This week, the Obama Administration released the first comprehensive summary of its budget proposal. The budget proposal is wide ranging, and includes, for example, proposed changes with respect to the taxation of “carried interests” in partnerships, as well as sweeping reform of the international tax area. One proposal would dramatically improve the treatment of “qualified small business stock” issued after February 17, 2009.

The budget proposal would modify IRC Section 1202 to provide for a complete exemption from capital gains tax for qualified small business stock issued after February 17, 2009 and held for five years, and the amount excluded would not be added back for alternative minimum tax purposes. If enacted, this would significantly enhance the tax incentives currently available for qualified small business stock. Under current law, the exclusion for purposes of the regular income tax system of 50% of the recognized gain on the disposition of qualified small business stock (which was increased by the recent American Recovery and Reinvestment Act to 75% for issuances in 2009 (after February 17, 2009) and in 2010) is substantially undercut by the combination of the high rate of tax (28%) applicable to the non-excluded portion of the gain under the regular income tax and the interplay between the AMT rules and Section 1202. Thus, historically, the principal federal tax benefit of qualified small business stock has been the ability to achieve “rollover” treatment of the proceeds from the sale of qualified small business stock under IRC Section 1045.

In light of the potential for this significant benefit associated with qualified small business stock, all venture financings should be analyzed very closely from a qualified small business stock standpoint. In addition, post-financing transactions, particularly stock redemptions, that potentially could undermine qualified small business stock status should be carefully reviewed.

The relevant provisions of the summary of the budget proposal related to qualified small business stock are below.

ELIMINATE CAPITAL GAINS TAXATION ON INVESTMENTS IN SMALL BUSINESS STOCK

Current Law

Taxpayers other than corporations may exclude 50-percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for at least five years. Under ARRA the exclusion is increased to 75 percent for stock acquired in 2009 (after February 17, 2009) and in 2010. The taxable portion of the gain is taxed at a maximum rate of 28 percent. Under current law, 7 percent of the excluded gain is a tax preference subject to the alternative minimum tax (AMT). The AMT preference is scheduled to increase to 28 percent of the excluded gain on eligible stock acquired after December 31, 2000 and to 42 percent of the excluded gain on stock acquired on or before that date.

The amount of gain eligible for the exclusion by a taxpayer with respect to any corporation during any year is the greater of (1) ten times the taxpayer’s basis in stock issued by the corporation and disposed of during the year, or (2) $10 million reduced by gain excluded in prior years on dispositions of the corporation’s stock. To qualify as a small business, the corporation, when the stock is issued, may not have gross assets exceeding $50 million (including the proceeds of the newly issued stock) and may not be an S corporation.

The corporation also must meet certain active trade or business requirements. For example, the corporation must be engaged in a trade or business other than: one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more employees; a banking, insurance, financing, leasing, investing or similar business; a farming business; a business involving production or extraction of items subject to depletion; or a hotel, motel, restaurant or similar business. There are limits on the amount of real property that may be held by a qualified small business, and ownership of, dealing in, or renting real property is not treated as an active trade or business.

Reasons for Change

Because the taxable portion of gain from the sale of qualified small business stock is subject to tax at a maximum of 28 percent and a percentage of the excluded gain is a preference under the AMT, the current 50-percent provision provides little benefit. Increasing the exclusion would encourage and reward new investment in qualified small business stock.

Proposal

Under the proposal the percentage exclusion for qualified small business stock sold by an individual or other non-corporate taxpayer would be increased to 100 percent and the AMT preference item for gain excluded under this provision would be eliminated. The stock would have to be held for at least five years and other provisions applying to the section 1202 exclusion would also apply. The proposal would include additional documentation requirements to assure compliance with the statute.

The proposal would be effective for qualified small business stock issued after February 17, 2009.

