Startup Founders Don’t Need To Make A Section 83(b) Election

A bunch of websites, including websites of large law firms, advise startup founders to make an election under section 83(b) of the Internal Revenue Code. They shouldn’t have relied on ChatGPT! For almost all startups and almost all founders, a section 83(b) election is unnecessary and foolish.

Section 83 is captioned “Property Transferred in Connection with Performance of Services.” Section 83(a) states the general rule:  if you receive any kind of property in exchange for performing services you have to pay tax on the value of the property. The property could be anything, an old car, a 17th Century Chippendale cabinet, Bitcoin, but in the world of startups the property is usually company stock.

Under section 83(a), if you’re hired as the CTO of Startup, Inc. and receive 10,000 shares of Startup, Inc.’s stock as as part of your compensation package, worth $1.00 per share, Box 1 of your W-2 will include that $10,000 of value, along with your very modest cash salary.

When startups hire CTOs and other service providers, they structure the compensation package so the CTO will stick around. Typically, Startup, Inc. would give you the 10,000 shares today but provide that they “vest” in four tranches, 2,500 today, 2,500 at the end of the first year, 2,500 at the end of the second year, and 2,500 at the end of the third year. If you leave at the end of the second year you own 7,500 shares while the other 2,500 shares disappear.

Section 83(a) says you don’t pay tax on the shares until they vest. So you’d pay tax on the first 2,500 shares this year, then pay tax on the second 2,500 shares next year, and so forth. That’s great! You don’t have to pay tax on the property you receive until it’s vested or, in tax code parlance, until it is no longer “subject to a substantial risk of forfeiture.” 

That’s very fair but in the startup world there’s a downside. You think the shares of Startup, Inc. are worth $1.00 today but you hope they’ll be worth way more in the future – that’s the whole point of the startup. And while section 83(a) allows you to postpone paying tax until your shares vest, the flip side is you pay tax on the value at the time they vest. If the shares are worth $1.00 today you pay tax on $2,500 this year. But if they’re worth $1.65 next year you pay tax on $4,125. And if they’re worth $3.30 the year after you pay tax on $8,250, up and up.

That’s where section 83(b) comes in.  By filing a piece of paper with the IRS – the section 83(b) election – you can choose to pay tax on all the shares today, even on the shares that aren’t yet vested, at their current value, rather than paying tax on the value in the future.

You’re making a bet. If you’re confident the company will succeed, you choose to pay tax on $10,000 today even though you don’t really own all the shares and only have to pay tax on $2,500, hoping to save a lot of tax in the future. If the company fails you lose your bet:  you’ve paid tax on $10,000 of shares that weren’t really worth anything. 

As you might have noticed already, the whole scenario has nothing to do with founders, for two obvious reasons:

  • Leah, the founder of Startup, Inc. didn’t receive her stock by promising to perform services in the future. She received her stock because she formed the company. She transferred to the company the idea for the business, her marketing plans, a little cash, a contract with her first customer, maybe some computer code or other property. In tax parlance she contributed the goodwill.
  • Leah didn’t make her own stock “subject to a substantial risk of forfeiture”! She formed the company and issued all the stock to herself. Period.

For those of you keeping track, the issuance of stock to Leah by her company was tax-free under section 351 of the Code because she owns more than 80%.

The situation I just described is true of about 99.8% of startups. In the other .02% of cases, perhaps a founder teams up with an investor before forming her company and agrees that some of her stock is subject to a vesting schedule. In those cases, and only in those cases, would section 83(b) be relevant.

If your main challenge as a founder is you don’t have enough stuff to file with the IRS, go ahead and file a section 83(b) election even though it’s unnecessary and meaningless. Otherwise spend your time on something else.

Be careful what you read on the internet!

Questions? Let me know

Crowdfunding web portal

Updated Crowdfunding Cheat Sheet

I first posted this Crowdfunding Cheat Sheet in January of 2014. Since then the rules have continued to change and improve. So here’s the current version, up to date with all the new rules and also expanded to answer questions my clients ask. For example, I’ve added a column for Regulation S because many clients want to raise money from overseas while simultaneously raising money here in the U.S.

I hope this helps, especially those new to the world of Crowdfunding.

CLICK HERE TO VIEW THE UPDATED CROWDFUNDING CHEAT SHEET

Questions? Let me know.

