You have to give credit to Delaware — they make paying your corporation’s franchise taxes “thrilling.”

For example, if you authorized 10,000,000 shares of common stock in your certificate of incorporation, you will receive a franchise tax bill stating “$75,075″ as the amount owed. This total is computed based on your startup’s number of authorized shares.

But it’s a good thing for your startup that Delaware offers an alternative way to compute your franchise tax bill: the “Assumed Par Value Capital Method.”

This was the topic of a post I wrote 2 years ago titled “The Delaware Freak-Out.” If you have a startup that is incorporated in Delaware, it’s probably a good time to revisit that post.

Sounds like a great deal, but there is more to a proper startup incorporation than simply filing the articles of incorporation with the Secretary of State. The 19 other “tasks” they list? Little or no value.

Want to vest your founders’ shares? Can’t do that through an incorporation service. In fact, typical incorporation services do not even offer a stock purchase agreement. And you can definitely forget about a technology transfer agreement or anything else IP-related. Documents like these are the critical components of a proper startup incorporation.

When you use an online incorporation service to incorporate your startup, you aren’t getting a deal on incorporation. Instead, you are overpaying for 1/10th of a proper startup incorporation.

If all you want to do is file a charter, you can “skip the lawyer.” And you can skip the incorporation service as well.

Advice Varies

There’s a wide range of counsel on this topic. Most lawyers will say you should have incorporated “Yesterday!” while some non-lawyers will say that you can wait until your first round of funding because “Google did it.” There’s no right or wrong answer on this one, but you probably did not need to incorporate yesterday nor should you wait until your first round to do so.

My advice to you is simply: Don’t incorporate a hobby. Incorporate when you are serious about making your startup a business.

But for those of you who prefer the quantitative, I put together the following decision matrix:

When to Incorporate Decision-Matrix

Answer the following questions and tally up your total score.

(1) Does your startup have more than 1 founder?

Yes –> 10 points
No –> 0 points

(2) Are you (and/or one of your co-founders) working on your startup full-time?

Yes –> 5 points
No –> 0 points

(3) Will your startup take longer than one year to exit?

Yes –> 5 points
No –> 0 points
Maybe –> 3 points

(4) Is your startup hiring developers or designers?

Yes –> 7 points
No –> 0 points

(5) Is your startup granting stock options or other equity compensation?

Yes –> 7 points
No –> 0 points

(6) Is your startup high-risk for a lawsuit?

Yes –> 10 points
No –> 2 points
Maybe –> 7 points

(7) Is your startup seeking seed or venture capital?

Yes –> 6 points
No –> 0 points
Maybe –> 3 points

(8) Is your startup signing contracts with third-party companies for business services (not for IP creation or development)?

Yes –> 4 points
No –> 0 points

The Results:

24 points or less: Save your $$$ on incorporation and spend it on an iPad.
25 points or more: Incorporate now (iPad version 2 will be better, anyways)

Feel free to suggest a revised/additional questions or weight to the matrix. Of course, this is meant to be more of a “fun” exercise for entrepreneurs rather than an absolute guide.

Because if you can log on to the Internet, you can handle the complexity of a corporation. Don’t be scurred.

Founder IP License Problem

Even if the founder offers the startup a completely startup-favorable license, the founder IP license scenario should be a non-starter for most startups. The problem is that even a free and exclusive license to the startup falls short of vesting IP ownership with the startup.

If the intellectual property to be licensed by a founder is a big piece of the startup’s technology, the founder license problem is amplified. If the startup doesn’t work out, and must be sold in a liquidation, the license agreement may be terminated. Quite simply, the startup will be without its only asset of value.

If the startup is without an important and valuable asset, why would someone invest in the startup?

Founder IP Should Become Startup IP

Founders should transfer their IP ownership to the startup. Founders create wealth through the ownership of their startup’s equity, and withholding the outright transfer of IP runs contrary to this principle. Even worse, the founder may be hedging his bet regarding the success of the startup.

If a founder is hesitant to transfer ownership of his IP at incorporation, a possible solution is to increase the founder’s equity share. This may be a “fair” thing to do, since how a startup should split equity between founders depends on various factors that include founder IP contributions.

Conclusion

A founder license of IP will greatly reduce–and likely eliminate–the chances an investor will consider your startup worthy of investment dollars. Thus, if you are a potential co-founder of a startup where another founder will only license his or her IP to the startup, I would think twice about joining the startup.