UPDATE (the following is from a WSGR client alert dated October 7, 2010)

The recent enactment of the Small Business Jobs and Credit Act of 2010 (SBJCA) may provide a substantial tax benefit to investors who acquire qualified small business stock (QSBS) on or after September 28, 2010, and before January 1, 2011. Entrepreneurs and investors considering forming or making investments in qualifying corporations, including owners of unincorporated businesses considering incorporation, should be aware of the potential advantages of acquiring QSBS during the relevant time frame.

Under the law prior to the enactment of the SBJCA, Section 1202 of the Internal Revenue Code of 1986, as amended, allowed an individual taxpayer to exclude 50 percent of any gain from the sale or exchange of QSBS held more than five years. This exclusion was increased to 75 percent for QSBS acquired after February 17, 2009, and before 2011. A portion of the excluded gain has been treated as an item of tax preference for alternative minimum tax purposes.

Under the SBJCA, an investor may exclude 100 percent of the gain from the sale or exchange of QSBS held more than five years that is acquired after September 27, 2010, and on or before December 31, 2010. Importantly, such gain is also eligible for exemption from alternative minimum tax, thus effectively eliminating tax on such gain.

QSBS Background

Stock of a small business generally qualifies as QSBS if the stock meets certain requirements, including: (i) the small business is a domestic C corporation; (ii) the taxpayer acquired the stock at its original issue in exchange for money or other property (not including stock) or as compensation for services; (iii) the small business is engaged in a qualified trade or business and uses 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses; (iv) the aggregate tax basis of the small business’s assets on the date after the stock is issued (including proceeds received in exchange for the stock) is $50,000,000 or less; and (v) with certain de minimis exceptions, the small business has not made any repurchases of stock within the two-year period starting one year prior to the date the stock was issued. A “qualified trade or business” is defined as any trade or business other than (i) any trade or business involving the performance of services, such as accounting, engineering, or consulting, or any other trade or business where the principal asset is the reputation or skill of one or more of its employees; (ii) any banking or financial business; (iii) any farming business; (iv) any mining or oil or gas business; and (v) any business of operating a hotel, motel, restaurant, or similar business.

In addition to the exclusions described above, under Section 1045 of the Internal Revenue Code, a taxpayer who (i) holds QSBS for more than six months (the original QSBS); (ii) sells the original QSBS in an otherwise taxable transaction; and (iii) during the 60-day period beginning on the date of such sale, purchases new QSBS (replacement QSBS) generally will recognize gain on its original QSBS only to the extent that the proceeds from such sale exceed the amount invested in the replacement QSBS.

FURTHER UPDATE (December 17, 2010)

The 100 percent exclusion was extended to QSBS acquired before December 31, 2011.

Adeo Ressi, the founding member of TheFunded, recently announced the establishment of TheFunded Founder Institute.

The Founder Institute helps founders launch innovative companies by providing training, services, and company-building assignments, such as incorporating the business, filing provision patents, and setting up books and records. The Institute offers a four month program, called a Semester, hosted initially in the Bay Area and then expanding to locations around the world. The program participants, the Founders, receive extensive training in weekly sessions overseen by three Mentors – two seasoned CEOs and one domain expert for each topic.

The driving beliefs behind the Institute are that (1) great founders are often overlooked by the current entrepreneurial ecosystem, and that (2) innovative startups have a dramatic positive effect on the global economy. Startup companies consume resources intelligently, put people to work in efficient ways, and produce market driven products at lower costs. Helping smart people start new companies should, in fact, help the global economy.

TechCrunch initially reported on the Founder Institute in March 2009.  The Founder Institute has recruited 25 executives to serve as mentors for the founders participating in the program.  The mentors will also lead weekly evening training sessions on company-building tasks.  Founders are not expected to quit their day jobs to participate in the program, which starts on May 19, 2009 and ends on September 8, 2009.  Sessions will be held in the San Francisco Bay Area at locations such as Stanford and Wilson Sonsini Goodrich & Rosati.  Class sessions and course material will be available online.  Although founders outside of the San Francisco Bay Area are welcome, founders in the Bay Area who are able to attend sessions in person are likely to benefit the most from interactions with mentor and other founders.  Future semesters are expected to be held in other locations.

