Handbook Clerky

In normal speech, person is generally synonymous with human. In law, however, a human is only one type of person. The law defines other types of legal people (also referred to as legal persons) that humans (also known as natural people or natural persons) can create.

A corporation is one type of legal person that humans can create. By allowing corporations to be considered legal people, the law makes it possible for them to hold legal rights and obligations separate from their owners.

Each state has its own rules about how to form a corporation. In Delaware, people form corporations by filing a document known as a certificate of incorporation1 with the Delaware Secretary of State.2 Once the filing has been accepted by the Delaware Secretary of State, the corporation comes into existence as a legal person.

The certificate of incorporation filed with the Delaware Secretary of State must name a registered agent for the corporation.1

The registered agent of a Delaware corporation must be physically located in Delaware, and is responsible for receiving legal and government communications for the corporation. There are many companies in Delaware that provide registered agent services for a fee. Most startups use one of these registered agent companies.

Although registered agents provide your corporation with an address in Delaware, they typically only allow the address to be used for communications from the Delaware Secretary of State and court-related notices, and return other mail to the sender. Consequently, startups should have a separate business address and use it exclusively whenever asked for an address (unless asked specifically for the registered agent’s address).2

Registered agents typically also serve as a filing agent for their customers. Filing agents make filings with government agencies, such as the Delaware Secretary of State. Registered agents charge a fee for their filing agent services.

Most startup attorneys, as well as Clerky, will automatically select a reliable registered agent for you at a steeply negotiated discount.

When a certificate of incorporation is filed to incorporate a new corporation, the Delaware Secretary of State requires that it be signed by an incorporator.1

With most startups, the incorporator elects the initial board of directors after the certificate of incorporation has been filed. The incorporator can elect him or herself to the initial board of directors. The incorporator typically executes a document called an Action of Incorporator (also called an [Initial] Action by [the] [Sole] Incorporator), in which the incorporator adopts bylaws for the corporation, sets the size of the board of directors, and elects the initial board of directors. The role of the incorporator ends there.

It usually doesn’t matter who the incorporator is, primarily because the corporation has no assets at the time of incorporation. If the incorporator elects an initial board of directorsthat his or her co-founders disagree with, they can simply incorporate a new corporation on their own. For this reason, the incorporator for a startup is typically the founder who is most willing to handle the paperwork. Some law firms have a paralegal or attorney serve as the incorporator.

The board of directors (often referred to as the board) is the governing body of a Delaware corporation. The board of directors has a specific number of seats. There is no minimum number of seats; solo founders are often the only director at company formation. Most startups are set up so that the size of the board can be easily adjusted at any time.1 The number of directors can never exceed the size of the board.

The board makes decisions either in board meetings or in writing (referred to as written consent). By default, the board can make decisions with a majority vote of the directors present in a meeting.2 Or if the board is making a decision by written consent, unanimous consent of all directors is required. In practice, most board decisions for early stage startups are made by written consent, due to simplicity.3

If a decision is made in a meeting, a quorum is also required. Quorum is the minimum number of directors that must be present at the meeting.4 This is usually a majority of the total number of directors. The board cannot make any decisions in a meeting if quorum is not met. Quorum is irrelevant for board decisions made by written consent, since written consents require the unanimous approval of all directors on the board.

As mentioned earlier, the initial board of directors is elected by the incorporator. Once a corporation issues stock, the stockholders control who is on the board of directors. For most startups, the board of directors consists solely of founders until the startup’s Series A financing. Venture capitalists typically join the board of directors in connection with a Series A financing.

The officers of a Delaware corporation are appointed (and removed) by the board of directors. Officers are in charge of managing the company day-to-day.

Most startups start off with at least a CEO and president, a CFO and treasurer, and a secretary. In an early-stage startup, the CEO and president are often the same person in order to avoid any confusion as to leadership, and because the roles are so similar. The CFO and treasurer are usually the same person as well.

There is no limit to the number of offices one person can hold, nor is there any requirement for offices to be held by different people. Solo founders typically hold all the offices in their startup, for example.

Under Delaware law, corporations are not required to define any particular officer titles.1However, most startups will need to register to do business in their home state, which may require the existence of the typical officer positions.

For most early-stage startups, the primary decision is who will be the CEO and President. Other officer titles tend not to have much meaning, since everyone is doing a little bit of everything and roles are constantly changing.