Now if your startup received a $5MM Series A investment from a venture capital firm, how many developers (that you can recall) would come out of the shadows of the internet and claim to be your startup’s long lost founder? The answer to this question depends on how well your startup secures its intellectual property.

Lost Founders

You may not consider a developer that worked 1 day on your startup 2 months before you incorporated a “founder.” But if your startup becomes a wild success, the developer will. Even worse, this lost founder will have more leverage now with your startup than if you had acquired his intellectual property at the outset.

Even if you aren’t worried about long lost founders laying claim to your startup’s intellectual property, your potential investors are. The status of your startup’s intellectual property, including whether you have signed agreements with all developers, is typically among the first set of questions your startup will receive from a potential investor. Thus, it’s wise to lock down your startup’s IP early to prevent the lost founder problem.

How to Lock Down the IP

One of the most important aspects of a startup incorporation is the ability to transfer intellectual property ownership from the founders to the startup. Each founder is issued shares in the startup in exchange for the founder’s intellectual property (and usually a small amount cash). In other words, the startup issues shares to the founder as consideration for the founder’s intellectual property and small check. This element of consideration is required for the formation of a valid, binding contract. The exchange is typically handled via a “Technology Assignment Agreement.”

But what about developers who work for the startup that aren’t founders?

Consideration for services rendered should be given to all developers and consultants that work on anything IP-related at your startup. This includes whether the developer or consultant worked prior to your startup’s incorporation or afterwards. Like the incorporation, the intellectual property transfer will be executed pursuant to a Technology Assignment Agreement.

The consideration given to developers and consultants does not have to include your startup’s equity. Consideration can also be cash. But since cash tends to be a scarce resource at startups, such consideration typically takes the form of restricted stock or stock options.

Conclusion

Like the lost-relative problem occurs only upon a winning lottery ticket, the lost-founder problem only occurs if your startup is successful. To avoid lost founders from showing up on your startup’s doorstep, take proactive measures to lock down your startup’s intellectual property.

(1) Indemnification

The startup can include language in both its charter and bylaws that indemnifies directors for expenses and losses incurred as a result of the director’s position. Indemnification is available only if permitted by the laws of the startup’s state of incorporation. Thus, language requiring the Company to indemnify its directors “to the fullest extent permitted by [State] law” is frequently incorporated into charters and bylaws.

(2) Indemnity Agreements

In addition to the indemnification provisions in the startup’s charter and bylaws, a startup may choose to sign a separate indemnity agreement with each member of the board of directors. Indemnity agreements will often contain terms that supplement the indemnification provisions found in the startup’s charters and bylaws. A board member may also desire this additional contract because the startup can’t change the indemnification contract terms without the director’s consent.

(3) Directors’ Insurance

A startup can purchase directors’ insurance (also known as a “D&O Policy”) to protect the directors. The D&O Policy doesn’t increase the directors’ personal liability protection. Rather, it helps to ensure that the director will be able to enjoy the indemnification benefits provided by the startup’s indemnification provisions and optional indemnification agreement. That is, the D&O policy’s proceeds will help supplement a startup’s likely lack the financial resources to sufficiently indemnify the directors.

But what if a director goes Patrick Bateman on my startup?

Keep in mind that the indemnity protections for directors (and the D&O policy) will include carve-outs for things like director intentional misconduct and bad faith. Thus, a director who commits intentional acts to harm the startup or acts strictly for his own personal enrichment would likely not be protected.

The federal exemption most likely available for founders is Section 4(2) of the Securities Act of 1933, while the state exemption is determined by the particular state’s law.

In California, founders typically use the registration exemption found in Section 25102(f) of California’s Corporations Code (see the next section for the full text). Section 25102(f) grants the issuer (the startup) an exemption from securities qualification for certain limited securities offerings.

As part of the exemption, founders in California must file a 25102(f) notice, also called a “Limited Offering Exemption Notice.”