The Founder Institute will assist founders in setting up meetings with potential investors and other parties throughout the semester.

Applications

The Founder Institute intends to accept between 75 and 100 founders for the initial semester, although the size may be limited.  Applications are due by May 10, 2009.  Applicants must:

• Have a preliminary idea and a passion to build something
• Have not yet incorporated, though the Founder Institute will make some exceptions for existing businesses
• Focus on a high tech or innovative sector, such as biotech, cleantech, and information technology
• Possess reasonable training or domain expertise
• Pass basic background and reference checks

The application fee is $50, which only partially offsets costs associated with processing applications.  If accepted, the founder must pay a $450 course fee to cover material and administrative costs.  Microsoft BizSpark has provided a limited number of scholarships to the program.  If a founder’s company raises more than $50,000 in debt or equity financing, excluding funds from the founder, within 18 months of formation, then the founder must pay a tuition fee of $4,500, which is used to cover the Institute’s expenses in providing the program.

Mentors

The Founder Institute has assembled 25 executives to serve as mentors for the participants and to lead weekly sessions.  Mentors for the Summer 2009 Semester include:

• Trip Adler – CEO, Scribd
• Michael Arrington – TechCrunch
• Joe Betts-LaCroix – CTO, OQO
• Jason Calacanis – CEO, Mahalo
• Russ Fradin – CEO, Adify
• Scott Heiferman – CEO, Meetup
• David Higly – CEO Higley & Company LLC
• Jay Jamison – Founder, Moonshoot
• Philip Kaplan – Entrepreneur
• Eugene Lee – CEO, Socialtext
• Bubba Muraka – Business Development, Facebook
• Scott Painter – CEO, Zag
• Aaron Patzer – CEO, Mint.com
• Peter Pham – CEO, BillShrink
• Mark Pincus – CEO, Zynga
• Alain Raynaud – CEO, FairSoftware
• Ken Ross – Founder/CEO, ExpertCEO
• Munjal Shah – CEO, Like.com
• Jen Shelby – Managing Director, Astia
• Jeff Stewart – CEO, Urgent Career
• Brian Thatcher – CEO, Empressr
• Joe Zawadzki – CEO, MediaMath

Additional mentors will be announced shortly.

Curriculum

The evening training sessions will be held weekly with various company-building “homework” assignments.  The curriculum is as follows:

Your Vision & Idea Types
May 19th, 2009: Identify a vision for your business
Description: How to articulate your vision and your passion. Does it involve intellectual property, model innovation, speed to market, market positioning? What is required for different types of ideas?
Mentors: Trip Adler | Philip Kaplan | Mark Pincus | Paul Harkins |

Basic Research
May 26th, 2009: Validate your idea with industry professionals
Description: Know your market, your competitors, and your idea. Can it be done? Will it work?
Mentors: Trip Adler | Mark Pincus | Jason Calacanis | Joe Betts-LaCroix |

Naming
June 2nd, 2009: Name your future business
Description: What’s in a name, and how do you choose a good one?
Mentors: Bryan Thatcher | Mark Pincus | Jay Jamison |

Intellectual Property
June 9th, 2009: File your provisional patents
Description: Practical strategy to getting your first patents quickly, cheaply, and with the necessary protections.
Mentors: Alain Raynaud | Eugene Lee | Joe Betts-LaCroix |

Roadmap
June 16th, 2009: Develop a plan to build your idea
Description: What it takes to get from an idea to an offering. What are common planning mistakes and how do you to avoid them?
Mentors: Trip Adler | Philip Kaplan | Munjal Shah | Jason Calacanis | Bubba Murarka |