Think Twice Before Giving Crowdfunding Investors Voting Rights

I attend church and think of myself as a kind person, yet I discourage issuers from giving investors voting rights. Here are a few reasons:

  • Lack of Ability:  Even if they go to church and are kind people, investors know absolutely nothing about running your business. If you assembled 20 representatives in a room and talked about running your business, you would (1) be amazed, and (2) understand why DAOs are such a bad idea.
  • Lack of Interest:  Investors invest because they want to make money and/or believe in you and your vision. They aren’t investing because they want to help run your business.
  • Irrelevant Motives:  Investors will have motives that have nothing to do with your business. For example, an investor who is very old or very ill might want to postpone a sale of the business to avoid paying tax on the appreciation.
  • Bad Motives:  Investors can even have bad motives. An unhappy investor might consciously try to harm your business or, God forbid, a competitor might accumulate shares in your company.
  • Lack of Information:  Investors will never have as much information about your business as you have. Even if they go to church, are kind to animals, and have your best interests at heart, they are unable to make the same good decisions you would.
  • Drain on Resources:  If you allow investors to vote you’ll have to spend lots of time educating them and trying to convince them to do what you think is best. Any time you spend educating investors is time you’re not spending managing your business.
  • Logistics:  Even in the digital age it’s a pain tabulating votes from thousands of people.
  • Mistakes:  When investors have voting rights you have to follow certain formalities. If you forget to follow them you’re cleaning up a mess.

I anticipate two objections:

  • First Objection:  VCs and other investors writing big checks get voting rights, so why shouldn’t Crowdfunding investors?
  • Second Objection:  Even if they don’t help run the business on a day-to-day basis, shouldn’t investors have the right to vote on big things like mergers or issuing new shares?

As to the first objection, the answer is not that Crowdfunding investors should get voting rights but that VCs and other large investors shouldn’t. The only reason we give large investors voting rights is they ask for them, and our system is called “capitalism.”

Before the International Venture Capital Association withdraws its invitation for next year’s keynote, I’m not saying VCs and other large investors don’t bring anything but money to the table. They can bring broad business experience and, perhaps most important, valuable connections. A non-voting Board of Advisors makes a lot of sense.

The second objection is a closer call. On balance, however, I think that for most companies most of the time it will be better for everyone if the founder retains flexibility.

To resolve disputes between the owners of a closely-held business we typically provide that one owner can buy the others out or even force a sale of the company. Likewise, while we don’t give Crowdfunding investors voting rights we should try to give them liquidity in one form or another, at least the right to sell their shares to someone else.

Give investors a good economic deal. Give them something to believe in. But don’t give them voting rights.

Questions? Let me know.

Improving Legal Documents In Crowdfunding: New Risk Factor For Supreme Court Ruling

It appears the Supreme Court is about to strike down Roe v. Wade, allowing states to regulate or outlaw abortion. Many states are poised to do so with varying degrees of severity. 

In his draft opinion in Dobbs v. Jackson Women’s Health Organization, Justice Alito states that the decision would not affect other rights, like the right to gay marriage (Obergefell v. Hodges), the right to engage in homosexual relationships (Lawrence v. Texas), or the right to contraception (Griswold v. Connecticut). In my opinion, you should take Justice Alito’s assurance with a large spoonful of salt.. Theoretically, all these cases rest on a constitutional right to privacy. If you knock that pillar down for one right it falls for all of them. On a practical level, Justice Alito himself voted against gay marriage and I have little doubt that there are at least five votes to overturn all these precedents.

Some states are already considering bans on contraception and surely challenges to gay marriage are close on the horizon.

When the COVID-19 pandemic swept the country, companies raising capital had to add one or more risk factor to their offering materials, describing how the pandemic could harm their businesses. I believe the Supreme Court’s opinion in Dobbs v. Jackson Women’s Health Organization calls for the same thing.

Imagine a SAAS company in Austin, Texas, looking to recruit talented young engineers. Imagine the company’s ideal candidate:  a woman who just graduated from Stanford with a specialty in AI. If she has one job offer from the company in Austin and another from a company in Oregon it isn’t hard to see why the Texas company would have a competitive disadvantage, all other things being equal.

