Question: What are the most tax effective ways for founders to “Pay themselves” for efforts in a startup after the initial startup share allocation round. Is there a more effective method apart from options?

Answer: Well, option grants are a tried and true method of post-funding Founder compensation, but not all options are created equal. Option grants to Founder employees working for a funded corporation should be made under the terms of a stockholder- approved employee incentive plan (“Plan”) that permits the issuance of incentive stock options (“ISOs”). With ISOs, the tax on any increased value of the underlying shares between the dates of option grant and option exercise is deferred until the underlying shares are sold—not on option exercise. In addition, with ISOs, the tax on such increased value can be paid at the preferential long-term capital gains rates, rather than the higher ordinary income rates, depending upon how long the underlying shares are held after ISO exercise (although the paying corporation would not be entitled to any compensation deduction for the value of the gained realized on sale of the shares underlying such ISOs). This is quite a difference from non–ISO options, or non-qualified options (“NQOs”), where the holder of the NQO is required to recognize ordinary compensation income on option exercise equal to the difference between the option exercise price and the fair market value of the underlying shares on the date of option exercise itself. Any tax payable on that gain is not deferred until the underlying shares are sold—resulting in the potential for a tax payment when there are no proceeds from the sale of the underlying shares to defray the tax. Finally, with NQOs, if the NQO holder is an employee – rather than an independent contractor –the gain recognized on option exercise constitutes “wages” with respect to which the company would be subject to withholding/payroll taxes.

A Founder of a corporation can also be compensated post-funding with “restricted stock”. Restricted stock awards are made without associated payment by the Founder recipient and can be made under the same Plan as ISOs. In general, a recipient of restricted stock must recognize ordinary compensation income when such stock vests, or immediately upon grant for the portion of such stock subject to an 83(b) election. The value of the award subject to tax equals the vesting date fair market value of the portion of the restricted stock that vests (or, in the case of an 83(b) election, the grant date fair market value of the entire grant). Such fair market value could be determined by reference to a recent arms-length equity or debt funding event for the company. If the restricted stock award vests over time – and no 83(b) election is filed– then the Founder would recognize ordinary compensation income on the vesting date (and the company would have a corresponding withholding and employment tax obligation in respect of such income) equal to the fair market value of the restricted stock that vests on that vesting date. Accordingly, this can create the “perverse” situation in which the Founder’s successful efforts to increase the company’s enterprise value could have an adverse “economic” impact by causing a corresponding increase in restricted stock valuation (and, thus, a corresponding increase in taxable income liability for the Founder and an increase in withholding and employment tax liability for the company) over the vesting period. The Founder and the company could find themselves in the unenviable position of being unable to sell (or otherwise monetize) a sufficient amount of the vested shares, or otherwise be unable to raise a sufficient amount of cash from other sources, to pay the resulting income tax liability or, in the case of the company, the resulting withholding and employment tax liability.

One means of addressing this increasing enterprise valuation “problem” is for the Founder to consider making an “83(b) election” to pay immediate tax on the value of the entire restricted stock award at the time it is granted, even though the entire award may never vest. By making this election the Founder would have only a single compensation tax event in respect of the restricted stock award, with the Founder immediately recognizing ordinary compensation income equal to the fair market value of all the restricted stock subject to the award determined without regard to the vesting to which the stock is subject. The Founder and the company would have an immediate compensatory tax event as a result of the election, and would need to have sufficient cash to pay the resulting income and withholding and employment tax liabilities, as applicable, at a time when cash may be in short supply for both the Founder and the employer-company. The subsequent vesting of the restricted stock in accordance with the original terms of the award would not be a tax event and the Founder would only recognize additional income in respect of such stock upon the actual sale of the stock (to the extent of any gain above the fair market value of the shares on the date of the original award). Any resulting taxable gain from such sale would constitute preferential long-term capital gain (rather than ordinary income) if the shares are held for more than one year from the date of the award. However, the downside of making the 83(b) election for a restricted stock award includes: (a) the Founder would not be entitled to claim any loss deduction (or otherwise have any refund claim) on any of the previously-paid income tax if the shares do not vest; and (ii) the Founder may only recover any decline in value of any non-forfeited restricted stock as a capital loss (even though the Founder would have paid tax at ordinary income tax levels by making the 83(b) election).

