In most cases, the answer is YES.
409A is a section of the Internal Revenue Code that governs the treatment of nonqualified deferred compensation and the income tax implications of receiving this type of compensation. Startups generally offer stock options as part of a standard compensation package, and are thus subject to comply with this section of the tax code. The goal is to determine the fair market value of the common stock. This is the value of the company will use to set the strike price for the stock options issued to employees.
The IRS says that there are three different routes a company can take in determining the fair market value of common stock. First, the board can make a judgment as to what the fair value is. This is quick and cheap, but it can be difficult to defend this valuation if the IRS decides to audit the company. Second, the valuation can be done by an employee who has expertise in performing such valuations. This is also quick and cheap, but most startups don’t have employees that have this type of experience. The third and most common route would be to hire an accounting firm to perform the valuation. This can be a very costly process.
There can be extremely high penalties for both the employee, and the company if the IRS determines that the value set forth was unreasonable. The IRS will determine what they believe is the fair market value of the stock, and all employees will be taxed on the difference, plus there will be 20% penalty. The company will also be taxed on any withholdings that should have been considered income under the IRS valuation.
After raising funding, a company should factor the cost of an external 409A valuation into the budget. The implications of trying to take a shortcut or avoiding it all together will be far more costly than paying for it to be done right at the onset.
When I was in college, I thought I had the greatest idea for a disruptive Internet startup. I had no idea how to go about pursuing it, but I was confident that if I was able to present it to the right people, the idea would sell itself and investors would throw money at it. Needless to say, I thought a lot about taking action but I never actually did. When I first started working with startups, I thought maybe I’d be able to kick this idea around with some VCs. At a networking event, I was chatting with a VC and told him that I had an idea I wanted to discuss. The first words that came out of his mouth were “Ideas are like water, they’re everywhere.” At the time, I was still new to startups and I don’t think his message fully sunk in, but those words stuck with me. Over the course of the last year and a half, I have learned a tremendous amount about entrepreneurship, and I now know exactly what this VC meant. The idea is clearly an important component of starting a successful Internet company. However, it is not a startup’s most important asset or indicator of success. Market and team are two much more determining factors.
Having worked with and around several early stage ventures, I’ve come to realize how common it is to shift business models, and in many cases completely abandon the original idea. If the market you’re in is big enough, there will be an opportunity to pivot and still build a product that can attract a large user base. After releasing a minimum viable product and letting users play around and give you feedback, chances are your product road map will be changed to some extent. After many iterations, things are likely to keep changing. The more constrained the market, the harder it is to make these adjustments. This is why market size is such an important factor and often an area that investors will focus on during the pitch.
Team, to me, is the most important indicator of success. I have come to believe that this holds true in the business world from the startup stage all the way to world domination. Execution is key, as there will likely be competitors working on solving the same problem. It is going to take an A+ team to muscle through adversity and beat the odds when they are so clearly stacked against you. I think that often venture capitalists and entrepreneurs will discuss the importance of having a strong team, but focus on the collection of individuals who have strong entrepreneurial minds. What’s often overlooked is the importance of how these individuals work together. There needs to be transparency among the team, and more importantly there needs to be balance in strengths and weaknesses. The stronger the unit, the quicker and more adaptable it will be.
Entrepreneurship is a scary journey that has extreme highs and lows. The “ah-ha” idea, more often than not doesn’t allow you to skip the journey. There is a lot of work to be done in between. Targeting the right market and assembling the strongest possible team are two of the best ways to help shift the odds.
If you’ve founded a company and been advised by a good accountant, more likely than not you’ve made a Section 83(b) election. This is designed to protect you from paying taxes on future increases in the company’s valuation as it relates to your portion of equity. I thought I’d spend some time explaining the details of why this needs to be done, what it means, and the consequences of not filing for this election.
What we’re going to focus on here is something called restricted stock. What exactly is restricted stock? This is stock granted (usually to an employee) that is not fully transferable until certain conditions have been met. In most cases, the restriction refers to the vesting schedule of the stock. When an employee remains employed by the company for a certain amount of time, his/her stock will vest, and thus become transferable. When an employee receives restricted stock, no income is reported, and thus the employee does not have to pay any taxes on the value of stock he/she receives. However, the tax code requires the employee to report the stock as income once it vests. This can create a huge tax liability for the employee when the shares actually vest.