Offices can usually be added through an amendment to the bylaws, or by the board of directors. Typically, an office must be formally created for a corporation before anyone can hold it. For example, if Chief Technology Officer is not an officer position, you can have an employee with Chief Technology Officer as their job title, but they would not be an officer of the corporation.

Ownership of Delaware corporations is represented by shares of stock. Stockholders are the people who own shares, and thus part of the corporation.1 Even though they are the owners of the corporation, stockholders don’t control the corporation directly (although stockholder approval is required for certain decisions). Instead, they control who is on the board of directors, which in turn controls the corporation through the corporation’s officers.

Structure

Startups usually issue either common or preferred stock. Preferred stock has additional rights and privileges that common stock does not have, with respect to liquidation and dividend preferences, at a minimum. Startups typically issue common stock to founders, employees, and consultants, and issue preferred stock only to investors.

Classes

A corporation’s stock can be organized into classes, which must be defined in the certificate of incorporation. Most startups start off with one class of common stock, conveniently called Common Stock. When they raise venture capital, startups typically amend their certificate of incorporation to create a class of preferred stock, conveniently called Preferred Stock.2

Series

The certificate of incorporation can also specify that a class of stock be further divided into different series. It is rare for common stock to be divided into series, but preferred stock is almost always divided into one or more series for each financing. A financing is usually referred to by the series of stock that was created for that financing. For example, if a startup raises money by issuing shares from a new series called Series A Preferred Stock, people would refer to that round of financing as the startup’s Series A financing.

Requirements to Issue

A corporation cannot issue stock unless:

1. the board has approved the issuance and
2. there are enough shares available for issuance.

If the stock is of a particular class, then there must be enough shares of that class available for issuance. Similarly, if the stock is of a particular series, there must be enough shares of that series available for issuance.

The first step in determining how many shares are available for issuance is to determine the number of authorized shares. The number of authorized shares is the number of shares the corporation is authorized to issue. It is impossible to issue shares that have not been authorized. The number of authorized shares is set in the certificate of incorporation. If the stock of the corporation is divided into classes or series, the certificate of incorporation must set the number of authorized shares for each class or series, as well as a total number of authorized shares. Most startups authorize 10 million shares of common stock at formation.

Then, to determine how many shares are available for issuance, take the number of authorized shares and subtract shares that have been issued as well as shares that have been reserved for some other purpose (for example, for issuance under a stock plan). On the off-chance the corporation has repurchased any shares, and those shares have not been retired, those shares would be added back in as shares available for issuance.

If a corporation wants to issue shares, but there are not enough shares available for issuance, it must file an amendment to its certificate of incorporation with the Delaware Secretary of State to increase the number of authorized shares.

Contracts are agreements that create rights and obligations enforceable by law.1

When you think of a contract, you probably think about a document that people sign. Many contracts are formed this way. However, contracts do not need to be in writing. You can create a contract simply by talking with someone else. Most attorneys recommend against creating oral contracts because they are unlikely to protect you as well as a contract written by an attorney would. You also don’t need to sign a contract in order to be bound by it. For example, two parties can create a contract by coming to an agreement over email.

Corporations rely on humans to enter into contracts. Before someone can enter into a contract on behalf of a corporation, he or she must have the authority to do so. In most startups, the board gives the CEO broad authority to enter into contracts, and empowers the CEO to then delegate that authority to others as they see fit.2 This is why contracts often ask for your title when you sign on behalf of a corporation. By specifying your title, you are indicating how you (hopefully) have authority to bind the corporation.

To determine when to form a corporation, founders typically consider the benefits set forth below.

Personal Liability Protection

Forming a corporation helps protect the founders from personal liability. If the corporation is sued, the assets of its founders are more likely to be protected.

Clarity with Co-Founders

When more than one founder is involved in the startup, the corporate formation processhelps clarify and formalize the relationship between the founders. This is particularly true with regard to equity ownership and intellectual property ownership.

Equity Ownership

During the formation process, founders decide how the equity ownership will be split. Additionally, founders often place restrictions on the ownership of their stock, some of which lapse according to a vesting schedule. Vesting incentivizes founders to work together for a certain period of time and also defines what happens to their shares if they leave the company before the end of that period. These early decisions help align interests and minimize ownership disputes.

