Should founders pay for their stock in cash or contribute intellectual property?

January 14, 2009

If a founder owns intellectual property that he or she plans on contributing to a company, the founder may want to pay for founder stock by assigning the intellectual property rather than paying cash.  Even though founders typically purchase stock for $0.01 or $0.001 per share, the aggregate purchase price can often be in the thousands of dollars.  (Or course, the par value can be set extremely low, such as $0.00001 per share in order to allow founder stock purchases at extremely low prices.)  Sometimes, a founder will choose to assign a business plan to the company for this purpose.  Nevertheless, there are number of risks associated with purchasing founder stock by means of assigning intellectual property, including:

  • difficulty in adequately defining the scope of what is being assigned or what the company needs in this regard now or in the future;
  • difficulty in making sure the assignment is properly perfected;
  • difficulty in accurately valuing the assets assigned, which could affect the company’s stock option pricing if the company’s auditors determine that the value of the intellectual property (and, by correlation, the fair market value of the common stock purchased) was significantly higher than stated; and
  • potential tax ramifications (the contribution must to reviewed to make sure that the transaction complies with Section 351 of the Internal Revenue Code in order to be tax free).

In order for an exchange of property for stock to be tax free under Section 351, there are two requirements.  First, the property generally must to transferred solely in exchange for stock of the company.  This is easily met because the founder typically does not receive any cash in the exchange.  Second, immediately after the transfer, the founder(s), including those transferring cash, must own (i) stock possessing at least 80% of the combined voting power of all classes of stock entitled to vote, and (ii) at least 80% of the total number of shares of each other class of stock.  If there is more than one founder, the contributions do not need to be simultaneous, but need to be at or around the same time as the other founders so that it is part of the same transaction in order for the transfers to be aggregated to meet the 80% test.

If a founder chooses to purchase stock by means of assigning intellectual property, the founder needs to execute a proper assignment so that title to the intellectual property is clearly transferred to the company.  In addition, the founder should generally always include at least some cash consideration in order to ensure that the par value per share is paid in cash.

Comments

  • Christine

    Very interesting post. What about in the case where the IP is owned by more than one inventor. If one of the inventors is a working founder and the other inventor is a founder who does not intend to work for the company for simply a nonfounder who will not be working for the company. My impression is that founders that leave the company are usually required to sell their shares back to the corp. Can the nonworking inventor be compensated in preferred or common shares that can be retained if they leave or don't work for the company?

  • http://www.startupcompanylawyer.com Yokum

    @Christine – It might be best to conceptualize the initial issuances of common stock as partially for past efforts (i.e. inventions that are being contributed) and for future efforts (i.e. sweat equity for performance). Stock for past efforts is fully-vested and is not subject to repurchase. Stock for future efforts is subject to repurchase (which repurchase right lapses over time). The founders need to determine the value allocated to past efforts versus future efforts. The non-working inventor probably needs some amount of fully-vested stock in order to induce him/her to assign IP to the company.

  • http://www.startupcompanylawyer.com Yokum

    @Christine – It might be best to conceptualize the initial issuances of common stock as partially for past efforts (i.e. inventions that are being contributed) and for future efforts (i.e. sweat equity for performance). Stock for past efforts is fully-vested and is not subject to repurchase. Stock for future efforts is subject to repurchase (which repurchase right lapses over time). The founders need to determine the value allocated to past efforts versus future efforts. The non-working inventor probably needs some amount of fully-vested stock in order to induce him/her to assign IP to the company.

  • umbe

    I'm in the process of founding an S-corp where I am 99% owner and I have a friend that will own 1% for consulting. I am not setting up any vesting for myself, it's straight assignment of the shares since I'm incorporating the business. My attorney indicated that I don't need to do an 83b election, and after reading some online I think he's correct as I didn't setup any vesting cycle but I'm interested in confirming that here. Also, I am developing software (it's a software company) and have contributed software in the form of an exclusive license to the company (I own and have developed all the IP). If I bring in investors later on and they impose some restrictions on me, could that adversely affect me if they put restrictions on my existing shares having previously skipped the 83b election? Thanks.

  • http://www.startupcompanylawyer.com Yokum

    @umbe – If you have an attorney, you should rely on his/her advise. You don't need to make an 83(b) election based on your fact pattern. If vesting is placed on your shares in the future, there is no need for an 83(b) election at that time and there is no negative consequence to not filing an 83(b) election earlier. Please read the disclaimers and consult with your own advisors.

  • umbe

    Thanks Yokum.

  • shearic

    Yokum – I'm having a hard time finding some info that I hope you'll be able to clarify quickly (with usual disclaimers naturally). I have two partners and we're forming an S-corp with stock with no vesting. The lawyer has said that the stock can just be assigned as opposed to purchased. I've done 3 other startups and the stock was always transferred by a purchase (ranging $0.001 to $0.01 per share), but those situations were restricted stock so were different.

    Question I have is whether stock can just be assigned to the founders this way and with no defined value for the stock. What worries me in the back of my head is what tax implications this could have for us individually.

  • http://www.startupcompanylawyer.com Yokum

    @shearic – I generally prefer to have founders pay at least par value for their shares even if they are transferring assets for their stock, in order to ensure that the shares are fully paid.

  • Nathan

    Yokum,
    I'm going to incorporate in Delaware and own 90% of my company and leave 10% floating shares to issue to people that want to help. How do I place vesting on the shares when I issue the 5%?

    Also, how is a forward split done?

    Thanks!

  • http://www.startupcompanylawyer.com Yokum

    @Nathan – vesting is placed on shares via repurchase provisions in a stock purchase agreement. A forward split is done by amended the company's articles/certificate of incorporation.

  • Nathan111

    Thanks Yokum! Where can I get a stock purchase agreement template to use? Also, what's the actual share purchase date? When the shares vest or when the share agreement is issued?

  • Nathan111

    I 've found a template at docstoc:

    http://www.docstoc.com/docs/6604405/Employee-Re

    So if the agreement issue date is 4/1/2010 and the purchase(closing date) date is 4/1/2011, and a liquidity event occurs on 4/2/2011, would this qualify as long-term capital gains?

  • Jeff

    I have seen restricted stock purchase agreement forms where the purchase price is par value and is paid, but then there is an additional paragraph that says that the founder contributes their IP/business plan as additional consideration for the company entering into the purchase agreement. Does this pose the same issues above that you raise generally in terms of assigning over IP or does the fact that its additional consideration sideswipe those issues?

  • LoganDavisson

    Hi Yokum,

    Can you explain the difference between restricted stock and founders stock. I am being told that there is no relevant difference, and that the recipient is in equally good stead with either.

    This representation, I might add, is being made ex post by a co-founder who, after failing to agree on my founders equity stake, was “advised” by our lawyers to just issue the founders stock and assign restricted stock to me. I have not yet talked to our lawyers directly about this, and, funny enough, feel that something odd might be going on.

    ~LD

  • Sean Crockett

    Regarding Section 351 of the IRC, does the second part of the 80% rule (i.e., “80% of the total number of shares of each other class of stock”) apply to issued shares or authorized shares? 

    For instance,  a solo founder who owns 5M shares of a company with 10M authorized (but no other shares issued) would own 100% of the issued shares, but only 50% of the authorized shares. In that case, would that founder fall within the 80% rule? The statute isn't clear.