Many founders mistakenly think their work is done once they have legally formed their business entity. They frequently end up regretting this mistake later when problems arise. These documents go into the legal foundation of your startup to make it even stronger so that when problems arise, your startup will stand firm and your founders protected.
In this guide, we’ll discuss the next documents needed after your business is formed. These documents include mostly agreements that are signed by the founders to protect the startup and to protect founders. They include:
- Equity purchase agreement
- Intellectual property assignment
- Indemnification agreement
- 83(b) election
Let’s take a look at each one individually.
1. Restricted Stock Purchase Agreement
A restricted stock purchase agreement (RSPA) has a founder contribute assets in exchange for restricted stock on a vesting schedule. This is the best way to distribute stock in an early company.
A restricted stock purchase agreement allows founders to mitigate the risk of a founder dropping out of the business. Restricted stock is actually just common stock that is placed on a vesting schedule. A vesting schedule delays the ownership of stock based on certain benchmarks. Usually all stock will vest after 4 years, starting with a one year cliff. This means that no stock vests until after one year.
RSPAs are essential for the stability of a startup. Investors and founders both prefer vesting schedules to make sure that no founder walks away from the company with a portion of ownership, never to do any work again.
In some situations, a company may choose to accelerate the vesting schedule of an employee. This is used as an incentive or an award for a high-performing employee. This allows the employee to receive the monetary benefit from the stock option much sooner, thereby creating a higher present value, and allows the company to expense the costs associated with the stock options sooner.
Let’s consider two examples
Ryan and Yuri make a company called Lightio. Shortly after forming the company as a C corporation to attract investors, they have their attorney draft and then they sign a restricted stock purchase agreement. This RSPA puts both Ryan and Yuri on a four-year vesting schedule with a 1-year cliff. Eight months later, Ryan totally bails because he’s sick of eating dry Top Ramen everyday for lunch. Ryan exits with no ownership in the company because he left before the first shares vested after the one-year cliff. Yuri is now the sole owner of the company, and he is able to raise seed funding even though Ryan bailed. After one-year, his stock begins to vest. Then after four years, all of his stock is vested.
Let’s see how this would go differently if they didn’t sign an RSPA.
After forming Lightio, Ryan and Yuri don’t sign an RSPA. Instead they split their shares 40/60 respectively. When eight months comes around, Ryan decides he’s leaving and taking his 40 percent of the company. This cripples the company. Yuri could continue working on the company, but whatever he does, 40 percent of the earnings will go to Ryan who isn’t even doing any work. Yuri isn’t able to raise any seed money because having a rogue 40 percent owner is a huge risk that no investor will take on. Lightio is forced to fold.
2) IP Assignment Agreement
Often times with technology startups, the value of the company is in its creations, or intellectual property (IP). It’s essential for the company to own the IP created by its founders or employees and for its members to not disclose the creations to other parties. This is usually accomplished with two legal documents:
- Confidentiality agreement
- IP assignment agreement
Each of these documents go by different names and have slightly different versions. A confidentiality agreement could be called a non-disclosure agreement (NDA), and an IP assignment agreement could be called a confidentiality and inventions assignment agreement (CIIAA) or a proprietary information and inventions assignment agreement (PIAA).
The confidentiality agreement requires the founders to not reveal proprietary information of the company for any reasons. This is especially important for keeping founders or employees from revealing information to competitors for any reason.
The IP assignment makes employees and founders assign all relevant intellectual property to the company.
Let’s consider another hypothetical with Ryan and Yuri and Lightio.
Eight months after signing the RSPA, Ryan leaves Lightio. When Ryan and Yuri signed the RSPA, they also signed a confidentiality agreement and an IP assignment. Ryan was doing the back-end development of Lightio. When he leaves, he says all of the code he developed belongs to him. Yuri informs Ryan that actually, he assigned the ownership of all of that code to Lightio. And that Ryan can’t tell anyone what they were building because of the confidentiality agreement.
Let’s see how it could go differently for Ryan and Yuri if they don’t sign an NDA and IP assignment.