Revenue
June 23rd, 2009: Create a revenue model for your business
Description: How to get it. How to grow it. How to track it. How to scale from the first sale to the millionth.
Mentors: Munjal Shah | Eugene Lee | Jay Jamison | Jen Shelby |

Books and Records
June 30th, 2009: Set-up accounting practices
Description: Set-up an accounting system to grow with your needs. What do you start with? Where do you end up after scaling?
Mentors: David Higley | Ken Ross |

Budgeting and Cash Flow
July 7th, 2009: Develop budgeting practices for your model
Description: What is right for a new business: annual, quarterly, or monthly budgets? What does a good budget process look like?
Mentors: Joe Zawadzki | Ken Ross |

Hiring and Firing
July 14th, 2009: Implement hiring policies and practices
Description: When to hire and when to fire? When is it ‘too late’? Choosing co-founders, and forming a founding team with a well-rounded skill set…
Mentors: Scott Heiferman | Joe Zawadzki | Jay Jamison | Paul Harkins |

Recruiting Success
July 21st, 2009: Identify world-class talent
Description: Who are the best in your field? Can you sell them on your vision?
Mentors: Jeff Stewart | Scott Heiferman | Russ Fradin | Bubba Murarka |

Exit Strategies
July 28th, 2009: Build a value generation plan
Description: How to prepare for an exit long before it happens. How to keep your start-up in the sights of both partners and buyers. How to build enterprise value every day. Don’t get caught off guard with an opportunity.
Mentors: David Higley | Peter Pham | Russ Fradin |

Vendors
August 4th, 2009: Select key vendors
Description: What to in-source. What to outsource. How to hire the best vendors for the best rates. What tools does the business need?
Mentors: Munjal Shah | Alain Raynaud | Peter Pham | Joe Betts-LaCroix |

Incorporation
August 11th, 2009: Incorporate the business
Description: How to set-up the right company structure to attract great employees and investors. What corporate formalities are required, and when?
Mentors: Ken Ross |

Marketing
August 17th, 2009: Create a messaging plan
Description: How to sell the story of your company and your offering.
Mentors: Bryan Thatcher | Scott Painter | Bubba Murarka | Joe Zawadzki | Jen Shelby |

Publicity
August 18th, 2009: Start outreach to key media sources
Description: Getting your vision and company name out there. From blogs to radio, what works and what does not?
Mentors: Philip Kaplan | Jason Calacanis | Peter Pham | Bubba Murarka |

The Funding Lifecycle
August 25th, 2009: Create a funding plan with targets
Description: What are the typical stages of the funding life cycle for different types of startup businesses? What kind of specific milestones should one expect to meet in order to progress through those funding stages?
Mentors: Scott Painter | Scott Heiferman | Russ Fradin | Paul Harkins |

Presentation
September 8th, 2009: Create a perfect pitchdeck
Description: How to explain and present your business to target partners and investors.
Mentors: Bryan Thatcher | Scott Painter | Eugene Lee |

Warrants and Bonus Pool

Each founder participating in a semester’s program will sign a Founder Agreement, which includes an obligation to grant a warrant to the Founder Institute to purchase 3.5% of the founder’s company’s fully-diluted capitalization immediately after an initial equity financing raising greater than $100,000.  The exercise price will be the price per share to other investors in the financing.  The founder’s company may terminate the warrant on or prior to the initial equity financing by paying the Founder Institute $100,000.  In addition, if the founder is removed or resigns as a director and does not certify to the reasonable satisfaction of the Founder Institute that such resignation or removal was voluntary, then the founder’s company must pay the Founder Institute $100,000.  Forms of the Founder Agreement and the warrant are available on the Founder Insititute website.

30% of the proceeds from the warrants received within five years from the start of a term shall be set aside in a bonus pool for the founders participating in a particular semester.  In addition, another 30% of the proceeds will be set aside for the mentors, with a portion of that based on founder reviews.

