Our Blog

Lawlace’s Insights

We offer a wide range of legal resources to entrepreneurs of all sizes – from formation to exit.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

Legal Fees Guide: Priced Rounds for Startups (U.S. Market)

Raising a priced round—whether Series Seed, A, or B—is a major milestone in a startup’s journey. But it can also come with sticker shock, especially when it comes to legal fees. This guide helps founders understand market pricing, what’s reasonable, and what makes a deal more expensive.

Raising a priced round—whether Series Seed, A, or B—is a major milestone in a startup’s journey. But it can also come with sticker shock, especially when it comes to legal fees. This guide helps founders understand market pricing, what’s reasonable, and what makes a deal more expensive.

All prices assume the company is incorporated as a Delaware C-Corp.

Market Legal Fees (Top-Tier Startup Law Firms)

Company-Side Legal Fees:

Investor-Side Legal Fee Caps (Paid by Company):

Legal Fees We Consider Reasonable at Lawlace

Company-Side Legal Fees:

Add $5K for a roll-up vehicle if required.

Investor-Side Legal Fee Caps (Paid by Company):

Lawlace Pricing (For Startup Clients)

For founders who have purchased our Startup Launch Package or Startup Due Diligence Package, we offer:

Series Seed Flat Fee: $25K and Series A Flat Fee: $45k.

Includes: term sheet review and negotiation, pro forma cap table, main and ancillary financing docs, due diligence (excluding a clean-up), negotiations and one closing.

No surprise hourly bills.

What Drives Up Legal Costs?

These are the most common factors that push your deal into "mid" or "complex" pricing territory:

⚠️ Corporate cleanup. If you started a company using DIY tools like LegalZoom, Stripe Atlas, or Clerky and did not issue founder stock properly—or used a lawyer who isn't experienced in venture-backed startup work—undoing the mess can easily double the fees. Cap table mistakes (missing or incorrect board consents and stock documents) and tax mistakes (e.g., 83(b), QSBS) are the most expensive to fix.

⚠️ Cap table renegotiations and disputes. For example, buying out a departed co-founder or founders selling a portion of their stock to investors (“cashing out”) adds complexity, negotiation, and custom drafting.

⚠️ Non-standard convertibles and side letters. Unique SAFEs and convertible notes with odd conversion terms, especially those raised at low valuation caps, often require renegotiation or complicated modeling before the round can close.

⚠️ Non-standard term sheet. Top-tier VC firms tend to use clean, founder-friendly terms. If your lead investor proposes unusual terms like warrants for common stock or oversized boards, the legal documents require custom negotiation and redrafting, which increases costs.

⚠️ LLC or non-Delaware structure. NVCA financing documents assume a Delaware C-Corp. If you’re an LLC, every doc must be manually drafted into an operating agreement and subscription agreement. This is the most expensive kind of financing we see. Choosing a state other than Delaware will also increase the fees on both the company and investor sides because venture lawyers are used to Delaware law, and secretaries of state (e.g., of Missouri) might not be familiar with long and complex charters—making filings more difficult and time-consuming.

⚠️ Rolling closings. Coordinating multiple closing tranches with separate investors requires legal time for updates and adjustments between each. Unusual escrow/timing needs can further increase complexity and cost.

💡Pro Tip: Negotiate a reasonable cap on investor legal fees to align incentives and control costs.

A high fee cap incentivizes investors to over-lawyer the round—prolonged diligence, redlines over immaterial issues, and endless back-and-forth. Founders often underestimate this: your own legal bill typically ends up 1.5–3x the investor's fee cap. Give them a $80K cap, and you might be signing up for a $240K round. Not worth it. Aim for $20K–$50K caps in early-stage deals.

Tips to Keep It Clean

Before fundraising, prepare a data room and use this free Due Diligence Checklist to ensure everything is in order.

Have questions about your upcoming round or want a personalized estimate?

Reach out to our team or explore our legal packages here.

This guide is for informational purposes only and reflects U.S.-based market pricing for startup financing deals. Your specific facts may vary.

Kristina Subbotina
April 18, 2025

Critical issues when issuing equity

We’re often asked what the “critical” or “most important” legal advice is when issuing equity to service providers. The truth is, there’s no single answer—several key considerations matter equally. Below is a brief guide to the most important aspects, based on our experience.

We’re often asked what the “critical” or “most important” legal advice is when issuing equity to service providers. The truth is, there’s no single answer—several key considerations matter equally. Below is a brief guide to the most important aspects, based on our experience.

Obtaining the 409A Valuation

When issuing equity to service providers, one of the most critical considerations is obtaining a 409A valuation. A 409A is an independent appraisal of your company’s fair market value (FMV) and provides a defensible basis for setting the price of stock or stock options. While not legally required to issue equity, a 409A valuation is essential for minimizing tax and legal risks—especially with stock options, where failure to price options correctly can trigger immediate income tax, steep penalties, and interest charges for recipients.

Issuing equity without a 409A valuation is particularly risky once your company has raised outside capital, generated revenue, or made significant progress, as these milestones suggest a higher valuation. For options, a 409A is must-have. For stock issuances, it’s still important to demonstrate a good-faith valuation, even if a 409A isn’t obtained.

Overall, a 409A valuation is a small upfront cost that provides significant protection, especially during future fundraising. For more detail, refer to this blogpost.

Signing the Service Agreement

Whenever you’re considering issuing equity to service providers, you must ensure that a written agreement formalizing their relationship with the company is in place. This could be an employment agreement, a consulting agreement, or an advisor agreement—but it should be properly documented and signed by both parties.

This is important for several reasons, including ensuring that the service provider is bound by confidentiality obligations and that all intellectual property created in the course of providing services is properly assigned to the company.

Additionally, the service agreement typically sets out the promise of an equity award—its size and terms—which protects the company from potential future claims by service providers seeking disproportionately large stakes. To avoid disputes over how much equity is owed, it’s best to specify a fixed number of shares rather than referring to a percentage of the company’s equity.

Creating the Equity Incentive Plan

An Equity Incentive Plan (EIP) is a formal plan adopted by a company to grant equity (such as stock options or restricted stock) to employees, contractors, advisors, and other service providers. The EIP helps keep the cap table organized, supports tax and legal compliance, and enables scalable equity granting as the company grows.

One of the main reasons why the EIP matters is Rule 701. This is a key SEC exemption allowing private companies to issue equity to service providers without registering the securities — provided the grants are made under a written and approved plan like the EIP. Relying on Rule 701 helps avoid burdensome registration requirements while ensuring compliance with securities laws.

To set up the EIP in your company, you’ll need both Board and stockholder consents approving the number of shares to be reserved, a document summarizing the terms of the plan, and the applicable form documents for future use.

If you're granting equity to service providers based in California, you'll also need to comply with California state securities laws. Most companies rely on the Section 25102(o) exemption, which requires a simple notice filing with the California Department of Financial Protection and Innovation (DFPI). This filing must be submitted within 30 days of the grant and helps ensure your company stays compliant at the state level.

Signing the Board Consent

Each equity grant must be individually approved by the Board. Approving the EIP alone—or entering a grant into Carta or Pulley—is not enough.

The Board Consent should specify the name of each purchaser, the number of shares issued to them, and the plan under which the grant is being made. If the shares are subject to vesting and acceleration (see below), the Board Consent should also outline the applicable vesting schedule and acceleration terms.

It’s important to keep in mind that the date of Board approval is usually considered the official grant date for tax purposes. This date starts the 30-day deadline to file an 83(b) election with the IRS. If the election isn’t filed within that window, the recipient may lose the potential tax benefits of early filing—like minimizing ordinary income and starting the capital gains holding period sooner.

In our other blogposts, you can find more information on how 83(b) elections work, what to do if the deadline is missed, and whether a filing is necessary if the purchaser is not a U.S. resident.

Choosing the Right Type of Equity Award

Stock v. options

Not all grants are the same. The first decision a company needs to make is whether to grant restricted stock or stock options.

With restricted stock, the recipient becomes a shareholder immediately, gaining all associated rights, including voting. The recipient must also pay for the shares upfront. If the 409A valuation is high, the cost can be significant and potentially unaffordable. Even if the company offers a loan to cover the purchase, the value may still be treated as taxable income. As a result, issuing restricted stock is usually only advisable when the company is very early-stage, with little or no outside funding or revenue.

Stock options are different. You don’t become a shareholder — or pay anything — until you choose to exercise the option. This means no upfront cost, no company loans, and no tax consequences until exercise. Cons?  No shareholder rights until the exercise.

NSOs v. ISOs

If the company decides to grant stock options, the next step is choosing between Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs).

ISOs are only available to employees and come with favorable tax treatment — if certain conditions are met (like holding the shares for more than one year after exercise and two years after the grant), gains may be taxed at long-term capital gains rates instead of ordinary income. However, ISOs might be subject to the Alternative Minimum Tax (AMT), which can be complex to manage.

NSOs, on the other hand, can be granted to anyone — including contractors, advisors, and board members — but they’re taxed as ordinary income at the time of exercise on the spread between the strike price and fair market value.

In short: use ISOs for employees when possible, especially early on. Use NSOs for non-employees or when more flexibility is needed.

Specifying the Vest Schedule

Deciding on the vesting schedule is a key part of issuing equity to service providers. Vesting means a stockholder earns ownership of their shares over time, following a set schedule.

There are two main types of vesting: time-based and milestone-based. Time-based vesting means shares vest over a fixed period—usually four years with a one-year cliff for employees and consultants, or two years for advisors—regardless of performance. Milestone-based vesting ties ownership to specific achievements, like delivering an MVP or reaching a certain ARR.

In both cases, vesting stops when the service provider leaves, unless the company chooses to accelerate some or all of the grant. Pro tip: include a signed Stock Power when entering into the Stock Purchase Agreement. If it’s not signed upfront, it may be difficult to get it later—especially if the relationship ends on bad terms.

Can a company skip vesting and issue fully vested shares upfront? Yes—but this comes with the risk that the person could walk away with the full grant shortly after joining.

Considering Acceleration Terms

Acceleration refers to the early vesting of unvested shares, typically triggered by specific events.

There are two common types of acceleration: single-trigger and double-trigger.

  • Single-trigger acceleration means that some or all of the unvested shares vest upon a single event—usually a change of control, like an acquisition. This is more common for advisors or in unique negotiation scenarios.
  • Double-trigger acceleration requires two events: a change of control and a termination of the service provider without cause (or resignation for good reason). This is more typical for founders and key executives.

Employees and consultants typically do not receive acceleration, unless it's specifically negotiated. Most standard equity grants don’t include it.

Pro tip: Be intentional about including—or excluding—acceleration. It can significantly impact outcomes in an exit scenario and should align with the person’s role and leverage during negotiations. If you want acceleration for a certain service provider, make sure it’s mentioned in the Board consent approving the grant!

Issuing equity to service providers can be one of the most powerful tools for attracting and retaining talent—but only if it’s done thoughtfully and in compliance with legal and tax requirements. From obtaining a 409A valuation to structuring vesting and acceleration terms, each step plays a crucial role in protecting both the company and the recipient.

There’s no one-size-fits-all answer, but with the right legal documentation, clear communication, and strategic planning, equity grants can become a strong foundation for long-term collaboration and growth.

Need legal help?

If you're not sure where to start or want a second set of eyes on your equity documents, feel free to reach out—we’re here to help.

Download a free, practical, founder-friendly equity issuance checklist and find our affordable legal packages for startups here.

Kristina Subbotina and Natalia Suvorova
April 8, 2025

How to Start a Startup in the U.S. as a Foreign Founder

Starting a company as a foreigner is the American dream in action—but making it a reality requires navigating legal, financial, and immigration complexities. From selecting the right business entity to securing visas and raising capital, every decision impacts your startup's success.

Starting a company as a foreigner is the American dream in action—but making it a reality requires navigating legal, financial, and immigration complexities. From selecting the right business entity to securing visas and raising capital, every decision impacts your startup's success.

This guide outlines the key steps foreign entrepreneurs must take to launch and scale a startup in the U.S.

1. Confirm Your Business Name is Available

Before incorporating, ensure your startup name is:

  • Unique – Search Google and check domain availability.
  • Legally Available – Verify name availability with the Delaware Secretary of State (you can check and reserve the name here) and the state(s) where the founders reside.
  • Trademark-Safe – Conduct a trademark search on the USPTO website (uspto.gov) to avoid conflicts.

💡 Why this matters: If your name is already trademarked, you risk receiving a cease and desist letter, forcing a rebrand that can disrupt your business.

2. Choose Your Business Structure & State of Incorporation

Your business entity affects fundraising, taxation, and governance:

  • LLC – Best for consulting or small businesses without venture capital ambitions.
  • C-Corp (Recommended for Startups) – Preferred by investors because it supports scalable equity compensation plans and enables venture-friendly governance. Certain tax benefits, such as the Qualified Small Business Stock (QSBS) exclusion, may also apply.

Most venture-backed startups incorporate in Delaware.

3. Incorporate Your Company

Once you've chosen an entity, follow these steps to legally form your startup:

  • Hire a Registered Agent – Required for official legal correspondence.
  • File a Certificate of Incorporation – Submit to the Delaware Secretary of State.
  • Appoint Directors & Approve Bylaws – Formalize your corporate governance.

4. Issue Founder Stock & Assign Intellectual Property (IP)

Proper stock issuance ensures legal clarity and prevents ownership disputes and derailed fundraising:

  • Founder Equity – Set up vesting, generally 4 years with a 1-year cliff, to align incentives.
  • IP Assignment Agreements – Ensure all intellectual property belongs to the company.
  • 83(b) Election – Must be received by the IRS within 30 days of board consent approving the stock issuance to avoid higher tax liabilities. If you plan on relocating to the U.S. during your vesting period (even if your company is incorporated elsewhere), you may be subject to U.S. tax on unvested stock. Filing an 83(b) election can help prevent a surprise tax bill.
    • 📉 Real Case: A UK founder at a German startup skipped the U.S. 83(b) filing, assuming their home country’s tax rules applied. Their startup raised $30M in six months, leaving them stuck with a massive U.S. tax bill on unvested stock—without liquidity to cover it.
    💡 What happens if you miss the 83(b) deadline? You’ll owe taxes on stock as it vests, meaning you could get taxed on millions in gains later, instead of pennies now.

5. Get an EIN & Open a U.S. Bank Account

An Employer Identification Number (EIN) is required to:

  • Open a U.S. business bank account.
  • Accept payments and process payroll.

💡 For foreign founders: Neobanks like Mercury and Brex simplify account setup.

6. Prepare for Fundraising

Before seeking investment, ensure your legal and financial foundation is solid:

  • Set Up a Data Room – Store all incorporation, legal, and financial documents.
  • Create a Strong Pitch Deck – Clearly present your vision, market opportunity, and business model.
  • Choose the Right Investment Structure – SAFE, convertible note, or priced equity round.

💡 Most early-stage startups use a SAFE for simplicity.

