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.