Intellectual Property

The formation documents should ensure that the company owns the intellectual property (commonly referred to as IP) created by the founders. IP is often at the heart of a startup’s value, so it’s important to make sure that the company can use the IP without any restrictions, even after founders depart.

Enables Investment

When done properly, forming a corporation enables the business to receive investments from third parties. Startup investors generally expect stock, or a security convertible into stock. Forming a corporation creates an entity that is capable of issuing this stock.

Enables Equity Compensation

Corporations can create stock plans and offer equity compensation to employees and consultants. Equity compensation is often key in attracting and hiring top talent, so the ability to issue it is a practical necessity.

Optics

Finally, some founders find that having a legal entity is helpful in projecting an image of company maturity to potential customers, partners, or investors.

For startups, the typical steps for forming a corporation are:

Incorporation

1. File a certificate of incorporation, signed by the incorporator, with the Delaware Secretary of State.

Post-Incorporation Setup1

1. Once the Delaware Secretary of State accepts the certificate of incorporation, the incorporator adopts bylaws for the company, sets the size of the board of directors, and elects the initial board of directors.
2. The board of directors appoints officers and authorizes the issuance of shares to the founders.
3. The founders purchase their shares from the company and become stockholders. If their stock is subject to vesting, the founders usually make 83(b) elections.
4. The founders enter into confidentiality and IP agreements with the corporation, known as CIIA or PIIA agreements.

Stock Plan Setup

1. The board adopts and the stockholders approve a stock plan.

Foreign Qualification

1. The corporation qualifies to do business in its home state (assuming it’s not located in Delaware).

Getting Help

It is important to make sure the company formation paperwork is done correctly. Unfortunately, it is practically impossible for most people to correctly complete the documents on their own, unassisted. This is true even when using forms or document generators provided by law firms for marketing purposes. Consequently, most startups use an attorney, software (such as Clerky), or both. Software helps take care of the clerical aspects of the paperwork, while attorneys are useful for legal advice.

Regardless of whether you are evaluating an attorney, software, or both, the most important criteria to consider are completeness and legal quality.

Completeness is relatively easy to evaluate. All experienced startup attorneys will be very familiar with the full set of steps above. With software, it is important to make sure the software will fully handle at least the full set of incorporation and post-incorporation setup steps. This is important because when software leaves the process hanging in the middle, it makes it more complicated to complete the company formation. The legal expense of doing so is almost always significantly greater than had the startup completed all of the first five steps together in the first place.

It’s hard for non-lawyers to discern the quality of legal paperwork. Absent obvious mistakes, issues with legal quality often escape detection until a VC or acquirer performs legal due diligence. Most startups never make it that far, unfortunately, so they never find out whether their formation was done properly. Even when startups make it to a legal due diligence process, they usually don’t publicize any issues that are discovered. All this makes it difficult to tell which lawyers and software produce high quality legal documents, and which are not. If you have access to fellow founders who have raised or been acquired for a significant amount, one imperfect approach is to ask around and see what lawyers or software they used without issue.

When forming a corporation, founders must decide how the equity should be allocated. In order to do this, founders typically consider:

• the relative percentages of the company each founder should own,
• a rough sense of what percentage of the company will be owned by employees and consultants, and
• whether they want to informally set aside shares for the possibility of entering an accelerator program (e.g. Y Combinator) or adding additional co-founders.

Using the standard 10,000,000 authorized shares, an example of a typical allocation would be:

• 8,000,000 shares divided among the founders
• 1,000,000 shares to be reserved for issuance under a stock plan for employees and consultants1
• 1,000,000 shares informally set aside for accelerators or additional co-founders

The corporation can always amend its certificate of incorporation to authorize more shares. This requires additional time and legal expense, so founders typically try to allocate shares at formation in a way that minimizes the chance a subsequent amendment will be required.

When startups issue stock to founders, they usually subject some or all of the shares to vesting. This means that even though the founders own their shares, the corporation can repurchase some shares if the founder ever stops providing services to the corporation.1The number of shares the corporation can repurchase is limited to the number of shares that have not yet vested.

When common stock is subject to vesting, it is referred to as restricted stock by startup attorneys. Restricted stock typically vests over time on a schedule known as a vesting schedule. The date when vesting begins is known as the vesting commencement date.