Founder friendly documents

The Founder Institute has developed Class F common stock, which provides founders with a maximum amount of control over the founder’s company.  TechCrunch and VentureBeat recently reported on this innovation and Adeo Ressi provided his thoughts in PEHub.  A form of Certificate of Incorporation that includes provisions for Class F common stock, along with a form of restricted stock purchase agreement are available on the Founder Institute website.  The Founder Institute requires founders to use these documents, or other documents approved by the Founder Institute, when forming a company.

[Disclaimer:  I represent the Founder Institute.]

Adeo Ressi, the founding member of The Funded, recently announced the establishment of The Funded Founder Institute.

The Founder Institute helps founders launch innovative companies by providing training, services, and company-building assignments, such as incorporating the business, filing provision patents, and setting up books and records. The Institute offers a four month program, called a Semester, hosted initially in the Bay Area and then expanding to locations around the world. The program participants, the Founders, receive extensive training in weekly sessions overseen by three Mentors – two seasoned CEOs and one domain expert for each topic.

The driving beliefs behind the Institute are that (1) great founders are often overlooked by the current entrepreneurial ecosystem, and that (2) innovative startups have a dramatic positive effect on the global economy. Startup companies consume resources intelligently, put people to work in efficient ways, and produce market driven products at lower costs. Helping smart people start new companies should, in fact, help the global economy.

The Founder Institute recently published a sample certificate of incorporation that Adeo used when incorporating the Founder Institute, Incorporated.  Adeo was focused on creating mechanisms to protect founders who may lose control of the companies they created after raising financing from investors.  The current customary form of venture financing documents has not changed much since with mid-1970s when they first became widely adopted in Silicon Valley.

Therefore, Adeo wanted to include a number of extremely founder-friendly provisions in the certificate of incorporation for companies formed in connection with the Founder Institute.  These provisions include a special class of super-voting common stock, called “Class F” common stock, which is named for “Founders.”

• Voting.  The COI includes Class A common stock, which has one vote per share, and Class F common stock, which has 10 votes per share.  Companies such as Google, Martha Stewart Living Omnimedia, Broadcom and others have super-voting common stock.  Super-voting common stock is sometimes seen in companies where founders or a family wish to maintain control of a company after obtaining outside investment.

• Protective provisions.  Similar to protective provisions in a Series A preferred stock financing, there are certain fundamental actions that cannot be taken without the consent of holders of more than 50% of the Class F common stock.  The Class F common stock protective provision basically provides:

As long as any of the Class F common stock is outstanding, consent of the holders of at least 50% of the Class F common stock will be required for any action that (i) alters any provision of the certificate of incorporation or the bylaws if it would adversely alter the rights, preferences, privileges or powers of or restrictions on the Class F common stock; (ii) changes the authorized number of shares of Class F common stock; (iii) authorizes or creates any new class or series of shares having rights, preferences or privileges with respect to dividends or liquidation senior to or common stock on a parity with the Class F common stock or having voting rights other than those granted to the Class F common stock generally; (iv) approves any merger, sale of assets or other corporate reorganization or acquisition, or the liquidation or dissolution of the Company; (v) increase the size of the board; or (vi) declares or pays any dividend or distribution.

• Directors.  Holders of Class F common stock are allowed to elect one director.  The Class F director has 2 votes per director, as opposed other directors, who have one vote. Section 141(d) of the Delaware General Corporation Law permits a company to have directors with more than one vote per director. This may address a situation where there is a desire to keep the size of a board small, but ensure that board “control” is maintained by a particular group of stockholders.

The Class F common stock and the Class A common stock otherwise participate equally with respect to dividends and distributions and other economic rights.  The Class F common stock can be converted into Class A at any time at the option of the holder, and will automatically convert if the holder dies or if the Class F common stock is transferred to someone other than another Class F holder or an entity for the benefit of a Class F holder.

Whether any of these provisions will survive after a typical Series A venture financing depends on the negotiating position of the parties.  At a minimum, people like Adeo and blogs like Venture Hacks are educating founders about financing terms that may be detrimental to founders.

