How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO

by Tom Taulli

  Now let’s return to your hypothetical venture and, of course, George. You and your cofounders have been busting your butts and it has become readily apparent during that first year that you’ve been working together that George is just not working as hard as the rest of you. Because you and your cofounders were forward-thinking when you formed your company and decided to reimburse each cofounder for his work with vested founders’ stock, you can buy George out of his percentage of stock much more easily than if you had given him an outright share in the company.

  Vested founders’ stock is a common business approach for Silicon Valley startups, and it works quite well for most parties involved—the Georges of the world notwithstanding. In fact, when a VC firm makes an investment in a company, the firm usually requires that the company begin using vested founders’ stock. If a venture already has a vesting program in place, it is unlikely that a VC firm will seek to undo this policy. The use of vested founders’ stock also shows the VC that the company’s founders are forward-thinking.

  In some cases, especially among technical startups, one or more of the company’s cofounders has already worked hard on the product before the other cofounders decide to jump onboard. Because of this unique situation, the company’s original cofounders may get credit for their early work by vesting a certain percentage of their stock, say, 5%, at the time of the company’s incorporation.

  Termination and Change of Control

  Sometimes companies with vested founders’ stock use a vesting schedule that accelerates when one of its founders is terminated without cause. In this type of situation, the terminated founder typically walks away from the venture with all of his shares in the company. In theory, this arrangement seems to make sense. After all, if a founder didn’t do anything explicitly wrong in his work for the venture, it isn’t exactly fair for him to be fired and receive no compensation for the time and energy he invested in the company.

  In reality, however, the case law for how to define cause is far from clear-cut, which means that even if you had due cause for terminating a founder, that founder would be able to claim that you didn’t have due cause and would walk away with a big chunk of your company. This doesn’t seem quite fair, either, now, does it? As a result, my suggestion is to avoid accelerated vesting schedules at all costs. However, if accelerated vesting is important to you and your cofounders, there is a better approach—partial acceleration. When your company uses partially accelerated vesting schedules, you maintain much more control over how many shares leave your company when one of your cofounders is forced out. For example, your company policy could be that founders who are terminated without cause are given an accelerated vesting schedule, but only for 6 months of that schedule.

  Accelerated vesting is also used in change-of-control events, such as when your company is acquired by another firm. If you and your cofounders believe that a change of control over your company may be likely, you can incorporate into your shareholder agreement a single-trigger acceleration clause, which states that the forthcoming event will trigger the acceleration of 100% of your stock options. Keep in mind, however, that a single-trigger acceleration clause may make it nearly impossible to sell your company, because potential buyers will likely be put off by a stipulation that allows the founders to walk away from the sale with a huge payoff.

  If you would like to provide for yourself in the event of a change of control but are wary of using a single-trigger acceleration clause for the reasons mentioned here, you might instead choose to include one or more of the following options in your shareholder agreement:

  Double-trigger clause: There must be a change of control and a termination without cause (often for a term of 12 months) for there to be 100% vesting.

  Compromise: At the time of the change of control, a partial amount of the shares will vest automatically, and then the rest are subject to a double trigger.

  Severance: The shares vest completely after the cofounders have been with the new company for a period of time, such as 1 to 2 years.

  83(b) election

  As most Americans would agree, taxes involve mind-numbing paperwork and onerous payments—and this is especially true for startups that don’t understand the Internal Revenue Service’s (IRS’s) core principles and choose to distribute vested founders’ stock. To avoid experiencing a big-time tax bite, read on.

  Continuing with our example presented earlier in this section, “Use Vested Founders’ Stock,” let’s suppose that your company has been in business for 1 year, which means that 62,500 of your 250,000 shares have vested. However, instead of its initial price of 1¢ per share, your company’s stock value has increased to $1 per share because the venture has made a lot of progress. Thanks to you and your cofounders’ hard work, the IRS will now tax you on your gain. In your case, your gain is $62,500 ($1 for every share that is vested) less the initial $2,500 investment you paid (known as the cost basis), or $60,000. To make matters worse, the IRS continues to tax your vested founders’ stock as it vests over time.

  Yes, you owe tax on this gain in share price, even though it is probably nearly impossible for you to sell your shares. The IRS does not really care if you don’t have the cash to pay your gains tax, either. It just sets up some type of payment program for you in the hopes that you eventually pay off the full taxed amount to the government.