7. Hire Employees, Advisors & Contractors

Hiring requires proper documentation to avoid future disputes:

  • Advisor & Consulting Agreements – Clearly define roles and compensation.
  • Employment Agreements – Include state-specific IP clauses to protect company assets.
  • Payroll & Compliance Setup – Services like Gusto and Rippling streamline hiring and tax compliance.
  • To issue equity to service providers, you need an Equity Incentive Plan and board consent approving the grants (just executing agreements or adding Carta entries does not equal a valid stock issuance).

Actionable Step: Gain insights from our article on How Much Equity Should Startups Give to Employees, Consultants, and Advisors? to structure competitive and fair incentive plans.

8. Stay Compliant & File Required Reports

After incorporation, ongoing compliance is critical to avoid fines or dissolution:

  • File a Beneficial Ownership Report (BOIR) – Required within 30 days of incorporation.
  • Securities Compliance – You might need to file Form D and state securities filings when raising capital.
  • Delaware Franchise Tax – Due by March 1st (for corporations) / June 1st (for LLCs) every year to maintain good standing.

💡 Missing compliance deadlines can result in thousands in penalties or even company dissolution.

9. Immigration Considerations for Foreign Founders

Starting a business in the U.S. as an international founder comes with unique immigration challenges. Whether you’re planning to establish your presence in the US, it’s crucial to understand the visa landscape and corporate structure considerations that can impact your immigration journey.

Here are some top visas available for founders and what you need to qualify

H-1B Visa (Self-Sponsoring H-1B for Entrepreneurs)

The H-1B visa is a popular option for skilled professionals, including startup founders. H-1B now allows for majority ownership by the employee, making it suitable for founders who hold significant equity in their companies. To self-sponsor, you must establish that the company is a separate legal entity from yourself. This often means demonstrating that the company’s board has the power to hire and fire you, even if you’re on the board, proving a valid employer-employee relationship.

Unlike regular H-1Bs, the self-sponsoring H-1B for entrepreneurs is typically granted for only 18 months rather than the usual three years. Despite the shorter duration, it can be renewed, but it requires careful planning to maintain compliance and eligibility. It involves several key factors:

  1. Proper Corporate Structure: The entrepreneur must demonstrate that the U.S. entity they are working for has the right corporate structure to establish an employer-employee relationship.
  2. Job Role and Responsibilities: The job duties outlined in the H-1B petition must remain consistent throughout the duration of the visa. Any significant changes in responsibilities or job titles may require filing an amended petition.
  3. Maintaining Specialty Occupation Criteria: The role must continue to meet the specialty occupation requirements, meaning that the job should still require a degree or specialized knowledge, and the entrepreneur must continue to perform those duties.
  4. Timely Extension Filings: Since the self-sponsoring H-1B is typically granted for only 18 months, entrepreneurs must plan to file for extensions well in advance. Extension petitions should include updated documentation proving that the business remains operational and that the position still qualifies as a specialty occupation.
  5. Ongoing Compliance with Labor Conditions: The employer (the startup) must continue to comply with the Labor Condition Application (LCA) terms, including paying the prevailing wage. Any change in work location or salary could necessitate an LCA update or an amended H-1B petition.
  6. Evidence of Business Viability: Extensions or renewals often require evidence that the startup is thriving or at least operational, which may include financial documents, revenue records, and proof of sustained operations and funding.
  7. Record-Keeping and Reporting: Entrepreneurs must maintain thorough records of their employment, corporate structure, and any changes that occur during their H-1B period. This documentation is essential if U.S. Citizenship and Immigration Services (USCIS) conducts a site visit or requests evidence during the renewal process.

The H-1B visa is subject to an annual lottery due to high demand, with only 85,000 visas available each fiscal year. Startups looking to hire or sponsor founders must navigate this lottery process, which typically takes place in March for the upcoming fiscal year beginning October 1.

If you already hold an H-1B visa and wish to transfer it to your company, the process is generally faster and does not require entering the lottery again.

O-1A Visa (Individuals with Extraordinary Ability)

The O-1A visa is an excellent option for founders who can demonstrate exceptional achievements in business, science, or technology. You must provide evidence of your accolades, media coverage, membership in prestigious organizations, or notable contributions to your field. This visa allows significant flexibility in how you structure your involvement with your startup. You will still need someone to hire/fire you and act as a signatory.

The O-1A visa is granted for an initial period of up to 3 years, with the possibility of indefinite extensions in 1-year increments as long as you continue to meet the eligibility criteria and maintain your extraordinary ability status. Additionally, the O-1A visa can serve as a strong foundation for pursuing a green card through the EB-1A (Alien of Extraordinary Ability) or EB-2 NIW (National Interest Waiver) categories, making it a valuable long-term pathway for highly accomplished founders.

EB-1A Visa (Extraordinary Ability Green Card)

The EB-1A visa offers a pathway to permanent residency for those with extraordinary abilities. Like the O-1A, it requires demonstrating exceptional achievements, but with a higher evidentiary threshold. Successful applicants often showcase a combination of awards, leadership roles, published material, and a substantial impact on their industry.

Unlike the H-1B, the EB-1A does not require an employer or a formal employer-employee relationship, so you are not required to set up a board of directors. You can self-petition and demonstrate that you intend to continue working in your area of extraordinary ability.

Corporate Structure Considerations for Visa Applications

Your company’s corporate structure plays a crucial role in your visa eligibility. Key aspects to consider include:

  • Ownership and Control: Employment based visas, like the O-1A and H-1B visa, require a clear separation between the founder and the company to establish a valid employer-employee relationship. Setting up a board of directors with independent members who have the authority to hire and fire the founder is essential to demonstrate this separation. There’s no such requirement if you get a green card like EB-1A.
  • Board Composition: Including U.S.-based board members and advisors not only strengthens your case but also signals operational legitimacy. The employer-employee relationship must be maintained throughout the duration of the visa. To minimize risks, it’s best to maintain the structure as initially presented in the visa application.

Officer Roles:

Clearly defining your executive role within the company can help avoid potential conflicts in visa applications, particularly for employment based visas like H-1B and the O-1A.

For founders choosing H-1B, this means that their executive role should align with the skills and qualifications they acquired through their degree(s). For example, if a founder has a degree in computer science, the executive role they take on in the company (such as Chief Technology Officer or CEO of a tech startup) should be related to their technical expertise.

The role doesn’t have to be a direct match, but it should clearly align with the skills and knowledge that the degree represents. This is important for ensuring that the H-1B petition is compliant with visa requirements.

For the O-1A visa, the role does not need to be directly related to the applicant’s degree, as the visa is based on extraordinary ability in fields such as business, science, technology, or the arts, rather than a specific educational requirement.

Avoiding Common Mistakes That Cost Founders Millions

🚨 Costly Mistakes to Avoid:

Not issuing founder stock properly → Leads to ownership disputes and derailed fundraising.

Failing to file an 83(b) election on time → Can create major tax liabilities as your stock appreciates; due diligence red flag.

Skipping trademark registration → Risks receiving a cease and desist letter and having to rebrand.

Raising funds without securities compliance → Can result in SEC penalties.

Structuring your company incorrectly for immigration → May prevent you from legally working in the U.S.

Ignoring compliance deadlines → Risk of fines or company dissolution.

FREE Startup Launch Checklist

To make this easier, download the complete startup launch checklist so you can track each step and ensure everything is in order.

📥 Download our FREE Startup Launch Checklist

This checklist includes every step from this guide, making it easy to follow as you launch and scale your startup in the U.S.

Do you need a lawyer?

Some founders DIY their incorporation, but if you want peace of mind and to avoid costly mistakes down the line, check out our Startup Launch Package. Experienced startup lawyers handle everything—from checking company name availability to creating a data room ready for investor due diligence—so you can focus on growing your business.

Ready to take the next step? Check out our Startup Legal Resources to access key legal tools and guidance tailored for foreign entrepreneurs.

Immigration Legal Services

Aizada Marat, Co-founder and CEO of Alma, is a Harvard-educated attorney dedicated to transforming immigration services. Her personal challenges navigating U.S. immigration inspired her to start Alma, simplifying the process for global talent.

Alma offers best-in-class U.S. immigration legal services to founders, critical employees at start-ups, technological workers, etc. serving them with a host of visas, including O-1A, H-1B, L-1, EB-1A, EB-2 NIW, among others.

Alma has worked with multiple founders from top accelerators, VCs, and entrepreneurship ecosystems such as Y Combinator, Techstars, Stanford, Pear VC, etc., helping them immigrate to the U.S. to start their companies or expand their businesses with 99% approval rates. Schedule a free immigration consultation.

Kristina Subbotina
March 19, 2025

15 Essential Questions to Ask a Potential Co-Founder

Choosing the right co-founder is one of the most crucial decisions for a startup’s success. These questions will help facilitate honest discussions and set the foundation for a strong working relationship.

Choosing the right co-founder is one of the most crucial decisions for a startup’s success. These questions will help facilitate honest discussions and set the foundation for a strong working relationship. This guide is based on insights from Y Combinator’s blog post and a detailed Reddit discussion on co-founder relationships.

1. Why do you want to do this startup? What are your personal goals here, both financial and non-financial?

Understanding motivations helps ensure alignment and commitment.

2. What will our roles and titles be? How will we divide responsibilities? Who will be CEO?

Roles inevitably evolve, but clarity on initial responsibilities and decision-making is crucial.

  • If co-founders can’t agree on who’s CEO, that’s usually a sign of unclear responsibilities.
  • The CEO typically focuses on fundraising, sales, and product strategy, while the CTO leads technical execution.
  • Co-CEOs can work if both are willing to compromise, but having one clear decision-maker is often more effective.
  • Garry Tan discusses Co-CEOs here.

3. Who has the last say?

A structured decision-making process avoids deadlocks and ensures efficiency.

  • In high-pressure situations (e.g., investor meetings), who speaks?
  • When decisions need to be made quickly, who takes charge?
  • Are there areas where leadership should shift depending on expertise?
  • One co-founder may be better suited for external relations (investors, customers), while the other leads internal execution.
  • Be mindful of fatigue—if one co-founder is running on no sleep, they shouldn’t be making critical decisions.

4. How will we split up equity?

Equity discussions should be handled early. YC’s co-founder matching manual provides guidance.

5. Where will the company be based? Where will we each live? Will we work together in-person or remotely?

Logistical alignment ensures smooth operations.

6. What idea will we work on? Are you open to pivoting?

Startups often need to pivot—establishing flexibility is essential.

  • Vision can (and should) change based on product direction and customer needs.
  • Who is driving the vision, and are both founders aligned on it?
  • Does the current vision excite both founders and the users?
  • If there’s disagreement on vision, what influences each perspective?
  • Sometimes, different backgrounds make it difficult to fully grasp the same pain points, which can cause misalignment.

7. What needs to happen for us to go full-time?

Define the conditions under which you will fully commit, e.g., raising funding or securing customers.

8. What is your personal financial situation? Can you work for free, and for how long? Will either of us invest personal money?

Financial alignment helps prevent surprises down the road.

9. What will our working schedule be? Are there non-work commitments that matter to you?

Expectations around workload and boundaries prevent burnout and resentment.

  • If co-founders don’t have social interactions, neither will employees.
  • Casual team gatherings can foster a stronger work culture.
  • Co-founders set the tone—if they never grab dinner together, why would employees want to bond outside of work?

10. How will we build our team? What culture and values matter to us?

Even early on, defining company culture influences hiring decisions.

  • Do we want an in-person or remote-first team?
  • How do we ensure we maintain our cultural values as we scale?
  • What is our approach to hiring and managing people?

11. What will we do if we disagree on an important decision? What if we decide we don’t want to work together anymore?

Conflict resolution and exit strategies should be addressed before tensions arise.

  • If we have a major disagreement, what’s the process for resolving it?
  • Do we need an external advisor or mentor to help mediate tough decisions?
  • If one co-founder wants to leave, how do we ensure a smooth transition?

12. Would we sell this for $5M? $100M? Are we waiting for the billion-dollar exit?

It’s crucial to understand long-term expectations—some founders are happy with an early acquisition, while others want to build a unicorn.

  • What’s our personal goal with this company? Financial independence, industry impact, IPO?
  • If an offer comes in at $100M in year 3, do we take it or keep growing?

13. Legal & Conflict of Interest Questions

These questions help uncover hidden risks that could impact the company later.

  • Have you ever been fired, gone to jail, or done anything that would materially impact your time with the company?
  • Do you sit on any boards of companies, and do you have any conflicts of interest with our project?
  • Do you have an active non-compete clause?

14. Will any of us be investing cash in the company? If so, how is this treated?

This is especially important in bootstrapped startups where one founder might be putting in personal funds.

  • Is the investment structured as debt, convertible debt, or equity?
  • If it’s equity, does the investing founder receive a different class of shares?
  • How do we balance financial vs. sweat equity contributions?

15. What happens if one of us wants to step back from the company or take on another commitment?

How do we handle external commitments?

  • Are side projects or advisory roles allowed, or are we expected to be 100% focused?
  • If one of us wants to step back temporarily, how do we handle that?

Performance & Role Adjustments

How have you found your performance and how have you found your co-founder’s performance? What can you do better?

  • Each co-founder should first assess their own performance before critiquing the other.
  • If someone lacks self-awareness, they should be open to structured feedback.
  • Be mindful of how feedback is delivered—intention matters as much as the message.
  • The GROW framework is a useful approach to feedback.

Do we need to consider any role switches or does anyone think they can do a particular activity better?

  • If one co-founder excels at investor relations, should they own that function?
  • If another co-founder has strong product instincts, should they lead roadmap decisions?
  • If there's unvoiced frustration about responsibilities, now is the time to address it.

Final Thoughts

Answering these questions openly and honestly will help set a strong foundation for your startup. Misalignment between co-founders is one of the top reasons startups fail—addressing these topics early can save you from future conflict and uncertainty.

Need Help Structuring Your Co-Founder Relationship and Protecting Your Startup?

Aligning with your co-founder is just the first step—now it’s time to legally protect your startup and set up the right foundation for growth. Check out our affordable legal packages for startups here.

Kristina Subbotina
March 19, 2025

How Much Equity Should You Sell in Each Round? A Founder’s Guide to Equity and Dilution

Raising capital is a balancing act: you need enough funding to grow, but you also need to protect your ownership so you don’t find yourself squeezed out of your own company. Many founders raise money without fully understanding dilution, only to realize too late that they’ve given away too much too soon.

Raising Capital Without Losing Control: A Founder’s Guide to Equity and Dilution

Raising capital is a balancing act: you need enough funding to grow, but you also need to protect your ownership so you don’t find yourself squeezed out of your own company. Many founders raise money without fully understanding dilution, only to realize too late that they’ve given away too much too soon.

