By Cliff Ennico
“I am a software developer. Most of my work is done for established companies on a contract basis, but lately I’ve taken some assignments from startup companies.
These companies usually pay me in cash (sooner or later), but one client has offered me a one percent interest in the company as a ‘thank you’ for the services I’ve rendered to the company to date.
I see no reason why I can’t accept this, but I’m concerned there might be a nasty surprise I’m not anticipating. Should I be worried?”
The short answer is . . . maybe, maybe not.
Owning a piece – even a small one – of a successful technology startup can make you filthy rich. But if the startup goes bust, you may be in the ‘line of fire’ when the lawsuits break out.
Here are some things to think about before you accept an ownership interest in any existing small business or entrepreneurial company.
Talk to Your Tax Advisor. If the company has been around for a while, and especially if it has revenue or profits (thereby enabling it to be valued), the ownership interest will be taxed to you as ‘ordinary income’ this year, and you will have to pay taxes on the fair market value of your shares. That could be a nasty surprise.
If the company is a corporation, you may be able to request a “Section 83 B Election” which will reduce your tax liability. Talk to your accountant about that, or read one of my prior columns on this topic (search online for “Cliff Ennico Section 409A” and you should find several).
Read the Fine Print. There are two sets of documents you need to get and review:
- The “formation documents” of the company — for a corporation, these are the Articles of Incorporation and By-laws; for a limited liability company (LLC), these are the Articles of Organization; and
- The owners’ agreement you will be asked to sign — for a corporation, this is the Stockholders’ Agreement; for a LLC, this is the Operating Agreement.
Here are some things to look for in these documents:
Voting Rights. Do you have the right to vote as an owner, or are your shares in the company “nonvoting,” giving you only the right to receive cash distributions or dividends?
Vesting Period. Do you have to wait to receive your shares? Does the company have the right to buy back your shares at a low price if you quit providing services to the company? Do you forfeit your shares if you are “fired” because the company finds a service provider they like better? Ideally, you should not lose your shares for any reason other than your own bad conduct.
Capital Contributions. Are you required to contribute money when the company says it’s necessary? What happens if you can’t?
Ideally, you should not be obligated to make capital contributions or loans when the company needs cash. If you are obligated, you should have the right to say “no”. If other, wealthier investors can cover your contribution, that’s fine – you still keep your shares, but you will have a slightly lower percentage of the company after the other investors kick in their money (this is called “dilution”).
Anti-Dilution Protection. If a big investor puts millions of dollars into the company, you don’t mind owning a smaller percentage of the shares. If the company raises money at a lower price than you paid for your shares (i.e. the value of your services), that’s a problem – you should have the right to maintain your percentage ownership in that case.
Buyout Rights. Watch out for language giving the company the right to buy back your shares at “book value” if something goes wrong – for example, you die or cease providing services to the company. “Book value” for a startup company is basically nothing. If the company has the right to repurchase your shares, it should be for the “fair market value” of your shares as determined by an independent appraisal, or by a well-recognized formula (for example, “three times the earnings before income taxes of the company averaged over the preceding three years”).
Protect Yourself Against Liability. With a corporation or LLC, the owners have no personal liability for debts or lawsuits, right? Well, yeah, that’s technically correct. But unfortunately, that doesn’t stop people from suing the owners as part of a lawsuit against the company, in the hopes a judge will “pierce the corporate veil” and allow the lawsuit to proceed against the owners individually.
Consider forming a single-person LLC as the vehicle for owning your shares – that way, you will have an additional layer of protection against lawsuits. Of course, you will also have the cost of maintaining that LLC, and if the company is a subchapter S corporation, you will have to own the shares personally (LLCs and other legal entities cannot legally own shares in S corporations).
Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series ‘Money Hunt’. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com. Copyright 2013 Clifford R. Ennico. Distributed By Creators Syndicate, Inc. Follow Cliff: @cliffennico.
