Taxation and Legal Issues Concerning Founders’ Shares
Founders’ shares are shares or ownership units of a company that are initially provided to a startup corporation or LLC. A person is considered a “founder” if he or she is one of the individuals who originally forms the company. These individuals are the first to obtain shares or ownership units; thus, “founders” and “founders’ shares.” Beyond being issued first-in-time, founders’ shares are the same as normal shares of stock or ownership units. With respect to corporations, there can be various classes of stock — such as common and preferred or Class A and Class B. These various classes of stock may have special rules assigned to them, such as non-voting or supra-voting attributes, or other rights and privileges.
A corporation is formed in California by filing articles of incorporation with the California Secretary of State’s office. There is a filing fee required and various information must be provided — such as name and address of the corporation and the number of shares authorized and to be issued. Once the bylaws are adopted, and the rest of the items required to form a corporation have been taken care of by your experience corporate attorney, the share certificates will be issued that indicate the names of the founder shareholders and how many shares were issued to each individual.
As a practical matter, founders’ shares matter with respect to small and medium-sized businesses because of the issue of control. If one founder has — or a small group have — more than 50% of the outstanding shares, then he, she, or they control the company. As such, they can control the direction of the company, hire various senior management, purchase assets, apply for loans, etc. Legal issues surrounding founders’ shares deteriorate if and when sufficient shares have been issued and the number of investors has sufficiently expanded such that no one individual or group has control.
With respect to taxation, often the second set of investors — high level employees, for example — want to purchase stock at a reduced price or at the price initially paid by the founders. This can be beneficial to a startup company since stock options can incentivize employees to work harder and can be a non-cash method of compensation (which might be important for a fledgling company). However, there are two important legal and taxation issues: first, if the price paid is less than fair market value, then, under some circumstances, taxing authorities will deem the difference between price-paid and fair market value as “recognized income.” Obviously, that can be problematic if the company is cash-poor. Second, issuing shares may, under some circumstances, constitute the offering and/or sale of securities. Here, there could be registration or other filing requirements. When contemplating the issuance of stock and/or ownership interests to employees and other individuals, it is important to seek the advice and counsel of a good San Diego corporate attorney.
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If you would like more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email. Mr. Leonard has been named a “Rising Star” four years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal. Mr. Leonard’s law practice proudly serves business owners in San Diego and the surrounding communities. Like us on Facebook.