This guide covers:

  1. What is dilution and how to approach it
  2. How much equity to sell in each round.
  3. Why founding team ownership declines over time.
  4. Why selling too much early can hurt founders.
  5. How to calculate ownership with post-money SAFEs and avoid unexpected dilution.
  6. How to fix your cap table if founders own too little equity.

By understanding these key factors, you can raise capital strategically without losing control of your company.

Dilution is Like a Pizza—Don’t Give Away Too Many Slices

Think of your cap table as a pizza.

At the start, you own the whole pizza—every slice belongs to you. As you raise money, you start giving slices away:

  • Investors take slices in exchange for capital.
  • Employees get slices as equity compensation.
  • Advisors and consultants might take a small slice too.

If you’re not careful, you’ll end up with too few slices for yourself. Some founders give away too much too soon and find themselves with no pizza left—despite having built the company.

The key is to only give slices to those who help grow the pie. If raising capital and hiring the right people increases the size of your pizza (i.e., the company’s value), then giving away slices is worthwhile. But if you give away too much early, you’ll struggle to keep control as the company scales.

How Much Equity Should You Sell in Each Round?

A reasonable target for equity sold at each funding stage is:

  • Pre-Seed: 10-15%
  • Seed: 15-20%
  • Series A: 15-20%
  • Series B and beyond: 10-15% per round

After Series A, a strong founding team usually retains at least 60% ownership, and founders typically lose majority ownership only after Series B. However, we see a trend of founding teams decreasing their ownership more rapidly due to larger pre-seed and seed rounds (see below).

Why Founding Team Ownership Declines Over Time (Including 2025 Trends)

The data shows that founding team ownership steadily declines as startups progress through funding rounds. Why?

  1. Early Convertible Instruments: Many companies raise substantial pre-seed capital via SAFEs or convertible notes. These instruments convert into equity at the first priced round, leading to dilution.
  2. Bridge Rounds & Extensions: Given the tough fundraising climate in 2023 and 2024, many startups had to raise bridge rounds, extension capital, or a combination of both. These rounds often come with additional dilution, particularly if they involve new investor protections or discounts.

Why Selling Too Much Early Hurts You

1. Founders End Up With Too Little Equity

Many founders don’t realize how dilution compounds over time. Selling too much in early rounds leaves you with little ownership by the time the company becomes valuable.

For example, if you raise a large pre-seed round at a low valuation, followed by a heavily diluted seed round, you might enter Series A with only 30-40% ownership left. Investors may hesitate to back a company where founders are not sufficiently incentivized to stick around.

2. The Company Might Be Forced to Do a Recap

If a startup is too diluted too early, new investors may refuse to invest unless a recapitalization (recap) happens. A recap restructures the ownership, typically by diluting existing investors and re-allocating equity to attract new capital.

How to Calculate Ownership with Post-Money SAFEs

Many founders miscalculate dilution when raising on post-money SAFEs. Unlike pre-money SAFEs, which dilute existing shareholders and investors together, post-money SAFEs only dilute existing shareholders—meaning founders often get diluted more than they expect.

Example Calculation of SAFE Dilution

Let’s say you raise $1M on a $10M post-money SAFE cap.

  • The post-money valuation is $10M, meaning the SAFE investors will own $1M / $10M = 10% of the company.
  • If you and your co-founder previously owned 100%, after the SAFE conversion, your ownership will be reduced by 10%, leaving you with 90% pre-Series A.

However, if you raise multiple SAFEs at different times, these dilute sequentially, which can stack up quickly. Founders often raise multiple SAFE rounds before Series A and are surprised when their ownership is much lower than expected.

Understanding Your Implied Discount When Raising a Priced Round

One of the biggest risks with low SAFE valuation caps is that when you raise your next priced round, early SAFE investors may get an unintended steep discount.

For example:

  • At pre-seed, you raised $500K on a $1.5M post-money SAFE cap.
  • Now, you’re raising a priced seed round at a $17M pre-money valuation.
  • Your early SAFE investors effectively paid a $1.5M valuation instead of $17M, meaning they received a 91.2% discount on the seed round valuation.

How to Avoid Unexpected Dilution with SAFEs

  • Model different dilution scenarios before signing SAFE agreements.
  • Raise only what you need to get to the next milestone, rather than stacking multiple SAFEs (volatile industries like web3/crypto might be an exception because you want to ensure you have a buffer for bear markets).
  • Consider valuation carefully—low valuation caps mean higher dilution.

How to Fix a Cap Table When Founders Own Too Little Equity

If you find yourself over-diluted, there are two key ways to fix your cap table:

  1. Renegotiate the SAFEs’ valuation caps as part of the priced round closing condition.
    • If the low SAFE valuations result in massive discounts (over 50%), consider amending them so the discount is capped at 20-50%.
  2. Issue additional shares to the founders.
    • Reserve extra shares in the option pool of the next financing round and allocate them to founders.

These approaches can help rebalance the ownership structure without requiring drastic changes to the company’s capital structure.

Final Takeaways

✅ Be strategic with dilution—aim to sell no more than 20% per round.

Strive to retain at least 60% ownership after Series A and lose majority ownership only after Series B.

✅ Be mindful of team equity allocations—give fairly, but don’t over-give.

Understand post-money SAFEs and model dilution before signing.

Your Cap Table is Your Pizza—Don’t Give Away All the Slices

Think carefully about who gets a piece of your pizza. Make sure that every slice given away is going to someone who will help grow the entire pie. If you sell too much too soon, you’ll find yourself left with crumbs.

Fundraising is about more than just raising money—it’s about keeping control. Being intentional about how much equity you sell will set you up for long-term success.

Big Law Expertise at Startup-Friendly Prices

For hands-on legal support in structuring and managing your startup’s equity, check out our Lexsy Fractional GC Subscription.

Also, don’t forget to grab our Free Equity Issuance Checklist to ensure legal compliance when granting equity.

By getting equity right from the start, you can keep your cap table clean, and avoid major headaches down the road. 🚀

Kristina Subbotina
February 26, 2025

How Much Equity Should Startups Give to Employees, Consultants, and Advisors?

One of the most critical decisions a startup founder makes is how to allocate equity among employees, consultants, and advisors. Equity compensation is a powerful tool for attracting top talent, aligning incentives, and ensuring long-term commitment.

How Much Equity Should Startups Give to Employees, Consultants, and Advisors?

One of the most critical decisions a startup founder makes is how to allocate equity among employees, consultants, and advisors. Equity compensation is a powerful tool for attracting top talent, aligning incentives, and ensuring long-term commitment. However, many founders make mistakes in equity distribution, often by miscalculating shares or giving away too much equity too early.

In this post, we’ll break down:

Equity benchmarks for employees, consultants, and advisors

Common mistakes founders make when issuing equity

How to structure equity grants to ensure fairness and transparency

How Much Equity Should Employees, Consultants, and Advisors Get?

While every startup is unique, equity distribution generally falls within these ranges:

🔹 Senior employees: 1-5%, we generally see 1-3% for senior employees, other than in the very early stages when you may have to go up to 5%. Grants of 5% and higher are considered “founder equity” and we don’t discuss it in this post. Typical vesting for employees is 4 years.

🔹 Regular employees, consultants & Advisors: 0.1% to 1%, depending on their role and contribution level. Typical vesting for advisors is 2 years, while for Board members—4 years.

🔹 Equity Incentive Plan (EIP) / Option Pool: Typically 10-20% of the company’s fully diluted shares. A 20% pool is on the higher end but may be justified if you plan to actively recruit top talent. We recommend setting the option pool based on a clear forecast of your hiring needs and planned equity allocations. For founders, it’s often preferable to keep the pool smaller and increase it at each round to spread the dilution across investors as well.

These percentages should always be considered on a fully diluted basis, which we’ll explain below.

A Smarter Approach: Building an Equity Budget

Benchmarking data, while commonly used, is often flawed. It relies on small datasets and fails to capture context, reducing equity decisions to a one-size-fits-all approach. Instead, founders should consider building an equity budget to manage their grants effectively. Your option pool should be viewed as a maximum spend, not a target—similar to managing cash burn. We recommend keeping 25-35% of your pool in reserve for flexibility in unexpected hires or higher-seniority recruits.

To start, answer these key questions:

  • Equity Set Aside: How much equity have you allocated for employees in your latest fundraising round?
  • Hiring Plan: How many employees do you plan to hire before your next round?
  • Position Breakdown: What roles (technical vs. non-technical, senior vs. junior) are you hiring for?

Equity Allocation Guidelines

  • Timing Matters: Early hires receive more equity. Expect a 20-50% decrease in equity grants as new employees join.
  • Technical vs. Non-Technical Roles: Technical employees often receive double the equity of their non-technical peers.
  • Seniority Levels: Senior hires get significantly more equity. A mid-level technical hire (baseline: 0.75%) scales up to 1.5% for a senior hire and down to 0.15% for a junior hire.

This approach suggests using a structured multiplier system for equity grants, which founders can customize based on hiring needs.

For a more detailed breakdown, check out this guide, which includes a calculator to help you structure equity grants for early hires effectively.

The Biggest Mistakes Founders Make in Equity Grants

1️⃣ Miscalculating Shares

Many founders issue the wrong number of shares to employees.

Why? Because they calculate equity incorrectly.

When you promise an employee, advisor, or consultant X% equity, how are you calculating it? Are you basing it on:

  • Authorized shares?
  • Issued & outstanding shares?
  • Fully diluted shares?

Our preferred way to structure grants is to offer a concrete number of shares based on a fully diluted basis.

What Does "Fully Diluted" Mean?

Fully diluted shares account for:

✅ Issued stock

✅ Issued options

✅ Warrants

✅ Options reserved in the stock option pool

In other words, it assumes that the entire option pool has been granted and that all options have been exercised.

Example Calculation

Let’s say your startup has:

  • Authorized shares: 10M
  • Founders' shares: 8M
  • Issued options: 400K
  • Reserved in option pool: 600K
  • Total fully diluted shares: 9M

Now, you hire an employee and grant them 90K options.

  • If calculated based on outstanding shares, this would equal 1.07%.
  • If calculated based on fully diluted shares, it’s 1%.

The number of options stays the same, but the perceived percentage changes. This can impact how attractive the offer seems to a candidate.

Notice that the 10M authorized shares were not included in the calculations because this number does not matter for this purpose.

2️⃣ Giving Away Too Much Equity Too Early

Early on, many founders give out excessive equity because they don’t yet know the value of their company.

For example:

  • Founders offering more than 1% to advisors, when most advisors should receive up to 0.75%.
  • Granting significant equity to early consultants who may not contribute in the long term.
  • Overcompensating early hires due to uncertainty about their actual impact.

While equity is an important tool for attracting talent, founders should be strategic and reserve enough for future hires, investors, and growth.

Key Takeaways for Founders

✔️ Be clear on percentages and calculate equity on a fully diluted basis.

✔️ Use an equity budget rather than relying solely on benchmarking data.

✔️ Offer a specific number of shares, not just a percentage.

✔️ Be mindful of over-granting equity early on—equity is valuable and should be allocated wisely.

✔️ Follow structured equity planning—consider vesting schedules, risk levels, and long-term needs.

✔️ Use a strategic approach—set aside enough equity to sustain hiring without excessive dilution.

For hands-on legal support in structuring and managing your startup’s equity, check out our Lexsy Fractional GC Subscription.

Also, don’t forget to grab our Free Equity Issuance Checklist to ensure legal compliance when granting equity.

By getting equity right from the start, you can attract the best talent, keep your cap table clean, and avoid major headaches down the road. 🚀

Kristina Subbotina
February 20, 2025

Crafting a Winning Pitch Deck for Early-Stage Startups: Key Elements to Include

This guide will walk you through the essential elements your pitch deck must include to effectively communicate your startup’s value proposition, market opportunity, and growth potential. By focusing on these key components, you’ll be better positioned to secure the funding and support needed to propel your startup forward.

In the fast-paced and competitive startup ecosystem, a compelling and well-structured pitch deck is crucial for capturing the interest of potential investors. A great pitch deck not only showcases your vision but also demonstrates your team’s ability to execute and deliver results. 

This guide will walk you through the essential elements your pitch deck must include to effectively communicate your startup’s value proposition, market opportunity, and growth potential. By focusing on these key components, you’ll be better positioned to secure the funding and support needed to propel your startup forward.

What Investors Look for in a Pitch Deck

When crafting your pitch deck, it’s important to address the following critical aspects that investors care about most. These elements will help you build a persuasive narrative and demonstrate that your startup is worth their time and money.

1. The Team: Proven Expertise and Collaboration

  • Key Questions: Does your team have the relevant skills and experience to succeed in this market? Have they worked together before?
  • Investor Perspective: Investors want to see a team with complementary skills, a strong track record, and the ability to execute. A cohesive team that has successfully collaborated in the past is a major plus.
  • Tip: Highlight your team’s expertise, past achievements, and why you’re uniquely qualified to solve the problem at hand.

2. The Problem: A Real Pain Point

  • Key Questions: How did you identify this problem? Is it a significant pain point for your target audience?
  • Investor Perspective: Investors are drawn to startups that solve critical problems—what they often refer to as “painkillers” rather than “vitamins.” They want to see evidence that the problem is real, urgent, and worth solving.
  • Tip: Use data, customer testimonials, or market research to validate the problem and demonstrate its impact.

3. The Solution: Unique and Scalable

  • Key Questions: How does your product or service work? How does it address the problem better than existing solutions? Do you have a competitive advantage (e.g., technology, intellectual property, or distribution channels)?
  • Investor Perspective: Investors are looking for solutions that are not only effective but also scalable and defensible. They want to see a clear path to growth and a “moat” that protects your business from competitors.
  • Tip: Clearly explain how your solution works, how it evolves over time, and why it’s superior to alternatives.

4. The Market: Large and Growing

  • Key Questions: Is the market large enough to generate significant returns? Why is now the right time to enter this market? Who are your main competitors, and what sets you apart?
  • Investor Perspective: Investors seek startups operating in large, growing markets with the potential to reach $100M+ in annual recurring revenue (ARR) within five years. They also want to understand your competitive positioning and how you plan to capture market share.
  • Tip: Use data to illustrate market size, growth trends, and your strategy for achieving significant market penetration.

5. Traction: Early Signs of Success

  • Key Questions: Do you have any early pilots, user traction, or revenue? What is your customer retention rate?
  • Investor Perspective: Traction is proof that your solution resonates with customers. Even early-stage startups can impress investors with strong user engagement, positive feedback, or early revenue.
  • Tip: Showcase metrics like user growth, retention rates, or pilot results to demonstrate momentum.

6. Go-To-Market Strategy: Clear and Actionable

  • Key Questions: Who are your target customers? How will you acquire them? What is your customer acquisition cost (CAC) and sales cycle?
  • Investor Perspective: Investors want to see a well-thought-out plan for reaching your target audience and scaling your business. They’re particularly interested in efficient and scalable customer acquisition strategies.
  • Tip: Outline your marketing and sales strategy, including channels, pricing, and customer acquisition costs.