The most popular vesting schedule, by far, is frequently referred to as 4-year vesting with a 1-year cliff. Under this vesting schedule, 1/4th of the shares subject to vesting will vest on the 1-year anniversary of the vesting commencement date (this is the 1-year cliff). After that, 1/48th of the total shares originally subject to vesting will vest every month.2 By the end of 4 years, all of the stock will have vested.

The second most popular vesting schedule is 4-year straight line vesting, which means that 1/48th of the total shares originally subject to vesting will vest every month. 4-year straight line vesting is the same thing as having 4-year vesting with a 1-month cliff.

The vesting commencement date is commonly set to the date the shares are issued to the founder. If a founder put substantial work into the startup prior to the stock issuance, it is not uncommon for the startup to give the founder some vesting credit. This refers to setting the vesting commencement date to an earlier date – often the date on which the founder started working on the startup full-time.

Vesting protects founders, investors, and employees. Consider two co-founders that have just begun work on a startup, and have decided to split the equity evenly. If one co-founder leaves after just a week and his or her stock is not subject to vesting, the remaining co-founder and other employees could go on working for years and still have the same level of ownership as the departed co-founder. By subjecting stock to vesting, startups avoid this kind of scenario.

When shares are subject to vesting, by default, the IRS treats it as a taxable event every time a portion of the shares vest. This means that whenever you have shares of stock vesting, the IRS considers as taxable income the difference between (1) the fair market value (FMV) of those shares at that time and (2) the price you paid for those shares.

For founders of successful startups, this can lead to a significant increase in taxes as the FMV of their stock increases. The taxable income is tied up in the form of illiquid stock, which makes it difficult for founders to be able to afford the tax increase. In addition, the process is likely to be a significant burden due to the number of times the FMV would need to be determined. For example, for 4-year straight-line vesting, the FMV would need to be determined 48 times.

Fortunately, the IRS allows recipients of restricted stock to elect alternative tax treatment through an 83(b) election. If you make an 83(b) election, you can disregard the vesting for tax purposes and consider the purchase of the stock to be the only taxable event. You would then recognize the difference between (1) the FMV of all the shares at the time you purchased the stock and (2) the price you paid for those shares as income for the current tax year. Founders typically purchase their shares at FMV, so if they make an 83(b) election, they typically do not have any taxable income from the purchase of the shares.

In order to make a valid 83(b) election, you must manually sign the 83(b) election (the IRS does not accept electronic signatures for 83(b) elections) and mail it to the appropriate IRS office within 30 days of the stock issuance. It is critically important to make the 83(b) election on time, as there is no easy way to fix a missed deadline for 83(b) elections.1

IRS regulations also require you to provide a copy of your 83(b) election to the company. As a founder, providing a copy to the company can be as simple as emailing a copy to your co-founders (if any). It is considered a best practice to store copies of all 83(b) elections in the company’s records.

In addition to making a valid 83(b) election, it is important to get evidence that you’ve done so. VCs and potential acquirers will look for this evidence as part of the legal due diligenceprocess, because missed 83(b) elections can cause startups a lot of problems down the line.

In order to get all possible evidence, most attorneys recommend mailing the 83(b) election to the IRS via USPS certified mail with return receipt requested. You should then retain the certified mail receipt as well as the return receipt when it comes back to you. In addition, most attorneys recommend including a request for the IRS to acknowledge receipt of your 83(b) election. In order to do this, you should include a brief letter to the IRS, along with a copy of your 83(b) election and a self-addressed, stamped envelope. The IRS will then typically stamp the copy and send it back to you. Unfortunately, the IRS occasionally neglects to do this (or it gets lost in the mail), which is why it is important to retain the certified mail receipt and return receipt.

Founders of a new corporation may contribute cash to the corporation, to help the corporation start operating.

Some founders are tempted to simply increase the purchase price of their common stock, to get the desired amount of capital into the corporation when they pay for their shares. Most startup lawyers recommend against this approach because it can affect the FMV of the common stock. The value of equity compensation for employees and consultants is tied to the difference between the common stock FMV at the time of issuance, and the price at which the equity is eventually sold. Therefore, startups typically try to avoid prematurely causing an increase in the common stock FMV, to maximize the value of the equity compensation.

Instead, founders typically contribute cash to the corporation in the form of a simple loan. With a simple loan, the company would be obligated to repay the founder at a later time, along with nominal interest.

