In addition to the other ways we’ve discussed here (stock options, phantom stock, stock appreciation rights), another way to compensate individuals working for a startup is to give them a cash payment upon a change in control of the company, called in the industry a “strip right”.
For example if a startup company has four founders each owning 25% of the shares, and they bring on another but don’t grant him or her shares, the initial founders can agree to pay the new individual a percentage of the “net proceeds” received from a “change in control” of the corporation. “Net proceeds” is usually defined as the gross proceeds received minus transaction costs and brokers commissions as well as some other items. A “change in control” is defined as it normally is in these agreements, and covers if the company merges with another or sells substantially all of the company’s assets. In such a case, the shareholders would receive cash (or assets it can sell for cash, like tradeable shares of the acquirer). The strip right agreement would require the shareholders that granted it to pay to the holder of the strip right, either a percentage or flat fee before they received their cash for the change of control.
In the example, if the four founders grant a 10% strip right, and a couple years down the road the company is sold for one million dollars, with transaction fees of $100,000, the holder of the strip right would receive $90,000 (net proceeds of $900,000 x ten percent). The shareholders would split the rest of the $810,000 and each receive $202,500.
One of the benefits of the granting of the strip right is that it is not taxable to the recipient. The downside, at least to the recipient is that they are not a shareholder of the corporation and they may never receive a cent if there is never a change in control. Due to its tenuous nature, the strip right is usually granted in connection with other compensation awards.
On March 25, 2015, the SEC adopted final rules amending Regulation A, referred to now as Regulation A+. These amendments were required by Congress via Title IV of the JOBS Act which was passed some time ago. (we are all still waiting for the Regulation Crowdfunding rules to be finalized).
The general rule is that when a company offers or sells a security, the security must either be registered or an exemption from registration must be relied upon. Regulation A has been on the books for a long long time and has been relied on very little.
Now the SEC has a tough job, its tasked with allowing companies to raise money via offerings of securities but on the other hand it needs to ensure that fraud does not run rampant. These two goals don’t have to be mutually exclusive, but the SEC has generally focused on the latter of the two at the expense of the first. Continue reading
Another item that could cause an entity taxed as an S corporation to lose the election is disparate distributions. Like most things, this is simple in theory but more complicated in application. The theory is that the shareholders of an S corporation are entitled only to the proportion of corporation distributions based on their percentage ownership of the stock. In other words, if you are a shareholder of an S corporation, you are entitled to the same proportion of distributions as you own shares (if you own 1/3 of the shares, you are entitled to 1/3 of the distributions). Continue reading
Owners of corporations elect S corporation taxation status for the pass through and other benefits the election provides. There are various things that can arise that would cause an S corporation to lose its election. In this and following posts, I’ll walk through some of the most common. The one I want to discuss now is the S corporation passive income restriction. Continue reading
I’m going to be posting a number of posts on the ins and outs of electing and operating a corporation which elects to be taxed as a small business corporation (an “S Corp”) with the IRS. There are many benefits to such an election, but there are also pitfalls that many owners run into that could jeopardize the election.
The first post in this series is simply how to make the election. Continue reading
In Specht v. Netscape Communications Corp., 306 F.3d 17 (2nd Cir. 2002), Users who downloaded certain software programs provided by Netscape filed a class action in federal court. Netscape then moved for arbitration which was required as per the download terms. There were, however, multiple ways to download the Netscape programs, some of which required an affirmative assent and some of which did not require any assent to the terms of the license (case is about the latter).
The 2nd Circuit found that users could download and use the software without having to view the full terms of the contractual arrangement including the arbitration clause. The Court stated that a reasonably prudent consumer would not assent to contractual terms that were so inconspicuous that they could use the product while totally overlooking them. You had to scroll down and click on the terms to see them.
The Court said what is needed is “clarity and conspicuousness” to ensure the user is cognizant of the terms of the license (emphasis mine). This is the phrase to keep in mind when clients are creating browsewrap and clickwrap agreements to bind users online.
Aside: Court seemed concerned that the Internet gives companies too many opportunities to exploit unsuspecting users. Simple rule is that if the user is not reasonably alerted to the contractual terms, she cannot assent to them.