Stepping back a bit from current events and meta issues, let’s talk about something more mundane, but nevertheless frequently asked by startup founders. What’s my stock worth, and why should I care?
Categories: I’d say there are three different types of “worth” that could be discussed here:
(1) worth to you,
(2) worth to others (what they would pay), and
(3) fair market value (FMV).
From an economic perspective, (1) and (2) are the most important. But from a legal perspective, (3) is the one you should care the most about. Think of FMV as something related to, but conceptually distinct from, what others think the stock is worth. And to be as absolutely straight-forward and jargon-free as possible as to why you should care about it, one word: taxes.
Why should I care?
A. Taxable Gain
First, virtually any time that someone gets stock with a fair market value above what they paid, that’s taxable gain. Naturally, whenever possible, you want to ensure that when you issue someone stock or options, they aren’t also being handed a tax bill with it. Unfortunately, the IRS doesn’t let you pay your taxes with options. Equity in your hand + cash out of your wallet = bad.
B. Regulatory Compliance
Second, with the understanding that promoting equity incentives can be valuable to companies and the economy as a whole, the IRS has provided some safe harbors (of sorts) through which you can issue options to employees while being able to defer taxes down the road, preferably around the time of a liquidity event (cash in your hand to pay that tax). Your attorney can discuss details with you in more detail, but the most important one for purposes of this discussion is: the exercise price of the option needs to be at fair market value.
C. Key Relationship between (1) and (3)
Notice the key relationship between (1) the value that you place on your stock and (3) fair market value. To the extent FMV is below what you and your employees view (subjectively) as the value of your startup’s stock, you’re able to give something that, at least to you and them, is worth more than what needs to be paid to avoid taxable gains. If FMV for tax purposes is $0.50 per share, but to me the stock is worth $2.00, I can pay $0.50 per share, get $1.50 worth of (subjective) gain, and not pay tax.
Nutshell: a low FMV relative to subjective value is a good thing.
So what’s the fair market value of my startup’s stock?
Never Sell Common Stock in an Outside Financing
The number one determinant of FMV is always (2) in the above list: what people are willing to pay for it. If/when the IRS chooses to look back at the FMVs you applied to your stock, that will be the first thing they look for. This is precisely why any competent startup lawyer will tell you that, while Common Stock is good for founders and equity incentives for services, you should almost never sell Common Stock in a financing. This will likely “taint” the FMV of your Common Stock, and effectively force you to set a significantly higher FMV for your stock options than you otherwise would have to. For that reason, it’s almost always recommended to do a financing either through preferred stock or convertible notes that will eventually convert into preferred stock. Because preferred stock has various preferences/privileges that Common Stock does not, you can sell preferred stock for, say, $2.00 per share, while still making a credible claim that the Common Stock is worth a fraction of that.
So how is it that founders and early employees are able to get millions of shares in their startups for practically nothing, without being taxed? Simple. At formation, the FMV of your startup’s stock is considered virtually nothing. Now, it’s certainly not worth nothing to you. But because you haven’t built an actual Company yet, the IRS accepts the argument that the huge amount of uncertainty and risk of failure make the stock worth fractions of a penny.
We generally issue founder stock at a price per share equivalent to par value (usually $0.0001 per share). So an issuance of 2,000,000 shares to a Founder would require a check for $200.00. Assuming that founder files her 83(b) election (bad news if she doesn’t), she won’t realize taxable gains until she decides to sell her stock.
Note that this is also an argument for getting your founder shares and early employee equity issued as soon as possible. The further along in your Company’s trajectory that you are (customers, revenue, investors), the greater likelihood that your Common Stock will have a higher FMV, and that the recipient will need to hand over meaningful cash either to you or the IRS in order to receive it.
After Formation, Financing
After formation, and as you move into seed funding, setting the fair market value of your Company’s stock becomes much more complex. Section 409A of the Internal Revenue Code is largely what drives that complexity, which this post is not meant to cover. The nutshell is that before a full venture capital financing, your lawyer will recommend that your Board of Directors use various “illiquid startup” guidelines to set the FMV of your stock. After a VC financing, you’ll likely get a formal 409A valuation from a bank or valuation firm, and use that to set the exercise prices of your options. There are a number of reputable valuation firms in Austin that we recommend to our startup clients, and, as with hiring a lawyer, you should be careful about going with the firm that offers the lowest price. That can come back to bite you.
- FMV is related to (but not the same as) your or a potential investor’s value of your stock.
- Issue equity and equity incentives as early as possible to avoid taxable gains.
- To avoid “tainting” the FMV of your Common Stock, never sell Common Stock in a cash financing.
- Consult with your attorney about setting the FMV of your stock as your company progresses.
Obligatory Disclaimer: I know you’re smart enough to know this, but this is not tax or legal advice. Things might be different in your particular context. Contact a professional before making a decision you might regret.