Alternatively, some founders structure the contribution as a seed investment in the form of a convertible note or safe. Founders should consider the impact a seed investment will have on control and relative economic outcomes, and any resulting side-effects on working relationships. Some future investors may seek to undo founder seed investments, if they feel the economics are too founder-friendly.

To issue equity to employees and consultants, most startups set up a stock plan. A stock plan is a company program used to issue stock options or restricted stock to employees and consultants. Stock plans must be set forth in a legal document that is adopted by the board and approved by the stockholders.1 Startups typically set up stock plans as part of the corporate formation process, even if they don’t have any immediate plans to hire people, because it is easier and cheaper to do all the paperwork at once rather than over time.

There are three primary benefits to using stock plans:

1. When a startup sets up and uses a stock plan properly, the startup and its employees and consultants can benefit from advantageous tax regulations.
2. Corporations must comply with securities regulations under federal and state laws whenever they issue any securities, such as stock or stock options. By default, a corporation will have to analyze securities regulations and potentially make filings each time it issues securities. With a stock plan though, corporations only need to make the analysis and any necessary filings once per relevant state, with respect to issuing stock or stock options to employees or consultants.
3. By using standardized terms for all equity compensation, startups can reduce the amount of time and money they spend on legal due diligence in future financings and acquisitions.

The name of a stock plan usually includes the year in which the stock plan was adopted. For example, if your startup adopted a stock plan in 2016, it would typically be named something like 2016 Stock Plan. This is done to distinguish stock plans from each other, since a corporation may adopt additional stock plans in the future (though, this is infrequent).2

When a corporation adopts a stock plan, it must specify the maximum number of shares that can be issued under that plan. The corporation can change this number later by amending the stock plan with approval of the board and stockholders. The corporation must reserve that maximum number of shares for issuance under the plan, and must have enough shares available for issuance in order to do so. The reserved shares are often collectively referred to as an option pool or stock option pool.

When fundraising, the main topic of negotiation is often the pre-money valuation used to calculate the price of stock issued to investors. Pre-money valuation refers to the valuation of the startup prior to the fundraising. The pre-money valuation matters because it determines the percentage of the corporation an investor will receive in exchange for their investment.

Startup investors typically calculate their percentage ownership based on the fully-diluted capitalization of the corporation. Capitalization, in this context, refers to the capital structure of a corporation – i.e. the structure of the equity and debt of a corporation. The term diluted refers to the fact that the ownership percentage represented by each share of stock is diluted each time new shares are issued. The term fully-diluted means that the capitalization is calculated assuming that all plans and obligations (whether outstanding or potential) to issue shares have been fulfilled.

Thus, a startup’s fully-diluted capitalization commonly assumes:

• all preferred stock has been converted to common stock;
• outstanding options, warrants, and other securities with a right to acquire shares have been exercised; and
• any shares reserved for issuance under a stock plan have been issued.

There is no single definition of fully-diluted capitalization. For example, un-issued shares reserved for issuance under a stock plan can be excluded from a fully-diluted capitalization. This is commonly done when the fully-diluted capitalization is being calculated in connection with the acquisition of a startup, since startups typically do not issue equity following an acquisition. By contrast, these shares are almost always included in a fully-diluted capitalization in the context of equity compensation. Another possible difference is with securities that convert into stock in connection with a preferred stock financing, such as convertible notes and safes. Some definitions of fully-diluted capitalization assume the conversion of these securities, while others do not.

The securities of a startup can almost always be ultimately converted into common stock, so it is common to see the fully-diluted capitalization expressed as a single number of shares.

One traditional way for startups to raise seed financing is to sell convertible notes (also referred to as convertible promissory notes). These seed financings are known as convertible note financings.

Notes (also referred to as promissory notes) are promises made by someone to pay a specified amount to the holder of the note (also known as the noteholder) at some time in the future, known as the maturity date. Convertible notes are notes issued by a corporation that convert into shares of the corporation’s stock upon certain events. When startups sell convertible notes, the notes typically obligate the company to repay the purchase price plus interest in the event that the note has not converted by its maturity date.1

Although they are notes, both the startup and the investor (i.e. the noteholder) usually intend for the note to convert into stock, rather than for the corporation to repay the note. Typically, convertible notes convert into shares of the series of preferred stock issued in the corporation’s next equity financing, as part of that equity financing. Convertible notes often also convert into shares of the corporation’s stock if the company is acquired or does an IPO. Most convertible notes have features known as valuation caps or discounts which affect the number of shares the note will convert into. Valuation caps and discounts are explained in our article about safes.

