Define your capitalization model coherently. This means deciding on a number of authorized shares, on the number of shares to be allocated to each class of stock if more than one class is used, on the number of shares to be issued initially to founders, on the number of shares to be allocated to a stock pool for later equity incentive grants, and on the number of shares to be kept in reserve. For example, you can have 10M authorized shares, all of which consist of common stock (if given a par value, it is typically very low, e.g., $0.0001 per share).
Of the 10M authorized shares, you might choose to issue 6M to the founders at inception, allocate 1M to an equity incentive pool, and keep 3M in reserve for future investors or co-founders. Or you can create added classes of stock as well: for example, a class of super-voting stock by which each share might have, e.g., 30x voting power as opposed to the 1x voting rights of the regular common stock; also, a class of founder preferred stock (so-called “FF” stock) by which founders can have a vehicle for cashing out a part of their holdings during interim funding rounds without the company’s having to mess up its common stock pricing and without the founders losing the capital gains treatment on any sale of stock done at that time.
Decide on control issues. Usually, the majority of voting shares controls the company. In Delaware, the effective exercise of control occurs through a board of directors and the person or persons holding the majority of voting shares controls who gets on the board. You can have one director only or you can have multiple directors. A typical number at inception is anywhere from one to three. Matters that are not part of a company’s ordinary course of business need board approval. For example, appointing officers, issuing stock, granting options, borrowing money, taking out a lease, etc. The board in turn appoints officers, who handle the operational or day-to-day affairs. Officers serve at the pleasure of the board and can be replaced at will by the board unless they have been given special employment contracts specifying otherwise.
Issue restricted stock to the founders. The standard is 4-year vesting. If you use a cliff, this is usually at the 1-year mark, at which point 25% of the grant will vest with the remainder typically vesting at the rate of 1/48
th per month until the entire grant is fully vested. If you do not use a cliff, then the entire grant will typically vest in a monthly pro rata way over the 4-year period. There is nothing magical about using four years or in using monthly pro rata vesting. These are customary terms. But you can use whatever you agree to. You can vest over two or three years or five years, as opposed to four. You can set vesting points at quarterly or annual increments.
But remember: whatever you do has to make sense for founders. Founders usually do not work for salary or at least not for anything close to market salary. They therefore expect reasonable vesting terms, and this is why they are usually set at the customary terms. Note also that you can mix and match with vesting. One founder can get an unrestricted grant and not be subject to vesting at all. Another can get the customary 4-year vesting at a monthly pro rata rate. Still another can get a grant where 10% or 20% is immediately pre-vested with only the balance subject to vesting.
And you can do this or a wide range of other variations all at the same time without having any legal restrictions on your ability to do so. You can even do a setup where founders just grant themselves shares outright, without restrictions, because they trust one another and do not believe there is any risk of a founder walk-away (this is rare). Whatever you do, just be aware that your investors can and often do expect that you conform vesting terms to what they want at the time of funding and so it can happen that your vesting will be redone at that time.
Use cheap stock to do the initial grants. Numbers like $0.0001 per share are customary and usual. So long as stock must be earned out through vesting, the tax authorities regard its value as service-related income. So, if two people are unsophisticated enough to set up a company by which one puts in $500K for half the stock and another gets the other half of the stock on terms by which he has to vest over four years, then each half is worth $500K and the person working for sweat equity realized $500K in taxable income for his shares under section 83(a) of the tax code (or possibly $250K on the theory that the company is worth what cash it has in it, but in any case a large number). Do avoid such problems by keeping the stock price cheap at inception.
In the vast majority of cases with startups, even when what they are doing is in fact incredibly valuable and whole swaths of the startup community are dying to be part of it, the law has no basis for putting a dollar value on that effort and therefore, when the founders say they are capitalizing the entire company with a grant of 6M shares at $0.0001/sh such that the entire company is worth only $600, well, there is no normal legal way to second-guess this.
Therefore, it is good practice to set up your company using this sort of pricing model. Founders know this. More important, investors know it too and they do not hold it against anybody in arguing over valuation in later stages. It is basically understood all round that all of this is for positioning only and has no real importance for determining valuation.
Just to emphasize, it is one of the crucial planning tools for startups to keep their stock price low often for long periods in the early phases of the venture in order to have maximum flexibility for offering equity incentives to key people, not just founders but to all early-stage people. At some point, you do an equity funding or other things happen by which you either can’t or don’t want to keep the stock price cheap anymore. But, until that happens, keeping the stock price low is routinely part of the strategic planning for how you do the initial setup and for how you do early-stage funding. It factors into a lot of things.
For any founder grants that are subject to vesting, each founder needs to file an 83(b) election within 30 days of date of grant. Do this right and do it without fail. Otherwise, the tax problems can be major. Don’t neglect formalities either (e.g., spousal consents).
It is important to put restrictions on transfer on all grants. Normally, this is a simple right of first refusal held by the company. VCs these days prefer much broader and more absolute restrictions on the stock of hot companies to prevent secondary trading markets from arising. But these normally come in during amendments made at the time of funding, not at inception. So too with things like drag-along rights, which can be important tools but, again, are typically left to a later stage.
Do IP assignments to capture all historic IP for the company if people have been working on IP-related things before company formation. Founders do not automatically give up IP rights to things they have been working on just because they become founders and get a big stock grant. They must assign any such rights to the company by a written instrument. Usually this is done as part of their getting a grant of stock and often is expressly stated to be the consideration they are paying for their stock.
Put in place mechanisms to capture IP going forward after the initial stock is granted. Again, it is not necessarily automatic. Make sure to have all employee-founders sign confidentiality and invention assignment agreements. Make sure to have all non-employee founders sign work-for-hire agreements. If you do not, they may wind up owning the IP they develop through their efforts on behalf of the company and this is so even if they are paid for their work on top of any stock compensation. Don’t leave these things to chance or make them hit or miss. You will be grilled on all such matters in due diligence in any significant funding round and at M&A. Button up these issues tight.
If contractors have helped with development, either before or after company formation, make sure you get IP assignments from them as well. It is not enough that they have been paid for their efforts. There also needs to be in place a work-for-hire agreement by which they assign IP rights. If none was in place when the work was done, get them to assign their rights by giving them small option grants in the venture or something similar. Do not leave loose ends here.
Set up an equity incentive plan. This can be deferred if need be but best practice is to do it up front. You will typically need to qualify the plan for securities law purposes. Allocate shares to a pool within the plan. This will need both shareholder and board approval. You can issue incentive grants or stock options outside a plan but you can’t issue incentive stock options in such cases and you need to do case-by-case compliance with securities laws to issue stock or options outside a plan. This is a major pain.
You can do it in select cases for good reason (for example, say you add another founder some months in and need to grant this person a large chunk of equity that would consume all or most of the shares in a pool – well, you can issue such stock outside the plan so long as you take proper steps to ensure securities law compliance for that grant). Once a plan is in place and shares are allocated to it, the board can make grants as it deems proper to employees or others without having to qualify each grant under securities laws. That is the main benefit of having a plan. When you have a lot of employees, etc., it is indispensable for administering equity incentives.
Qualify your Delaware corporation with your home state by registering it as a foreign corporation so it can do business in your state.
The above is a checklist of key issues that need to be addressed. As with any company formation, however, there will also be a laundry list of small formalities that also need to be addressed. Either educate yourself to find out what they are and comply with them or work with professionals who know what they are doing to cover such points.
The above is also by no means the only way to set up business as a startup. It is the conventional way and is best suited to rapid growth/massive scale ventures that will be seeking significant outside funding relatively early on.