Finally, if the Founder’s business is being conducted as a “limited liability company” (rather than as a corporation), a Founder can be compensated by being issued a “profits interest” in the limited liability company— a specially designed economic interest in a company’s profitability. Under current IRS guidance, such a “profits interest” could be issued free of income tax and withholding/employment taxes. In addition, since such a “profits interest” would constitute an interest in the limited liability company, the Founder would be taxed on, or receive a deduction equal to, his/her allocable share of the limited liability company’s income and gain or loss, as applicable. Also, except for the Founder’s share of certain assets of the limited liability company, the Founder would recognize preferential long-term capital gain if the “profits interest” was held for more than one year prior to its sale. That said, however, it should be noted that Congress is currently considering legislation that could subject certain types of “profits interests” to ordinary income treatment (e.g., carried interests in private equity funds).

Answer provided by Peter Rothberg – (website, LinkedIn @FatherR), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question:

1. Is it legal and acceptable for a start up to receive donations from fans or well wishers through its website to fund business operations? For example, having a donation section which enables fans to send donations via checks or accepts credit card payment from the website or paypal account.
2. Are there tax implications?
3. Does this impede or cause complications if the firm expects to be funded by an angel or VC in the ensuing months.
4. Is there any other question i should have asked but did not mention?

Classic Scenario: The business focuses on a particular team or sport; publishes fan content and creates a professional social media website that aggregates fans of that particular sport and it facilitates their viral communication on its platform. Examples include Lakers-Fan, Yankeestown and The Red Sox Fan Site

Donation is used fund commuting, interviews, video processing, website maintenance, hosting cost, consultants and much more.

Answer:

Although in the context of for profit businesses the concept of “donation” or “gift” –a nontaxable contribution–doesn’t usually fit, “fan” donations to your startup business  might not be taxable income to the Company. The fan donations  should be for the purpose of adding to the capital of the Company, cannot be contributed in payment for specific goods sold or services provided by the Company  and  must be employed to generate additional Company income—in other words, the donations must benefit the Company itself and not constitute some form of a quid pro quo payment.

Where you could run into trouble is if the IRS considers the donations to be “solicited “ by the Company. If they are, the dollar amount of the fan donations could be viewed as additional taxable Company income. Just having a place on your web site where fans can make a donation to the Company “in gratitude” for the Company’s pursuit of its mission, without a public campaign for such donations or your web site turning into a ”beg-a-thon” for them, may not qualify as solicitation. But a detailed legal analysis, based upon the specific facts surrounding the donations, is very important here.

If you intend these donations to constitute a significant portion of the Company’s operating funds during its startup phase, and you plan to seek venture capital or other institutional financing for the Company, I’d seek a formal memorandum from your counsel or accountants on the issue. The folks that finance your Company will want comfort that you’ve paid all applicable taxes along the way. If you don’t pay taxes on these contributions when you should have, not only will it blow your credibility with those folks, but it will leave you with an expensive bill due to the IRS and state taxing authorities—not only will you owe the back taxes that were unpaid but you’ll owe interest and penalties on top of it.

So, be careful!

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What are the advantages and disadvantages of convertible debt vs. equity?

Answer: As we’ve discussed in previous postings, I am very much in favor of the convertible note scenario for non-institutional rounds of financing. To recap, the convertible note structure replaces the sale by early stage companies of equity securities, at a set valuation per share, with the sale of promissory notes that are convertible into Company equity in connection with the next round of equity financing by the Company (usually defined as the “first round of institutional equity financing”).