Despite their popularity, many people consider convertible notes awkward to use. Even though investors and startups do not typically think of convertible notes as an obligation of payment, they must agree on an interest rate2 in order to issue a convertible note. If a note has not converted by its maturity date, the investor and company must spend time and energy deciding what to do (usually, they extend the maturity date).

These problems exist because convertible notes were not originally designed for seed financings. They were originally designed for bridge loans – loans made by VCs to companies they invested in, to help those companies survive until their next round of venture capital financing. Startups began using convertible notes for seed financings because the paperwork and negotiation was considerably simpler than for an equity financing.

Recently, various organizations have created alternative forms of investment designed for seed financings from the ground up, in order to address the problems with convertible notes. In Silicon Valley and other major startup ecosystems, these alternatives are gaining popularity over convertible notes.

The most popular replacement for convertible notes are safes (short for simple agreement for future equity), created by Y Combinator. Like convertible notes, safes can convert into preferred stock.

Types

There are three major types of safes – safes with a valuation cap, safes with a discount, and safes with both. These correspond to the three major flavors of convertible notes.

Valuation Cap

When a safe converts into preferred stock, the conversion price is used to determine how many shares the safe converts into. The conversion price is typically calculated in the same way the price per share of the preferred stock is, by default. That is, by dividing the pre-money valuation by the fully-diluted capitalization.

Valuation caps are a limit on the pre-money valuation used to determine the conversion price. By limiting the pre-money valuation, valuation caps ensure that safes will convert into a minimum percentage of the company, as calculated prior to the preferred stock financing. There is no floor on the percentage of the company that the safeholder ultimately ends up with however, since that depends on the amount invested by others in the preferred stock financing.

Valuation caps are also referred to as conversion caps or target valuations.

Discount

The conversion price can also be set to have a fixed discount from the price per share of the preferred stock. This ensures that the safeholders will get a better deal than subsequent preferred stock purchasers.

Valuation Cap & Discount

Some safes have both a valuation cap and a discount. When safes with both a valuation cap and discount convert, the more investor-favorable method is used – i.e. the method that results in the safe converting into more shares.

Acquisition

By default, if a safe has not already converted by the time the company is acquired, the investor has the choice of (1) receiving their investment back1 or (2) having the safe convert into common stock using the same valuation cap or discount as for a preferred stock conversion.

When investors have significant negotiating power, they may negotiate to have the safe specify an option to receive a multiple of their investment back (typically 2x). This has the effect of increasing the minimum acquisition price at which founders and employees will receive proceeds from an acquisition.

Others

Other notable convertible equity forms include the KISS (created by 500 Startups).

While most startups issue convertible notes or safes in seed financings, some issue preferred stock (which is standard for post-seed financings). Financings where the startup sells preferred stock are known as equity financings, since preferred stock is a form of equity.

Typically, startups create a new series of preferred stock for each equity financing. Startups issuing preferred stock in a seed financings will usually call the new series Series Seed or Series AA. These financings often use forms based on those used in post-seed financings, but that are specifically adapted for seed financings.

By convention, for post-seed investments, the series are designated by letters in alphabetical order. For example, the series created for the first post-seed financing is typically called Series A Preferred Stock. The series created for the next financing is usually called Series B Preferred Stock, and so on.

The people you hire to work at your startup will either be employees or independent contractors (commonly referred to as consultants by startups).

When startups hire employees, they typically have the employees sign offer letters. When startups hire consultants, they usually enter into consulting agreements (or independent contractor agreements) with the consultants.

For both employees and consultants, startups should also enter into agreements to make sure (1) the worker is bound to confidentiality and (2) the company owns the IP the worker creates. These agreements are typically called Confidential Information and Invention Assignment Agreements (CIIA Agreements) or Proprietary Information and Invention Assignment Agreements (PIIA Agreements).

Classification

At the federal level, the U.S. Department of Labor (DOL) and IRS have separate criteria for determining whether someone is an employee or consultant.

Under the DOL guidelines, whether someone is an employee or consultant depends on how economically dependent that person is on your startup:

If the worker is economically dependent on the employer, then the worker is an employee. If the worker is in business for him or herself (i.e., economically independent from the employer), then the worker is an independent contractor.