After signing the RSPA, Ryan begins talking with a better funded competitor of Lightio, Light X. Ryan starts telling Light X how he’s building Lightio. Eventually, when he leaves Lightio, he claims ownership over all of his code and takes it with him to Light X. Ryan is now #SAD.
3) Indemnification Agreement
An indemnification agreement protects founders and directors from actions of the company. Forming as a corporation or an LLC also does this by limiting liability of the owners, but an indemnification agreement goes even farther by requiring the company to cover damages to the owners.
In any indemnification agreement, there are two parties:
- The indemnitee, who is protected from any liability
- The indemnifier, who promises to reimburse the indemnitee
In this case, the indemnitee is the founders and the indemnifier is the company. The indemnification agreement protects founders and directors by requiring the company to pay for any damages attributed to owners.
Here’s a hypothetical with Ryan and Yuri.
Two years after the formation of Lightio, Ryan and Yuri are still working happily together. Early on, they signed an indemnification agreement. Their company produces insanely-bright smart-lights that are unfortunately too bright. An unhappy customer brings a lawsuit against them, claiming Lightio made her go blind. Since Ryan and Yuri had never opened a business bank account and had been treating the company as an extension of their personal lives, the corporate veil is pierced and they are held personally liable for the damages caused to the customer. They owe $500k each to the customer. Luckily, Lightio has $1M in cash and since they signed the indemnification agreement, Lightio needs reimburse Ryan and Yuri for the payment of these damages.
Alternatively, if they hadn’t signed this indemnification agreement, they would need to pay the $1M themselves.
4) 83(b) Election
An 83(b) election is a document filed with the IRS that is designed to save founders a ton of money on taxes. 26 US Code §83(b) allows for shareholders to elect to be taxed on the shares at fair market value at the time of issuance rather than at the time sale.
Normally, with restricted stock, a founder doesn’t need to pay taxes on it until it is determined that she will get to keep it or the property becomes transferable. This occurs once the shares vest or once they are sold. Usually, this is an ok thing, but with startups, it presents a major opportunity. Since the shares aren’t worth anything when they are first issued to founders, founders can elect to be taxed at that value instead of later when the shares are worth substantially more.
So a Section 83(b) election is made by sending a letter to the IRS requesting they tax the founder on the date the restricted stock was granted rather than on the scheduled vesting dates. This letter must be sent within 30 days of issuing the shares.
This is a big win.
Let’s see how it works out in another hypothetical with Yuri.
At the time of formation, Yuri distributes the shares of Lightio between Ryan and himself. Yuri gets 60 percent. Within 30 days of receiving the shares, Yuri files an 83(b) with the IRS. The IRS taxes Yuri on the fair market value of the shares, which is $1. One year later, when the fair market value of the share is $1M, and the shares vest, Yuri isn’t taxed at all. He just saved a ton of money on taxes.
Alternatively, let’s say Ryan didn’t file an 83(b). Instead of being taxed at issuance, Ryan is taxed on the fair market value of the shares at the time of vesting. Their value is $1M, so Ryan ends up paying a lot more on taxes.
Once your business is formed, your journey through legal-paperwork land has just begun. We’ve discussed the next four steps in your journey.
- Make and sign an equity purchase agreement
- Have all founders and employees sign an IP assignment agreement
- Have all founders make and sign an indemnification agreement
- All shareholders should probably make an 83(b)election
What Can Savvi Do For You
Creating these documents can be tricky, and many founders honestly forget about them. It’s not until it is too late that a founder remembers she should have done them. Savvi takes care of this for founders. At Savvi, we combine technology with actual experienced attorneys to provide expert legal services efficiently. Savvi helps founders get legal work done quickly and properly so they can sleep well at night and get on to doing what they do best: building their business.
Savvi includes all of these documents in our Founders’ Packet that is included in our Entity Subscription.
Savvi can actually complete this whole process for you. Get started by making an account.
Startup Legal Documents FAQ
What is the standard vesting schedule for a startup?