California Corporations Code section 25102(f)

California Corporations Code section 25102(f) exempts from the provisions of section 25110:

“Any offer or sale of any security in a transaction (other than an offer or sale to a pension or profit-sharing trust of the issuer) that meets each of the following criteria:

4. The offer and sale of the security is not accomplished by the publication of any advertisement. The number of purchasers referred to above is exclusive of any described in subdivision (i), any officer, director, or affiliate of the issuer, or manager (as appointed or elected by the members) if the issuer is a limited liability company, and any other purchaser who the commissioner designates by rule. For purposes of this section, a husband and wife (together with any custodian or trustee acting for the account of their minor children) are counted as one person and a partnership, corporation, or other organization that was not specifically formed for the purpose of purchasing the security offered in reliance upon this exemption, is counted as one person. The commissioner may by rule require the issuer to file a notice of transactions under this subdivision. However, the failure to file the notice or the failure to file the notice within the time specified by the rule of the commissioner shall not affect the availability of this exemption. An issuer who fails to file the notice as provided by rule of the commissioner shall, within 15 business days after demand by the commissioner, file the notice and pay to the commissioner a fee equal to the fee payable had the transaction been qualified under Section 25110.”

California set forth the requirement of the 25102(f) notice via California Code of Regulations (CCR)Section 260.102.14, since section 25102(f) only “allows” California to require the notice (see the bold language above).

When to File the 25102(f) Notice

The 25102(f) notice must be filed with, or mailed to, the Commissioner within 15 calendar days after the first sale of a security in the transaction in California. The “first sale” in California occurs when the startup has obtained a contractual commitment in California to purchase securities the startup intends to sell in connection with the transaction. No subsequent 25102(f) notices are required for sales in connection with the same transaction.

How to File the 25102(f) Notice

As of July 2005, startups must file the 25102(f) Limited Offering Exemption Notice electronically, via the California Department of Corporations website here. Startups can file the 25102(f) notice in person or by mail only if they can prove hardship. Hardship is essentially if the startup can’t use a computer without unreasonable burden or expense or you can’t provide information requested on California’s website without unreasonable burden or expense.

25102(f) Notice Filing Fees

Filing Fees are calculated based on the value of securities proposed to be sold:

$25,000 or less — $25.00
$25,001 to $100,000 — $35.00
$100,001 to $500,000 — $50.00
$500,001 to $1,000,00 — $150.00
Over $1,000,000 — $300.00

Here’s a link to a 25102(f) Notice in PDF form.

Under this vesting schedule, founders will vest their shares over a total period of four years. The one year cliff means that the founders will not get vested with regards to any shares until the first anniversary of the founders stock issuance.

Upon the one-year anniversary, the founders will each vest 25% of their total shares. Vesting will usually occur monthly after the cliff expires.

Here’s what a “4 Years with a One Year Cliff” vesting schedule looks like in a legal document:

“…25% of the total number of Founder1′s Shares shall be released from the Repurchase Option on the one-year anniversary of this Agreement, and an additional 1/48th of the total number of Shares shall be released from the Repurchase Option on the corresponding day of each month thereafter, until all of Founder1′s Shares have been released on the fourth anniversary of this Agreement.”

The “Repurchase Option” is simply the company’s option to repurchase Founder1′s unvested shares upon Founder1′s departure from the startup company. Also, you should note that vesting schedules trigger other complex issues such as tax, so please don’t simply copy the above text and paste it into a stock purchase agreement.

Authorized Shares Method

Delaware sends out their franchise tax bill invoices based on the number of shares the startup corporation has authorized, known as the “Authorized Shares Method”:

-$75 for 1-5,000 shares;
-$150 for 5,001 – 10,000 shares; or
-$150 PLUS $75 for each additional 10,000 shares (or portion thereof) above 10,000 shares.

Thus, if your startup authorized 10,000,000 shares, your startup’s DE tax bill will likely be $75,075. Not exactly a number a bootstrapped startup wants to see, right? Thankfully, there is an alternative way to calculate your startup’s DE franchise taxes–and one that is very likely to lead to a much lower tax bill.

Assumed Par Value Capital Method

Instead of using the Authorized Shares Method, a Delaware startup can choose to have its annual franchise taxes calculated using the “Assumed Par Value Capital Method.” In this method, your startup’s Delaware franchise tax bill is calculated based on all issued shares, authorized shares, and total gross assets in the following manner:

Step 1: Divide Total Gross Assets by Total Issued Shares (“Assumed Par Value”)
Step 2: Multiply Assumed Par Value by Total Authorized Shares (“Assumed Par Value Capital”)
Step 3: The franchise tax is calculated at $350 per every $1,000,000 or portion thereof of Assumed Par Value Capital.

