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If you’re reading this, you’ve likely decided to take the leap and found a startup. Or, you’re at least thinking about making the leap. Startup founders are faced with a number of critical decisions at formation. Certain decisions are specific to the startup and others apply across the board. The concepts discussed below routinely come up in my work with startups. This is part one of a two part post. Stay tuned for part two in a future post.  

1.   Choice of Entity.

While each startup’s individual circumstances will dictate which entity is most appropriate, a typical high growth startup that is likely to seek venture financing and/or issue equity compensation to service providers will most often opt for a C Corporation. The remainder of this post assumes that the startup has opted for a C Corporation.

2.   State of Incorporation.

After the founders have selected the entity type, they must decide which state to incorporate in. I typically recommend either Delaware or the state where the startup’s principal business is located.

Certain investors strongly favor Delaware because its corporate law is business friendly and well established. While Delaware is a great default choice, founders should be aware that incorporating in Delaware will result in additional annual filing fees and business registration expenses if the business’s principal place of business is in another state.

3.   Equity Split; Vesting.

One of the initial corporate actions of the newly formed corporation is the issuance of equity to the founders. Many factors go into determining how the founders will allocate equity among themselves, including expertise applicable to the startup’s business plan, intellectual property contributed by a founder, and whether a founder is committed to the startup on a full or part-time basis.

In addition to the equity split, the founders should determine if their shares will be subject to vesting, whether time-based, performance-based (i.e. based on the achievement of certain goals or milestones), or both. If shares are subject to vesting and a founder decides to move on from the venture before vesting occurs, unvested shares are forfeited back to the corporation. In that case, the remaining shareholders’ relative ownership percentages will increase on a pro rata basis.  

Also note that even if shares are not subject to vesting at formation, it is possible to impose a vesting obligation after the fact by giving the corporation the right to repurchase shares upon a termination of a founder’s services. Imposing a vesting obligation after the fact most often occurs when a startup raises outside capital, as investors want to ensure that founders with large blocks of shares are committed to the venture.

4.   83(b) Elections.

In the event shares are subject to vesting, the founders should ensure that they timely file 83(b) elections with the IRS. 83(b) elections allow the recipient of shares subject to forfeiture to elect to pay tax on those shares based on the current fair market value of the shares. Absent an 83(b) election, the founder pays tax on their shares as they vest at the fair market value of the vested shares at the time of vesting. For a startup founder receiving shares at a nominal price, paying tax on this nominal amount is almost always the sensible choice.

The filing must be made within 30 days of the date of transfer of the stock, with no exceptions. While this issue may seem personal to a founder’s own tax situation, this issue is often raised during due diligence when raising outside capital or selling the business, and special attention should be given to ensuring that the election is made as intended.  

Stay tuned for part two of this series in a few weeks!