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The One Thing Startup Founders Must Do After Incorporating

Updated: Aug 14, 2019

After you create a corporation, be sure to issue yourself stock.

I get it. You are a poor, self-funded startup founder and you want to devote the fewest resources possible to anything that is not building your business; in a vacuum, this makes perfect sense. While your logic is seemingly reasonable, the IRS tends to disregard reasonable logic and stick with formality. Let me explain...

Imagine for a moment that you proceed down the typical startup path, with the hopes of bootstrapping your way to a monolithic business. You find out that you need a corporation to sell your product or service to big customers, so you choose the path of least resistance and file your business’s articles or certificate of incorporation in [insert name of state here, but it should probably be Delaware] without doing anything more.

One year after incorporating, you find yourself with a business that has a $1,000,000 run-rate, a $5,000,000 pre-money valuation and investors throwing cash at you. What could possibly be the problem? Well, on your way to building a formidable startup, the corporation you created has grown in value, which means the fair market value of the corporation’s stock has grown. In order to take the investment dollars being thrown at the company, you will need to catch up on the corporate formalities, including stock issuance. Because you only filed an incorporation document one year prior without doing more, a present issuance of stock will create a taxable event of that could carry considerable value.

If the company issues stock to you after the company is actually worth something, the IRS views the issuance as equivalent to the company paying you (taxable) income equal to the fair market value of the stock issued to you. Of course, this scenario assumes that your stock is not subject to vesting restrictions, or that if your stock is subject to vesting (which it probably should be), you made an 83(b) election (which you probably should make). This is the point where the IRS comes knocking at your door demanding cash for the illiquid startup stock you just received. An attorney may be able to mitigate the liability created by the stock issuance, but it is unlikely that you will be able to avoid the tax hit altogether.

Attorneys can fix a great number of problems. For example, if after incorporating, you were to issue yourself stock using a stock purchase agreement that does not have all the fancy bells and whistles that most investors would like to see, an attorney can most likely help to put those bells and whistles in place at a later time. However, the boundaries of what a corporate attorney can fix are usually set by tax laws (and securities laws), as you can see from the example above.

The bottom line is this: After incorporating, don't put off your stock issuance.

*This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.*



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