The upside to the convertible note structure is that you can get to a deal faster—without the haggling over valuation at an early stage of a company’s development when there usually isn’t a whole lot upon which to base that discussion. As a result of the transaction being a debt deal, the covenants and protective provisions with respect to Company operations are more abbreviated than those found in equity deal documentation. It is also unnecessary to spell out the detailed management and interest transfer provisions that are always found in institutional-level equity purchase documents. This translates into a transaction that allows the Company to obtain equity-like cash funding much faster and less expensively.

The downside to the convertible note structure results from the convertible note holders demanding a conversion rate for their debt that reflects too high a discount to the purchase price paid by the institutional players in the equity round. The institutional equity players are familiar with the convertible note structure and in almost all cases accept a discount of up to 15%–an acceptable cost for the “early funding” risk taken by the note holders. But when the convertible note holders demand a discount in excess of that level (and they frequently do—especially if the distance between note funding and equity round exceeds 12 months), you can run into resistance from the institutional round players. This can hold up—or kill– your equity round while the note holders and the institutional equity players have fun playing “chicken” –at your expense– over the acceptable level of discount to the purchase price.

So, be careful sports fans. It’s dangerous out there.

Answer provided by Peter Rothberg – (website, LinkedIn Twitter), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What legal language does a typical disclaimer on a website have to have? (For review websites, product or business reviews.)

Answer: The type of disclaimer to be used on a web site is a very fact sensitive issue. You must first establish the nature of the transactions taking place on the website, and then select the disclaimer that best fits that situation. Not a one size fits all.

In the case presented here, we have a web site that will publish endorsements of products and other services. There is recent guidance from the Federal Trade Commission (FTC) on the subject of endorsements and testimonials. The context of the discussion is that the FTC considers endorsements and testimonials to be a form of advertising for the product or service being discussed, and applies “Truth in Advertising” concepts to those pronouncements and discussions. As a result, when there exists a connection between the endorser and the seller of the advertised product that might materially affect the weight or credibility of the endorsement (i.e., the connection is not reasonably expected by the audience of the endorsement), such connection must be fully disclosed.

So, in the event that a particular “endorsement” appears on a website that a reasonable consumer might not expect to be publishing  reviews of products or services that are sponsored by providers of the subject products and services, the fact of that sponsorship  must be disclosed. That disclosure can take the form of a Disclaimer on the website that is so placed that the reasonable site visitor can find it and be able to relate it to the subject  endorsements. If all the reviews on a website are “sponsored”, then a more general Disclaimer should appear quite prominently on the website, and perhaps also in the website’s Terms of Service.  A typical Disclaimer might take the following form: “THE VIEWS EXPRESSED ABOVE BY [IDENTIFY THE ENDORSER] ARE SPONSORED BY [IDENTIFY THE SPONSOR] AND MAY NOT REFLECT EITHER THE INDEPENDENT VIEWS OF [IDENTIFY THE ENDORSER] OR AN OBJECTIVE REVIEW OF THE PRODUCTS AND SERVICES DISCUSSED.”

Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What are Important key points for IP Assignment Agreements between employer/service purchasers and employee/independent contractors?

Answer: For startup companies, or any company for that matter, that values its intellectual property, making sure that it owns the intellectual property that is created for it by employees and independent contractors is key. Many companies think that they can rely on “common law” or state and federal statutes alone to protect their rights in intellectual property created by employees or independent contractors, but that is not the case.

Although an employee’s work product belongs to his or her employer under state and federal laws, there is always a definitional question concerning that work product. It is not controversial to assume that intellectual property developed during regular business hours by an employee, using an employer’s resources (e.g., the employee’s office computer), would belong to the employer. But who owns intellectual property developed by the same employee, during the period of his or her employment, at home and using personal resources? Does it matter if the intellectual property developed at home is related to the employee’s employer-related duties? These are the types of questions the answers to which are murky if all you do is rely on state and federal statutes for guidance. Agreements entered into by the employer and its employee, at the time that employment commences, are essential tools in making certain that the employer owns, and gets an assignment from the employee, of all intellectual property developed by the employee during the “scope of employment” –which is a term defined in that employer/employee agreement.  For example, in many such agreements, intellectual property developed during the scope of employment would include the employee’s work product created while at home, whether or not using the employer’s resources, if that work product related to the type of projects that the employee worked on during office hours expressly for the employer. However, such work product developed by the employee during his or her “personal time” and that did not relate to matters that the employee worked on “at the office” would be considered outside the “scope of employment” and the employer would have no rights to it. Where the line on “scope of employment” gets drawn is a matter of contract—and is sometimes hotly contested. Employers that are overly aggressive in this area are apt to have a problem employing the best, most creative employees.