See Wage and Hour Division, U.S. Department of Labor, Administrator’s Interpretation No. 2015-1, https://www.templateroller.com/template/1929134/administrator-s-interpretation-no-2015-1-the-application-the-fair-labor-standards-act-s-suffer-or-permit-standard-in-the-identification-employees-who-are-misclassified-as-independent-contractors.html.

The IRS looks at the degree of control and independence:

Facts that provide evidence of the degree of control and independence fall into three categories:

1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

See Internal Revenue Service, Independent Contractor (Self-Employed) or Employee?, https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee.

Various states also have their own criteria as well. You should check the state where your startup is located, as well as any states where you hire people, to see what their criteria are.

Note that in most cases, the classification does not depend on the term or documents used by the startup. A government agency may classify someone as an employee even if you refer to them as a consultant and have them enter into a consulting agreement. The penalties for misclassification can be serious.

Minimum Wage

Federal law typically requires that employees be paid at least the federal minimum wage, and some states (including California) and municipalities have implemented their own higher minimum wage standards. The minimum wage is a cash standard, so companies can’t use stock or options to satisfy this requirement. This means that startups cannot legally pay employees in equity compensation alone, even though many startups still do this.

Federal law has an exception for employees that own 20% or more of a business, which can apply to many founders if certain conditions are met. However, not all states with minimum wage laws have a corresponding exception. For example, California’s minimum wage laws do not have such an exception. This means that California’s minimum wage applies to founders in California, even when the federal minimum wage does not.

Prior Agreements

Some people may have entered into contracts that restrict their ability to work as employees or consultants. For example, a person who is a full-time employee at one company may be contractually prohibited from working for another company at the same time.

Advisors

Advisors are a type of a consultant. Startups typically enter into an advisor agreement with them, which roughly covers the same topics as a consulting agreement and CIIA agreement would.

Interns

Paid interns are a type of employee. To hire a paid intern, a startup should use an offer letter and CIIA agreement, just as they would with any other employee.

It is almost always impractical for startups to legally have unpaid interns. Under the Fair Labor Standards Act, as interpreted by courts, unpaid interns are only permitted when the employer “derives no immediate advantage from the activities of the intern… and on occasion its operations may actually be impeded” (in addition to other requirements).1

In addition to salaries, a significant component of compensation in startups is in the form of equity issued under a stock plan.

Types

There are two primary forms of equity compensation: restricted stock and stock options.

Restricted Stock

Restricted stock, as the term is used by startups, is common stock that is subject to vesting. As with founders, employees who receive restricted stock will typically want to file an 83(b) election.

Startups can either sell shares of restricted stock or give them to people for free. If a startup sells shares below their FMV, the recipient must include the difference between the purchase price and the FMV as taxable income. If they give the shares for free, the recipient must count the FMV of the shares as taxable income.

Terminology

Some people use the term RSU, short for restricted stock unit, synonymously with restricted stock. However, RSUs are not restricted stock; instead, they are promises to issue restricted stock at a later time. RSUs are not commonly used by early-stage startups.

Stock Options

Stock options (also referred to simply as options) are a type of security that allows people to purchase common stock at a fixed price (known as the exercise price or strike price) in the future. People that own stock options are known as optionees.

Purchasing shares through a stock option is known as exercising a stock option. Until they exercise the stock option, the optionee does not own the shares underlying the stock option. Thus, someone who only owns a stock option and no shares is not a stockholder.

Stock options are typically subject to vesting, similar to restricted stock. Standard stock options can only be exercised to the extent the underlying shares have vested. For example, if a standard stock option is only halfway vested, the optionee can only exercise the stock option for half the shares covered by the stock option.

A special type of stock option, known as an early-exercisable stock option, allows the optionee to exercise before the underlying shares have completely vested. When an early-exercisable option is exercised early, the unvested shares sold to the optionee are subject to a right of repurchase until they have vested. You can read more about early-exercisable stock options in this blog post by Yokum Taku.

With stock options, recipients must pay for the shares but do not need to do so until they decide to exercise the stock option. To comply with a set of tax requirements known as 409A, the exercise price of a stock option must be at least the FMV of the shares at the time the stock option is granted.

