9 Questions When Dividing Founder Equity

By Charles Weinstein, EisnerAmper LLP

A trio of 20-somethings has a great new product idea tied to the gig economy. Each brings something unique to the table, and all are committed to getting this disruptive innovation to market. While they have to address a myriad of issues, one issue they overlook at their peril is dividing ownership in this embryonic company. Splitting start-up equity among founders can be an emotionally charged experience. However, there are some tips for refining the process:

  1. Are All Founders Created Equal? Topping the to-do list is deciding if the founders will split equity evenly or unevenly. While expedient, this approach may not reflect the relative contributions of the founders. Will an equal ownership split impede future decision-making because founders have the same voting rights? There’s no one-size-fits-all answer. Take the time to fully examine the many facets of equity.
  2. What factors would favor an uneven split? This is the age-old question of ideation versus execution. Are you betting on the jockey or the horse? The answer is really both. Look holistically at who is investing capital, bringing in key contacts, providing elbow grease and leveraging experience. Decide if more risk and sweat deserve extra equity.
  3. When do we tackle this issue? There’s no exact time; it can take years for an idea to turn into a business. However, the equity distribution decision should be made early in the process, prior to external capital investment. As you reconcile this, take some time to get a lay of the land now and what it may be in several years. Have a discussion that is open, thorough and practical.
  4. How can we determine the best unequal split? There are some guidelines you can use. It can be milestones based on owners’ expected roles and performance, or you can assign a weighted average to some of the aforementioned parameters to arrive at an “equity score.” There are several online equity calculators you may want to try.
  5. How about a vesting schedule? To really gauge the founders’ commitment, equity might vest over several years. VCs generally like to see a one-year cliff; if an owner leaves within a year of formation he/she walks away from all or most of his/her equity.
  6. Are there equity levels? First, determine and allocate shares for founders and then establish an option pool for key current and future employees. Explore phantom stock as an alternative incentive.
  7. Are there tax implications? Shares are often used to lure staff and talent. According to Internal Revenue Code Section 83B, company founders can elect to pay tax on unvested restricted shares when they are issued, at a presumably lower value than paying tax on them when they vest. The caveat is they may not have cash for the tax liability. Conversely, they can pay taxes on income as shares vest, which could be at a higher value. It can make a significant financial difference for owners, and they have a short window in which to make the 83B election.
  8. What about company valuation? VCs and founders often have a different opinion on valuation. At the company’s inception, founders need to look at valuation and equity, from a number of perspectives, both now and into the future, perhaps, five years out. Shareholder agreements should include guidance in the event of an exit. Will there be a put option or call option for founders who leave? Remember, buybacks can be expensive.
  9. Are there other VC considerations with respect to owner equity? Because shares will get diluted when angels and VCs enter the picture, it again necessitates that owners look at both the journey and the destination. Investors want a return commensurate with their risk level. Thus, founders need to have a vision and a long-term commercial strategy. VCs may recognize company limitations (technology, sales, and marketing) unseen by owners. In this case, founders need to be knowledgeable about the business’ prospective cash needs and the impact future dilution may have on ownership amounts.

The conversation regrading founder’s equity is often overlooked or deferred while the focus is on making dozens of other, sometimes more exciting, start-up decisions. Dividing founder’s equity sets an important tone. Talk it through. Make every effort to avoid the “let’s just shake on a number and move on” approach. In addition to the economic ramifications, don’t discount the emotional ones, particularly if the new company involves friends or family members.

Charles Weinstein is the CEO of EisnerAmper LLP.  With more than 35 years of public accounting experience, Charly is an author and frequent speaker on the topics of governance, mergers and acquisitions, and public and private financing. Contact him at charles.weinstein@eisneramper.com.

This article originally appeared in VC-List.com.

Start-Ups and Small Businesses Shouldn’t Overlook These R&D Tax Credits

 Written By Emmalee MacDonald, EisnerAmper

The 2015 Protecting Americans from Tax Hikes (“PATH”) Act included various changes to the Research and Development credit (“R&D credit”) that are mostly beneficial for start-ups and small businesses.

Payroll

PATH enables a qualified small business to elect to claim a certain amount of its R&D credit as a payroll tax credit against its employer portion of FICA liability, rather than against its income tax liability.

A qualified small business for this purpose is defined as a corporation, partnership, LLC or individual that, with respect to any taxable year:

  • Has gross receipts of less than $5M.
  • Did not have gross receipts for any taxable year preceding the 5-tax-year period ending with the tax year.

In other words, in order for a company to qualify to utilize the payroll tax offset in 2017, the company must not have more than $5M of gross receipts in 2016.  It must also not have had any gross receipts in tax years prior to 2012. The definition of gross receipts is not clearly defined within the section, but many interpretations point to the following guidance: Gross receipts include all sales (net of returns and allowances), service income, interest, dividends, rents and royalties, and any income from incidental or outside sources.

The amount of the credit is limited to the lesser of $250,000 per year or the amount of the R&D credit computed on the taxpayer’s income tax return.  Any credit that exceeds the amount of the taxpayers FICA tax liability in a given quarter may be carried forward to future quarters.

Process for Claiming the Payroll Tax Offset

  • Compute the R&D credit on the 2016 or subsequent income tax return on Form 6765.
  • Complete Form 8974, which is a new form, to report the credits elected to offset FICA tax.
  • File payroll Form 941 with Form 8974 attached for each quarter that there is an offset.

A taxpayer may only claim the election for 5 years for a maximum credit of $1.25 million. Any election to apply the R&D credit to offset payroll tax cannot be revoked without the consent of the IRS.

These changes afford small businesses and start-ups an excellent opportunity to realize the tax benefit of their R&D credits, whereas in the past they may have had to wait years to reach profitability or even been precluded from using their credits due to various limitations.

During the current tax filing season, consideration should be given to the preparation of elections, calculation of the R&D credit and timely filing of the returns in order to enable taxpayers to obtain the largest possible benefit from the new PATH Act rules.

AMT

In the past, the R&D credit could not be used to offset Alternative Minimum Tax (“AMT”), with limited exception. The PATH Act provides the ability for certain taxpayers to utilize the credits to offset both regular or AMT for tax credits generated during tax years beginning on or after January 1, 2016. Credits generated in prior years typically will not be eligible to offset AMT, but can continue to be carried forward to offset future regular tax in accordance with previous tax law.

The AMT offset is available only to eligible small businesses. Eligible small businesses are those that are a:

  • Corporation, the stock of which is not publicly traded
  • Partnership
  • Sole proprietorship

In addition, the average annual gross receipts of such corporation, partnership or sole proprietorship for the 3-taxable-year period preceding the taxable year must not exceed $50 million. For example, if the business wishes to utilize the credit to offset AMT in 2016, its average annual gross receipts for tax years 2013, 2014 and 2015 must not exceed $50 million. Any partner or S corporation shareholder claiming a pass-through credit must also meet the gross receipts test for its pass-through credit to be eligible to offset AMT.

Emmalee MacDonald is a senior tax manager at EisnerAmper. She focuses on the technology and life science sectors. Contact her at 732-243-7466 or emmalee.macdonald@eisneramper.com.