Stock Purchase Agreement: Why it Matters for Your Startup

A startup stock purchase agreement is a legally binding document that outlines the terms and conditions of the purchase of startup stock. The agreement aims to protect both the purchaser (which could be a founder, employee or investor) and the company by establishing clear expectations for the investment.

Most startup stock purchase agreements will include restrictions, such as vesting and restrictions on transfer, which will be discussed below. So the title of the document is often the Restricted Stock Purchase Agreement (RSPA).

One of the main advantages of a startup RSPA is that it provides clarity on how much equity a purchaser will receive in exchange for their investment. This helps to avoid any confusion or misunderstandings later on, which can be particularly important in fast-moving startup environments. With so much uncertainty surrounding early-stage investments, having a solid legal document in place can provide peace of mind for everyone involved.

There are several key terms and conditions that should be included in the RSPA. These include:

  • Sale of Stock
  • Consideration
  • Vesting
  • Limitation on Transfer
  • Investment and Taxation Representations

Of course, every company is different, so it’s worth hiring legal counsel to both draft and educate you on what’s right for your startup. If you are looking for legal counsel, feel free to reach out to us here.

Sale of Stock

The purpose of the RSPA is to transfer stock from the company to the stockholder. At incorporation, the stockholder is the founder. This section will describe the number of shares and the class of stock issued to the founder.

Consideration

The company does not simply grant shares to founders. Instead, founders are purchasing the shares from the company.

Consideration is a legal term that refers to something of value that is exchanged between parties as part of a contract. The consideration must be sufficient to support the contract, which means that it must have some value in the eyes of the law. In general, courts will not enforce contracts that lack sufficient consideration.

In the context of a startup RSPA, consideration is generally in two forms: cash and the assignment of intellectual property:

  • Cash. Founders pay a nominal amount of money for their shares — typically $0.0001 or $0.00001 / share. The math typically works out to $100 for the totality of the authorized shares. So, if a founder is being issued 25% of the authorized shares, then she is paying $25. Since the value is so low, many founders think it’s fine to skip the payment to the company. Don’t do this. Cut the $25 check to the company and make a copy of it for your records to ensure that you can prove that there is sufficient consideration for your shares. This can also help avoid disputes or issues related to the valuation of the intellectual property being assigned. You don’t want to have someone down the line question your ownership of your own company.
  • Intellectual Property. In addition to the cash, founders also contribute any related intellectual property to the company as additional consideration for the purchase of shares. It’s essential that the company, not the individual founder, owns all the intellectual property related to the company. This may include patents, trademarks, copyrights, trade dress, designs, wireframes, code base, business plans, collateral, email lists, etc. It is essential to execute a proper assignment so that title to the intellectual property is clearly transferred to the company. The founder should seek the advice of an attorney to ensure that the assignment is properly drafted and executed.

Vesting

It is incredibly common for one of the founders on the team to leave the company within the first year. A vesting schedule requires the founders to earn their equity over time and allows the startup to ensure that this founder is not leaving with a large portion of ownership in the company.

Vesting acts as both a reward and a motivator for founders. The reward: The longer you add value to the company, the higher stake you’ll have in the company. The motivator: If you’re not adding value to the company, you’ll have less (or potentially no) ownership in the company.

The most common vesting term for startups is four years with a one-year cliff. So, how does it work?

Let’s say James is a founder of our startup Gregarious Games Inc., and he is granted 4 million shares on a four-year vesting schedule with a one-year cliff. For the whole first year, the founder receives zero shares. But on the one-year anniversary, they receive all of the equity from year one: In this case, 1 million shares, or one-fourth of the total equity award. Then they will vest the remaining 3 millions shares over the remaining three years on a monthly schedule, or 8,333 shares per month.

Note that vesting is technically a right for the company to repurchase the founder’s shares. This is known as the Repurchase Option. The Repurchase Option lapses as the founder continues to work for the company. Here is typical language for a four-year vesting schedule with a one-year cliff:

1/4th of the Vesting Shares shall be released from the Repurchase Option on the 12-month anniversary of the Vesting Commencement Date (as defined below), and an additional 1/48th of the Vesting Shares shall be released from the Repurchase Option on the corresponding day of each month thereafter (and if there is no corresponding day, the last day of the month), until all Vesting Shares are released from the Repurchase Option. The Vesting Commencement Date is the date of this Agreement.