The situation for independent contractors is quite different. While the state and federal law presumes that an employee’s work product belongs to the employer, unless an independent contractor makes an express statement that his or her work product created in connection with the performance under a consulting agreement belongs to the purchaser of that performance as “work for hire”—it doesn’t belong to the purchaser.  Rather ownership stays with the developer: not the situation that is typically desired by the purchaser of the services. As a result, where the purchaser of the services wants ownership of the product of the independent contractor’s work, the consulting agreement must clearly state that the results of the performance under that agreement by the developer is a “work for hire” that belongs to the purchaser. The conversation surrounding the nature of the “work for hire”—much like that concerning the “scope of employment”—must be worked out in the developer agreement. For example, perhaps only part of the intellectual property developed under the contract will belong to the purchaser of the services, with the balance being owned by the developer. But in such instances perhaps the developer who retains such ownership will license the retained work product, or other intellectual property owned by the developer, to the purchaser of services under the contract to permit full utilization of the work product produced under the contract and owned by the purchaser. Again, these terms can be highly combustible, and one size does not fit all. Independent contractors who are over- zealous in retaining ownership rights to the work product produced under the terms of development contracts may find themselves without clients.

Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: What is the one term/clause/function you hate seeing in Capital Raising documents for your founders and wish was abolished forever?

Answer: I truly despair about “full ratchet” down provisions in the anti-dilution sections of angel/venture capital amended charter documents. Full ratchet provisions grant investors immunity from down rounds by adjusting the conversion to common equity price of the preferred they acquire to equal the same lower price per share at which the company may subsequently issue common equity after their initial investment.

I believe this provision grants investors a status in the company that is unwarranted–providing almost a guaranty against any dilution of their position in the company, unlike any other company participant, and without further investment on their part.  Once an investment is made, I believe it is warranted that the angel/venture capital investor  share the risk of a down round with all other participants in the company, or at least be protected from that risk with a more even-handed “weighted average” formula (allowing the conversion price to float down based on the magnitude of the sale price reduction balanced against the size of the new investment and the percentage ownership of the prior investor in the company) that includes specific carve-outs from the application of the formula to a price reduction on subsequent issuances (e.g., issuances pursuant to stockholder approved employee plans or issuances in other than capital raising transactions, such as mergers and acquisitions).

The absolute guaranty against dilution provided by full ratchet terms distorts the relationships between Company participants, stretching the separation that already exists between the common and preferred equity holders. I much prefer the better alignment between the investment classes that comes with the weighted average–combined with sensible  carveouts to applicability– formula. This allows company management to run the Company and recommend the issuances of equity even at reduced prices when it makes sense, without risking a total realignment of investment interest in Company equity as a result of that decision.

Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question: Why would I, as a founder, prefer priced shares (Prefs or Equity) over a Capital Note?

Answer: If the context of this question is the Founder’s company doing a capital raise, and the company is a startup (or even a more mature company being evaluated for investment by non-institutional investors), I would prefer to raise money through an issuance of convertible notes—with the notes being convertible into equity under identified circumstances and terms sometime down the road. This method results in less intensive legal procedures and costs on the uptick, and kicks the “valuation” can down the road until the institutional investors are involved. They are better equipped to make an evaluation decision that will “stick” with later investors. Angels and friends and family are notorious for providing evaluations that too high—which goes down nice in the beginning, but gives you a real hangover later on when you seek true VC investment.

Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.

Question provided by Faraz Qureshi – an Ultra Light Startups member.

Answer provided by Dennis Yu CEO of BlitzLocal – and panelist at SEO for New Websites on Thursday, March 4.

Faraz’s Question:

Can anyone comment on the value (from SEO standpoint) of submitting blog posts to ‘article aggregation’ sites? For example, I’ve posted blog posts/articles to this site:  http://ezinearticles.com/ but not really sure how much [SEO] value its adding.  Any thoughts?

Dennis’s Answer:

The simple answer is that if sounds too good to be true, it probably is. Such is a nature of shortcuts to high rankings and “guaranteed #1 rankings”.  Every year for the last 10 years, we’ve seen new versions of mass submission software, content “generation” (randomization) scripts, and outsourced SEO firms selling their wares.

The medium answer is that if Google or Bing can’t distinguish you from a spammer, then you’re guilty until proven innocent. So if a spammer can submit a ton of articles to ezinearticles or other directories, whether auto-generated or created by low wage people offshore, then you have no advantage.  Search engines base rankings on linkjuice and trust– are you getting links from high authority sites.  A cnn.com isn’t going to link to a spammer, so if you can get such high quality sites to “endorse” you by linking to your site, then that’s a massive trust signal.

Because you’re guilty until proven innocent, the strategy of relying solely upon having great content isn’t sufficient. I could have the best article about a particular topic put on a brand new domain and at the same time create some crappy article on wikipedia for the same topic—who do you think will win in the SERPS (search engine results pages)? At the same time, you can’t get links from high authority sites unless you do have great content. So if you place your great content on these article distribution sites, it’s not the direct linking value that matters, but the SECONDARY effect of actual humans reading your article, writing about it, and then linking to you from their sites.

The long answer is that search engines use a mix of signals to see who actually deserves to rank for a particular keyword.  Imagine that– the goal of the artificial intelligence is to judge as accurately as if a human were choosing which pages among many should show up first.  Forget SEO for a second– do you think your content deserves to outrank what’s already there?  If your content sucks, then search engine trickery will get you only so far.

Ranking in search engines is like passing a lie detector test.  Thus, two strategies– You can either be telling the truth or be an expert at lying. A lie detector measures dozens of signals– your pulse, blink rate, fluctuations in voice patterns, perspiration, and so forth– knowing that a liar can probably keep some signals in check, but not ALL of them.  Likewise, if you want to rank in search and want to fake it, you can generate a natural looking page creation and link velocity, a natural looking mix of high quality and low quality sites linking to you, a natural looking keyword density or theming around certain topics, and so forth.

That’s why there’s been so much discussion about how to buy links in a way that doesn’t look spammy, create auto-generated content that isn’t quite duplicate content, create fake twitter profiles that look like they might just be human (“forgive my English, I am a foreign exchange student”), and so forth.  With the explosion of social media– everyone generating content everywhere they go– the problem of surfacing the “right” search results is more like a needle in a haystack.  Just too many pages to sift through– and they’re multiplying like nuts, especially as social networks make this information public by default.

If you already have a high power site (Google PageRank or SEOmoz mozRank 6 or higher), then you can play the Demand Media, Mahalo, or Patch.com strategy of barely human content that sits under a high power domain to flow down link juice.

If you have a great social site– stupid doggy tricks or other voyeuristic/humorous content– then you can send signals via actual traffic and mentions in social sites, even if those links don’t pass juice.  Yes, the search engines use actual traffic and mentions in rankings, since a popular article created a couple years ago might have gotten 50 links, but that same article created today might get 5 links and 100 tweets.

So to answer your question, using article submissions may give you a slight boost, but cannot substitute for the core of great content and great promotion of the content.  If you’re doing something a spammer can do, it’s probably not high value.  If you think there’s a shortcut via software, you’re likely taking a huge risk, making someone else rich, or both.

Question provided by Jonathan Rosen – an Ultra Light Startups member.

