Startup formation and governance
Founders’ initial legal decisions have far‑reaching consequences. Mistakes made during formation are often discovered only later and can be expensive (or impossible) to fix. Common missteps include failing to obtain IP assignments from all founders or neglecting vesting schedules, resulting in the company losing control of its own intellectual property if a co‑founder departs. Without dispute‑resolution clauses in founders’ agreements, conflicts can divert attention from building the business. Clear founders’ agreements, vesting terms and mechanisms for handling disputes mitigate these risks and signal to investors that the company is well‑governed.
An attorney can also help draft core governing documents such as the certificate of incorporation and by‑laws to ensure clean ownership records and regulatory compliance. Stockholders’ agreements are essential when multiple owners are involved; they govern how shares may be transferred or repurchased and provide dispute‑resolution mechanisms. For companies partnering with universities or other companies, collaboration agreements clarify roles, protect intellectual property and reduce the risk of conflicts. Confidentiality and intellectual‑property assignment agreements protect trade secrets and ensure that IP created by founders, employees or contractors legally belongs to the company. Finally, investment agreements define how capital enters the company and can protect founder control during fundraising.
Key takeaway
Experienced counsel helps founders choose the right entity, allocate equity among co‑founders, and document assignments and vesting schedules so that IP and control stay with the company. Well‑drafted governance documents also reduce friction in future fundraising and due diligence.
Fundraising: SAFEs, convertible notes and priced rounds
There are three common ways startups raise capital: priced equity rounds, convertible notes and SAFEs (Simple Agreements for Future Equity). Each has different legal and financial implications:
| Instrument | Description | Advantages | Watch-outs |
|---|---|---|---|
| Priced equity round | Direct sale of preferred shares at an agreed price; investors and founders know exactly what they’re giving up. | Standard for larger rounds; clear valuation; investors have certainty. | Time-consuming and expensive (legal fees and due diligence); less flexible for small raises. |
| Convertible note | A debt instrument that converts to equity later; carries a maturity date and interest. | Cheaper and faster than priced rounds; allows founders and investors to delay valuation until the next round. | Investors may insist on valuation caps or discounts to limit risk; debt status means potential repayment at maturity. |
| SAFE | An agreement giving investors the right to receive future equity; not debt. | No maturity date or interest; quick and inexpensive; can be raised in small increments. | Still requires careful negotiation of valuation caps; multiple SAFE rounds can complicate the cap table and dilute existing holders. |
Early legal advice helps founders select the right instrument for their stage and strategy. Counsel can also help negotiate SAFE or note terms—such as valuation caps, discount rates and pro‑rata rights—and ensure compliance with securities laws. For larger raises, an attorney coordinates due diligence, prepares disclosure schedules, and helps founders understand investors’ preferred stock rights.
QSBS and exit tax planning
Qualified Small Business Stock (QSBS) under Section 1202 of the U.S. tax code offers founders and early investors the potential to exclude up to 100 % of capital‑gains tax on the sale of qualifying stock. To qualify, stock must be:
- Acquired directly from the company after Sept. 27 2010 and held for at least five years. Transfers or restricted stock grants may still qualify if an 83(b) election is made and the stock vests.
- Issued by a U.S. C‑corporation engaged in a qualified trade or business with aggregate assets under US$50 million before the issuance. Converting an LLC to a C‑corp can sometimes preserve QSBS eligibility.
- Held without a disqualifying event. Redemptions are a common trap: if the company repurchases stock within two years before or after issuing QSBS, the tax benefits for that issuance may be lost. Similar pitfalls apply to tender offers and failing to maintain a qualified business.
An attorney experienced in QSBS can help founders structure equity issuances, choose the appropriate business entity, plan stock redemptions, and manage asset thresholds to maximize the exclusion. They can also advise on 83(b) elections, tax basis planning, and how to preserve QSBS treatment through reorganizations or conversions.
Equity compensation: stock options, RSUs and restricted stock
Aligning employees’ incentives with the company’s success is vital for early‑stage startups. Equity compensation tools have different mechanics, tax implications and risks:
Stock options
Stock options grant employees the right to buy shares at a specified “exercise price” after meeting vesting conditions. They are common at early‑stage companies because employees do not pay anything until they exercise. This allows startups to offer high-value compensation without cash outlays. However:
- Value uncertainty: employees benefit only if the company’s stock price exceeds the exercise price.
- Vesting and expiration: options typically vest over four years (often with a one‑year cliff), and employees may have only a few months to exercise after leaving.
- Tax: employees pay taxes when they exercise options; for incentive stock options (ISOs), taxes may be deferred until shares are sold.
Restricted stock and RSUs
Restricted stock involves purchasing shares upfront; vesting governs the right to retain the shares. This can be attractive for founders or very early hires when the company’s valuation is low. Employees receive voting rights immediately and the company may repurchase unvested shares if the employee leaves. On the downside, employees must pay fair‑market value (or recognize income on the discount) and companies must track 83(b) elections.
Restricted Stock Units (RSUs) promise to deliver shares once vesting conditions (time or performance goals) are met. Employees do not need to pay to receive RSUs and they are taxed when the shares vest. RSUs are simpler to administer than options but can be costlier for the company because they have intrinsic value. They are typically used by later‑stage companies or those with stable valuations.
Comparing options and RSUs
| Feature | Stock options | RSUs/Restricted stock |
|---|---|---|
| Upfront cost for employees | None—employees pay only when exercising options. | No payment for RSUs; restricted stock requires an upfront purchase or tax on the discount. |
| Tax timing | Options are taxed at exercise (ISOs may defer). | RSUs are taxed as ordinary income when shares vest; restricted stock may require an 83(b) election to start the holding period. |
| Risk to employees | Options can become worthless if the share price never exceeds the strike price. | RSUs deliver shares regardless of price and thus carry less risk. |
| Reward potential | Options offer greater upside if the company’s value grows. | RSUs provide certainty but may offer lower upside if the stock remains flat. |
| Dilution | Shares are issued only upon exercise, so dilution is delayed. | RSUs and restricted stock dilute ownership immediately at vesting or grant. |
Key takeaway
An attorney can help design equity incentive plans, choose between options and RSUs, ensure compliance with securities and tax laws, handle 409A valuations and 83(b) elections, and explain trade‑offs for employees and the company.