Let’s try using an example to understand. Scott joins the team at Twit.ly and receives stock that will vest in 2 years on the condition that he is still employed by the company at that time. At todays valuation, Scott’s total stock is worth $1,534. During the course of the next two years, Twit.ly experiences massive growth. By the time Scott’s stock vests, his shares are worth $524,198. According to the tax code, Scott must report $524,198 in taxable income even though he most likely cannot liquidate his ownership stake. That means he’s facing a potential tax liability of about $180,000.
If you make a section 83(b) election within 30 days of stock purchase, you are electing to pay taxes on the value of the stock at that time, not when it vests. Rather than paying income tax on the entire fair market value upon vesting, you’ll pay tax only on capital gains when you choose to sell your stock. In the example above, Scott will pay tax on the $1,534 when he is granted the stock. He will then only be liable for capital gains taxes when he actually sells the stock at a later date. If you hold onto the stock for more than a year, the capital gains will be classified as “long-term” and you’ll pay much less in taxes on that amount than you would have if it were taxed as ordinary income. Long story short, make sure you remember to make this election when founding a company or receiving restricted stock as an employee. It might not be ideal to have to pay a tax upfront, but it can be the best insurance you’ve ever purchased if the dream comes true and you hit it big.
I’m going to begin a new series of posts called Startup Lessons Learned. Each post will focus on one lesson I’ve learned or observation I’ve made from my experiences working with and around several early stage ventures. Some of these topics may seem obvious at first glance but I urge you to read on and learn from my experiences.
Don’t Obsess Over Your Competition
You have a vision. You’re going to build a website so awesome that it completely disrupts the current landscape as we know it. You’re going to amass a user base in the millions. You’ve raised some capital, put together a solid team, and have spent the past few months building this thing from scratch. And then it happens. The ULTIMATE blow. TechCrunch has just profiled a company you’ve never even heard of who is working on the exact same product. Ugh. You go check out their site and it’s pretty. Really pretty. You play around and find out that they’re taking a slightly different approach to solving the same problem. So you decide you’re going to beat them at their own game. You shift you’re short-term priorities and go after your competition because you know that you can do what they’re doing but you can do it better.
This reactive approach can get you into a lot of trouble very fast. As a startup that has raised capital, you must use each dollar as efficiently as possible to give yourself the best chance to succeed. After all, you’re trying to create as much value as possible by the time you’re ready to raise more capital. By easily getting side tracked from your product roadmap and making adjustments purely based on what others are doing, you’re wasting both limited resources and time. This is suicide.
It can be disconcerting to know that someone else is working on solving the same problem as you are. However, you need to have the confidence to stick to your plan and only make adjustments for the right reasons. Continue building according to the plan and get your product in front of users as quickly as possible. Let your users dictate the changes you make. It’s important to realize that if someone else out there is working on a solving the same problem that you are, that validates the market. Chances are that for every competitor you discover, there are several more that you haven’t even heard of yet. Don’t let this sidetrack you. Your investors have invested in you for a reason. Your team has joined you for a reason. People believe not just in the market, but in your ability to build something that fills a need.
For the past several months we have been working on building a social network targeted exclusively at college students. After our beta launch this week, we received a decent amount of press. Much of the coverage has drawn parallels to Facebook when it launched as a college only site several years ago. I find it interesting that the college specific network model implemented by Facebook, which drove its’ early success, has not been replicated until now.
As Facebook has evolved tremendously and become a universal platform for internet users, we found an opportunity to fill the void they left. We do not suspect that CollegeOnly will replace Facebook as the only social network used by college students. We do believe that we have a product that can serve as an online dashboard for a student’s life at college and complement other social networks.
I’m interested to see how users will use the features and interact with each other. We have many ideas that we’ve been testing and I’m excited to start implementing some new features after the site has been polished. Stay tuned for updates.
I finally found a new way to listen to and discover music. Previously I listened to music exclusively through iTunes. When I had a separate work computer, I listened to music through my iPhone while I was at work. I dabbled in some streaming services (Lala, Rhapsody, Pandora, etc.), but each seemed to have significant shortcomings.
A friend invited me to a new service that he claimed would rival Spotify when it was released in the US. For those of you who have never heard of Spotify, I suggest reading this site which does a great job explaining this highly anticipated new service. After accepting the invite and signing up for my free account, I found that Rdio seemed to be similar to Rhapsody and Lala, but with a much slicker interface. It’s much easier to navigate through different screens and find the music your looking for. I also love the way the music player is displayed prominently but also slighty off to the side.