For founders, vesting schedules help ensure that employees remain committed to the company over the long term. This is especially important in the early stages of a startup when retaining key talent can make or break the success of the business. If you want to learn more about vesting, click here.

Limitation on Transfer

Typically, startup common shares have a limitation on transfer known as the Right of First Refusal (ROFR). The ROFR is a provision that allows the company to buy shares from shareholders before they sell them to an outside third party. With an ROFR, the company has the option, but not the obligation, to participate in any potential sale of company stock. ROFR provisions benefit the startup because they provide protection against taking on random shareholders who may not share the same long-term vision for the company or the other founders.

So, how does an ROFR work? When a founder receives an offer for shares in the company from a third-party buyer and before accepting the offer, the founder must notify the company and provide them with an opportunity to match that offer. The company usually has a certain time period to consider such a purchase. If the ROFR holder decides to match the offer, then they can purchase shares in the company from the selling shareholder at the price set forth in the third-party offer.

If you’d like to learn more about ROFRs, click here.

Investment and Taxation Representations

These clauses ensure that founders are in securities and tax compliance. It’s smart for a founder to have the RSPA reviewed by counsel to help the founder understand what they are agreeing to.

83(b)

An 83(b) election is a personal (not company) tax decision. So why do most founders choose to make the 83(b) election?

Normally, a founder will report only the value of the stock that vested in a given tax year as taxable income. For example, if employees have a four-year vesting schedule, they will report the value of the stock vested in each of those four years.

However, under section 83(b) of the tax code, an employee may choose to include the value of restricted stock as income at its fair market value on the date it was granted, rather than when it vests. This option can be valuable for employees who believe that their company’s stock will appreciate significantly over time.

By filing an 83(b) election, employees can lock in their tax liability at the time of the stock grant or purchase, instead of waiting until the stock vests. This can help employees reduce their overall tax burden. By paying taxes on the value of the stock when it is granted or purchased, they may avoid paying higher taxes later when the stock vests and potentially increases in value.

Let’s continue with the example from above. James has 4 million shares that vest over four years at a fair market value of $0.0001/share. The company does well, and the stock value increases. Yay! In year two, the stock price is $0.10 per share; in year three, it is $1 per share; in year four, it is $2 per share. So, how much in taxes would James pay on that stock if he didn’t make the 83(b) election, and how much does he pay if he made the election?

Option A — No 83(b) Election

  • In year one, James is paying taxes on ordinary income of $10 (1,000,000*$0.00001).
  • In year two, James is paying taxes on ordinary income of $100,000 (1,000,000*$0.10).
  • In year three, Jame is paying taxes on ordinary income of $1 million (1,000,000*$1).
  • In year four, James is paying taxes on ordinary income of $2 million (1,000,000*$2).

Option B — 83(b) Election

  • In year one, James is paying taxes on ordinary income of $40 (4,000,000*$0.00001).
  • In year two, James is paying taxes on ordinary income of $0.
  • In year three, James is paying taxes on ordinary income of $0.
  • In year four, James is paying taxes on ordinary income of $0.

Obviously, Option A is a far worse tax scenario for James. He will have a significant tax bill in years three and four. Remember, though the startup stock is valued at millions of dollars, that does not mean James has millions of dollars in his bank account. Startup stock is generally illiquid until much later in the startup life cycle. Furthermore, most founders aren’t paying themselves a high salary. So, in year three and four, it’s possible that James’ tax bill may exceed his salary. I’m sure this would not be a fun surprise for him and his partner.

To avoid this outcome, founders should consult with their personal tax advisors to see if it’s right for them. Every person’s tax situation is unique, but it’s likely that an 83(b) election will save the founder a significant amount on taxes.

There is a firm 30-day window to file. Founders must file their 83(b) within the first 30 days after their RSPA was executed or they miss the opportunity. If you’d like to learn more about the 83(b), click here.

In conclusion, a startup RSPA is an essential legal document that outlines the terms and conditions of an investment in a startup company. It provides clarity on how much equity an investor will receive in exchange for their investment and helps to avoid any confusion or misunderstandings later on. There are several key terms and conditions that should be included in the RSPA, such as Sale of Stock, Consideration, Vesting, Limitation on Transfer, and Investment and Taxation Representations. If you are considering starting a company or making an investment, it’s worth hiring legal counsel to both draft and educate you on what’s right for your startup. If you’re looking for legal counsel, feel free to reach out to us here.

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