How to Choose

Often, startups start off issuing restricted stock to avoid dealing with 409A, and then switch to issuing stock options as the FMV increases. This is because the FMV of a startup’s common stock usually starts low and grows over time. As the FMV increases, restricted stock becomes less affordable for employees and consultants. Even if startups give the shares for free, the tax burden can often be too large for people to bear.

Percentages & Shares

When offering equity compensation, startups commonly describe the offer as a percentage. For example, a startup might offer a prospective employee “0.25% of the company”. Most attorneys recommend against this common practice (even if the offer is verbal). This is because stating equity compensation as a percentage can lead to confusion and conflict in the future, for a few reasons:

• there are multiple ways to count the total number of shares in a corporation, and consequently multiple ways to calculate a specific number of shares based on a given percentage;
• even when everyone agrees on one method of calculation, the resulting number can change in the time between when an offer is made and when the equity is actually granted; and
• some people may not realize that their percentage ownership can be reduced by future dilution.

By convention, percentages typically refer to the percentage of the startup’s fully-diluted capitalization, measured as of a particular date.

Example

A startup has a fully-diluted capitalization of 10,000,000 shares on a given date. If the startup offers an employee 25,000 shares on that date, the shares would commonly be said to represent 0.25% of the company’s fully-diluted capitalization as of that date.

When making an offer to a prospective employee, startups can help illustrate the value of the number of shares being offered, by providing the information necessary to calculate a percentage at a given point in time.

Example

You want to offer a prospective employee “0.25% of the company”. The fully-diluted capitalization of your company at this time is 10,000,000 shares. Therefore, the offer should be for 25,000 shares.

You would tell the prospective employee that the equity compensation component of the offer is for 25,000 shares. Then, to help the prospective employee understand the value of that number, you can tell the prospective employee that the current fully-diluted capitalization of the company is 10,000,000 shares, so the 25,000 shares would represent 0.25% of the current fully-diluted capitalization (as of that conversation).

Employees & Consultants

Section 409A of the Internal Revenue Code (referred to as 409A) imposes stiff penalties for issuing stock options with an exercise price below the FMV of the shares at the time the option is granted.

The safest way for startups to comply with 409A is to obtain a 409A valuation from a qualified independent appraiser when they are ready to issue stock options. A 409A valuation attempts to determine the FMV of the startup’s common stock as of a specific date, known as the valuation date. IRS regulations provide a safe harbor for 409A valuations obtained from qualified independent appraisers – the burden of proof is on the IRS to show that they are grossly unreasonable. Without a 409A valuation, it would be up to the company to prove that the exercise price of a stock option was not grossly unreasonable.

409A valuations from independent appraisers are valid until the earlier of (1) the 1-year anniversary of the valuation date, or (2) the occurrence of an event that would materially change the value of the corporation. After a 409A valuation becomes invalid, the startup will need to obtain a new 409A valuation in order to continue issuing stock options under the 409A safe harbor.

As startups get more mature, they typically have accounting firms perform financial audits. Audit firms often require companies to get prior 409A valuations redone by new appraisers if they have doubts about the quality of the initial valuations. Thus, when selecting an independent appraiser for a 409A valuation, you should try to get a sense for how their valuations have held up under scrutiny by audit firms.

Vesting acceleration provisions enable vesting to be fast-forwarded when certain conditions are met. There are two broad categories of vesting acceleration: double-trigger and single-trigger. The number of triggers refers to the number of events that have to occur in order for the acceleration to kick in.

If someone has double-trigger vesting acceleration (commonly referred to as double-trigger acceleration) on their stock or stock options, that typically means the vesting will accelerate if (1) the company is acquired and (2) that person is terminated in connection with or following the acquisition1. This is the most common type of double-trigger acceleration, although there are many other possibilities. For example, some double-trigger acceleration provisions only allow for the acceleration of vesting for a certain percentage of the shares. Or, more rarely, the triggers themselves may be different.

The most common form of single-trigger vesting acceleration (commonly referred to as single-trigger acceleration) is for vesting to accelerate if the company is acquired. A far less common form of single-trigger acceleration is for the vesting to accelerate if the stockholder is terminated.

Double-trigger acceleration is standard for stock issued to founders, and is occasionally used for executive-level hires. It is not typically given to other employees or consultants, because it is viewed as undesirable by acquirers and consequently VCs. Naturally, single-trigger acceleration is viewed as even more undesirable. Single-trigger acceleration is usually only given to advisors, if at all.