5 of the Dumbest (and Most Costly) Startup Mistakes, Part 4

5 Dumbest Mistakes

For those of you who just joined in, I am a corporate partner at a Gunderson Dettmer – a Silicon Valley based law firm that works exclusively for technology companies and VC’s. I make my living working for startup companies but I want to help you spend less money on lawyers.

I spend an awful lot of time (usually on short notice the night before an important deal is supposed to close) fixing preventable problems. An awful lot of these problems relate to hiring, compensating and incenting early employees. All of them cost money and time that I would rather see invested in building teams and product.

Over the next few Wednesdays I’ll be posting a few short pieces that may help you avoid, last minute fire drills, unnecessary accounting or legal fees, angry investors and perhaps an occasional lawsuit or regulatory audit. Hopefully by highlighting a few of the most common employment related problems I can help you avoid them.

5 of the Dumbest (and costly) Mistakes Startups Make with Their People, Part 4

1. MISTAKE # 1 OF 5: Not Understanding Obligations to Prior Employers

2. MISTAKE #2 OF 5: Failing to be Informed About Employee Rights with Respect to Wages

3. MISTAKE # 3 OF 5: Employees Versus Independent Contractors

4. MISTAKE # 4 OF 5: Failing to File Those 83(b) Elections

Without getting too deep into the weeds, an 83(b) election refers to a tax code section that allows the taxpayer to make an election on when to pay taxes in connection with the acquisition of certain kinds of stock.

Founders in a typical startup will acquire their stock subject to vesting – if they leave the company, the unvested portion of the stock can be repurchased by the Company at cost, or at the lesser of cost or the then current fair market value of the stock. That repurchase right is the key element for 83(b) purposes.

A founder who makes the 83(b) election is electing to measure the tax consequences of the purchase at the time of the purchase. Failing to make the election means that the tax consequences are measured at every vesting date during the entire vesting period.

Since the tax is on the spread between the fair market value of the stock and the price paid, so long as fair market value is paid at the outset, there should be no spread at the time of the election and no tax on that acquisition (there will of course be tax on the gain when the stock is eventually sold).

The big “gotcha” in failing to make the election is that the fair market value is reassessed at each vesting period and it can change dramatically during the typical 4 year vesting period.

When you imagine that a typical startup (where founders’ stock is purchased for fractions of a penny) can conceivably go through several rounds of financing and even an exit or IPO during the standard 4 year vesting period, the tax consequences of that ever increasing spread between fair market value and the original purchase price can get really ugly.

83(b) elections have the added issue that the election must be made within 30 days of acquiring the stock or it is missed. There are no second chances or ways around the deadline.

Next week I will address mistake #5 OF 5: Ignoring Internal Revenue Code §409A One Last Tax Code Reference – Section 409A

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