Companies are already trying to mitigate the risk. For example, Starbucks has announced free travel to employees to states where abortion is legal. But even that might not eliminate the risk. Do women want to travel out of state for medical care? And, in any case, many states where abortion is or will be illegal are trying to make it illegal to travel out of state for an abortion

Whatever the realities of the marketplace, our job as securities lawyers is to make investors aware of risks so our clients can’t be sued afterward. I suggest the following or something like it in the offering materials of any company where recruitment is important

State Laws Might impair the Company’s Ability to Recruit: The U.S. Supreme Court [seems poised to overturn] [has recently overturned] women’s privacy rights in health care decisions set forth in Roe v. Wade. Moreover, the reasoning used by the Court in overturning Roe v. Wade suggests that other constitutional rights could also become subject to restriction by the states, including the right to gay marriage and use of contraception. Texas, where the Company’s headquarters are located, has enacted strict laws regulating abortion and its political climate is such that it might seek to limit or take away other rights as well. These state laws could impair the Company’s ability to recruit and retain personnel and could put the Company at a competitive disadvantage with companies in other states.

Questions? Let me know.

Using A SAFE In Reg CF Offerings

The SEC once wanted to prohibit the Simple Agreement for Future Equity, or SAFE, in Reg CF offerings. After a minor uproar the SEC changed its mind, and SAFEs are now used frequently. I think prohibiting SAFEs would be a mistake. Nevertheless, funding portals, issuers, and investors should think twice about using (or buying) a SAFE in a given offering.

Some have argued that SAFEs are too complicated for Reg CF investors. That’s both patronizing and wrong, in my opinion. Between a SAFE on one hand and common stock on the other, the common stock really is the more difficult concept. As long as you tell investors what they’re getting – especially that SAFEs have no “due date” – I think you’re fine.

The reason to think twice is not that SAFEs are complicated but that a SAFE might not be the right tool for the job. You wouldn’t use a hammer to shovel snow, and you shouldn’t use a SAFE in circumstances for which it wasn’t designed.

The SAFE was designed as the first stop on the Silicon Valley assembly line. First comes the SAFE, then the Series A, then the Series B, and eventually the IPO or other exit. Like other parts on the assembly line, the SAFE was designed to minimize friction and increase volume. And it works great for that purpose.

But the Silicon Valley ecosystem is very unusual, not representative of the broader private capital market. These are a few of its critical features:

  • Silicon Valley is an old boys’ network in the sense that it operates largely on trust, not legal documents. Investors don’t sue founders or other investors for fear of being frozen out of future deals, and founders don’t sue anybody for fear their next startup won’t get funded. Theranos and the lawsuits it spawned were the exceptions that prove the rule.
  • The Silicon Valley ecosystem focuses on only one kind of company: the kind that will grow very quickly, gobbling up capital, then be sold.
  • Those adding the SAFE at the front end of the assembly line know the people adding the Series A and Series B toward the back end of the assembly line — in fact, they might be the same people. And using standardized documents like those offered by the National Venture Capital Association ensures most deals will look the same. Thus, while SAFE investors in Silicon Valley don’t know exactly what they’ll end up with, they have a good idea.

The point is that SAFEs don’t exist in a vacuum. They were created to serve a particular purpose in a particular ecosystem. To name just a couple obvious examples, a company that won’t need to raise more money or a company that plans to stay private indefinitely probably wouldn’t be good candidates for a SAFE. If it’s snowing outside, don’t reach for the hammer.

If you do use a SAFE, which one? The Y Combinator forms are the most common starting points, but in a Reg CF offering, you should make at least three changes:

  1. The Y Combinator form provides for conversion of the SAFE only upon a later sale of preferred stock. That makes sense in the Silicon Valley ecosystem because of course the next stop on the assembly line will involve preferred stock. Outside Silicon Valley, the next step could be common stock.
  2. The Y Combinator form provides for conversion of the SAFE no matter how little capital is raised, as long as it’s priced. That makes sense because on the Silicon Valley assembly line of course the next step will involve a substantial amount of capital from sophisticated investors. Outside Silicon Valley you should provide that conversion requires a substantial capital raise to make it more likely that the raise reflects the arm’s-length value of the company.
  3. The Y Combinator form includes a handful of representations by the issuer and two or three by the investor. That makes sense because nobody is relying on representations in Silicon Valley and nobody sues anyone anyway. In Reg CF, the issuer is already making lots of representations —Form C is really a long list of representations — so you don’t need any issuer representations in the SAFE. And dealing with potentially thousands of strangers, the issuer needs all the representations from investors typical in a Subscription Agreement.

