Issuing Ownership Stakes

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Issuing Ownership Stakes

Once you have decided on an entity type and the allocations of ownership, profits, and control among founders, the next step is to issue the ownership stakes. In an LLC, the ownership unit is a membership interest owned by members , with one or more managing members who are most active in the management of the LLC. A partnership has partners who own partnership interests . A limited partnership will have limited partners who enjoy limited liability but little control and general part ners who enjoy control but full liability for the partnership's debts . A corporation is owned by shareholders who own stock . Ownership of a corporation can bring other complexities, which will be covered in this section.

While the terms describing what it is one "owns" are different for each entity, they share many of the same legal issues and trouble spots that need to be addressed. Owners should have a written agreement in place laying down the owners ' expectation in a number of areas: control; how ownership will be affected by certain events such as death, departure , and addition of new owners; and what to do when an owner wishes to sell. The "Ownership Agreements" section of this chapter covers the main scenarios and points to consider.

This section will explain:

  • The form and special considerations of ownership in a corporation.

  • Recommended provisions in ownership agreements.

Ownership of a Corporation: Equity

This section addresses issuing ownership in corporations, which will provide a good framework for understanding concerns of sharing ownership no matter what your entity type. Ownership comes in the form of shares of stock, which are also known as equity .

Tax Rules Regarding Stock and Stock Option Grants

The animating principle behind the IRS regulations regarding stock and option grants is that the government wants to encourage business development while preventing employees from getting a free ride by camouflaging all of their income as stock, which can be taxed at the lower long- term capital gains rates.

Taxpayers are taxed on the value of equity received. Value is determined in the IRS's eyes through "valuation events" like financing rounds. If they receive equity in exchange for services, they are taxed on the fair market value of the equity as though they had been given cash. If they are given options, they are taxed on the difference between the fair market value of the stock at time of election and the exercise price (what the person pays to exchange the option for an actual share of stock) of the option.

The goals, in descending order, of an equity incentive program, are

  1. To get a bye on as much of the asset's value as possible.

  2. To have as much equity appreciation qualify for LTCG treatment as possible, with a maximum rate of 20 percent, instead of OI, which has a maximum rate of 38.6 percent.

  3. To defer the "taxable event," (the time when tax becomes due), as long as possible (thereby theoretically allowing the taxpayer to invest and receive interest/returns on that money during the interim).

To Founders

Generally speaking, founders and employees will receive common stock subject to vesting. Another incentive to incorporate early and issue stock is that if you wait until the eve of a financingfor instance, if you will be receiving an equity investment from a publisherthe IRS could deem it as discounted stock and tax you on the spread.

Stock versus Options

Founders can take stock or options, but stock is generally the wiser choice for two reasons.

  1. If a founder will not be an employee, she will not qualify for a tax-privileged option plan.

  2. Capital assets such as stock must be "held" for a certain amount of time to gain special tax status, 12 months to be a LTCG and five years to be QSBC. Stock is a capital asset ( assuming that it is vested or the owner has filed an 83(b) election, discussed in the 83(b) section, which follows ), but stock options are not, meaning that holding periods only begin running when stock is purchased. If you qualify for the QSBC exemption (see Sidebar: Small Business Corporation Stock), you will want to start the five-year holding period as soon as possible.

Vesting

Vesting, where the company retains the right to repurchase some or all of a stock/option grant until certain dates, is a mechanism for the corporation to grant stock or options while retaining the right to repurchase them should the employee leave the company. Cliff vesting is the norm, whereby some amount of a grantee's stock will vest at the end of a long period, say, one year, and the remainder will vest monthly over, for example, the next three years.

NOTE

NOTE

If the grantee leaves early, the compa ny may repurchase the stock (or in the case of options, invalidate the options), at the lower of the employee's cost or the fair market value of the stock.

83(b) Election

The IRS only considers you to "own" stock that is not subject to a substantial risk of forfeiture . Stock or options subject to vesting is considered to be at a substantial risk of forfeiture, and therefore not actually owned until it vests.

