By Cliff Ennico
While technology startups and small businesses have much in common, their legal and tax issues are quite different. Here are several significant questions raised at last week’s program on “Representing the Start-Up Venture,” a panel discussion I hosted for the New York State Bar Association (details at http://www.nysba.org/store/events/registration.aspx?event=0DS64).
S Corporation or Limited Liability Company (LLC)? It used to be that small businesses were always set up as LLCs, while startup ventures were set up as regular or “S” corporations. Panelists agreed that the S corporation is becoming a difficult choice for startup founders, because:
- They cannot issue the preferred stock that “angels”, venture capitalists and other professional investors want; and
- While management teams are increasingly multinational, ownership of S corporations is limited to U.S. citizens and “green card” holders.
Percentages or “Units of Membership Interest”? Panelists agreed that startup founders are increasingly opting for the LLC format, but with “bells and whistles” that make the company look and function like a corporation, such as:
- “Units of membership interest” (shares of stock) in lieu of ownership percentages;
- Multiple classes of voting and nonvoting membership interest;
- One or more classes of preferred equity granting preferential payments to owners upon the liquidation of the company and other “preferred stock” type benefits; and
- A two-tier management structure with a “board of managers” (board of directors) making strategic decisions and “officers” (a president, vice president and so forth) making day to day operational decisions.
Compensating “Sweat Equity” Players. When it is formed, a startup can issue shares to its founders without worrying about tax consequences, because the business has essentially a zero value. Once a “valuation event” occurs, however, the shares have value, such that compensating owners with shares (so-called “sweat equity” shares because the recipient doesn’t pay cash for them) requires them to pay income tax on the fair market value of the shares in the year they are received.
Panelists commented on how easy it is to establish a “value” for a startup without intending to do so. One panelist vividly illustrated this problem as follows: “Let’s say Moe starts a company. He issues founders’ shares to himself, which have no value so there’s no tax problem. Larry wants to work for Moe’s company. They agree that Larry will receive X shares in the company for each Y hours Larry works. Still no value, so no tax problem. But now along comes Curly who wants to work for Moe’s company. They agree that Curly will bill Moe’s company for his services at $100 per hour, payable in shares at the rate of one percent of the company for each 50 hours of work ($5,000). Because Curly’s compensation is based on the monetary value of his services rather than the number of hours worked, Moe has now established a value of $500,000 ($5,000 x 100) for his company. Not only will Curly have to pay tax on those shares, but every other sweat equity owner that Moe deals with thereafter will have to pay tax as well.”
The key to avoiding this trap, panelists agreed, was to put off as long as possible creating a “valuation event” for the startup company and, when a “valuation event” occurs, issue stock options or “clawback shares” (shares that are subject to a repurchase right for two to three years after they are issued) to “sweat equity” owners in order to defer taxes on those shares.
Dealing with Millennial Entrepreneurs. Panelists commented on the challenges of dealing with entrepreneurs in the so-called “millennial” generation (basically anyone under the age of 30), for a number of reasons:
- They reject formal hierarchical management structures, preferring instead to work in free-floating “flat teams” without “bosses” in the traditional sense;
- They insist on their companies having a social mission equal (if not superior) in importance to the goal of realizing a profit for shareholders; and
- They reject the concept (traditional in capitalist economies) of labor having no value, viewing employees and shareholders as having equal claims on a company’s resources.
Lawyers and accountants on the panel commented that it was often difficult to get paid by millennial entrepreneurs, not only because startups are traditionally short on cash but “because the founders wonder why you want to receive payment in cash when all of the other ‘team’ members are willing to work for nothing until the business is successful.”
Valuing the Startup Venture. Panelists agreed that it is difficult if not impossible to value a startup using traditional valuation methods. While a small business can be valued using multiples of pretax earnings (EBIT) or sales, a venture can have a value that is much higher. As one panelist commented: “Just recently Facebook spent $2 billion buying a smartphone app developer with no revenue, much less profit. What multiple of EBIT was Facebook using when it bought that company? I don’t remember learning that kind of math in high school.”
Cliff Ennico (www.succeedinginyourbusiness.com), a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books.