[Update:  Class F common stock is discussed in Techcrunch, VentureBeat, PE Hub and the WSJ.  In addition, Marc Andreessen has a blog post strongly supporting dual class stock structures in certain circumstances.]

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.

Under Internal Revenue Code Section 1202 , a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of “qualified small business stock” held for more than five years may exclude 50% of such gain from gross income for regular income tax purposes.  The amount of gain that may be taken into account for purposes of the exclusion is subject to a limitation equal to the greater of: (i) $10,000,000 (less previ­ously excluded gain attributable to the disposition of other shares issued by the company), or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.

Under IRC Section 1045, an individual may roll over proceeds from the sale of a qualified small business stock held for at least six months, when the proceeds are used to purchase qualified small business stock in another company. This effectively defers the tax due on any gain on the stock.

However, the maximum tax on long-term capital gains is 15% for most taxpayers and a 28% rate applies to gain on qualified small business stock.  The effective tax rate after the 50% exclusion is 14%.  Therefore, there is no substantial benefit to qualified small business stock unless the gain is rolled over into other qualified small business stock.

Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. 

Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify.

In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.

Please note that certain redemptions, including (i) redemptions of stock from the holder of qualified small business stock (or a related person) and (ii) certain significant redemptions occurring within one year before or after a stock issuance may disqualify any newly issued stock.

[Note: please go ask your own tax advisors any questions about qualified small business stock because I will not answer technical questions in the comments.]

Failing to make a timely 83(b) election with the IRS is something that could lead to disastrous tax consequences for a startup company founder or employee.

Founders typically purchase stock pursuant to restricted stock purchase agreements that allow the company to repurchase “unvested” stock upon termination of employment. Similarly, employees may “early” exercise options subject to the company’s ability to repurchase “unvested” shares upon termination of employment.

Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize income (the difference between fair market value and the price paid) until the stock vests. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock.

Typically, the purchase price for the stock and the fair market value are the same. Therefore, if an 83(b) election is made, there is no income recognized. Thus, a founder/employee should almost always make an 83(b) election. The benefits of an 83(b) election generally are starting the one year capital gain holding period and freezing ordinary income (or alternative minimum tax) recognition to the purchase date.

If the founder/employee does not make the 83(b) election, then he or she may have income at the stock “vests.” The income will be substantial if the value of the shares increases substantially over time.

For example, assume that a founder purchases stock for $0.01 per share (fair market value is $0.01) and the stock is subject to four year vesting with a one year cliff. The founder does not make an 83(b) election. At the end of the one year cliff, if the stock is worth $1.00/share, then the founder would recognize $0.99/share of income. As the remaining stock vests each month, the founder would recognize income equal to the difference between the fair market value and $0.01/share. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

If the founder had made an 83(b) election, the founder would not recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date.

In order for an 83(b) election to be effective, the individual must file the election with the IRS prior to the date of the stock purchase or within 30 days after the purchase date. There are no exceptions to this timely filing rule. The last possible day for filing is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. For example, if the stock is purchased on May 16, the last possible day for filing is June 15. The official postmark date of mailing is deemed to be the date of filing. The election should be filed by mailing a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his or her tax returns. If the election is mailed after the 27th day, the individual should hand deliver the letter to the post office to obtain an official date-stamp on the certified mail receipt. A copy of the election should be provided to the company, and another copy should be attached to taxpayer’s federal income tax return for the year in which the property is acquired.

[Note:  this post will likely get updated in the near future.] 

I’ve been asked by a few people about the Series FF stock that has been advocated by the Founders Fund. Matt Marshall of Venture Beat reported on this invention in December 2006. See here for an Inc.com report in March 2007. Michael Martin blogs about economic incentives associated with the Series FF and founders receiving some liquidity in connection with a venture financing. Series FF stock has also recently received some attention due to the announcement of the Founders Fund raising a $220 million fund in December 2007. See additional coverage from Venture Beat, TechCrunch and the Mercury News.

