I have a new CTO co-founder - how do I issue them their equity?
You've recently got your idea off the ground, you had a friend "hack" your idea together, you've been through an incubator program and you've now hit the right time to get a co-founder, being someone who knows how to code and hence will be called CTO. Yay!!
The next big hurdle is to figure out how much equity to give them. That's a separate blog post (example here from 500 startups if you need some inspiration). In this case, let's say you keep 75% of founder equity and the CTO has 25%.
Lots of methods have been used to issue the equity to the new co-founder and many of them create inadvertant tax hell for the founders, plus a mess for future capital raising rounds which then needs to get cleaned up before incoming investors will cut a bigger cheque.
This quote says it all: "I didn't even think about the tax bit". Most don't, mainly because it lurks below several layers of paperwork, and comes and bites you later on.
Most tax accountants also don't deal with complex capital structures hence are not always sure what to do with this one. This is one area where good advice is helpful. A sign of a good incubator / accelerator program is access to that kind of advice & support.
Let's say you have done a deal with an incubator program where you (the founder) owns 80%, the incubator has 10%, and 10% is set aside for an employee share scheme (ESOP). This is represented by 80 shares to you, 10 to the incubator and 10 reserved for the ESOP. (What happens to the 10 ESOP shares if you don't have employees yet? Read more here. )
You have a shareholder agreement that requires shareholder approval to issue new shares, however is silent on what to do if you add a co-founder. What do you do?
The tax problem
Let's say you have an understanding with your incubator shareholder (this may be a conversation or written on a text message somewhere) where you'll split the 80 shares between yourself and the CTO, once they come on board.
This would mean, of the 80 shares for founders, you keep 60 (75%) and transfer 20 to them. Simples!! If someone suggests this to you I have one word for you - run!!
Due to the fact you already have an MVP and traction, your company already has some kind of value. While under the ASIC rules you can transfer these shares for $1, the ATO can "look through" this to assign a value to the 20 shares you transferred.
Let's say your current valuation is $1m. 20 shares (20%) is worth $200,000. You've just potentially created something called a capital gain of $200,000 you, as the founder, would have to report as income which will create a tax bill. Given no cash has changed hands, there is no cash to pay the tax. Ouch!!
If this is you, this is fixable. It takes a very capable tax accountant who's also familiar with the ASIC rules to do so, which will cost money you would rather invest in building your product and reaching your customers.
The rule, if you have a new equity owner coming in, is to issue new shares. Always. It is the safest way to avoid this issue.
Continuing this example and holding the rule that you will own 75% of founder equity and the CTO will own 25%, the simplest thing to do is issue 27 shares. Founder equity = 80 + 27 = 107. Total shares = 100 + 27 = 127.
The problem with this is your incubator has now gone from owning 10% (10/100) to 7.8% (10/127). Unless this was specifically agreed during the program, it is unlikely they'll agree to that level of dilution and remember they need to approve the issue of new shares.
Let's say you reach an agreement with them they'll drop to 9% ownership and the ESOP pool can take the full dilution. The table below shows the # shares before and after to achieve all the various outcomes.
This means issuing 3 shares to yourself, 28 to the CTO and 2 to the incubator. How much are these shares issued for? For the incubator this can be done for $1. For yourself and the incoming CTO, the issue is making sure this isn't deemed as "salary" by the ATO. There are solutions to this - a good tax accountant in your world is your best friend here.
It would make sense to update your shareholders agreement with the table above and ensure all investors sign it as your audit trail on the issue of these shares. This is not essential but is good corporate governance.
Does this look complex? Yes. Why is there not a straightforward answer here? Two main reasons. The first is the ASIC and ATO rules are built to deal with different issues and hence don't work well together.
The second, and far bigger driver, is managing the expectations of your investors. They are human beings who will make commercial decisions to get themselves the best outcomes. None of these can be "boxed in" to a set of mathematical rules.
Hence why it is worth making sure you have access to someone who knows how to navigate through this to ensure you get the best, least administratively painful outcome.
What should this founder have done differently? Potentially deal with the inclusion of a CTO in the initial program and shareholder agreement. The shares for that CTO could have been set aside and issued once they came on board, thus making all of this substantially easier.