7. Fundraising: Clear Ask and Use of Funds

  • Key Questions: How much funding have you raised so far? What is your burn rate? How much are you looking to raise, and how will you use the funds?
  • Investor Perspective: Investors want to know how much capital you need, how you’ll use it, and how it will help you achieve key milestones. They also want to understand your current financial health and runway.
  • Tip: Be specific about your funding requirements, the terms you’re offering, and how the investment will drive growth.

Why Team and Market Matter Most

For early-stage startups, the team and market are often the most critical factors for investors. A top-tier team with a proven track record can adapt and pivot as needed, while a large and growing market provides the opportunity for significant returns. If you can demonstrate a strong team and a compelling market opportunity, you’ll be well on your way to winning investor confidence—even if your solution evolves over time.

Final Thoughts

A well-crafted pitch deck is more than just a presentation—it’s a storytelling tool that highlights your startup’s potential and convinces investors to join you on your journey. By addressing the key elements outlined above, you’ll create a pitch deck that not only captures attention but also builds trust and excitement around your vision. Remember, clarity, data, and a compelling narrative are your best allies in securing the funding you need to succeed.

Kristina Subbotina
February 10, 2025

In the middle of raising my first $1M, I found out that my co-founder had not issued equity in our company to me. I had to pay $200k out of pocket.

Real story:

A startup founder used Stripe Atlas to incorporate and issue founder equity. The CEO co-founder forgot to issue shares to his co-founder and instead entered into a founder agreement and “issued” shares to him via Carta. WRONG! Having a founder agreement doesn't mean you have founder equity. And Carta does not issue equity—it’s a cap table management tool that allows you to record stock issuances.

What you actually need to issue founder equity:

  1. Board consent approving the stock issuance
  2. A stock purchase agreement between the founder and the company
  3. An assignment agreement to assign past intellectual property (IP) to the company, and a confidentiality and IP assignment agreement to assign any future IP to the startup

Founder agreements are not a good idea for early-stage startups because:

1) They create unnecessary complexity. Stock issuance documents already cover key terms; you can include all necessary protections (vesting, transfer restrictions, etc.) directly in the stock documents, making a separate agreement redundant.

2) They don’t provide real ownership. A founder agreement doesn’t grant equity; it just outlines intentions, which can lead to disputes later.

3) They can cause misalignment. If equity isn’t formally issued, founders might misunderstand their rights, leading to conflicts over ownership and control.

4) Investors prefer clean cap tables. Founder agreements don’t show up on the cap table, but they can create confusion and legal risks during due diligence.

Instead of using founder agreements, startups should issue equity directly with all the necessary terms baked into the stock issuance documents.

If you're preparing for fundraising, grab this free investor due diligence checklist to make sure your legal is in order.

If you’d rather have it done for you—and fix any gaps to ensure you're fully ready for investor due diligence—check out our Startup Due Diligence Package.

P.S.: Not legal advice—I’m a lawyer, but not yours (yet).

Kristina Subbotina
February 7, 2025

How Steve Jobs Lost Control of Apple—and What Founders Can Learn

This post dives into what happened to Jobs from a legal and governance perspective and offers actionable lessons to help founders avoid a similar fate.

In 1985, Steve Jobs, the visionary co-founder of Apple, was ousted from the very company he built. The story of his firing has become a cautionary tale for startup founders, especially those navigating venture-backed companies. Losing control of your company is not uncommon, and in some cases, it’s a direct consequence of decisions made early in the company’s journey.

This post dives into what happened to Jobs from a legal and governance perspective and offers actionable lessons to help founders avoid a similar fate.

What Happened to Steve Jobs?

Corporate Governance and the Role of the Board

Jobs’ ousting came down to the authority of Apple’s board of directors, which oversees a company’s management and has the power to hire or fire executives. Despite being a co-founder and chairman, Jobs was subject to the board’s decisions.

The Turning Point

Jobs recruited John Sculley as Apple’s CEO in 1983, believing Sculley’s business expertise could help Apple scale. However, tensions arose when the Macintosh, Jobs’ passion project, struggled commercially. The board sided with Sculley, believing Jobs’ leadership style was harming Apple’s growth.

In a critical board meeting, Jobs was stripped of his operational role. While he remained chairman for a time, he ultimately resigned, leaving Apple behind.

Why Did Jobs Lose Control?

The key reason Jobs was ousted was his lack of a controlling stake in Apple. Over multiple funding rounds, Jobs diluted his ownership to raise capital for Apple’s growth. At the time of Apple's IPO in 1980, Jobs owned approximately 14% of the company, which was diluted to around 12% shortly thereafter. By 1985, venture capitalists and institutional investors held significant influence over the board.

This is a common scenario for founders of venture-backed startups. As you raise capital, you dilute your ownership—and potentially your control.

Lessons for Early-Stage Founders

  1. Plan Your Dilution
    • To maintain control, plan your fundraising strategy carefully. Aim to limit dilution to 10–20% per round and preserve majority ownership from Pre-Seed to Series A.
    • By Series B, losing majority ownership is normal, but you can still protect your influence through smart planning.
    • There are only two ways to minimize dilution: raise less money or at a higher valuation. No magic here, unfortunately.
  2. Pick a Term Sheet with Founder-Friendly Terms
    • The first priced round you take will set the precedent for all future rounds. For example, if you accept a seed term sheet with two investor directors, you might lose control of the board as early as Seed!
    • Future investors will typically demand the same (or better) rights than earlier investors. Setting founder-friendly terms at the seed stage is crucial.
    • If you have a choice, do not accept a term sheet that causes you to lose control early on. Instead, consider raising via SAFEs (while monitoring dilution carefully) until you receive a term sheet with terms that protect your position as the founder.

The Takeaway

Being ousted like Steve Jobs is rare, but it’s not impossible. Founders often lose control due to early decisions around governance, term sheets, and equity. By planning your dilution, negotiating founder-friendly terms, and understanding the long-term impact of your fundraising decisions, you can protect your role and your vision for the company.

Call to Action

If you’re preparing to raise outside capital, check out our packages that will help you prepare: 

These tools are designed to help you prepare for fundraising, protect your vision, and avoid costly mistakes.

Disclaimer: This post is for informational purposes only and does not constitute legal or tax advice. Consult professionals for tailored guidance.

Kristina Subbotina
January 27, 2025

My new co-founder needs to pay $100k+ for their shares in my pre-seed, pre-everything startup. Here's what happened.

A client recently obtained a 409A valuation to issue equity to a new co-founder. The valuation for their pre-revenue startup, which had raised less than $400k, came in much higher than the nominal value they had expected.

A client recently obtained a 409A valuation to issue equity to a new co-founder. The valuation for their pre-revenue startup, which had raised less than $400k, came in much higher than the nominal value they had expected.

Why did this happen?

409A valuations are highly dependent on the firm's methodology. The IRS doesn’t prescribe a specific approach, leaving valuation firms with a lot of discretion.

For example:

Pulley often ties valuations for pre-revenue startups to the total invested capital, which can result in a higher FMV. Personally, I don’t believe a company’s value should simply equal the amount it has raised. We all know that number can be meaningless—after all, a company could go out of business in a month.

Carta, on the other hand, factors in the company’s stage, market conditions, and comparables. I agree with their approach, which can lead to lower FMVs, however, we’ve seen cases where Carta assigns valuations at par value (!) for startups with revenue that raised over $800k through convertibles. I don’t agree with this approach either and often recommend founders opt for a higher, more defensible valuation.

We’ve worked with founders who’ve faced both extremes:

  • One founder received a valuation so low it assigned shares at par value ($0.00001). They took the risk and accepted it.
  • Another founder rejected the low valuation and chose a more defensible (but higher) valuation instead.

What’s the takeaway?

If your 409A feels out of line, it’s probably not your fault. Different firms use different methodologies. The only real issue arises if you provided overly optimistic projections to the valuation firm. Otherwise, the valuation reflects the firm’s unique interpretation of IRS guidelines.

What do you do when you get a prohibitively high valuation?

Here are a few options:

1. Reject the valuation

If it’s still in draft before it gets finalized, you can reject it and try a different provider. Keep in mind that even if you don’t get better results, you’ll likely spend another $3k–4k on the process.

2. Accept the valuation

If you decide to move forward, we can help structure the consideration as a loan or issue equity grants as stock options. It’s not ideal, but sometimes you have to make the best of the situation.

Here is more information on the importance of 409A valuations, when they are required, when they’re optional, and the factors that influence the valuation you receive. 

Kristina Subbotina
January 23, 2025

I got a $50k franchise tax bill but only had to pay $450. Here is how I saved $50k on taxes.

Learn how I saved $50k on taxes and get your free Delaware franchise tax calculator.

Received a Delaware franchise tax bill for your startup that seems too high? 

Don’t panic. Delaware typically uses a calculation method that results in higher taxes.

It’s called the “Authorized Share Method” and here is how it works: 

Franchise taxes are calculated based on the number of shares authorized in your charter. For example, a company with 10,000,000 shares might owe $85,165.

Alternatively, you can calculate taxes using the “Assumed Par Value Method”. You divide the company's gross assets by its issued and outstanding shares. Use the figures from the U.S. Form 1120, Schedule L, or a recent balance sheet.

Most startups benefit from using the Assumed Par Value method, which ties tax to total assets. Just ensure that your issued shares are at least one-third to half of your authorized shares to avoid high taxes. This method usually works best for startups.

Find our FREE Delaware franchise tax calculator here.

Kristina Subbotina
January 23, 2025

Why Choose a Delaware C-Corp for Your Startup (in 99% of cases)?

This guide explains why, in 99% of cases, a Delaware C-Corp is the best choice for venture-backed startups.

When it comes to registering your startup, you’ll need to address two important decisions: (1) incorporating in Delaware versus your state of residence, and (2) choosing between an LLC and a C-Corp. This guide explains why, in 99% of cases, a Delaware C-Corp is the best choice for venture-backed startups.

Small Business vs. Startup:

Before diving into the details of incorporation, let’s clarify the distinction between a small business and a startup. This distinction will determine your funding strategy, growth potential, and the best legal entity for your business.

Key Differences:

  1. Growth Potential:
    • Startups: Aim for rapid growth and scalability, often pursuing innovative solutions to disrupt or create new markets.
    • Small Businesses: Focus on steady, incremental revenue growth, often targeting local or regional customer bases in established markets.
  2. Exit Strategy:
    • Startups: Plan to scale quickly and exit through acquisition or IPO, often resulting in substantial financial rewards for founders and investors.
    • Small Businesses: Typically aim to build long-term, sustainable businesses with stable cash flow and eventual acquisition.

To Determine if You’re a Startup:

Ask yourself:

  • Is there a viable path to generate $100M in Annual Recurring Revenue (ARR) within five years?

If the answer is "no," your business likely aligns more with small business characteristics. Small businesses often benefit from LLC structures due to their simplicity and pass-through taxation, while venture-backed startups almost always require the scalability and tax advantages of a C-Corp.

Why Incorporate in Delaware?

Delaware is the gold standard for incorporation, offering unique advantages that make it the preferred choice for startups and established corporations alike.
Key Benefits of Incorporating in Delaware:

  1. Established Corporate Law: Delaware has a well-developed legal framework and a Chancery Court that exclusively handles equity-related cases. This provides fast, predictable outcomes for businesses.
  2. Investor Familiarity: Venture capitalists and their legal counsel expect startups to incorporate in Delaware because its laws are well-understood and investor-friendly.
  3. Governance Flexibility: Delaware’s corporate governance laws are designed to accommodate startups as they scale, offering flexibility in structuring ownership and equity.

Why C-corp. vs an LLC?‍

In 99% of cases, I recommend registering your startup as a Delaware C-corp.If you're planning on raising venture capital and issuing equity awards to service providers, I recommend opting for a standard Delaware C-corp. In my many years of legal experience, I've seen only a few startups formed as LLCs. And here are the examples:

  • When a startup is not a startup.

The first scenario is when a startup is not really a startup but a small business. The fact that an LLC is not subject to double taxation may make it a more attractive entity choice for a small business, especially if the founder knows the small business won't grant many service providers equity or have a lot of investors (or any institutional investors).

  • When the QSBS does not apply, and founders want to distribute profits to themselves.

Typically, high-growth startups don't make distributions as they reinvest cash into their growth. However, there are rare exceptions. For instance, I've seen a web3 startup that generated more than $100M from the outset, and the founders wanted to distribute some of that cash to themselves. Since they've already exceeded the $50M threshold, the QSBS exemption no longer applies. This situation is extremely rare, and investors generally resist it. Unless you're a highly sought-after startup generating substantial revenue right from the start, you would need to convert your LLC into a C-corp if you later decide to seek venture capital. This conversion can be a complicated and costly process, requiring the involvement of lawyers and tax professionals.

A few disadvantages to consider when registering your startup as an LLC:

  1. The process of issuing equity awards becomes complicated. In an LLC, you would need to issue membership units to individuals, which would be taxed as ordinary income rather than capital gains.
  2. Foreign investors might be required to file a U.S. tax return. An LLC is taxed as a partnership, meaning the tax liability is passed on to its members. Consequently, your investors could potentially establish a permanent presence in the U.S., necessitating any foreign investors to file a U.S. tax return – a situation many investors find undesirable.
  3. Legal fees can increase significantly. If you pursue equity financing as an LLC, you can expect legal fees to be much higher than those for a standard C-corp. In a regular equity financing, I typically use standard NVCA documents. However, when I represented an investor investing in a high-profile startup that generated over $100M in revenue from the start and was formed as an LLC, all those NVCA documents had to be incorporated into the operating agreement and subscription agreement. This necessitated almost drafting from scratch and meticulously reading every word. You don't want a lawyer charging $1k an hour to scrutinize every single word of your 80-page investment documents. It was the most complex and expensive equity round I've managed – good for lawyers (we made a substantial profit), but not so advantageous for the business folks involved.
  4. Accounting fees are also likely to rise. Annual tax compliance and accounting service fees will generally be higher in an LLC (typically, you can anticipate an additional $10k per year)

Founder FAQ:

Founder: “If I start my company in Delaware, do I need to move there?"

No, but you’ll need a Delaware registered agent (typically $50/year). If you operate in another state, you may also need to register your Delaware corporation as a foreign entity and hire a registered agent there.

Founder: "Why not an LLC? Doesn't it have fewer formalities and no double taxation?"

While it’s true that an LLC has fewer formalities and avoids double taxation, one of the most significant advantages of using a C-Corp is the favorable tax treatment it offers to both you and your investors, particularly in relation to Qualified Small Business Stock (aka QSBS).

Founder: "What is QSBS and why should I care?"

QSBS is a special stock that meets the requirements of Section 1202 of the Internal Revenue Code (IRC).

If you acquired QSBS after September 27, 2010, you might qualify for a 100% exclusion of the gain from the sale of your stock.