I’ve reviewed the Certificate of Incorporation of a couple of WSGR clients that have implemented Series FF stock. (Please note that anyone can obtain the Certificate of Incorporation of a Delaware company from the Secretary of State of Delaware.)

The Series FF is an interesting mechanism for founders to obtain liquidity in connection with a venture financing. Below are the main features of the Series FF stock:

• The Series FF is basically identical to common stock except that it is convertible at the option of the holder into the same series of preferred stock issued in a subsequent round of equity financing if the buyer of the Series FF purchases it in connection with the equity financing.
• The conversion into preferred stock can only occur if the buyer of the Series FF pays the same price per share as the shares of preferred stock sold in the equity financing.
• The conversion into preferred stock can only occur if the board approves the conversion.
• The Series FF is convertible into common stock at any time at the option of the holder.
• The Series FF automatically converts into common stock upon a qualified IPO or upon the consent of holders of a majority of Series FF.

By the way, the Series FF preferred stock doesn’t need to be called Series FF.  It can be called Series A, Series Q, Series Z, Series X, etc.  The Founders Fund has managed to do some branding by referring to it as Series FF.

Below are some things to keep in mind about Series FF stock:

• Pricing of the stock is complicated. Generally, stock should be issued at fair market value (otherwise, there may be deemed income from the company to the founder). If the Series FF is not issued at initial incorporation, then issuing the Series FF stock at a later point in time will require the founders to pay more than a nominal amount to purchase the shares. As I will describe in a later post, founders stock is typically issued at a very nominal price per share, such as $0.001, so that the company may initially issue 10,000,000 shares for $1000.
• If the Series FF is issued immediately prior to the Series A financing, then the price per share of the Series FF probably should be at least the same as the Series A. In some respects, the Series FF may be more valuable than the Series A in the future if it can convert into a later round of preferred stock with a liquidation preference greater than the Series A. On the other hand, there is significant risk that the holder never receives liquidity because the board might not allow a conversion to occur (or investors may not be willing to purchase).
• Legal fees incurred in issuing Series FF may be higher. This is because the Series FF receives some amount of custom drafting and tweaking compared to a typical incorporation. In addition, many attorneys are not familiar with the concept and there are costs incurred in “reinventing the wheel” and getting everyone comfortable. The additional costs involved in setting up the Series FF may be wasted if the future board does not allow the founders to obtain liquidity.
• It is unclear whether venture funds are willing to allow founders to sell a portion of their stock in connection with a venture financing. Implementing the Series FF before an equity financing sends a message to potential investors that the founders want liquidity in connection with an equity financing. This may not be a good thing to mention when looking for early rounds of financing. However, venture funds may be willing to allow founders to sell in the following situations:
  • The venture fund has to agree to it because there are multiple terms sheets in a competitive deal.
  • The company is doing well (i.e. valuations above $100M and nearing an IPO) and the founders would rather sell the company that wait longer for liquidity.
• Investors prefer to purchase newly issued shares supported by a legal opinion, representations and warranties and various contractual rights. I’m not sure what benefit the company receives by facilitating the sale by the founders as the company does not receive the funds from the investors.
• Other mechanisms exist to allow founders to receive liquidity in connection with a venture financing. Companies can repurchase founders common stock for cash, subject to various limitations. The main issue that the Series FF solves is the price difference between preferred stock and common stock. If common stock is repurchased by the company at the same price as preferred stock is being sold to investors, then the fair market value of the common stock for option pricing purposes probably should be the preferred stock price. However, in a company nearing an IPO, the common stock FMV will likely be very close to the preferred stock price anyway. Therefore the Series FF stock probably only incrementally solves for a situation where founders want liquidity and want to preserve a significant price difference between the common stock and preferred stock in an early stage venture financing. (I’ll write a future post about option pricing and 409A in the near future.)
• Because the Series FF will likely only be issued to founders due to timing and pricing issues associated with issuing the Series FF, other employees may be upset that founders are receiving some liquidity.
• There is some risk of claims against the founders that sell (and the board) if the company never reaches a liquidity event. The other stockholders (including disgruntled employees) might argue that the company should have issued new shares to the investors and received the funds that the founder received from selling the stock.
• Despite carefully drafted releases, venture funds may reluctant to purchase the shares due to potential claims by disgruntled founders that they were forced to sell their stake at a low price compared to the price in an eventual liquidity event.