Answer provided by Andy LoCascio – President of Sound Strategies, Inc. an Ultra Light Startups affiliate

Jonathan‘s Question: How does one create a low cost SEO plan when the range of products they sell is extremely broad and not focused on category of products or services?

Andy’s Answer: Rather than think of this as a low-cost SEO plan, we need to address this as how to get maximum SEO benefit from a limited budget.  You start by putting together a detailed keyword analysis.  This will allow you to build a strategy based on competition and traffic for phrases that are most likely to generate sales on your domain.  You could keep the cost of the analysis down by limiting it to just the higher margin items.  Too many site owners skip this step and waste their efforts targeting phrases for which they can never obtain effective rank.  If you are not in the top 5 in the retail world, you will not see any sales.

At minimum the keyword analysis must include the daily search volume and an assessment of the competition for each phrase.  Assessing the competition is critical and involves examining the first page of results for the phrase and looking at factors such as page rank, titles, and page content for each result.  However, it is important to realize that there are other factors that contribute to phrase rank.

If you use an SEO specialist to provide the keyword analysis, you should rely on their experience to help you arrive at the best strategy for your budget.

The keyword analysis will also provide you the information you need to get maximum benefit from your content.  You should optimize your page titles and content based on the phrases you feel that you can compete for.  Diluting your titles and content in an attempt to target phrases with stiff competition is a common mistake.

You also need to come up with a comprehensive plan for inbound link acquisition and link exchange.  You are going to need a lot of properly formatted inbound links (with optimal anchor text).  Once again, refer back to the item analysis and try to focus on specific items or groups of items where you have the best chance of success.

SEO is an investment in your website.  Your goal is to get a reasonable ROI on the initial budget.  During the campaign you will learn how your site interacts with the competition and then you can make an informed business decision about subsequent expenditures.

Additional Relevant Articles

• How to fail at SEO (without really trying)
• Maximize Your SEO Spend, Now!
• Get Linked! (Maximize Your Inbound Hyperlinks)
• New Website SEO
• Choose the Right SEO Specialist (linked above)

For more information on this and related topics, join us at SEO for New Websites in New York on March 4, 2010

Question provided by Stephen Smyth – an Ultra Light Startups member.

Answer provided by Dennis Yu CEO of BlitzLocal – and panelist at SEO for New Websites on Thursday, March 4.

Stephen’s Question: Would like panelists to comment on the this blog post that asserts “If someone charges you for SEO, you have been conned”

Dennis’s Answer: There are a lot of misconceptions about SEO and definitely a lot of snake oil out there.  This fellow is broadbrushing and being inflammatory– perhaps even engaging in a SEO strategy called link-baiting– to grab attention and links.  The question of whether SEO is a scam is a well-worn argument where we don’t need to re-hash the basics.  Read this:
http://searchengineland.com/dear-fox-news-seo-is-not-scamming-24301

SEO is the process of getting more traffic and conversions to a website through any non-paid method.  So if you charge money to build a website for a client, is that a scam, too?  SEO is the latest term (albeit faddish) for good old-fashioned webmastering.  Holding contests on Facebook to encourage fans to submit stories about your product or service, which then results in more traffic and links — is that a scam?

Performing SEO should have nothing to do with finding loopholes in search engine algorithms or generating fake content– it should be in direct alignment with what’s right for users, doing things that provides real value.  A large number of folks who claim to be SEO experts do bilk folks who are not wary– and that is just wrong.  But there are as many folks who provide measurable value by doing things that do fall into the category of basic webmastering, which does provide immense value.

Looking at your Google Webmaster Tools to determine what pages are being indexed and where you have 404 errors– is that bad SEO?  How about doing some keyword research to see what keywords are worth ranking on?  How about telling search engines which urls should be canonical, so it’s easier for them to index and crawl?  This stuff may be common sense, but lots of folks need it.

Here’s an example of what a simple SEO analysis can look like

For more information on this and related topics, join us at SEO for New Websites in New York on March 4, 2010