In a Masterclass in 2023, Rachel shared advice on how to set up your company for acquisition, by talking through problems she often sees with founder-led companies.
When you start a company, you likely don't issue yourself shares. And if you have co-founders, you likely have vesting on your shares. And vesting, if people don't know, is when there is a time base element of when you receive your ownership. The typical time based element is four years with a one year cliff, meaning that you don't vest into all of your shares until you have been working on the company for four years. It is very typical when there are co-founders or a founding team involved, and it is definitely recommended when you have a bunch of co-founders, because the reality is it's all exciting when you start. But as things go on, people might realize that entrepreneurship isn't for them, or they don't really want to do this for the long haul, and decide after maybe a year or two years if they want to leave the company. And it's important at that point that they aren't leaving with 50% of the company in the case of two founders.
83 B is a tax specific filing that has to be made when there is vesting on shares. It is a tax benefit if you file it. And what happens in deals is if investors find out that they haven't been filed, it could affect the purchase price, because that, at the end of the day, affects the founders or whoever got shares and didn't file an 83 B take home cash amount. So if an 83 B isn't filed, that can really affect the purchase price. And if you're a founder, it should be something on top of your mind too. If you didn't file an 83 B of what your tax consequences and tax obligations are going to be upon sale. So 83 B's is something that we are constantly reminding founders of if we are helping form the company, which we do sometimes. But also if a company comes to us and has already been formed, we will look into whether an 83 B was filed. And if it wasn't filed, we can talk to tax counsel if there's anything that can be done to fix the issue.
So it's something to look into if there is vesting on shares, whether an 83 B was filed. Also, just to make sure there is documentation of the founder shares, you are technically supposed to purchase your shares. If you are founding a company, you should purchase your shares. If you own 90%, you should write a check to the company for $90. So .0001 if that's what you're valuing the company as when you start. This is what we do a lot of the time. We advise founders on how to properly start the company, if they are are in that stage. But it is really important. Investors will want to know during an acquisition whether 83 B's are filed, and that's usually part of the diligence request list.
I would say that this is the number one thing we see. People will say that they are giving equity to a consultant or an advisor, for getting .25% of the company, or 2% of the company, and there is no board consent approving it. There's no actual stock option agreement or restricted stock purchase agreement. It is just an understanding. And in reality, that person has no equity in the company, they have promised equity.
Every equity grant should have a board consent that approves it, even if you are a single board of directors. And it should also have the corresponding paperwork so that the person can actually get the shares and knows the restrictions to the shares.
I worked on a client before that their equity was done via email. So every time they had a new employee or new consultant, they would email them and say, your equity grant is .25%, and it's going to be a four year vesting schedule, one year cliff, and that was it. So you could imagine the nightmare diligence we had to do to puzzle and piece back together what this cap table look like. And it was a month long, excruciating process to go back and figure out what equity was actually granted, what equity was actually promised, to clean it all up and issue it. And that would be a huge delay on a deal. And we have seen that delay deals where there is promised equity out there that was not properly documented. You can learn now how to do it yourself. If you do not have legal counsel, obviously, Carta, Pulley, they are great resources. But you definitely have to figure it out, and have somebody on your team, if it's not you, really in charge of managing the cap table and making sure that equity is properly documented.
Focus on service provider agreements that make sure that IP ownership rights stay with the company. Obviously, if you have somebody working on a really important part of the business, engineering, consulting on what the product mechanics are going to be, they need to have IP ownership in their agreement. And that doesn't mean that they can't be an independent contractor. They can be, but independent contractors need to make sure that they are also signing IP right and licensing sections of their agreements. So if you have a standard contractor agreement that you're having people that are working on the product, or really anybody that's working on the company, you want to make sure there is a really good IP section that makes sure that the IP and ownership rights stay with the company. This is really important when you are also working with people that work at a university. It's really important to make sure that the university does not own everything that is being worked on for your company.
The fourth thing is consent, or blocking rights to one party. We see this a lot with accelerator agreements. If you know of accelerators, you can join an accelerator. They will sign you up for one of their cohorts, they get really involved. A lot of times they also will write a check into the company and be one of the first investors. What we see is while this all seems too good to be true, you really have to look at the agreements, because a lot of these accelerator agreements do have terms that have consent rights or blocking rights. And even though they aren't in the day to day of the company, or really helping the company as they grow and scale on the daily, they could potentially block a sale because you need their approval to get the sale done.
For more, check out Rachel's masterclass here.