  • The 100% gain exclusion applies to federal tax only. Some states, like California, do not follow this federal tax treatment. Nonetheless, a 100% federal tax exclusion is a significant benefit.
  • The exclusion is limited to the greater of $10 million or 10 times the holder's adjusted tax basis, up to a maximum of $500 million.

Example:
If you purchased founder stock for a nominal price near $0 and sold it for $10M after five years, you would not pay any federal capital gains tax if it qualifies as QSBS.

Founder: "The max benefit is $10 million?"

It’s possible to increase this maximum amount by gifting shares to other taxpayers, each of whom has their own $10M limit.

Example:
If a founder owns $30M worth of QSBS, they could gift $20M to two other taxpayers, each of whom would have their own $10M exclusion limit. If all eligibility requirements are met, this could result in a total exclusion of $30M.

However, it’s critical to consult a tax professional before making any decisions regarding QSBS or gifting shares.

Founder: “Sounds amazing. How do I qualify for QSBS?”

The requirements are somewhat complicated, but most early-stage startups meet them:

  1. U.S. C-Corp: The company must be a C-Corp, not an S-Corp, LLC, or partnership.
  2. Original Issue: Stock must be purchased directly from the company.
  3. Gross Assets: The company must have no more than $50M in gross assets before and immediately after the stock is issued.
  4. Active Business: At least 80% of the company’s activities must involve a qualified trade or business (professional services like law, consulting, and financial services do not qualify).
  5. Five-Year Holding Period: QSBS must be held for at least five years before the sale.

Founder: “Can I reinvest gains from QSBS without paying taxes immediately?

Yes, Section 1045 allows both founders and investors to defer capital gains taxes by rolling over QSBS proceeds into new QSBS within 60 days of the sale.

Example:
A co-founder sells their shares in a startup for $5 million after holding them for more than six months. Within 60 days, they reinvest the $5 million into a new startup by purchasing QSBS. The $5 million in exit money is not taxed immediately, as the co-founder deferred their capital gains tax under the QSBS rollover provision. If the new QSBS is held for five years, they may qualify for the full Section 1202 exclusion on the gains from the new stock. This provision provides flexibility for founders and investors to continue supporting startups while avoiding an immediate tax burden.

Founder: “What can go wrong with QSBS?”

Even if you meet all requirements, QSBS can be disqualified in certain scenarios:

  • Substantial stock repurchases, especially those exceeding the de minimis thresholds. If the company repurchases stock during the restricted period, the stock may lose its QSBS eligibility. Learn more in our QSBS Checklist.
  • If the five-year holding period is not met.
  • If the company exceeds the $50M gross asset limit.

It’s vital to work closely with your legal and tax advisors to ensure compliance.

Founder: “If I already registered my startup as an LLC, what can I do to take advantage of the QSBS?

To qualify for the QSBS, your startup would need to convert from an LLC to a C-corp.As long as the assets of the LLC are valued at $50 million or less at the time of conversion, the gain exclusion is determined based on 10 times the fair market value of the assets of the LLC at that time. This is due to a rule that treats the basis of property as equal to its fair market value when it is contributed to the C-corporation.The same rule applies if the startup were formed as a C-corp but the founders contributed valuable IP or other assets to the C-corp at the time of formation.For example, if the startup is worth $49.9 million at the time of conversion, the maximum QSBS gain exclusion (across all founders) is $499 million, compared to the standard $10 million limit. However, note that capital gains tax would apply to the first $49.9 million in proceeds before the QSBS exclusion kicks in.

Founder: “So it’s best to start as an LLC and before hitting $50M in gross assets convert to a C-corp.?

No. Generally, this strategy isn’t recommended unless your startup won’t need to raise capital from venture funds for a while (because VC funds will push you to convert into a C-corp), or if you are a serial, sophisticated founder who can time the C-corp conversion to coincide with the maximum QSBS benefit. And even then, things might go wrong with this strategy. Here are some examples:

  • Your startup isn’t a home run. A home run in the venture world is typically considered to be a 10x return on investment (ROI) or greater. In the example above, the first $49.9 million of gain is subject to capital gains tax. So if the company hits a “single” or “double,” rather than a “home run,” this approach could result in a higher tax on the founders upon exit than would be paid if the company were originally formed as a C-corp, and all shares qualified for QSBS treatment.
  • You have to sell your shares before the 5-year holding period. Waiting to convert to a C-corp will delay the start of the five-year holding period. So, if you wait too long to convert and sell your stock in a taxable transaction before the five-year holding period expires, you could lose the QSBS benefit entirely. While there are a few potential exceptions regarding the "tacking" of holding periods and "rolling over" in a tax-free exchange, these fall outside the scope of this post. To learn more, it's best to consult with a tax professional.
  • Investors might be unhappy. Because the value of the company at conversion counts toward the $50 million asset limit, the founders are effectively using up some of this limit. So, there may be less ability to provide the QSBS benefit to other investors. In order to minimize the loss of QSBS benefit for investors, it's important to consider whether the extra basis can be gradually reduced through depreciation or amortization over time.
  • Service providers might be unmotivated. Once you convert to a C-corp with the higher valuation for purposes of maximizing the QSBS benefit, the company’s valuation for purposes of granting employee equity will likely be higher as well.
  • Congress might get rid of the QSBS. In 2021, Congress proposed to reduce the 100% gain exclusion to 50%, but it did not pass. Who knows what happens in the coming years.

Overall, starting as an LLC has its downsides. LLCs are less common and may be less understood by investors and employees. Additionally, setting up and managing an LLC can be more expensive from both legal and tax perspectives. For example, the company is required to provide K-1s to members and treat members as self-employed.Given the complexities involved, it's advisable to seek assistance from an experienced accounting firm to ensure the conversion is executed properly, which can be a significant expense.

Founder: “Do investors care about whether my startup is a C-corporation?

Yes, they care a great deal and generally expect you to register your startup as a C-corp for the following reasons:

  • QSBS treatment. A C-corp is essential for the QSBS treatment, which can save a lot of money on taxes. If your investors qualify, it allows them to take $10M or 10 times their investment free of capital gains tax. This significant sum makes investors pay close attention to the QSBS and require the company to covenant in the investment documents that it won't jeopardize the QSBS qualification.
  • QSBS rollover. Section 1045 allows investors who have held QSBS for more than six months to defer recognizing gains from the sale of the stock if they reinvest the proceeds in another QSBS within 60 days from the sale. By doing so, they defer capital gains taxes until the newly acquired QSBS is sold. This rollover provision offers a tax deferral opportunity for investors who wish to continue investing in startups without immediately recognizing and paying taxes on their gains.
  • UBTI rules. You may already know that venture funds have their own investors, often referred to as limited partners or LPs. Many of these LPs are tax-exempt entities such as pension funds or endowments. Another factor that influences why venture investors generally prefer investing in C-Corps over LLCs is the Unrelated Business Taxable Income (UBTI) rules imposed by the IRS. UBTI can be generated from an LLC's business operations, and tax-exempt entities might have to pay taxes on this income. Conversely, C-Corps do not generate UBTI for their investors.

These are the reasons why venture funds will push you to convert an LLC into a C-corp. before investing.

Founder: “How to Set Up a Delaware C-Corp”

Here are your options:

  1. DIY Route: Start with our free startup launch checklist or watch this free YouTube guide.
  2. Startup Launch Package: If you’re building a venture-backed startup, ensure everything is done right from the beginning with this lawyer-assisted package. It includes incorporation, equity issuance, incentive plans, cap table setup, templates, and an investor-ready data room.

Final Takeaway

For startups planning to raise venture capital and scale quickly, a Delaware C-Corp is the clear choice. Its benefits—ranging from QSBS tax exclusions to scalability and investor appeal—make it the gold standard for founders.

Disclaimer: This post is for informational purposes only and does not constitute legal or tax advice. Consult professionals for tailored guidance.

Kristina Subbotina
January 23, 2025

This startup issued $5M of founder stock for just $100 and its founder got hit with a multi-million dollar tax bill.

Issuing founder stock or options at the wrong price can lead to massive tax liabilities and IRS scrutiny. A 409A valuation helps ensure compliance, minimizes legal risks, and keeps investors confident. Learn why it matters and when you need one to safeguard your startup's future.

Here is what happened and how to avoid it:

Some startups that fail to handle founder stock issuances correctly try to fix the problem later, often when the company is significantly more valuable. However, you cannot simply issue stock or stock options at par value when the company’s actual fair market value (FMV) has already increased. This can lead to major tax liabilities and penalties if not handled properly.

Example:

Imagine a startup issues valuable founder stock (subject to vesting) for just $100, and the founder timely files a Section 83(b) election. The IRS or a future law firm or accounting firm performing diligence later determine the FMV of the stock was significantly higher - $5M. This discrepancy creates significant tax liabilities for the company and for the grantee. Here’s a high-level summary of the potential implications, using assumed/hypothetical tax rates for ease of math:

  1. Missed Withholding and Income Reporting: The IRS considered the $5M FMV as taxable income for the founder. The company was responsible for withholding taxes but failed to do so.  Assuming the founder has a marginal income tax rate of approximately 40% (state and federal), the founder’s tax bill is $2,000,000 plus missed payroll taxes and penalties and interest.  These extra amounts can easily equal an extra 10% of the cumulative tax liability.  The company also has exposure for failure to properly withhold and report on millions of dollars of income.  The company and the founder also have an increased risk of a state and/or federal tax audit.
  2. Diligence Red Flag: Large stock issuances post-incorporation at or near par value are easy to spot and sure to draw close scrutiny from venture capital firms and acquirers.  This may result in reduced valuations, money escrowed, and specific indemnities in an M&A transaction.

One of the ways to avoid this disaster is to do 409A valuation.

What is a 409A Valuation?

A 409A valuation is an independent assessment of the fair market value (FMV) of a private company’s common stock. It is named after Section 409A of the Internal Revenue Code, which governs the tax treatment of deferred compensation arrangements, and in some cases, imposes very punitive excise taxes. At a high level, deferred compensation under 409A refers to any arrangement where compensation is earned in one taxable year but paid in a later year.  If deferred compensation is not compliant with, or exempt from, Section 409A, there can be hugely punitive taxes imposed, including on stock options structured incorrectly.  Restricted Stock is generally never subject to Section 409A, however, stock issuances can still create tax risks if the IRS deems the FMV of the stock to be undervalued.

Do you need a 409A Valuation?

When issuing restricted stock or stock options, many founders wonder whether they need a 409A valuation. Legally, a 409A valuation isn’t required to issue stock or options. However, a 409A valuation is valuable because it is an independent third party’s assessment of the fair market value (FMV) of your company’s shares, providing a defensible valuation for tax and compliance purposes. When your company effectively relies upon a 409A valuation when issuing stock options, it creates a rebuttable presumption that the 409A valuation price is the correct exercise price for 409A purposes.  In other words, the IRS has the burden of proof to demonstrate that the 409A valuation was incorrect, which is powerful protection and generally is enough to satisfy all future investors or acquirers that review your grants. 

Why is a 409A Valuation Important?

Obtaining and effectively utilizing a 409A valuation ensures that stock options and stock issuances are granted at an appropriate price, minimizing legal and tax risks. While a 409A valuation is not legally required to issue stock or stock options, failing to have one can expose companies and service providers to significant risks. For example, if the IRS determines that stock options were granted below FMV, the consequences can include:

  • Immediate income tax on the discounted portion of the option.
  • A 20% additional penalty tax.
  • Interest on underpaid taxes.

For stock issuances, the risks are primarily related to missed withholding taxes, which, while still important, are generally less severe than the risks associated with stock options due to the incredibly punitive tax regime the IRS applies to discounted stock options.

When Can You Skip a 409A Valuation?

There are rare instances where issuing options without a 409A might work, but they are limited in scope and risky. For example, if the company is at a very early stage with no revenue, no external funding, and minimal progress on its product or IP, some founders may choose to skip a 409A for small restricted stock grants. However, the consequences of being wrong are significant, and we strongly advise that you consult with sophisticated tax and corporate counsel before doing so.

Factors That Increase or Decrease Risk

To help evaluate your risk tolerance, here are some selected common factors that suggest the company’s value has risen:

Some Factors that Increase Risk

  • Outside capital raised or expressions of interest: This includes SAFEs, secondaries, tenders, or other indications of value (such as LOIs) that establish or imply a higher FMV.
  • Revenue: Generating revenue is a strong indicator of increased company value.
  • Substantive progress on the company’s products or services: Demonstrable milestones can increase valuation.
  • Valuable intellectual property (IP): Patents or proprietary technology add to a company’s perceived value.

Some Factors that Decrease Risk

  • No outside capital raised and no expressions of interest: Absence of external funding indicates that there is no external benchmark against which the value of the company can be defined, making it harder to determine a precise fair market value.
  • No revenue: Absence of revenue is one less external benchmark against which the value of the company can be defined.
  • Stealth mode: Operating without significant progress or valuable IP can keep valuations low.
  • Issuance of stock at a price higher than par value or nominal value: This approach helps mitigate concerns about underpricing.

Recommendations

  1. Avoid Issuing Stock at Par Value. We generally do not recommend issuing stock at par value, except to founders at or near the time of incorporation.  Stock issuances at par value outside of the time of incorporation will receive heavy scrutiny in diligence.
  2. Good Faith Valuations. If you choose to forego a 409A valuation for stock issuances, applicable US tax law requires that the company’s board determine the fair market value in good faith.  As part of this good faith determination, it is prudent to demonstrate good faith by adjusting the stock price upward compared to par value. The exact adjustment will depend on your company’s circumstances, but this step can reduce IRS scrutiny and show an effort to account for changes in value.
  3. Always Use a 409A for Stock Options. Unlike stock, issuing stock options without a 409A valuation is almost never advisable due to the severe tax penalties for employees and potential reputational and litigation risks for the company.

Conclusion

While you’re not legally required to obtain a 409A valuation to issue stock or stock options, it’s a critical tool for managing risk, especially as your company grows. For stock options, a 409A is essential to avoid draconian penalties, and if you do issue stock options without a 409A valuation, investors will question it every time you raise money or go to sell. For stock issuances, it’s about balancing risk and demonstrating good faith in pricing. Always consider your company’s stage, progress, and funding when evaluating whether to proceed without a 409A.

If you’re unsure, consult with a trusted legal or financial advisor to assess your situation and determine the best path forward. The cost of a 409A valuation is small compared to the potential financial and reputational risks of skipping one.

Disclaimer

We caution that the above is a summary and general in nature (it does not, for example, address partnership equity incentives or non-US tax implications) and does not address specific circumstances that may be important to you individually.  It is not individualized tax or legal advice.  Always work closely with a skilled startup lawyer to navigate these complex situations effectively and to ensure compliance with tax laws while minimizing liabilities.

Thank you

We appreciate Brett Good, who co-authored this blog post.

Kristina Subbotina
January 7, 2025

All about SAFEs

When it comes to raising venture funding, startups have several popular instruments at their disposal: SAFEs, convertible notes, and NVCA documents for priced equity rounds. In this post, we’ll dive deep into SAFEs.

