead to fines and, depending on the severity and type of violation, other civil and criminal penalties for the company and other responsible parties. Given the complexity of navigating securities laws, startups should work with knowledgeable securities counsel for even the earliest stages of financing and equity compensation.

Last updated May 6, 2024

Section 409A of the Internal Revenue Code, and the Section 409A Treasury regulations, are U.S. federal tax laws and regulations that effectively require companies to grant stock options with an exercise (or strike) price at or above the underlying shares’ fair market value as of the grant date. If an option is granted with an exercise price below fair market value, the option recipient may have to pay income taxes, interest, and penalties, potentially negating the option’s economic benefit. If the option recipient is an employee, the company must also withhold income and employment taxes on an underpriced option. Failure to do so could result in the company paying interest and penalties on the under-withheld amounts.

Obtaining a valuation from a qualified, independent appraiser and using the appraised value to set the option exercise price is a “safe harbor” valuation method under the Section 409A regulations. If a company doesn’t use a safe harbor method, it bears the burden to prove its value determination was reasonable if challenged by the U.S. Internal Revenue Service (IRS). This can be difficult and time-consuming, often involving extensive correspondence and accountants’ fees. A safe harbor valuation method provides a presumption of reasonableness, meaning the burden shifts to the IRS to prove that the valuation was “grossly unreasonable.”

A company’s 409A valuation report is valid for 12 months following the valuation date (which isn’t always the same as the report date) or until a material event affects the company’s value, whichever comes first. Therefore, expect to obtain a new 409A valuation at least annually, or more often if your company is fundraising or reaching other critical milestones during that period. Many startup lawyers view signing a term sheet for equity financing as an event that causes a 409A valuation to expire.

Obtaining a third-party 409A valuation is among the simplest safe harbors to qualify for and can serve as inexpensive insurance against avoidable tax issues. If a company doesn’t get a valuation report to set its option exercise price, it may end up spending more to address questions about potential tax consequences in the middle of a financing or M&A transaction than it would on the 409A valuation.

Valuation costs can vary based on the company’s stage, the number of stockholders, and the time frame for completing the valuation. Subscription valuation services, often bundled with cap table management software, are now available to help companies keep their valuation reports up to date.

The process of engaging a 409A valuation firm, providing necessary information, reviewing a draft report, and finalizing the valuation typically takes two to six weeks. The company will need to provide an updated cap table, financial statements and projections, and schedule a call between the appraiser and company management. Be aware of this timeline to avoid delays.

Some founders worry that a 409A valuation, especially one with a low fair market value, might negatively affect the valuation an investor or acquirer assigns to their company. However, this concern is unfounded. Sophisticated investors and acquirers value companies differently and for different purposes than valuation firms. They care more about whether a company has diligently obtained 409A valuation reports for its option grants than the specific value indicated in the reports. In fact, a lower 409A fair market value can make a company more attractive to employees and recruits. This is because the company can grant its stock options with a lower exercise price, leaving more room for an increase in the value of the shares. Experienced valuation firms understand this and will work with companies, within reasonable limits, to establish lower, yet still defensible, fair market values.

Last updated May 6, 2024

Qualified Small Business Stock (QSBS) refers to stock that qualifies for tax benefits under Section 1202 of the U.S. Internal Revenue Code. This section allows the seller of QSBS to exclude up to 100% of capital gain on the shares from federal income tax. As of May 2024, any QSBS acquired after September 27, 2010, is eligible for this 100% exclusion. The exclusion is subject to limits of either $10 million or ten times the taxpayer’s adjusted basis in the QSBS, whichever is greater.

To qualify as QSBS:

The stock must have been originally issued by a domestic C-corporation. The corporation’s gross assets must be $50 million or less at the time of and immediately following the stock issuance.
The taxpayer must have acquired the stock at its original issue in exchange for money, property (excluding stock), or as compensation for services provided to the corporation.
While the taxpayer owns the stock, at least 80% of the corporation’s assets (by value) must be used in the active conduct of one or more qualified trades or businesses defined in the Internal Revenue Code, which excludes most professional services.
The corporation must qualify as an “eligible corporation” as defined in the Internal Revenue Code.
With some exceptions, the corporation must not have conducted significant redemptions of its own stock for one year before and one year after issuing the stock to the taxpayer, and must not have redeemed stock from the taxpayer for two years before and two years after issuing the stock to the taxpayer.
The taxpayer must not be a corporation.
The taxpayer must hold the stock for a minimum of five years.
The benefits of QSBS can be substantial, especially for long-term stockholders with significant capital gains. Founders, early employees and investors in startup companies are often able to avail themselves of QSBS. With proactive tax and estate planning, there may be an opportunity for taxpayers to “stack” QSBS benefits. However, certain actions by a company, like poorly timed stock redemptions, can result in the loss of QSBS treatment. Therefore, it is crucial to involve tax and legal professionals to properly structure transactions and avoid the unintended loss of QSBS benefits.

Last updated May 6, 2024

“Fully diluted capitalization” refers to the total number of a company’s outstanding shares, options, warrants, and other convertible securities. This total is calculated as if all these securities were fully exercised or converted into the most basic unit of shares. For a Delaware corporation, this basic unit is usually the company’s common stock. The fully diluted capitalization is then expressed on an “as-converted to common stock” basis. Besides options and warrants, convertible securities can include convertible promissory notes, SAFEs, and convertible preferred stock.

The definition of fully diluted capitalization can change depending on the context. For instance, in startup fundraising, shares of common stock that are reserved but unissued under a company’s option pool are usually included in the fully diluted capitalization for price calculations, even though these shares are not outstanding or held by anyone. However, during a company’s sale or liquidation, these shares would be excluded from the fully diluted capitalization calculation used to allocate proceeds, as no one has a claim to these shares.

Understanding fully diluted capitalization and its components is crucial for founders and investors to comprehend their ownership and the potential impacts of transactions.

Last updated May 6, 2024

Louis Lehot

LLehot@foley.com

+1.650.796.7280

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