Ask HN: Corporate structure for equity?
Recently I was approached by a business man who wanted a project developed. We started working out a spec, I gave him a quote, and he gave me a counter-offer that was pretty fair and offered some equity (10%) to make up for the difference between my initial price and his counter. Normally, I'd start cutting features, take his counter offer, and tell him to keep his equity. But this guy has an _uncanny_ ability to build buzz and successful (profitable) products.
This is a SaaS type deal which will be profitable from day one. There's no way we're going to be a target for acquisition or IPO, but I think it's probably going to do 100k < net income < 250k in the first year. (At which point I'm hoping to sell my shares back to him.)
What kind of corporate structure should we choose? I know everyone says C-corp in Delaware, but we're not raising any $. Should we still go with a C-corp? How would liquidation/transfer of this stock work? If I sell my shares to my partner, is it taxed as long-term capital gains?
How would owners draw work? Am I immediately entitled to 10% of the profits the second we become profitable? Is there a buffer period before I'm able to draw? Do we agree in advance on how much money gets reinvested into the business? I'd imagine that'd be his call since he's the majority holder, but is there a way to guarantee a percentage of profits I can draw out on a regular basis? What's the convention here?
As a partner, am I entitled to inspect the books whenever I feel like it? I don't have any reason to believe he'd screw me but I'd like to cover my bases rather than have things get messy later on.
Thanks guys! :)
7 comments
[ 2.7 ms ] story [ 27.3 ms ] threadWith an LLC you literally own a percent of the company, rather than a number of shares (which equates to a percent). This can be bought or sold just like shares. However, you may choose to put restrictions on exactly what circumstances one of you can sell, and to whom, and with what provisions. Often, the other partner gets right-of-first-refusal to buy at the price that you were about to sell it at. This would be fine in your case, since your partner is your target.
LLCs can divest their profits to shareholders at the end of each fiscal year, at which point it is taxed as personal income. With a corporation, this would be considered a dividend. Dividends are "post-income" -- they are paid from profits, not revenue. This means that the money is taxed as corporate profit (15%) before it reaches you. Then you are taxed again as an individual.
Furthermore with a C Corp you pick up a bunch of reporting requirements. For starters, you need a Board of Directors, and you are required to have an Annual Meeting, the minutes of which must be filed with the government.
I'm not sure about financials. My understanding is that as a member of an LLC you are privy to all of that, but you can do a lot with the operating agreement to change defaults, so make sure you have your own counsel if your partner is the one drawing up the docs.
This sounds a little messy. Draws/dividends aren't mandatory or an entitlement. As the majority holder and presumably the CEO, draws, reinvestment, and fat bonuses (to him) would be at his discretion.
If you really want to do this as an ownership thing, I'd ask for preferred shares and explicitly enumerate some rights/protections. (You have the right to inspect the books; a mandatory dividend payout; spell out his compensation in advance; etc.)
What about doing this as a partnership/royalty deal? You take 10% of all proceeds, net of hosting expenses? That sounds like it would be much cleaner. He could still buy out your share of the partnership at a later date.
If the business succeeds in 12-18 months then the money to pay you will be there, if it doesn't then the contract will be worth as much as your "shares" (zilch).
The issue with equity, no matter the structure, is that it comes with a pretty difficult tax burden. That equity counts as taxable income. Be prepared for that... If this guy is forming a new entity to cover this, there is still going to be some level of initial valuation. You'll be taxed on 10% of that. If there is some sort of vesting schedule in place, it gets even more complex (in that situation you need to fill out a form electing to be taxed on the whole amount today, rather than as it vests).
The point being: You need to be concerned with more than just the structure of the entity, but how this will effect your personal income situation as well.
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As for the rest, there is already some good advice here. If you go the LLC route, then you need to specifically talk to a lawyer to ensure that you are protected when the operating agreement is drawn up. With a LLC there is very little implicit protection for you, everything has to be specifically spelled out in the partnership agreement.
A C-Corp would give you more options, for things like preferred stock.
The suggestion about taking this is a revenue share is probably sage advice. If you're goal is to generate passive income, then equity is not the answer. Equity has no intrinsic value until you actually sell the business (and depending on the structure it may not have value then). I've seen partnership agreements that give x% to a partner, but provide a minimum floor for another. Meaning that when the company sold the first partner took $10M right off the top, and then the other partner only got 10% of the rest.
In other words, if you go the equity route you really need a lawyer and a CPA to help you sort through all of the implications. This is not simple stuff.
...this guy has an _uncanny_ ability to build buzz and successful (profitable) products.
If he is that good, why would he offer you 10% of his new product just to shave a little bit off the initial development cost?
Get a really good lawyer who has done this many times before. Be sure to do a shareholder's agreement -- a prenuptial agreement for the business. Things WILL go sideways. Mr. Wallet will think his money caused the venture to flourish. You'll think "Meh, my ideas were so good his money wasn't really needed." Resentment ensues. Business dies.
Oh. And say all the hard stuff now. Talk it through. All of it. "What if I decide I hate your guts? Then what?" Etc.
But yeah. As one of the commenters said, why are you getting equity when Mr. Wallet could just rent your brain? Ask him: "Why me rather than someone else?" "Why now?" "Why this arrangement?"
Hint: sometimes Mr. Wallet has less wallet than he appears to have. Maybe not your Mr. Wallet, but I've seen this happen.
EDIT: done correctly, the legal fees for setting up your business would be large. A non-amateur lawyer might go north of $20K by the time it's done. Maybe the transaction costs of setting up co-ownership aren't worth it. Maybe you follow the Hollywood approach: take a small percentage of the gross.
/Phil.