When it comes to raising venture funding, startups have several popular instruments at their disposal: SAFEs, convertible notes, and NVCA documents for priced equity rounds. In this post, we’ll dive deep into SAFEs.

For the past 8+ years, I have been a corporate lawyer representing startups and venture funds throughout their lifecycle. This includes formation, financings, day-to-day business operations, and exits. I’ve worked both at Cooley and two venture-backed startups as their first legal counsel. I've represented thousands of startups, most of which are in the early stage, and nearly all have raised venture funds at some point. One of the most popular instruments for raising venture funds is SAFEs. SAFEs are often preferred for pre-seed and even seed rounds of financing due to their affordability and speed of execution.

What is a SAFE?

A SAFE, or Simple Agreement for Future Equity, was introduced by Y Combinator (YC) in 2013. It is a concise, open-source financial instrument granting investors the right to receive equity at a future date. This occurs when the company conducts a priced equity financing round and sells shares of preferred stock. At that point, SAFEs convert automatically, and SAFE holders become stockholders.

It's essential to understand that SAFEs are not shares but rather instruments that convert into shares in the future.

When does a SAFE convert into equity?

SAFEs primarily convert into preferred stock during the company’s next priced equity financing round. The conversion terms may include:

  • A conversion price discount, or
  • A valuation cap, depending on the SAFE form.

Some SAFEs feature a "most favored nation" (MFN) clause, allowing investors to adopt better terms from future convertible instruments issued by the company.

If the startup doesn’t undergo an equity financing round, the SAFE converts during a Liquidity Event (e.g., acquisition, merger, or IPO). In this case, SAFE holders receive the greater of:

  1. Their initial investment, or
  2. The value based on the SAFE’s valuation cap or discount.

In a Dissolution Event (e.g., voluntary winding up, bankruptcy, or other liquidation), SAFE holders are entitled to repayment of their investment after creditors are paid. However, there may not be significant assets left for repayment in many cases.

Types of SAFEs: Pre-Money vs. Post-Money

The Evolution of SAFEs

  • 2013: YC introduced pre-money SAFEs to replace convertible notes. These SAFEs were intended for bridging to priced equity rounds but soon became a common fundraising tool for seed rounds.
  • 2018: YC introduced post-money SAFEs to address the growing complexity of SAFE rounds. Post-money SAFEs provide more clarity for founders and investors by explicitly accounting for ownership percentages.

What Do “Pre-Money” and “Post-Money” Mean?

  • Pre-Money Valuation: The company’s worth immediately before new investment.
  • Post-Money Valuation: The company’s worth immediately after new investment.
  • Pre-Money SAFE: Excludes the SAFE investment when calculating ownership percentages. Pre-money SAFEs technically result in less dilution for founders but frequently lead to unanticipated dilution, especially in multiple SAFE rounds.
  • Post-Money SAFE: Includes all SAFEs in the capitalization, offering greater clarity and predictability.

Other Key Considerations

  1. Raising Amounts Near the Valuation Cap:Raising amounts close to or exceeding the post-money valuation cap can result in negative ownership for founders. For example, raising $5M on a $5M post-money valuation cap would leave no equity for founders.
  2. How Much Can a Startup Raise?:Typically, startups raise up to $2M through SAFEs (though I’ve seen outliers go up to $8M, which I don’t recommend). The more a founder raises, the more diluted their ownership becomes.
  3. Preparing for SAFE Financing:To ensure a smooth process:
    • Data Room: Prepare a data room with all corporate documents for investor due diligence. Use this free data room checklist.
    • SAFE Draft + Board Consent: Work with legal counsel to prepare a SAFE draft and obtain board approvals.
    • Securities Compliance (For Larger Rounds): File Form D with the SEC and state blue sky filings after closing. For smaller rounds, filings may be deferred based on your risk tolerance.
    • Startup Convertible Financing Package

Which SAFE Should You Use?

In most cases, startups use a post-money SAFE with a valuation cap. This provides clarity on investor ownership and founder dilution.

Find SAFE templates on the Y Combinator website.

If you'd like us to handle your SAFE financing end-to-end, check out our Convertible Financing Package.

Disclaimer: This post is for informational purposes only and should not be considered legal or tax advice. Consult legal and tax advisors for tailored advice.

Kristina Subbotina
November 20, 2024

Comparing Stock Grants vs. Stock Options: Key Considerations for Equity Compensation

When structuring equity compensation, companies often consider granting stock or offering stock options, each with unique implications on ownership, taxation, and financial risk.

When structuring equity compensation, companies often consider granting stock or offering stock options, each with unique implications on ownership, taxation, and financial risk. This comparison table outlines the key differences between stock grants and stock options across critical factors such as tax treatment, market risk, flexibility, and the timing of the Qualified Small Business Stock (QSBS) benefit. Understanding these distinctions can guide companies and recipients in selecting the most suitable form of equity to meet their financial goals and strategic needs.

Overall, purchasing stock outright is often a better choice, if feasible.

Kristina Subbotina and Natalia Suvorova
November 18, 2024

$10 million mistake: how the lack of a consulting agreement led to a startup's shutdown 👇

A startup founder hired a developer without a contract. When the developer claimed IP ownership and sued, investors fled, and the startup collapsed. Learn how to protect your venture with proper consulting agreements.

$10 million mistake: how the lack of a consulting agreement led to a startup's shutdown 👇

A startup founder, eager to launch the MVP, hired a developer online without a formal consulting agreement. Everything seemed fine until, just before a major funding milestone, the developer demanded a huge payout, threatening to withhold the intellectual property unless paid.

Negotiations fell apart, and the developer brought in an aggressive attorney, dragging the startup into an expensive lawsuit that quickly drained its resources.

The legal battle scared off investors, shifted focus, and burned through funds, leaving the startup in ruins.

One promising venture, destroyed by the simple oversight of not formalizing the relationship.

Tip: Always use formal agreements with service providers. A clear contract protects your IP and keeps things running smoothly as your startup grows.

Must-Haves in Your Consulting Agreement

  1. Defined Scope of Work: Clearly outline the consultant's tasks, and if the project scope is clear, include milestones and deadlines. Emphasize that time is of the essence to make delays a material breach.
  2. IP Ownership: Your startup's future may hinge on its IP. Ensure all intellectual property created by the consultant is assigned to your company.
  3. Confidentiality Clauses: Safeguard your proprietary information with stringent confidentiality obligations.
  4. Payment Terms: Detail how and when the consultant will be paid to avoid disputes. Whether it's a fixed fee, hourly rate, or milestone payments, clarity is key.
  5. Independent Contractor Status: Clarify that the consultant is not an employee to avoid employment tax and benefit obligations. Indicators include the consultant's control over their work, use of their own tools, and the ability to work with other clients.
  6. Term and Termination: Specify the agreement's duration and how either party can end it. Include notice periods and any post-termination responsibilities.

What to Avoid in Your Consulting Agreement

  1. Vague Language: Ambiguity can lead to legal battles. Use precise, understandable language.
  2. Overly Restrictive Covenants: Non-compete clauses should be fair and enforceable. Overly broad restrictions might be unenforceable.
  3. Unlimited Revisions or Open-Ended Projects: Set boundaries on revisions and project scope to prevent endless work cycles.
  4. Ignoring Conflict of Interest Provisions: Ensure the consultant isn't working for competitors or engaged in harmful activities.
  5. Forgetting Applicable Law and Dispute Resolution: Define the governing law and how disputes will be resolved to avoid jurisdictional headaches.
  6. No Mention of Subcontracting: If the consultant can subcontract, specify approval rights and ensure subcontractors are bound by the agreement.

Engaging Foreign Contractors

Hiring across borders? Here are additional key considerations when contracting with foreign consultants.

Different IP Rules Abroad

IP ownership rules vary dramatically by country. Watch out for these common issues:

  • Assigned copyrights may revert to the original owner after a period
  • Some countries require periodic IP assignment renewals instead of one-time deals
  • Considering getting local legal advice to understand IP rules in that specific country

Check Your Existing Contracts First

Your current agreements might already limit your ability to hire foreign contractors:

  • US government contracts often restrict foreign contractors
  • Partners in regulated industries may prohibit overseas work
  • Review all existing agreements before starting international hiring

Extra Due Diligence Required

Foreign contractor agreements face heavy scrutiny during investments and M&A deals. Get legal advice before signing to avoid future deal-killing issues.

A consulting agreement is your startup's shield and strategy. It protects your IP, maintains confidentiality, and sets clear expectations. Don't let your startup become another cautionary tale. Invest in a solid consulting agreement and secure your startup's future.

DISCLAIMER:

This blog post is not legal or tax advice. I'm a corporate lawyer, but not your lawyer (yet).

Kristina Subbotina
November 14, 2024

LLC to C-Corp Conversion vs. Starting Fresh: Navigating the Options

Deciding on the right legal structure for your startup is a pivotal choice with long-term implications for operations, fundraising, and growth.

Deciding on the right legal structure for your startup is a pivotal choice with long-term implications for operations, fundraising, and growth. A Delaware C-corp is usually the optimal choice for venture-backed startups, but the question remains: should you convert your existing LLC into a C-corp, or start a new C-corp from scratch? Each path has its own financial and procedural nuances, and understanding these can guide you to the best decision for your startup's future.

Converting an LLC to a C-Corp can be intricate and costly, but it's a path that preserves the history and continuity of your existing business. This process involves a number of additional steps compared to the incorporation process, including:

  • Board and LLC Member(s) Approval of Conversion;
  • Valuation of the LLC’s Assets;
  • Transfer of the LLC’s Assets and Liabilities to a C-Corp;
  • Assignment of the LLC’s Agreements to a C-Corp;
  • Conversion of Equity;
  • Notifying Stakeholders of Conversion;
  • Compliance with Other State Requirements (may vary depending on the state).

Revaluing the company's assets may lead to immediate tax liabilities, particularly if there has been significant appreciation in the value of the business. In addition, legal fees tend to be higher due to the complexities of ensuring the conversion aligns with both state and federal tax laws. However, the continuity maintained through conversion can be a significant advantage, particularly for startups with established customer relationships, credit history, and operational track records that can be leveraged in future fundraising efforts.

One significant advantage of converting an LLC to a C-Corp is the potential for increased Qualified Small Business Stock (QSBS) benefits. This strategic move sets the founders' basis in the new C-Corp stock at the LLC's fair market value at conversion, potentially allowing for a tax exclusion of up to 10 times that basis. For instance, if an LLC valued at $10 million converts to a C-Corp, and the founders later sell the stock for $100 million, they could exclude a substantial portion of the gain from tax — far exceeding the exclusion had the entity started as a C-Corp.

However, founders must consider the timing: the QSBS's five-year holding period begins at conversion, and to maintain 'qualified small business' status, the conversion must occur before the company's assets surpass $50 million. This foresight in structuring can lead to significant tax savings, making the conversion route a potentially lucrative option for LLCs poised for growth.

Forming a New C-Corp offers a clean slate, which can be particularly appealing if your startup is pivoting its business model or if you are looking to streamline your cap table for future investment rounds. The costs associated with forming a new C-Corp are generally lower, as the process involves standard state filing fees and a more straightforward legal process. While this option lacks the continuity of an existing business, it can simplify administrative processes and set clear expectations for investors regarding the equity structure and governance of the new entity. Additionally, a new C-Corp can take full advantage of C-Corp tax benefits from the outset, without any carryover of tax attributes from a previous LLC structure.

Here's a more detailed comparison:

While forming a new C-Corp might initially seem more cost-effective and straightforward, it's crucial to consider the long-term strategic implications for your startup. The continuity of an existing business can be a significant asset, particularly if you have established operations and business relationships that you wish to maintain. Conversely, the clean slate of a new C-Corp might be more appealing to investors and can simplify the equity structure for future fundraising efforts.

Ultimately, the decision should be made in consultation with legal and tax experts who can provide tailored advice based on your startup's specific circumstances. The right choice will align with your long-term business goals, operational needs, and fundraising strategy, setting your startup on the path to success. Remember, the structure you choose now will lay the foundation for your startup's journey ahead — make it count.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. For advice specific to your circumstances, consult with a qualified attorney or reach out to Lawlace at www.lawlace.com.

Kristina Subbotina and Natalia Suvorova
October 21, 2024

Top Five Lessons from Founder Divorces

In the startup world, founder separations are more common than you might think. We've seen outcomes that range from amicable to deeply contentious, each offering valuable insights into how timely and strategic legal actions can significantly shape the course of these situations. Here are five scenarios inspired by real-life cases (with details altered for privacy) and the lessons they teach about navigating founder separations.

In the startup world, founder separations are more common than you might think. We've seen outcomes that range from amicable to deeply contentious, each offering valuable insights into how timely and strategic legal actions can significantly shape the course of these situations. Here are five scenarios inspired by real-life cases (with details altered for privacy) and the lessons they teach about navigating founder separations.

1. Invest in a Detailed Operating Agreement (or bylaws if your company is a corporation)

Two founders launched their LLC with a 50/50 ownership split. They drafted an Operating Agreement but never signed it, yet operated as if it was binding. Over time, disagreements arose over the balance of contributions versus rewards, leading one partner to consider leaving.

The situation became complex when the departing partner sought to sell their stake externally. The unsigned Operating Agreement essentially blocked the sale without the other founder’s consent. Additionally, leaving without mutual agreement risked accusations of wrongful dissociation and legal liabilities. Despite its informal status, the unsigned document still held potential enforceability.

The remaining partner used this leverage, threatening legal action to prevent an unapproved exit. After prolonged negotiations and significant legal expenses, they reached a new agreement: the departing partner stepped down, reduced their ownership stake, and was freed from ongoing obligations except in the case of a future company sale.

This scenario shows the pitfalls of not finalizing an Operating Agreement. Properly drafting and executing a fair agreement upfront could have saved substantial time, money, and stress.

Recommendation: Take the time to draft and sign a fair, mutually acceptable Operating Agreement (or bylaws if your company is a corporation). This crucial step opens discussions about future scenarios and sets clear expectations, sparing you from complications later on.

2. Secure IP Assignment

A startup hit a rough patch when its founders disagreed on key business strategies, leading to a split. The departing founder began leaking the company’s core information on a public blog, a potential disaster for the startup.

Luckily, the company had secured IP assignment and confidentiality agreements from all founders during incorporation. A cease-and-desist letter, citing these agreements and threatening further action, was issued and proved effective; the blog posts were taken down, and IP remained protected.

Moreover, the founder's equity was subject to a vesting schedule and a pre-signed stock power, enabling the company to repurchase the unvested shares with minimal input. A nominal amount was sent to the founder’s address to finalize the stock repurchase.

Recommendation: Always have IP assignment, confidentiality agreements, and a stock power in place from day one. This ensures that your startup’s intellectual property and shares remain protected in case of disputes.