At every vesting date, the IRS thinks of you as receiving incomesubject to withholding and income taxequal to the value of the stock at the date of vesting less whatever you pay for the vesting shares. This could result in unpleasant consequences if your stock's value experiences rapid gain over your vesting schedule.

Figure 2.11. The 83(b) election can minimize the tax bite of vesting equity compensation.

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Fortunately, the IRS allows you to escape this by filing an 83(b) election within 30 days of the initial purchase of your shares. An 83(b) election is an agreement to pay the amount of tax that would be due if the stock were not subject to vesting. Essentially, you pretend that you have received all of the stock at the date of the election, and pay whatever tax would be due if that were the case. Usually, it is zero, because you will be paying fair market value for the stock and, because there will not have been any appreciation in the stock's value, there will be no spread. LTCG tax will be due when the stock is ultimately sold.

Acceptable Consideration

It surprises many founders that they are required to furnish valid consideration (payment) for their stock, or face IRS income tax. State laws regarding acceptable consideration vary, so check your state statute for restrictions. Cash and most kinds of property with a documentable value are acceptable. Fortunately, founder stock is usually very inexpensive, $.01 per share, so cash-strapped entrepreneurs can afford to buy a stake in their own company. Some states allow past services, but others do not consider the promise of future services or other promissory notes to be valid.

If you are contributing property, you will want to avoid paying income tax on the value of the shares you receive by making a Section 351 election. This is available if and only if:

  • The property is transferred solely in exchange for stock of the company; and,

  • Immediately after transfer, all transferors (cash and property, not solely service providers) own stock with at least 80 percent of combined voting power of all classes of stock entitled to vote and at least 80 percent of total number of shares of each non-voting class.

If there will be more than one transferor, the transfers do not need to be simultaneous, but rights need to have been defined in an agreement and documents effecting the transfers need to be summarily executed. You need to file a 351 election on your tax return to receive this treatment. If you do not qualify for a 351 election, you will likely pay income tax on the receipt of shares and qualify for capital gains treatment on any appreciation thereafter.

NOTE

CAUTION

If a founder will be donating property, she should give assurances that she owns all rights in and to the property, especially if it's intellectual property. Otherwise, the company could be liable for dam ages to third parties caused by the use of the property, for example, if it were stolen. It is also a fine idea for the company to obtain guarantees and indemnifications from the transferor or third- party insurance in case problems arise.

To Investors

Later investors often receive convertible preferred stock or preferred stock with warrants . There are two main reasons for this:

  1. Investors like preferred stock because it carries payment priority over common stock (preferred stockholders are paid back first) in case of bankruptcy. Some investors try to get upside participation as well in the form of conversions or warrants attached to the preferred stock.

  2. The company wants to avoid having all of its equity priced at the valuation the investors paid, because it would be much more expensive for employees and founders to purchase. A company can point to the preferred stock's extra rights and show the IRS that the common stock should be valued at a significant discount, thus enabling the company to continue giving out common stock and options at advantageous exercise prices and minimizing the tax liabilities to their employees.

To Employees

An employee option plan is valuable to employees if

  1. They receive stock options at a low valuation and can exercise and sell those shares at a later date; the grant is taxed at LTCG and not OI rates; and

  2. The employee does not incur an undue or poorly timed tax obligation.

Figure 2.12. Qualifying stock options can allow more of the option on value to classify or the lower LTCG rates.

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The receipt of an option is not a taxable event. Only the exercise or sale of the underlying stock is. An option is not a capital asset, so in order to receive LTCG treatment on the underlying stock, the IRS requires you to hold it for at least 12 months from the time you exercise your right to purchase the stock.

There are two kinds of employee incentive option programs: those that qualify for favorable IRS treatment and those that do not. The benefit of qualifying is that the employee pays no ordinary income tax at exercise, andeven betterthe employee defers the taxable event until the under lying shares are sold . The spread on the shares (fair market value less exercise price) will be taxed at LTCG rates if the stocknot the optionis held for more than one year from exercise, and two years from the date the option was granted. Otherwise, the employee faces OI tax on the spread. To qualify for this kind of tax treatment, the options must be granted to an employee, and the exercise price must be 100 percent of fair market value at date of grant (110 percent if grantee owns more than 10 percent of the corporation).