The founder of a Reg CF funding portal might have come from the Silicon Valley ecosystem. In fact, her company might have been funded by SAFEs. Still, she should understand where SAFEs are appropriate and where they are not and make sure investors understand as well.

Questions? Let me know.

Don’t Use a Series LLC as a Crowdfunding Vehicle

At least one high-volume Crowdfunding portal is using a series LLC as a crowdfunding vehicle. It’s a terrible idea.

A “series LLC” is a relatively new concept. Rather than form a new limited liability company for a business, you can form a “series” of an existing limited liability company. Think of the parent LLC as a building and the series as a cubicle in the building. If you do everything right, the assets and liabilities of each series are segregated from the assets and liabilities of every other series.

EXAMPLE:  A company wants to conduct two businesses, one an asbestos business and the other an auto dealership. It creates Series X to conduct the asbestos business and Series Y to conduct the auto business. Under Delaware law, if the company does everything right, maintaining separate books and records, creditors of the asbestos business can’t get at the assets of the auto business and vice versa.

That’s great in theory. But there are two problems.

The first is that while Delaware law is clear, as far as I know the series structure has never been tested in a bankruptcy court. Bankruptcy courts have enormous power to achieve equitable results and often use that power aggressively. Suppose the asbestos company has caused 57 children to develop a rare but deadly form of cancer and the assets of the asbestos company aren’t sufficient to pay the economic damages. Will a bankruptcy court allow the parent company to walk away with the auto business intact? Maybe, maybe not.

The second problem is that some states simply disregard the Delaware law. Arizona is one of them. Its statute provides:

A foreign limited liability company, its members and managers and its foreign series, if any, have no greater rights and privileges than a domestic limited liability company and its members and managers with respect to transactions in this state and relationships with persons in this state that are not managers or members.  A foreign series is liable for the debts, obligations or other liabilities of the designating foreign company and of any other foreign series of that designating foreign company, arising out of transactions in this state or relationships with persons in this state and a designating foreign company is liable for such debts, obligations or other liabilities of each foreign series of that designating foreign company.

That means if the kids got sick is in Arizona, the court is going to ignore the series and take the assets of the auto business, no question.

Now let’s think about a crowdfunding vehicle.

Suppose the funding portal has created crowdfunding vehicles, or SPVs, for three issuers, Company A, Company B, and Company C. It’s created each crowdfunding vehicle as a series of one limited liability company.

Two years from now a bankruptcy court somewhere in the United States declines to respect the separateness of the series structure. Immediately, the crowdfunding vehicle of Company A is subject to all the liabilities of the crowdfunding vehicles of Company B and Company C, and vice versa nine different ways. When the investors in Company B lose all their money because of a lawsuit involving Company C they’re going to sue, and because Company B didn’t even tell investors about that risk, its founders are going to be sued personally – and successfully.

Now let’s say someone from Arizona invests in the crowdfunding vehicle of Company C. Later, it’s revealed that Company C failed to disclose material information in its offering. Under the Arizona law that investor can sue the crowdfunding vehicles of Company A and Company B. The investor wins that lawsuit and now investors in Company A and Company B have claims against their own company and their founders.

It’s a legal disaster.

And for what great benefit did the funding portal take that risk, using a series LLC rather than a separate LLC as the crowdfunding vehicle? To save about $150 in filing fees. Really.

That’s why using a series LLC as a crowdfunding vehicle is such a terrible idea. If a funding portal tells you to use a series LLC as your crowdfunding vehicle remember Nancy Reagan’s famous slogan:  Just Say No! And if you already have a crowdfunding vehicle formed as a series LLC, change it right away.

And for that matter, remember that you don’t need a crowdfunding vehicle in the first place.

The Legal Liability of Funding Portals: Update for TruCrowd Complaint

A few weeks ago I posted about the potential legal liability of funding portals. Lo and behold, on September 20, 2021 the SEC brought an enforcement action against an issuer and its principals, and also against the funding portal, TruCrowd, Inc., dba Fundanna, and its owner, Vincent Petrescu.

Here’s a link to the Complaint. If you take the Complaint at face value – and readers should bear in mind that there are least two sides to every story – this is a lesson in how a funding portal can get into hot water with a questionable issuer.