3. Clarify Ownership Early

In a startup’s early days, two individuals began collaborating on a concept without locking down equity splits or formalizing their roles, thinking it was too soon. Months later, a falling out occurred, and the collaborator filed a lawsuit, claiming 20% ownership based on their contributions.

Without formal agreements—like stock issuance or advisory contracts—the collaborator’s contributions legally remained his own. The case went to court to determine his ownership stake, creating a risky and costly situation. The ongoing litigation needed to be disclosed during due diligence, potentially deterring investors, and the financial strain of the lawsuit posed a serious threat to the startup.

Recommendation: Define and document ownership stakes and contributions from the outset. This clarity can prevent costly legal disputes and ensures your startup remains attractive to investors.

4. Give Milestone-Based Equity

A tech startup encountered a major obstacle when its CTO, due to receive a substantial equity stake, delayed development for nearly a year. This stall disrupted product launch timelines and broke commitments with potential clients.

Fortunately, the startup had a consulting agreement in place with milestone-based equity provisions. When it became clear the CTO wouldn’t deliver, the agreement allowed the company to terminate without granting equity, as milestones hadn’t been met.

The CTO’s lawyer challenged the termination, but the clear, well-written agreement left little room for dispute. The startup was prepared to defend its position in court if necessary.

Recommendation: Structure equity grants for contractors around project milestones. This approach ensures equity is earned through performance and provides a clear basis for action if expectations aren’t met. A well-crafted consulting agreement with milestone-based equity provisions aligns contractor incentives with your startup’s success.

5. Formalize Relationships with Service Providers

A startup founder hired a developer through an online platform without formalizing the relationship with a consulting agreement. As the startup neared a significant funding milestone, the developer demanded an excessive payment, threatening to withhold IP assignment until compensated.

When negotiations stalled, the developer hired a litigious attorney and initiated a lawsuit against the startup. The legal battle drained resources, both financial and temporal, and diverted focus from the core business.

The litigation proved too burdensome, deterring potential investors due to the unresolved IP issues. Ultimately, the startup failed, a direct result of the unresolved IP conflict and the financial strain of the lawsuit.

Recommendation: Always formalize relationships with service providers through clear agreements. This proactive step protects your startup from potential disputes and ensures smooth operations as you grow.

Each of these cases highlights the importance of proactively addressing legal safeguards to protect founders and their startups. Taking these lessons to heart can help prevent costly disputes and preserve valuable resources as you grow.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. Each startup situation is unique, and the examples provided here are generalized for illustrative purposes. For advice specific to your circumstances, consult with a qualified attorney or reach out to Lawlace at www.lawlace.com.

Kristina Subbotina and Natalia Suvorova
October 17, 2024

Up to 2 years in prison and $10,000 in fines: a price startups might pay for skipping a 20-minute filing

The Corporate Transparency Act (CTA) now mandates US companies to submit Beneficial Ownership Information Reports (BOIRs) of the company’s “beneficial owners” and related company information. The goal is noble and important: enhancing transparency to combat financial crimes. Yet, many founders are still unaware of this requirement, let alone the specifics. Here is what you should know about the BOIR in just 5 minutes.

What is it?

Simply put, BOIR is a report that reveals who controls the company and, in some cases, the person(s) who filed the incorporation documents.

Who should file?

Any company formed in the US, or any non-US company that registers to do business in the US, by filing a document with a government office, unless exempt.

There are 23 types of entities exempt from BOIR, including financial institutions, publicly traded companies, entities involved in private equity and venture capital, tax-exempt entities, and “large operating companies” (those with over $5M in gross receipts/sales for the last year, more than 20 full-time employees in the US, and a physical office in the US). Additional detail on each exemption, including specific required criteria, is provided by FinCEN in Section 1.2 of its Small Entity Compliance Guide (opens in a new tab).

Who needs to be disclosed?

It depends on your company’s incorporation date:

  • Companies created before January 1, 2024, should disclose only their “beneficial owners”. A beneficial owner is someone who directly or indirectly owns or controls at least 25% of the company’s ownership interests or exercises ‘substantial control’ over the company.
    • An individual is considered to have substantial control if they are a senior officer (like a CEO, President, General Counsel, CFO, or COO), can appoint or remove officers or majority of directors, or significantly influences key business decisions, financing, or company structure.
    • FinCEN also includes a ‘catch-all’ provision for those with “any other form of substantial control.” In the absence of clear guidance on this, it is up to the company to determine who to report as beneficiaries.
    • The ownership interest criteria extends beyond equity, stock, or voting rights to capital or profit interests, options, and convertible instruments. For example, if someone is entitled to get 25% or more of the profits, they should be disclosed as a beneficiary. Additionally, If an individual owns or controls more than 25% of a reporting company through one or more entities, the company must disclose only that individual, and not the intermediate entity. Special exceptions apply, such as (i)when ownership is held entirely through an exempt entity (i.e., entity not obligated to disclose its beneficiaries), or (ii) when the same individuals are the beneficial owners of both the reporting company and the intermediate entity (for more details, please refer to FinCEN’s BOI FAQ here).
  • Companies created on or after January 1, 2024 must also disclose ‘company applicants,’ meaning those who filed or controlled the filing of the incorporation documents. While the direct filer should always be disclosed, the person controlling the filing must be reported only if several people were involved in the filing process. Each company will have at least one and a maximum of two company applicants. If the company hires a law firm to assist with its formation by coordinating the filing through a corporate formation service, an individual from the law firm may be listed as the company applicant. Identifying the second company applicant will need to be determined on a case-by-case basis.

How do you file?

Visit https://boiefiling.fincen.gov/fileboir and choose between online filing and uploading a PDF prepared offline. You’ll need the company legal name, jurisdiction of formation, tax identification number, and address. For each beneficiary and company applicant, provide the full name,  date of birth, current address, and a photo of an official ID (like a state-issued driver’s license or passport). Watch out for typos, errors will necessitate filing an amended report!

As an alternative to collecting and submitting sensitive personal information for individuals required in the company’s BOI report, those individuals can obtain a “FinCEN identifier” directly from FinCEN.

FinCEN identifier

The reporting company can then include the FinCEN identifier in its BOI report instead of the individual’s personal details. FinCEN identifiers are particularly useful for individuals who serve as company applicants or beneficial owners for multiple companies, such as VCs. Individuals must generally keep the information provided to FinCEN (e.g., address details) up to date to maintain their FinCEN identifier.

Individuals can create an account and apply for a FinCEN identifier through the FinCEN ID application platform. The identifier is automatically generated once a complete application is submitted. Reporting companies may want to encourage beneficial owners to obtain FinCEN identifiers to reduce the amount of sensitive personal information they need to collect and submit directly to FinCEN with their BOI reports.

When do you file?

Deadlines for initial BOIR filings are:

  • Existing companies as of January 1, 2024, must file by the end of 2024;
  • Companies incorporated in 2024 have 90 calendar days post-incorporation to file, but effective January 1, 2025, the deadline shortens to 30 days.
  • If any information disclosed in the BOIR changes, companies have 30 days to file an updated report.

There is a safe harbor from penalties for filing incorrect or inaccurate BOI reports, provided that the report is corrected within 90 days of when it was filed.

What if we don’t file?

FinCEN warns that willful failure to report or submitting false information can result in hefty fines, including civil penalties of up to $500 per day, up to two years of imprisonment, or a $10,000 criminal fine. Beneficiaries may face personal liability for the company’s failure to file BOIR, especially if they withhold required information.

Don’t let non-compliance cost you. Stay informed and take action to meet your BOIR obligations! If you need help submitting the initial BOI report or making updates on your behalf, feel free to reach out.

Note:

A federal district court ruled the CTA unconstitutional as of March 1, 2024. FinCEN has paused enforcement of the CTA for the plaintiffs involved in this case. FinCEN announced an appeal on March 11, 2024. While the appeal's outcome is pending, the ruling's broader impact is unclear, though FinCEN suggests it will continue CTA enforcement for non-plaintiffs. The following content was created before the ruling, assuming the CTA's enforceability.

Kristina Subbotina and Natalia Suvorova
September 19, 2024

Should Non-US Taxpayers Make an 83(b) Election?

The 83(b) election is a crucial consideration for many startup founders and employees who receive stock subject to vesting. But what about non-US taxpayers? Let's explore this complex issue.

What is an 83(b) Election?

An 83(b) election is a tax filing that allows individuals to be taxed on the value of their stock at the time of grant rather than when it vests. This can be particularly beneficial if the stock is expected to appreciate significantly over the vesting period, typically four years for founders.

The Non-US Taxpayer Dilemma

The US Internal Revenue Service (IRS) hasn't provided explicit guidance on whether non-US taxpayers can make an 83(b) election.

The “homerun” is if a founder has performed services exclusively abroad in exchange for their restricted stock and is planning to move to the U.S. but has not done so yet. If they make an 83(b) election before they are caught in the U.S. tax net, when their shares later vest, they will pay no U.S. tax and will only pay tax when they sell. However, please note there are many complications, and it puts someone on the IRS radar when they weren't before. If in doubt, I'm happy to put you in touch with my tax counsel.

If you decide to proceed with filing an 83(b) election, here are some challenges and potential solutions:

Challenges for Non-US Taxpayers

1. Taxpayer Identification Number (TIN): An 83(b) election requires a TIN, such as a Social Security Number (SSN) or Individual Taxpayer Identification Number (ITIN). Most non-US taxpayers don't have these.

2. Unclear Guidance: Without clear IRS direction, there's uncertainty about how to proceed without a TIN.

3. ITIN Application: Applying for an ITIN is an option, but eligibility isn't guaranteed, and the process may not be completed before the 83(b) filing deadline.

Potential Solutions

- Writing "N/A" in place of the TIN

- Applying for an ITIN and writing "applied for" on the form

Key Takeaways

  1. While not explicitly addressed by the IRS, filing an 83(b) election may benefit non-US taxpayers who might become subject to US taxes in the future.
  1. However, there are a lot of complications and it puts someone onto the IRS radar when they weren't before.
  2. The process is complicated by the TIN requirement and lack of clear guidance for non-US taxpayers.
  3. Consult with a qualified tax advisor or attorney to determine the best course of action for your specific situation.

If you decide to file an 83(b) election, you must file within 30 days of your stock purchase date. There is no remedy for a late filing, but there are some less-than-perfect solutions to fix it. Read more in my blog post here.

Remember, tax laws and regulations can be complex and subject to change. Always seek professional advice tailored to your individual circumstances when making important financial decisions.

Kristina Subbotina
July 17, 2024

Missed the 83(b) Election Deadline? Here's What You Can Do

One of the critical elements of compensating early-stage employees and founders is to understand Section 83(b) of the tax code on founders’ shares (aka restricted stock)

When you are transferred stock in your startup that is subject to vesting or exercise a stock option prior to vesting (a so-called “early-exercise” stock option), you have a 30-day window to file an 83(b) election with the IRS. This election allows you to pay income taxes upfront based on the difference between the fair market value (FMV) of the shares at the time they are transferred and the price you paid. Typically, founders who acquire stock at incorporation pay a nominal price and face no immediate tax if the FMV equals their purchase price. Let's compare the outcomes associated with vesting using the below examples, assuming that you are the sole founder and the par value is equal to the FMV on the date of transfer.

With an 83(b) Election: $0
If you elect to file an 83(b) right after receiving your 8 million shares priced at $0.00001 each, totaling $80, and the FMV at that time is also $0.00001 per share, your tax liability would be minimal or nonexistent because the FMV matches your purchase price.

This strategic decision allows you to lock in the FMV at grant, meaning any future appreciation in the stock's value due to company growth will not increase your tax burden under this election.

Future sales of these shares would then be subject to capital gains tax (long or short-term, depending on the length of your holding period), which could be lower than the ordinary income tax rate.

Without an 83(b) Election: $1,850,000
Suppose you do not make an 83(b) election; then you will pay the ordinary tax rate on the vested shares. If your share value increases to $8M four years later (with the FMV of each share increasing to $1), here’s how your tax liability would unfold, assuming the highest tax bracket of 37% (for simplicity’s sake, we have assumed no penalties or state/local taxes apply), that the FMV of the shares increases each year and the shares vest evenly over four years:

- Year 1 Vesting: 2 million shares vest at an FMV of $0.25 per share (2,000,000 shares x $0.25 = $500,000 FMV).
 - Tax at 37% = $500,000 * 37% = $185,000

- Year 2 Vesting: 2 million shares vest at an FMV of $0.50 per share (2,000,000 shares x $0.50 = $1,000,000 FMV).
 - Tax at 37% = $1,000,000 * 37% = $370,000

- Year 3 Vesting: 2 million shares vest at an FMV of $0.75 per share (2,000,000 shares x $0.75 = $1,500,000 FMV).
 - Tax at 37% = $1,500,000 * 37% = $555,000

- Year 4 Vesting: 2 million shares vest at an FMV of $1 per share (2,000,000 shares x $1 = $2,000,000 FMV).
 - Tax at 37% = $2,000,000 * 37% = $740,000

Total Tax Over Four Years Without 83(b): $1,850,000

This scenario demonstrates that without the 83(b) election, you are liable for taxes on the FMV at the time each portion vests, potentially leading to a much higher tax burden as the value of the shares increases.  It's also important to note that the taxes estimated in these scenarios can be imposed on illiquid shares. This means that even though you are liable for substantial tax payments, the shares you hold may not be easily sellable or convertible to cash to cover these taxes. Without the ability to sell the shares, you will almost certainly face significant financial strain trying to meet your tax obligations.

Managing a Missed 83(b) Election:
Unfortunately, if you miss the 30-day window to file an 83(b) election, it cannot be filed late.  However, there are a few methods practitioners normally turn to mitigate the damage:

1. Removing the Vesting Schedule.  Accelerating your vesting makes the shares fully yours immediately.  Generally, when you do not file an 83(b) election, property is subject to taxation as it vests, so when you accelerate vesting, you accelerate the taxation.  If the FMV has increased by the time you remove the vesting schedule, you must pay taxes on the difference between this new FMV and the original purchase price. Estimating this potential tax liability before removing the vesting schedule is crucial to prevent significant financial strain.

However, boards and investors often struggle with accelerating the vesting of awards when an employee misses a section 83(b) election. Without vesting, equity incentives have no retentive effect, and the employee can quit without any risk of forfeiting the shares. Investors do not like fully vesting stock for something that was (in their view) the grantee's fault.

2. Making the Shares “Transferrable”.  Another solution to a missed section 83(b) election is to make the property transferable by you to a third party. When property becomes “transferrable” within the meaning of Section 83, the fair market value of the property is included immediately in the service provider’s income. In effect, a result very similar to a timely section 83(b) election has been achieved.  As with removing the vesting schedule, you are subject to immediate taxation on the difference between the FMV on the date the shares become transferable and the original purchase price.  