The standard vesting schedule for equity in early-stage startups is to have the equity vest monthly over 4-years, with a 1-year cliff.
When does an 83(b) election need to be filed?
The 83(b) election needs to be filed within 30 days from the date the equity is granted. That means if shares are granted on January 1, then the 83(b) must be filed by January 31. Don’t forget about this date and don’t delay.
What if I miss the 83b filing window?
Oops. This makes for a big problem. Generally speaking, you’re in a tight spot. But you may not be fully screwed.
There’s two possible options to remedy the situation if you miss the 83b filing window.
- Accelerate the vesting – The 83(b)’s power comes from allowing stock to vest slowly and by being taxed early on. However, if you just speed up the pace of vesting and it vests while it is still worthless, then you’ll still be taxed only a small amount. This of course destroys the vesting schedule but could be the best option.
- Annul and reissue – Sometimes it is possible to annul the stock that was issued and reissue the stocks. This is only possible if it is done in the same calendar year as when the stocks were issued.
How is equity percentage calculated?
To calculate an equity percentage simply list company’s total outstanding shares as the denominator and an individual’s shares as the numerator.
Should I reserve shares for future investors?
Something rookies do is reserve shares for future investors. This is totally not necessary. However, founders shouldn’t issue all of their authorized shares, in case they need to issue more common stock to future employees. When a new investor comes along, everyone’s share shrinks to make room for the new investor and the whole charter is usually amended.
What is equity dilution?
Equity dilution occurs automatically when more shares are issued, making room for more shareholders. The size of the pie increases so everyone’s piece shrinks.
When should a spouse sign an equity agreement?
In Common property marriage states, a spouse should sign an equity agreement.
Sometimes states consider any property earned while in a marriage to be community property of the spouses. California is one of these states. That means if a person founds a company while married, 50 percent of that person’s shares will belong to her spouse. States do this to recognize the joint role played by spouses in the betterment of the community.
This issue can be resolved many ways, one of those is by having the spouse sign an equity agreement.
What is “fully-diluted ownership percentage”?
Ownership percentages of a company can be calculated based on an “issued and outstanding” basis or a “fully-diluted” basis. Let’s take a look at issued and outstanding first.
What are issued and outstanding shares?
When a corporation issues stock to a person, those shares are categorized as “issued and outstanding.” This is because the shares are both issued in that they have been granted and outstanding in that they have yet to be bought back. When ownership percentage is calculated based only on issued and outstanding shares, the percentage is usually inflated.
Consider this cap table as an example. Based on the total of 5 million shares issued and outstanding, Yuri owns 60 percent of the company and Ryan owns 40 percent.
|Name|| Shares |
Issued and Outstanding
|Percentage Issued |
This ownership will shrink when it includes fully diluted shares.
How does dilution work?
Calculating ownership percentage based on a fully diluted basis includes two other types of shares in the calculation: stock options and the unallocated option pool.
Sometimes corporations will give an employee a stock option: an option to buy stock at some point in the future. Once bought, these shares would then become issued and outstanding. Also, companies often reserve an unallocated stock pool. These are shares the company can issue at some future date; these would also then become issued and outstanding.
Calculating ownership percentage based on a fully diluted basis assumes these two types of shares, options and unallocated, to be issued and outstanding for the sake of the calculation.
Therefore, the cap table would look like this.
Issued and Outstanding
| Percentage |
As you can see, when calculated on a fully diluted basis, ownership percentages can change and usually shrink.
What happens when your stocks vest?
Etymologically, “to vest” means “to clothe” or “put on.” When a founder’s shares vest, the founder is figuratively putting on the shares. Until the shares vest, they do not belong to the founder.
Vesting schedules are used to maintain stable ownership of a company. If a founder leaves before his shares have vested, then he leaves them behind.
What happens to unvested shares when I leave the company?
Unvested shares are returned to the company at no cost. They never left the ownership of the company.
What happens to unvested shares at an M&A event?
If, in a merger or acquisition, the buyer is buying shares, she would buy both vested and unvested shares.