Brad Feld just sent out his first Finance Fridays post called “Getting Started -Allocating Equity and Founder’s Investment”.
This post is not about financial statement literacy, but is meant to begin setting the stage for the hypothetical company that will be the subject of the Finance Fridays series. In particular, this first post deals with allocating initial equity between 2 founders. I posted a comment to the post as follows:
“Brad, the split could have been 50/50 regardless of Jane’s $$ contribution, right? My point is that while Jane and Dick negotiated the split is was basically arbitrary.
Also, someone recently argued with me that in your scenario Dick would actually have taxable income on the value of his shares based on the value “attributed” to the shares derived from Jane’s investment and implied valuation. I argued “no” and that Jane’s cash investment would just increase the tax basis of her shares. Do you agree?”
My comment was based on a situation that I was just encountered in which one founder was putting in real cash and the other 2 founders were putting in IP and sweat. An advisor took the position that if Founder “A” put in $60K and got 33% of the company, then the other Founders “B” and “C” (who also got 33% of the company) would have taxable income of $60K each. I argued against this position instead saying that Founder A would simply have $60K added to his tax basis in his shares (so that when Founder A sold the shares later his gain would be $60K less). And that Founder B and C would be unaffected…….and that this situation happens all the time!
Hopefully I will get some responses to the comment and let you know. Chime in.
ithaca VC 
Founder A could loan the money to the company at a small interest rate with stipulation that debt is paid at next round of funding.
Indeed, but be warned not to create to make “hair” on your cap structure. VCs often view founder loans negatively and instead say “hey, just treat that like equity, same as us”.
Zack – thanks for the comment, the question, and joining in on the conversation. That’s how everyone in the community will learn since I (a) don’t have all the answers and (b) will certainly say some things that aren’t right, or aren’t clear.
Following is what I posted in the comment thread.
Correct – the split was arbitrary. We are setting up a case where it’ll roll through the balance sheet. Plus, Dick and Jane agreed they were equal partners, but Dick acknowledged that Jane’s cash contribution should give her more of the company.
As long as things are structured correctly and Dick and Jane both file 83-b elections you are correct. However, if they don’t structure things correctly, there could be a valuation step up issue. Any good early stage / formation attorney will get this right in the founders documents.
Thanks Brad. On the 83b elections, I think that is only required if the founders’ stock is vesting (i.e., restricted stock). Might have to ask Jason :))).
Of course, I recommend that the founders protect themselves from each other with vesting in any event.
thx again for replying and BTW, I plan on reblogging all your Finance Fridays.
Zach,
A few thoughts and questions from my own experience (i.e. discussions w/ our lawyer)….
Doesn’t the $60k taxable income for founders B and C only occur if they were to cash out (and someone else actually bought in for that amount)? …in which case it would be treated the same as capital gains?
Another scenario that might trigger taxes might be redistribution of equity (say founder B transferring equity to Founder C) after the initial issuance, which I think is considered a “taxable event”…however, I think valuation does play a role in this case. Any insights from your experience?
Emile
well the advisor was saying $60K taxable income at time of receipt of stock. that is exactly what i took issue with.
on redistributions, they are immediately taxable and should be avoided. have the company grant options instead to accomplish the same result.