This fix is also not without its issues.  The amendment itself is highly technical.  The shares must be fully vested if transferred to a third party, which investors do not like.  There is very little guidance on the transferability fix from the IRS.  For example, what are the parameters on who it can be transferable to and can normal company protective provisions like the right of first refusal continue to apply following a transfer?

In both cases, it’s crucial to obtain a 409A valuation to determine the stock’s fair market value.  This will help you to understand the tax implications associated with accelerating the vesting following a missed section 83(b) elections.  Depending on your company’s financial circumstances, your investors may be amenable to offering you a loan (which must be bona fide debt in order to be respected by the IRS) or paying you a discretionary bonus in order to help with any attendant tax consequences.

Canceling and Re-Granting Unlikely to Work:

Most tax advisors believe it is not effective to rescind the grant of property and make another grant of property that would be accompanied by a timely made section 83(b) election. This strategy likely does not work for tax purposes because the first grant would not be actually rescinded under the law. The IRS and courts would likely view this as an attempt, devoid of economic substance, to cure a late section 83(b) election.

Where does the Company come into play?

If you don’t make a section 83(b) election, the company has a withholding obligation on each applicable vesting date and can incur substantial penalties if such withholding is missed.  It is also important to note that the company should be keeping execution copies of section 83(b) elections. A common misconception is that the company doesn't need to maintain records of Section 83(b) elections because it is a personal tax election for the grantee. While this is true to some extent, a requirement of making a Section 83(b) election is that a copy must be given to the entity for whom the services are performed. Therefore, maintaining these records is crucial for compliance and to avoid potential complications during due diligence.

We caution that the above is a summary and general in nature (it does not, for example, address partnership equity incentives or non-US tax implications) and does not address specific circumstances that may be important to you individually.  It is not individualized tax or legal advice.  Always work closely with a skilled startup lawyer to navigate these complex situations effectively and to ensure compliance with tax laws while minimizing liabilities.

Because this topic is so complex and important, I, as a startup lawyer, work with Brett Good, an experienced compensation and benefits counsel. We wrote this blog post together.

Kristina Subbotina
June 12, 2024

The Ultimate Qualified Small Business Stock (QSBS) Checklist for Startups and Their Investors

Below is a checklist to assist you in conducting a preliminary audit of the stock's status.

Section 1202 of the Internal Revenue Code can be a game-changer for startup founders and investors. It allows for a 100% exclusion from U.S. federal income tax on gains from the sale of qualifying small business stock (“QSBS”), with certain limitations, provided the stock has been held for at least five years. In practical terms, this means no federal capital gains tax on your stock sale gains, up to $10 million or 10 times your adjusted tax basis, whichever is greater.

For instance, if you're a founder who obtained stock at virtually no cost and later sell it for $25 million, your tax basis is near zero, setting your exclusion limit at $10 million. Therefore, you would only pay capital gains tax on the remaining $15 million. If the capital gains tax rate is 20%, your tax would be $3 million — a substantial saving from what would have been a $5 million tax bill without the QSBS exclusion. Certain states such as California have not adopted QSBS so you may still owe state income taxes on the full amount. With some advanced planning it may be possible to “stack” multiple $10 million exemptions or to take advantage of the 10 times basis rule.

The most common pitfalls that could cause you to lose QSBS benefits are repurchases and redemption of stock by the corporation. Investors frequently request various representations regarding the QSBS eligibility of the company’s stock during the company’s priced equity rounds (usually series seed and Series A).

Below is a checklist to help a stockholder (“Taxpayer”) conduct a preliminary audit of the stock’s status, but it’s not exhaustive, and consulting with a tax lawyer is highly recommended. Given the significance of these benefits, I strongly advise working with a tax lawyer; I work with Daniel Cousineau.

QSBS CHECKLIST

If you answered “No” to any of the questions below, you might have a QSBS issue.

  1. Was the stock first issued after August 10, 1993? Stock obtained through conversion  from an LLC to a C corporation is treated as the issuance of new stock.
  2. Has the company been a domestic C corporation during the entire time the Taxpayer held the stock?
  3. Has the company been an eligible corporation for nearly all of the Taxpayer’s holding period? An eligible corporation means any domestic corporation but does not include:some text
    • Domestic international sales corporations ("DISC");
    • Regulated investment companies, real estate investment trusts, real estate mortgage investment conduits, or financial asset securitization investment trusts; or
    • Cooperatives.
  4. Did the Taxpayer obtain the stock directly from the company when initially issued (either directly or via an underwriter), through:some text
    • purchase with money or in exchange for other property (excluding stock), or
    • receipt as compensation for services rendered to the corporation, except for services as an underwriter of the stock?
  5. At least one of the conditions 5(a) or 5(b) below must be met:some text
    • The company has been recognized as a specialized small business investment company, licensed under Section 301(d) of the Small Business Investment Act of 1958 (as it was on May 13, 1993), for nearly the entire duration that the Taxpayer held the stock.
    • The company has met the active business requirement during the Taxpayer's holding period for the stock (the "Active Business Test"). To pass the Active Business Test, the company should be involved in one or more qualified trades or businesses. A "qualified trade or business" is any trade or business except for:some text
      • any trade or business mainly involving the performance of services in sectors such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the primary asset is the reputation or skill of one or more of its employees;
      • banking, insurance, financing, leasing, investing, or similar business;
      • farming business (including tree farming);
      • any business that involves the production or extraction of products for which a deduction is available under Section 613 or 613A (i.e., natural resources production or extraction); and
      • businesses operating hotels, motels, restaurants, or similar.

    • Furthermore, the company must actively use at least 80% (by value) of its assets in conducting one or more qualified trades or businesses. Cash and investments can be counted towards this 80% if they meet certain conditions:some text
      • they are held for the reasonable working capital needs of a qualified trade or business, or
      • they are held for investment and are reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or increases in working capital needs of a qualified trade or business (such assets defined as "Working Capital") shall be treated as used in the active conduct of a qualified trade or business.*
    • *Note for startups: if starting two years after the company was formed, if more than half of the company's total assets are in cash or investments, then that excess portion won't be considered as being actively used in the company's day-to-day business operations. In other words, when new cash comes in, for the first two years, 100% of that cash is considered a 'good' asset (working capital) that counts towards the active trade or business requirement. After that initial two-year period, for the next two years, only 50% of that cash is considered a 'good' asset that contributes to the active trade or business requirement.

      For example, let’s say a company raises $20 million. For the first two years, this $20 million is counted towards determining if at least 80% of the company’s assets are used in an active trade or business. In years 3-4, only $10 million of this would count as good working capital. If the company’s total assets are valued at $100 million during this time, $90 million would be considered 'good' and $10 million 'bad', so they would still meet the 80% requirement. However, if the company's total valuation is less than $50 million, then the $10 million of cash would be a bad asset, and they might not meet the 80% test.

      It’s important to deploy the cash within this timeframe, and it is worthwhile to keep track of this usage.
  6. For a startup to keep QSBS tax benefits, it needs to actively use at least 80% of its assets in its business. Here's how the rules apply:some text
    • First Two Years: All cash raised counts fully towards this 80% active use requirement.
    • Years Three to Four: Only 50% of any remaining cash counts towards active use.
  7. Example: If a startup raises $20 million:some text
    • First Two Years: All $20 million is considered active.
    • Years Three to Four: Only $10 million of the initial $20 million counts as active. If the startup's total assets are worth $100 million during this time, $90 million needs to be active to pass the 80% test. They meet the requirement since $80 million of other assets plus the $10 million from cash are active. If the total assets are only $50 million, then not enough of the company’s assets are active, risking their QSBS eligibility.
  8. Essentially, the startup has a few years to effectively use or invest its cash in business operations to ensure it meets the QSBS requirements.some text
    • The company will not meet the Active Business Test during any period when:some text
      • more than 10% of its assets’ value, after deducting liabilities, is in stocks or securities in other corporations that are not its subsidiaries, except for stocks and securities that are considered Working Capital; or
      • over 10% of its assets’ value is in real property not used in the active conduct of a qualified trade or business.
  9. BOTH of the following statements are true:some text
    • The company hasn't (and doesn't intend to) purchase more than a de minimis amount of its stock from the Taxpayer or any related person during the four-year period starting two years before the stock was issued. Any purchases made from the Taxpayer or related persons that total either (i) 2% or less of the Taxpayer's and related persons’ held stock, or (ii) $10,000 or less, are considered negligible.
    • Furthermore, the company has not engaged in, nor does it plan to engage in, purchasing its stock during the two-year period starting one year before the issuance of the stock if the total value of such purchases at the time they are made exceeds 5% of the total value of all its stock at the start of that two-year period. However, purchases by the company of its stock that do not exceed (i) 2% of the total outstanding stock at the time of purchase or (ii) $10,000 are considered de minimis.
      When considering this question, the following are not considered "purchases":some text
      • The company's buyback of stock from a seller who acquired the stock through service as an employee or director of the company, when this is connected to the seller's retirement or a genuine termination of such services;
      • The transfer of stock from a shareholder of the company to an employee or independent contractor (or their beneficiary), even if it is considered that the stock was first transferred to the company as per the relevant Treasury Regulations;
      • The company's acquisition of stock from the estate, beneficiary, heir, surviving joint tenant, spouse, or a trust of a deceased person (or their spouse), if the purchase takes place within three years and nine months following the person's death;
      • The purchase of stock due to the seller's disability or mental incompetence;
      • The acquisition of stock related to the divorce of the selling shareholder, as defined in the appropriate tax regulation section.
  10. Throughout the period starting on August 10, 1993, and ending just after the stock was issued, did the company (or any predecessor) maintain cash and the total tax basis of all other assets at $50M or less at all times?

THANKS

Special thanks to Daniel Cousineau for helping to review this blog post.

DISCLAIMER:

This blog post is not legal or tax advice. I'm a corporate lawyer, but not your lawyer (yet), and I will never be your tax lawyer.

Kristina Subbotina
April 25, 2024

The BOIR Filing Requirements for Startups

Did you know that new FinCEN regulations are likely to affect your company's compliance requirements?

Almost any company formed in the US, or any foreign company that registers to do business in the US, needs to file this report. Let's dive into who, when, where, and what needs to be filed.

In September 2022, the U.S. Treasury's Financial Crimes Enforcement Network (FinCEN) enacted new ownership reporting rules under the Corporate Transparency Act. Starting January 1, 2024, companies formed on or after that date have 90 days to report their ownership details to FinCEN. From 2025 onwards, any newly established company must file its report within 30 days of its formation or registration. Additionally, companies existing before December 31, 2023, have the entire year of 2024 to comply.

Beneficial Ownership Information Report ("BOIR") Requirements

Who should file BOIR?

Any company formed in the US, or any foreign company that registers to do business in the U.S. by filing a document with a secretary of state or a similar office, is required to comply with reporting requirements unless it falls under one of the specified exemptions:

A few words about the most notable exemptions:

  • The “Investment Company / Adviser” exemption is limited to entities registered with the SEC (RIAs) and venture capital fund advisers.
  • The “Large operating companies” include any company that employs more than 20 full-time employees in the U.S., generates more than $5M in gross receipts or sales in the U.S., and maintains an operating presence at a physical office within the U.S. Subsidiaries of large operating companies are also exempt from BOI reporting, provided that the subsidiary’s ownership interests are controlled or wholly owned by the exempt entity.

Who should be disclosed in BOIR?

1. Beneficial owners - each one of the following individuals:

(a) Individuals exercising substantial control:

      (i) Senior officers (President, CEO, CFO, COO, GC or any other officer performing similar       functions); or

      (ii) Individuals having appointment / removal authority with respect to senior officers or a .       majority of the board (similar body); or

      (iii) Important decision-makers (determination / substantial influence over decisions on       entity's business, finances, or corporate structure); or

      (iv) Individuals having any other form of substantial control;

(b) Individuals owning or controlling at least 25% of the ownership interests or voting rights (including convertibles, options, and other privileges).

Exceptions to the beneficial owners are (i) minor children, (ii) nominees, intermediaries, custodians, or agents, (iii) employees whose control is derived solely from the employment status (save for senior officers), (iv) inheritors, and (v) creditors.

2. Company applicant(s) (min. one and max. two individuals):

    (a) Direct filer (required) - individual who actually filed the certificate of incorporation (for domestic entities) / registration (for foreign entities); and

     (b) Individual directing or controlling the filing action (only if there was other individual who was in charge of incorporation / registration, even       though did not actually file documents).

If the reporting entity is created / registered to do business in the U.S. before Jan 1, 2024, such entity is NOT required to report a company applicant(s).

What information should be disclosed in BOIR?

1. For the reporting company:

(i) Full legal name;

(ii) Any trade name or “doing business as” name;

(iii) Complete current U.S. address;

(iv) Jurisdiction of formation (including (a) State/Tribal jurisdiction for a domestic reporting entity or (b) State/Tribal jurisdiction of 1st registration for a foreign reporting entity); and

(vi) IRS TIN, including a EIN (or, if a foreign reporting company has not been issued a TIN in the US, its foreign TIN and the name of the issuing jurisdiction).

2. For each beneficial owner and each company applicant required to be reported:

  • (i) Full legal name;
  • (ii) Date of birth;
  • (iii) Complete current address;
  • (iv) Unique identifying number and issuing jurisdiction from one of the following non-expired documents:
    • (a) U.S. passport;
    • (b) identification document issued by a State, local government, or Indian Tribe issued for identifying the individual;
    • (c) State-issued driver’s license; or
    • (d) if none of (a)–(c) are available, a foreign passport; and
  • (v) An image of the document from which the unique identifying number was obtained.

When to file BOIR?

1. For initial reports:

    (a) If the reporting entity is registered by Jan 1, 2024, it should file an initial BOIR by the end of     2024;

    (b) If the reporting entity is created / registered to do business in the U.S. after Jan 1, 2024,     then initial filing is due within 90 days after receiving a public notice on incorporation /     registration (as applicable);

2. For amended / corrected reports: within 30 days after change has occurred / the reporting entity has become aware of the inaccuracy in a BOIR. Companies are not otherwise required to submit BOI reports on an annual or other periodic basis.

How to file BOIR?

The procedure is pretty straightforward. In order to file a BOIR on behalf of a reporting entity, one needs to:

(i) visit BOI E-Filing System;

(ii) choose one of two options:

    (a) prepare an offline PDF BOIR and submit; or

     (b) prepare a BOIR online via the system and submit.

There is no fee for submitting the BOIR to FinCen.

If you need help with this, feel free to reach out.

What are the penalties for not complying?

If someone knowingly gives false or incomplete information to FinCEN, or doesn't report the required details at all, they could face up to $10,000 in fines and two years in prison. This includes situations where someone prevents the necessary information from being reported by not providing or submitting it.

Additional sources: BOIR Requirements and Filing Instructions (attached).

DISCLAIMER

You should always consult your own lawyer. While I am a lawyer, I may not be yours (yet). Please note that the information provided here is for informational purposes only and should not be considered legal or tax advice.

Kristina Subbotina
February 12, 2024