The allegations against the issuer and its principals are straightforward:  they failed to disclose the criminal record of one of the principals; they used investor money for personal purposes; they misled investors about a purported real estate project.

More interesting for our purposes are the allegations against the funding portal and its owner. Calling TruCrowd and Mr. Petrescu “gatekeepers,” the SEC alleges, among other things, that:

  • TruCrowd and Mr. Petrescu allowed the offerings to proceed despite multiple warning signs of possible fraud or other harm to investors.
  • Mr. Petrescu participated in drafting the inaccurate Form C and offering statement.
  • TruCrowd and Mr. Petrescu failed to order a “bad actor” check.
  • Mr. Petrescu ignored warning from a securities lawyer.

It’s hard to walk away from a big commission. But this enforcement action illustrates that sometimes you have to.

Crowdfunding Real Estate

PODCAST: The Storage Investor Show

Real Estate Crowdfunding in 2021 with Mark Roderick – episode 9

In This Episode:

  • Updates to Accredited Investor qualifications
  • Who qualifies as a “Finder” of capital?
  • Title III crowdfunding changes
  • How can sponsors and investors take advantage of recent changes
  • Why crowdfunding is a marketing business

Guest Info:

Mr. Roderick concentrates his practice on the representation of privately-owned and emerging growth companies, including companies in the technology, real estate, and health care industries. Mark specializes in the representation of entrepreneurial, growth-oriented companies and their owners.

Why I’m Grateful This Thanksgiving

My 10th great-grandfather was William Bradford, the leader of the Pilgrims, so I have a special fondness for Thanksgiving. Feeling a little out-of-sorts that COVID-19 kept family members away — and then realizing how little that meant relative to the real suffering of so many — I made my annual list of things I’m grateful for:

  • I’m grateful that while we couldn’t get together on Thanksgiving Day, my family is safe and healthy.
  • I’m grateful for my new law firm, Lex Nova Law, and partners I admire and trust. Character really does matter.
  • I’m thankful to live in a dynamic, capitalist country. All things considered, capitalism has done a terrific job during the pandemic, delivering goods and services through channels invented on the fly.
  • I’m grateful for Zoom and the other technologies that have allowed me to work during the pandemic without missing a beat.
  • I’m grateful for the nurses and doctors working on the front lines, putting their own lives at risk to save others, showing a kind of dedication those of us in the white collar world don’t see often.
  • I’m grateful for governors and elected officials around the world who acted courageously to save lives and for Anthony Fauci, an American hero.
  • I’m grateful for American entrepreneurs, with their unquenchable faith that things can be done better.
  • I’m grateful to the SEC for trusting American entrepreneurs and ordinary citizens, as it lays the foundations for the Crowdfunding ecosystem.
  • I’m grateful for the hundreds of thousands of investors who have expressed faith in that ecosystem with their hard-earned dollars.
  • I’m grateful that American democracy survived its greatest threat since the Civil War and that, despite some creaking of the old timbers, the machinery of our democracy worked again. Maybe blockchain or some other technology will make future elections easier, but until then we rely on the integrity of thousands election workers of both parties working together despite their ideological differences. Because of their hard work and decency, on January 20, 2021 our country will enjoy the miracle of another peaceful transition of power.
  • I am thankful to live in a diverse, changing, sometimes-chaotic country where it often seems we disagree about everything (we don’t). Like others, I worry that so many Americans have chosen alternative realities and conspiracy theories, but I have faith that these afflictions, like others in our history, will prove temporary.
  • Most of all I’m grateful for my clients, a diverse, energetic, endlessly-creative group of entrepreneurs who are making America better and in the process making my life infinitely more rewarding.

Perhaps 2021 could be a little less. . . .interesting? No matter how that turns out, let’s all step into the future with thanksgiving and hope.

As always, thanks for reading.

MARK

SEC (Finally) Approves Crowdfunding Changes

With uncanny precision, I predicted the SEC would approve the Crowdfunding changes no later than August 31, 2020. I was right on target except for the month and year.

The SEC Commissions just voted 3-2 to adopt the changes effective 60 days after they’re published in the Federal Register.

It looks as if there were no significant changes to the proposals made on March 4th, but I’ll let you know shortly. You can read the full text and SEC explanations here.