Various ways of forming a business organization – Sole Proprietorship vs. Partnership vs. Corporate vs. Limited Liability Company

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Common Stock vs. Preferred Stock

Stock represents the equity ownership of a company. In the startup world, there are two types of stock broadly: common stock and preferred stock. Common stock is usually something is given in exchange for your effort (sweat stock) whereas preferred stock is something that is given in exchange of the money that you invest in the company. So, usually founders initially have common stock and investors have preferred stock.CommonandPreferredStock.pngInitially, both these stocks have different values. The usual norm is to start with a common stock of $0.01 or $0.001 per share. As the company spends more time and it starts to build some assets or market performance, then the common stock will be slowly gaining in value. Common stock is usually priced at 10% of the preferred stock. The initial common stock is typically issued for some past work that the founders might have done, technology and any other assets.

If the company goes to IPO, all the stock is converted into common stock. Therefore, before going to an IPO the common stock and preferred stock converge. Following are some charts showing the various ways of converging common and preferred stock.

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A very aggressive common stock pricing strategy looks like the below

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A conservative common pricing strategy looks like the below

CommonandPreferredStock-3.png

 

 

 

 

Different ways to create value – product, dollar, speed, convenience

Traditionally, they say there are four ways of creating value:

  1. Product
  2. Cost/Price
  3. Speed
  4. Convenience

Entrepreneur magazine says that there are three ways of creating value – Price, Quality and Speed. Remember the days when places like printing companies and auto body shops posted cartoons that showed an employee laughing hysterically, accompanied by a line like, “You want it when?” Or how about a placard like this? “Price. Quality. Speed. Choose any two.”

In the mindset of days past, customers had to expect steep prices to get top quality at breakneck speed. For top quality at low prices, they expected long waits. And if they wanted delivery fast and cheap, they expected to compromise quality.

That was then. Today, customers have different expectations. They want and are used to receiving price, quality and speed. As a result, successful businesses deliver on all three fronts to win and keep customers. Be Good at Everything and Great at Something

Brian Tracy in this post talks about the 7 ways of adding value to business.

 

 

Vesting of Founder’s Stock

This is a post written by George Deeb and the link to the original article is here.

Founders of a startup are frequently surprised when venture capital firms or other investors ask for vesting provisions to be placed on the founders’ stock.  The investors are seeking to provide sufficient incentive for each founder to work through the company’s critical early formation and development phase.  If a founder leaves the startup early in the process, it would be unfair to the other founders and the investors for the departing founder to receive a “free ride” on the continuing efforts of the other founders.  The vesting terms cause a forfeiture of the unvested shares, or a repurchase at a low cost, upon termination of employment, thereby eliminating the free ride.

A typical vesting structure is a period of four years beginning either upon the formation of the company or the closing of the first round of outside financing, with a one-year cliff, meaning that 1/4th of the stock vests on the first anniversary.  Thereafter, the stock vests ratably with 1/48th of the stock vesting each month.  In some cases, the stock instead vests annually with 1/4th of the stock vesting on each anniversary.  In either case, the founder is 100% vested on the fourth anniversary.

The logic of this typical structure is that it takes a full year to get through the formative stage, and thereafter, the value of the company increases incrementally.  The typical vesting schedule tracks this common growth pattern, rewarding the founder proportionately for services during these stages.

But, startups come in many shapes and sizes, and founders can request and obtain variations from the four-year vesting schedule in appropriate circumstances.  Following are a few of the most common reasons to adjust the vesting schedule:

  1. Other Contributions – If a founder has contributed money, intellectual property, or other assets to the company, the stock issued in return for those contributions should be fully vested, because the value has been provided in full and is not contingent on the future services. Any remaining stock issued for services would still be subject to vesting.
  1. Prior Service – If the VC investment is being made after the formation of the company, the founders frequently are able to obtain credit for the prior services. For example, if the VC investment is made one year after formation, the stock could be 25% vested upon closing the investment, and the remaining stock would be subject to a three-year vesting schedule.

3.  Shorter Startup Period – If founders reasonably anticipate a shorter period to bring       products or services to market, profitability, or sale of the company, then investors have a shorter risk period and the vesting schedule can be reduced commensurately.

  1. Track Record or Expertise – If a founder has a proven track record or expertise that is particularly needed for the company, that founder may be able to leverage this strength into a shorter vesting schedule. But don’t overplay this hand – if the investor is convinced a founder is critical, the investor may decide that vesting is even more important, to protect against the damage to the company if this key founder leaves the company.

 

Vesting stock commonly raises two additional issues: acceleration of vesting and the tax treatment of vesting stock.

Founders should always ask for the vesting of their stock to accelerate upon (a) a sale of the company or (b) a termination of employment without cause.  This formulation for vesting is called “single-trigger” acceleration, because the acceleration is “triggered” upon the occurrence of either one of the two events.  Investors usually want “double-trigger” acceleration, in which acceleration only occurs if the founder’s employment is terminated without cause following a sale of the company.  Investors are concerned that single-trigger acceleration will make the company more difficult to sell because, if all stock vests upon sale, buyers will be unwilling to take the risk of founders leaving the company shortly following the sale.

Finally, vesting stock creates a tax trap that first-time founders do not expect.  The tax code treats the grant of stock to a company officer or employee as compensation for services rendered.  The founder is required to recognize income equal to the value of the stock.  When a company is initially formed, the stock usually has no value, so the taxable income is $0.  But, if vesting is placed on the stock, IRS regulations deem the stock to be granted on the date of vesting.  If the company’s value increases over time, as anticipated, then the stock gains greater and greater value upon each vesting date and the founder must recognize income on each vesting date.  If the startup goes well, this income is quite significant, resulting in substantial income tax at a time when the founder may not have cash available to pay the tax.