All other option grants are non-qualifying. When the grantee exercises, she recognizes OI on the spread, subject to income and employment withholding. Any additional gain in security is treated as capital gains.

Ownership Agreements

Ownership agreements are contracts that govern relations among owners of an enterprise including what owners can do with their shares/membership interests/partnership interests, how an owner leaves the company, and so forth. These are extremely important contracts as they set many of the ground rules for resolving conflict and allocating power, so be sure you have experienced counsel helping you.

Transferability of Ownership

All founders and founder-employees should sign a shareholders' agreementsometimes referred to as a stock purchase agreement or buy-sell agreement granting the company the ability to maintain ownership with the ship's current crew and to provide liquidity in particular situations as necessary. This agreement lays out the valuation methodology, order of purchaser priority (to whom the share is offered first, second, and so forth), and to whom a shareholder may sell in the event she leaves the company. The three primary means of regulating share ownership are the right of first refusal, the buy/sell, and the co-sale agreement.

  • Under a right of first refusal, the company has first pick of any shares sold by the founder/employee at the price being offered to the founder/employee by a third party. This has the functional effect of parking the stock; no buyer wants to negotiate a price knowing that it will be offered to an outside party.

  • The buy/sell agreement generally stipulates that:

  1. The shareholder may only transfer his or her shares in accord with the buy-sell agreement.

  2. Certain transfers to family (or other designated parties) are permitted, for instance, on death or disability of the shareholder.

  3. The company has the option or obligation to purchase the shares from the family/designated party for fair market value, and the transferee is obligated to sell. Pricing is difficult because there is no third party or liquidity event; appointing an account of mutual choosing is often helpful.

  • A co-sale agreement is frequently used where parties are concerned about a majority owner selling his or her share to an outsider. This agreement allows other shareholders to replace a portion of the stake being sold with their own shares. Example: An outsider wants to buy all of the majority owner's 400,000 shares, and a 50/50 co-sale is in place. The other shareholder may sell 200,000 shares and the majority owner may sell 200,000 shares to the third party.

NOTE

CAUTION

Marriage, divorce, and death can give rise to spousal rights in the shares. Consult with the attorney preparing your shareholder's agreement about the marital property laws of the states in which shareholders reside to understand their effects on the company and other shareholders.

Figure 2.13. Illustration of the right of first refusal.

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Partnership and LLC Considerations

Partnership and LLC agreements will have additional clauses peculiar to their form, including:

  • Profit and Loss Allocation. Because profits and losses may be allocated according to owners' wishes, the partnership agreement and LLC operating agreement should set forth the proportions for allocations of profits and losses.

  • Capital contributions. Partnerships and LLCs may have capital contribution requirements, which may require owners to commit to providing a set amount of supplemental funding should the company require it.

  • Distributions. A partnership or LLC agreement will set up rules for how, when, and how much money is distributed to the owners. There are usually conditions, for example, only capital in excess of $X may be distributed. Such distributions are sometimes referred to as the "draw."

  • Departure/Admission of new partners or members. Partnerships and LLCs tend to be closely held and intimately managed, making the departure or addition of new owners a big deal. To be sure that this process is managed carefully , the ownership agreements will usually set out the procedure for termination, voluntary withdrawal, and admission of new owners.

  • Dissolution. Ownership of LLCs and partnerships is not as freely transferable as with a corporation. Generally, these entities legally dissolve on the departure of a member or partner, so the ownership agreements usually set out ways to continue the company's existence in case of legal dissolution .

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Game Development Business and Legal Guide
Game Development Business and Legal Guide (Premier Press Game Development)
ISBN: 1592000428
EAN: 2147483647
Year: 2003
Pages: 63

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