Here’s an example of a calculation of a startup with total gross assets of $250,000, 5,000,000 issued shares and 10,000,000 authorized shares:

Step 1: $250,000/5,000,000 shares = $0.05 Assumed Par Value
Step 2: $0.05 * 10,000,000 shares = $500,000 Assumed Par Value Capital
Step 3: $350 * ($500,000/$1,000,000) = $175.00 Franchise Tax

(Note: The example assumes the startup’s actual par value on its shares (i.e., in the charter) is lower than the assumed par value. Otherwise, the actual par value is used in place of the assumed par value in Step 2 above)

Conclusion

Most startups will benefit by using the Assumed Par Value Capital Method when calculating its Delaware Franchise Taxes. The problem is that your startup isn’t given this option until it actually logs on to the Delaware state site to file and pay the annual franchise tax.

Here is a link to a Delaware Franchise Tax Calculator. Here is a link to FAQ regarding Delaware Taxes.

UPDATE: Delaware increased its minimum franchise tax using the assumed par value capital method to $350.

LLCs are great because they are “simple.” But eventually the startup will have complex legal needs and the startup LLC will end up having to draft corporation-like provisions into its documents. It ends up being much easier to convert to a corporation at that point rather than adapting the LLC to operate like a corporation.

(1) IT DEPENDS

If you’ve ever hired a lawyer, you will (unfortunately) hear the phrase “it depends” several times. In this situation, the “it depends” hinges on the respective past/current and future contributions of the founders:

Past/Current Contributions:
- The Idea
- Business Plan
- Intellectual Property
- Cash (Consider structuring this separately from the founder split.)

Future Contributions:
- Time
- Opportunity Cost (i.e., Is one founder making a larger sacrifice?)
- Industry Expertise

After taking the above items into consideration, a startup team will rarely end up with an equal split. And for what it’s worth, a startup team should rarely end up with an equal split. On the other hand, I don’t recommend the startup team create a complex methodology to come up with the solution. Save the fanciness for the code.

(2) QUICKLY

Rather than pushing forward with development & implementation, co-founders run the risk of spending too much time on the equity-split decision. In addition to multiple startup-wide meetings and emails about the split, the individual co-founders will spend time wrangling with the matter as well. However, it’s not going to “kill” the startup if this decision takes a bit of time.

The main reason to have this determination done very quickly is that the startup team gets to have — and conclude — its first difficult conversation. There’s no avoiding difficult conversations at a startup. Don’t start with the first one.

Regardless of how you decide to split the intial equity pie, seriously consider vesting your founders shares.

Finding out whether you can reserve your desired corporate name in Delaware isn’t as exciting as landing a 5-letter domain with a domain registrar, but at least you don’t have to pay to search like other states.

The sample startup documents, located at docstoc.com, include:

- Bylaws
- Certificate of Incorporation
- Initial Stockholder Consent
- Invention Assignment Agreement
- Restricted Stock Purchase Agreement
- Indemnification Agreement
- Initial Board Consent
- Action by Incorporator
- Plain Preferred Term Sheet

My 3 quick caveats regarding the docs:

(1) Looks like they are set up for a California-based Delaware corporation.
(2) Don’t forget to send in your 83(b) election form in the Restricted Stock Purchase Agreement.
(3) Consider whether you have to file a 25102(f) notice if your startup has ties to California.

TRANSFER THE INTELLECTUAL PROPERTY TO YOUR STARTUP COMPANY

In the episode, Coverplay Inc., was looking to raise about 350k from the show’s angel investors. A few investors made proposals and one particular investor offered Coverplay’s 2 founders 350k in exchange for 40% of their company. Coverplay countered with 350k in exchange for 30% of the company…and 10% of the patent. The show went to commercial and I said to my wife “Uh oh, their corporation doesn’t own the patent.”

After the break, all the investors pulled their deals off the table. Without the intellectual property, there was no business. The investors (rightfully) assumed the patent was owned by the company. In essence, Coverplay was asking for investment in something they didn’t own. (Side: This is happening often on the show. Many entrepreneurs are claiming they own the IP when they really don’t.)

Coverplay explained that Allison Costa, one of Coverplay’s founders, owned the patent. Then Allison further explained that her ex-husband also owned part of it as well. I can only assume that Costa had some type of patent license deal with Coverplay.

When starting a company involving intellectual property, you must transfer the IP to your startup. For example, if the intellectual property is developed prior to incorporation, you can transfer the IP via the founder’s stock purchase and tech transfer agreement.

A corporation’s registered agent must be located within the relevant state. For example, if your Texas company is incorporated in Delaware, your company will need to hire a registered agent in Delaware. If your Texas company is incorporated in Texas, you or another shareholder or officer could be the Texas registered agent (assuming each resides in Texas).