I am curious to see whether the Founders Fund has managed to invent something that will be broadly accepted or just a novel feature that is occasionally used by companies that have a connection to the Founders Fund.

I will likely update this post (without warning) with more thoughts as I hear feedback from various people.

I think that founders stock before a venture financing should be subject to the same general vesting terms as one would expect after a venture financing. A typical vesting schedule is four year vesting with a one year cliff. This means that 25% of the shares will vest one year from the vesting commencement date, with 1/48 of the total shares vesting every month thereafter, until the shares are completely vested after four years. The vesting commencement date can be the date of issuance of the shares, or an earlier date, in order to give the founder vesting credit for time spent working on the company prior to incorporation and/or issuance of the shares.

Some founders want to accelerate vesting upon a termination without cause or a constructive termination. (I will get around to defining these terms in future posts.) I’m not sure that this is really in the best interest of the founders. It is extremely difficult to terminate someone for cause, so termination of a founder will generally result in his/her shares being vested. For founders that have never worked with each other, I would generally counsel against acceleration of vesting upon a termination without cause or a constructive termination. If personalities clash or things don’t work out and a founder needs to be forced out, the remaining founder(s) will kick themselves for allowing the departing founder to leave with a significant equity stake.

If there is acceleration upon a termination without cause or constructive termination, I think the amount of acceleration should be similar to the amount of severance that a person may receive in the same situation. If six to 12 months of severance might be justified if a person is terminated without cause, then six to 12 months vesting acceleration seems reasonable. Of course, the typical norm in technology companies is that there is no severance in any situation.

In addition, some founders may want to accelerate vesting upon a change of control. Single trigger change of control vesting means that the shares accelerate upon a change of control. This isn’t in the best interest of investors because the fully vested founders have little incentive to continue to work for an acquiror after a change of control. In order to incentivize these people, additional options may need to be granted, which increases the cost of the acquisition to the acquiror, potentially to the detriment of the investors. Double trigger change of control vesting means that the shares accelerate upon a change of control AND the founder is terminated without cause or a constructive termination occurs within 12 months of the change of control.

The amount of shares that accelerates upon these events can be 100%, or written as a certain number of months of vesting, such as twelve. I’ve had one VC express a strong opinion that the amount of vesting upon one of these events should not be 100%, but rather 12 to 24 months of vesting acceleration, due to the fact that it is extremely difficult to terminate someone without cause. I think that double trigger 100% acceleration for founders or certain executives is fairly accepted among investors. However, extending that protection to rank and file employees is not common.

In any event, VCs are likely to impose their own vesting terms and acceleration upon a Series A financing, so it may not matter what terms are implemented when the initial founders shares are issued. However, reasonable vesting and acceleration terms may survive the Series A financing, especially if it would be difficult to renegotiate with a critical founder in a team with multiple founders.

Generally yes.  Even though the founders stock is issued and outstanding, the company can have the right to repurchase the shares.  The right of the company to repurchase the shares will lapse over time or upon certain events, similar to vesting of options.  There are two primary reasons for subjecting founders stock to vesting even before a venture financing.

1.  If there is more than one founder, then each of the founders should want the company to be able to repurchase the unvested shares if one of the founders leaves.

2. If the terms of founder vesting are reasonable, there is some chance that the terms of the founder vesting may survive the venture financing.