One of the most common mistakes founders, employees and investors make is failing to make an 83(b) election when receiving restricted stock.  We will focus on founders, but the premise remains the same for employees and investors alike.

Founders typically purchase stock pursuant to restricted stock purchase agreements or similar agreements which contain restrictions on the stock, with the shares either vesting over time, or the issuer having a right to repurchase the shares at the sale price which expires over time.  As an example, under a typical vesting or repurchase expiration schedule, the stock vests over a four year period, with a one year cliff.  This means a founder would own 25% of their stock free and clear after year one, and another 25% of their original stock grant would similarly become owned free and clear of any restrictions on each subsequent year.

83(b) refers to a special tax election a founder may make with the IRS to notify the tax authority that they have purchased stock that has not yet vested or has restrictions on ownership, but that they would like to recognize the income associated with the ownership of the stock immediately.  An 83(b) election would also start the holding period used in determining long term capital gains treatment. If a founder chooses not to make an 83(b) election, the founder would not recognize income (the difference between fair market value on the day the shares become owned free and clear, and the price paid) until the stock vests or the restriction lapses.  Additionally, the holding period for determining long term capital gains treatment would not begin until the shares have vested.  Failing to make a timely 83(b) election with the IRS can lead to substantial tax liability when the stock vests or the restriction lapses.

Often the purchase price of the stock and the fair market value of the stock on the purchase date is de minimis.   If a founder makes an 83(b) election on the purchase date the founder would often not have any taxable income to recognize, and the vesting dates or dates upon which the repurchase right lapses would no longer be taxable events.  However, if a founder fails to make a timely 83(b) election, the stock’s fair market value may increase and the founder would then realize substantial taxable liability upon the vesting date based on the increase in value – even if the founder does not sell the stock and therefor does not have the liquidity to pay the tax bill.

As an example, assume two founders each receive 1,000,000 shares of stock for the purchase price of $10.00 on the day the company is formed.  Because the two partners want to give each other incentive to be fully engaged in the company for at least 4 years, they agree to a repurchase right for the company that lapses as set forth above.  The first founder makes an 83(b) election and the second chooses not to.  Because the shares have no value on the day the company was formed, the 83(b) election would not create an additional tax burden on the first founder in year 1, and when the repurchase right lapses, because the election has been made, the lapse of the restriction over the next four years would not be a taxable event – instead, the first founder would not report any income on the shares until they were sold, at which time the founder would presumably be in a better position to pay the tax bill, and may be taxed at the lower capital gains rate as opposed to the income tax rate.  The second founder is in a much pricklier situation.  If we have the imaginary company grow to a $1,000,000 valuation in year one, and then double each year thereafter, and assume the two founders remain 50-50 owners of the enterprise, the second founder would be imputed $125,000 of income upon the first restriction expiration date; $250,000 on the second, $500,000 on the third and $1,000,000 on the fourth.  In each case, the math is (x) 25% of 1,000,000 shares becoming owned free and clear (250,000 shares), divided by (y) 2,000,000 shares outstanding times (z) the company’s valuation.  Not only would the second founder have to eat the tax bill on each of these years without a liquidity event to fund the payment, but the shares may be imputed at the higher income tax rate as opposed to getting capital gains treatment.

In order to make an 83(b) election a founder simply needs to fill out a form and send it to the IRS. The form is generally provided to the founder by the company and accompanies the restricted stock purchase agreement (or similar documentation).  An 83(b) election must be made no later than 30 days after the purchase date of the stock. This is a strict deadline and there are no exceptions!

Whether a founder should file an 83(b) election is complicated and facts sensitive.  This blog post is not intended to provide legal or tax advice. Founders, employees and investors should consult a tax advisor and legal counsel to discuss the facts and circumstances of their particular situation.

Incorporating in the State of Delaware is the logical choice for a large number of companies we represent.  Many founders think incorporating in their home state is the best option, however that is not always the case.  There are several reasons companies incorporate in Delaware, some of which will be discussed below.