The social features allow users to view what the people who the follow are listening to. This is a great way to discover new music. However, what really roped me in was the iPhone app. After adding music to your collection, you can access those songs directly from the iPhone. A feature called “sync to mobile,” allows you to listen to the songs in your collection without a 3G or Wi-Fi connection on the phone. This means that the music is not actually streaming, but lives on the phone. I find this feature to be truly remarkable.
Only time will tell how the music industry will respond to the new digital world. I think that services like Rdio and Spotify are on the right track with the “all-you-can-eat” subscription based business model. Rdio seems to incorporate strong social features with a slick interface to provide a revolutionary experience for music lovers. If their music catalog continues to grow, I think this could be the next big thing.
I’ve been a Dropbox user for some time now, but I haven’t appreciated the true value of this product until very recently. When I heard about Dropbox, it seemed like a no brainer to join, but it did not seem like something that I desperately needed to use. I had one laptop that I used as both my personal and work computer. Dropbox allowed me to backup files and share them with other users. The limited storage that came with the free account (2GB) was hardly enough to allow me to backup my media, but I felt that it was a good place for me to keep important Word docs and .pdfs to ensure that a hard drive crash wouldn’t wipe out these files.
I also began to use Dropbox as a “Network Drive” for business purposes. Working at a small startup without the resources to implement a full fledged in-the-air storage and file sharing network, this seemed to be the perfect temporary solution for us to share small files.
After I began to use two laptops, and started playing around with the Dropbox iPhone app, I realized that it might make sense to use Dropbox as a replacement for the “My Documents” folder on my computer. Why not keep all of my files in this unified folder? This way, I can have my important documents stored and synced automatically across each of my computers and my iPhone, and backed up over the air. If I ever needed to access one of these files from a different computer, I could just login to dropbox.com and download it.
Since this epiphany, I have yet to turn back. Dropbox has replaced the “My Documents” folder on both of my computers. I now save all of my documents in the Dropbox. I especially love the idea of being able to share files larger than Gmail’s upload size limits with my friends. My only concern is that if for some reason — accidentally or not — a file were to get deleted from one machine and then synced across all of my machines, the file will be lost forever. If there can be some sort of safety net to prevent this issue, I’d have to say that Dropbox is the most useful new service I have seen in a very long time.
The Perfect Game is probably the rarest feat in Major League Baseball. It has happened only 20 times in the history of the sport. I find it remarkable that two of those 20 Perfect Games took place in the 2010 season, and both before Memorial Day. What may not get remembered is Armando Galarraga’s Perfect Game that occurred this week. This is because with two outs in the ninth inning, Jim Joyce, the first base umpire, botched a call at first base that cost Galarraga the Perfect Game. This is unacceptable. The runner was clearly out. Galarraga deserves to become a member of an elite class of pitchers. This incident has convinced me that it is now time to implement instant replay. I understand the merits to keeping the game true to the way it was played a century ago. I also understand how certain scenarios such as balls and strikes, or fair and foul calls cannot be examined under the instant replay. However, with bad calls piling up, we need to at least address this issue and start to allow instant replay for safe/out calls. There is absolutely no good reason that we need to still leave these calls to human judgment. The technology exists. Now lets make the game more efficient and reward the players who actually deserve to be rewarded, and not let bad luck determine such important calls.
A company called Audioo presented last week at TechCrunch Disrupt. From the way I understand it, their pitch is that they’re aiming to become the Blippy for voicemail. For those of you not familiar with Blippy, they’re the Twitter of credit card purchases. That means when you purchase something on you’re credit card, it shows up in a feed that is broadcast to your followers. Blippy also links to other services like iTunes, and SeamlessWeb, and will broadcast your line item purchases. Many critics of Blippy felt that this was taking social way too far. People don’t want to broadcast private information about what they’re buying. Even more criticism came from those who felt that security would be a huge issue. Their concerns were well warranted. Blippy had a major breach when users’ credit card numbers were appearing in Google searches. The problem was quickly remedied, but left many people feeling very vulnerable and reluctant to use this service. Audioo wants to take your voicemails and transcribe them into text and then broadcast them in a feed to your followers, and allow you to tag certain messages to group specific content. This has to be the stupidest idea that I’ve ever heard. I honestly cannot imagine one circumstance in which I’d want a private voicemail broadcast to the entire world. This seems to me like the ultimate sign of a tech bubble beginning to form in which anything with the buzzwords “social,” “local,” or “mobile” can get funding. I could be wrong, but with this one I really think I’m calling it right.