The registered agent must be available during normal business hours and supply a physical address in the relevant state–no P.O. boxes or private mailboxes. Since this address is public record, some people opt to hire registered agents to maintain privacy.

The most common mistake startup companies make is failure to update the name and/or the address of the startup’s registered agent. For example, if you fail to update registered agent information with the secretary of state, your company could be sued–and lose–without your knowledge. In Texas, the secretary of state becomes the registered agent on behalf of your startup if your startup fails to maintain a registered agent, or the registered agent listed with the secretary of state cannot be found with “reasonable diligence.”

Rates for registered agents tend to range between $50 to $360 per year. Finally, here’s a link to the Delaware General Corporation Law regarding registered agents.

Thus, failure to make an 83(b) election could leave the founder with a tax bill without experiencing a liquidity event.

The 83(b) election neutralizes this potential disastrous tax consequence, and the founder recognizes “income” upon the initial restricted stock purchase. This income is usually $0, as the initial restricted stock purchase price is usually made at FMV.

The Class F Common offers founders various protective provisions such as:

-2 to 1 Board votes per founder relative to non-founder board members
-10 to 1 share votes relative to regular common shares
-Monthly vesting with no cliff
-Approval rights on new investments, liquidity events, increases to Board size, etc.

Why did the Institute create Class F? They answer this question on their website (www.founderinstitute.com):

Since the internet bubble burst, a number of enhanced protective provisions have been introduced into preferred stock. As an example, “participating preferred” has become commonplace since the last crash. Meanwhile, there have been comparatively few advances to protect founders, who are forced to accept historically bad investment terms and being terminated from their companies by investors in the current economic environment.

They also go on to claim:

Class F is [the] most founder-centric shares created to date, including more generous than the infamous founder agreements of Larry and Sergey at Google. Companies in the Institute also have a warrant that requires permission from the Institute when a founder is removed from the Board of Directors, or the company will suffer a financial penalty.

The set of startup documents include the Certificate of Incorporation and the Stock Purchase Agreement, along with Institute-specific Founders Agreement and Warrant. Check them out here.

LegalZoom just doesn’t offer the documents a typical startup needs: Shareholders Agreement? Nope. Stock Purchase Agreements? No. Tech transfer agreements? Nada.

What about the quality of LegalZoom documents? Robert Shapiro, co-founder of LegalZoom, explains the quality of LegalZoom documents in a 2004 interview:

“And everything we do at LegalZoom is an original document. We’re not a form-filling service. Our documents are first-rate.”

Look, I’m sure they have some great documents, but I’m calling bullsh!t on every document at LegalZoom being an ‘original’ document. For those that don’t remember, Shapiro is the dude that represented O.J. Simpson. Take that for what it’s worth.

If you don’t have the resources to hire a startup lawyer (or just don’t want to), then simply don’t hire anyone to incorporate your startup. Not your accountant, not your financial planner, and definitely not LegalZoom.

Instead, do it yourself and save even more money. If you need help, I think you’ll find that employees at the Secretary of State are very helpful. They will not be able to help you draft your documents, but they will answer your questions about incorporating. And some states will have template articles of incorporation you can use.

Delaware’s Division of Corporations contributed $700.8 million in revenue to the state in fiscal 2007. That was about 22% of the state’s total revenue.

According to Mark Roe, a Harvard Law Professor interviewed in the Deal Journal article, most of the Division of Corporations revenue comes from corporate franchise tax fees:

The current situation is that Delaware’s corporate tax base is eroding. On Delaware, it can have a big effect because Delaware gets about one-sixth to one-quarter of its state budget from corporate franchise fees.

Thus, If I’m reading the article correctly, Delaware doesn’t take in a lot of revenue from new incorporation fees. Delaware’s incorporation fees vary (click here for Delaware’s corporate fee schedule), but usually fall well below states like Texas which charges $300 for a new LLC or corporation. So will Delaware raise its incorporation fees to help make up the decreased Division of Corporations tax revenue?

The problem with raising incorporation fees is that Delaware needs to attract new filings, especially from out-of-state businesses. Raising incorporation fees would obviously not be a step in that direction. But it may be a better alternative, at least politically, than raising the state sales or corporate income tax.

And even if Delaware doubled or tripled its new incorporation fees, it wouldn’t affect a potential recommendation whether new startup company should incorporate in Delaware.