1. Delaware Law

The State of Delaware has been the preferred home to large corporations and small companies from across the globe for many years.  As a result, they have specialized courts that only deal with corporate disputes and issues.  Delaware law is extremely predictable and is largely seen as business friendly.  All Delaware judges are thoroughly trained in all sorts of business matters, so there is comfort knowing that the judge will be someone that knows exactly what they are talking about.  This is not always the case in other jurisdictions.  Decisions are generally issued via written statements, thus making it easier to review and ensures predictability. While many of the safeguards Delaware has in place wont effect a company until an issue arises, some even effect a company on day one.  For example, the State of Delaware will allow a company to decide most operational issues for themselves.  Other states like to dictate how a company should be operated and create sometimes burdensome and inapplicable restrictions on companies and its shareholders.  Delaware is well known for providing maximum flexibility in the structuring and operation of business entities, including the allocation of rights, risks and duties among founders and shareholders.

2. Privacy

Delaware does not require officers and directors names be listed in the formation documents.  In fact, most of the time the documents merely list the attorney who filed them with the State of Delaware.

3. Simplicity

Delaware makes it extremely quick and easy to form an entity.  Generally, filings will come back the same day.  A handful of Delaware registered agents have direct connections to the Division of Corporation’s electronic database, and can file your company’s formation documents electronically.  Formation in Delaware can not only be quick, but also cheaper than other jurisdictions.  The initial formation costs, as well as all ongoing fees are generally among the most affordable in the country.

4. Investor Expectations

Virtually every investor in the United States (and perhaps the world) is familiar and comfortable with Delaware law.  Law students across the country study the Delaware corporation statute and the decisions of Delaware courts interpreting that law.  As a result of their client’s needs and law school teachings, many lawyers are far more familiar with Delaware law then they are with their home jurisdiction.  Many investors will require a company be incorporated in Delaware before making an initial investment.   If you plan on raising funds from an investment bank or venture capital firm, you will likely be forced to become a Delaware entity.  The cost of converting a foreign entity into a Delaware company is far more expensive than any initial formation costs.

These are just some of the reasons it may make sense to form your company in the State of Delaware.  This blog post is not intended to provide legal advice. You should consult legal counsel to discuss the facts and circumstances of your particular situation.

Clients frequently ask us the differences between “stock options” and “warrants” and which is the right instrument for compensatory arrangements. Stock options and compensatory warrants are a great way to align the interests of a company with another individual or entity.

Of the two, stock options are more commonly used for compensatory purposes and can be issued to key employees, officers, directors, board members and other service providers.  Typically, the company will have a stock option plan under which they can issue a maximum number of stock options.   The issuance of stock options will be governed by the stock option plan and will usually have a vesting period, repurchase rights in the event of termination of service and other restrictions. The stock option is being used as a compensatory vehicle in order to increase an individual’s (or entity’s) overall compensation.

On the other hand warrants are not issued pursuant to any stock option plan and typically will not come with vesting restrictions.  Warrants are more typically associated with investment transactions, however they can be used similarly to stock option as compensation.  The typical term for the exercise of a warrant lasts longer then a stock option – it is not uncommon to see a warrant that lasts for ten years (although that is far more common with investment transactions), while a stock option will typically have a much shorter exercies period.  While a warrant can be used for compensatory purposes, it is important to note that a compensatory warrant will likely be taxed just like the compensatory stock option, while a investment warrant will have far different tax implications).

In short, stock options and warrants can both be used for compensatory purposes, but it is far more common to issue stock options under a stock options plan.  The differences are largely superficial and can be minimized by drafting either document to suit your company’s needs.  Before deciding which instrument is right for a company it is important for both the company and the recipient to consult its attorney and tax advisor.

Peter Minton was quoted in the Chicago Tribune on using competition to your advantage:

“As fellow professionals, other attorneys are actually one of my best sources of clients and can be great resources for my practice and clientele. I may bring them in for a client because of a conflict with one of my other clients on a project, for extra help during an upswing in business or if the other attorney is just a better fit for the client’s immediate legal needs.”

The full story is available here.

Congratulations to Peter Minton who has been named one of New York City’s Rising Stars for a second consecutive year by Super Lawyers!  Peter’s bio can be found here.