Stock For Services: The Passage of Time Approach

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP

2002-08-02

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Stock For Services: The Passage of Time Approach: The complementary device for allocating the founder his cheap stock tax-free (stock for services) involves organizing the start-up entity as soon as the founder starts to consider a maiden voyage. To the extent the founder receives his shares well prior to the first-round financing, the founder/taxpayer can argue that the passage of time and events accounts for the increase in value–$10 for the investors' stock versus 10¢ for his shares. The risk is that the IRS will successfully argue "step transaction." However, that argument is vitiated if the financing was only a contingency when the founder's stock was issued, the moral of the story being that it usually does not cost anything to organize the startup as early as possible and may provide substantial tax comfort.

The lesson, in sum, signaled by the discussion in this and the previous section is that the early bird catches the worm. Once the first round of financing has occurred, the dimension of the "cheap-stock" issue changes. It is considerably dicier to contend that the preferred "eats up" value when common shares have traded in the interim or otherwise been priced in arm's-length transactions. The planning process must shift to the arena of executive compensation, that is, stock equivalents, stock options, restricted stock bought with borrowed company funds, and so forth. (The importance of the question whether the employee shares are issued at less than fair-market value is not confined to the tax arena. Bargain stock will create compensation expense on the company's books, impacting earnings as the discussion in Chapter 11 of Book 0, "Compensating Your Key Executives," points out in greater detail.)