  This is an ugly situation for sure, but if you file an 83(b) election with the IRS, you can avoid the whole mess. How is this so? When you file an 83(b) election, you are—for tax purposes—treating your stock as though it was fully vested at the time your startup was formed. As a result, you pay taxes on the amount your stock was worth when you initially purchased it, rather than waiting to pay taxes on it until it appreciates down the line. Therefore, if you had filed an 83(b) election at the outset of your company’s formation after paying 1¢ per share to get your venture going, your gains tax would have been $0 when the price per share rose to $1 a year later.

  By using the 83b election, you also start the clock ticking for long-term capital gains treatment. If you hold on to your stock for more than a year, your maximum tax rate on those shares is 15%. In other words, make sure you file an 83(b). Period. But remember, you must file an 83(b) election within 30 days after purchasing your company’s stock. There are no exceptions to this rule, and filing is as simple as sending a letter to the IRS. Don’t forget to use certified return receipt to make sure the IRS has received your paperwork. Your company should also keep a copy of the 83(b) so that you can include it with the following year’s tax return.

  Payment for Stock

  When a company is first started, its value is usually minimal, which makes it fairly easy for the founders to buy the company’s stock. If you recall from our previous example, each founder had to pay only $2,500 for 250,000 shares of stock, at a price of 1¢ per share. This is a fairly common situation.

  Yet even a few thousand dollars can be tough for young founders to spare. Because of this, some founders offer to contribute their intellectual property, such as existing computer code or even a business plan, as payment for the shares. Although substituting intellectual property for cash might seem reasonable, it can cause huge headaches down the road. Not only is intellectual property difficult to value, but the contribution could result in adverse tax consequences for your company. There could even be difficulties in ensuring that the corporation actually owns the intellectual property. Therefore, to keep things clean, the best approach is for all parties to contribute cash. If a founder is serious about the venture, he will find a way to scrounge up a few thousand bucks.

  File Your Patents

  In March 2012, Yahoo! filed a patent infringement suit against Facebook in an attempt to blunt the social network’s progress and delay its IPO. Interestingly, this was not the first time that Yahoo! had engaged in such legal practices. During Google’s IPO in 2004, Yahoo! launched a lawsuit against the search engine behemoth and was able to snag shares in the offering as a s
ettlement. And Yahoo! is not the only major player in the tech world that is aggressive in going after the competition in the courtroom. At the time of this writing, operators big and small around the globe are embroiled in patent wars.

  Strangely enough, at the time that it was sued by Yahoo!, Facebook was rather lackadaisical about pursuing patent rights. In fact, it had filed for only 60 patents in its 8 years in operation. Facebook, however, did not allow Yahoo! to use a lawsuit to gain an edge in the market. Instead, the company leveraged its resources to fight back. Facebook shelled out $550 million to purchase patents from Microsoft (the company had bought them from AOL for $1.1 billion a few weeks earlier), and it also purchased roughly 750 patents from IBM (the price tag was not disclosed).

  How critically important are patents to the tech industry? They are so important that large tech operators have bought rivals for the main purpose of obtaining ownership of their patents. This appears to be the case with Google’s $12.5 billion deal for Motorola Mobility Holdings. Or look at Apple. In 2011, the company joined with others in a consortium to pay $4.5 billion for patents from Nortel Networks (which had gone bust).

  True, a startup cannot engage in these kinds of massive monetary transactions, but there are certainly ways to protect your company’s intellectual property. Think early on about how to obtain patents for your innovations. Owning the intellectual property rights to your inventions may help to blunt patent infringement lawsuits in the future, and it also could increase the core value of your company when you go out to raise funding, sell your company, or go public.

  The law has undergone major changes recently with the America Invents Act. If your product is global—and most Web-based products are—then you must file your patent application before you disclose publicly the details of your new technology. Because of this stipulation, it often makes sense to file a provisional patent, which gives you a grace period of 1 year before requiring that you file a full-blown patent. A provisional patent is not particularly difficult to file, and it also is affordable (the filings fees are $250 or less). Regardless of the type of patent you decide to file, however, it is important that you obtain the assistance of an attorney that specializes in intellectual property law before attempting to file a patent yourself. The complexities of intellectual property law can be mind numbing.

  Think Creatively About Your Company Name, Register Your Trademark, and Secure Your URL

  One of my favorite t-shirts is from a company called Yammer, which is a social network for businesses (the first investor was Peter Thiel). It seems that whenever I wear it—which just has the logo and the name of the company— some random stranger stops to ask me, “What is Yammer?” One time a woman who must have been in her 70s walked by me and kept saying, “Yammer, Yammer, Yammer.” It’s catchy, isn’t it?

  Yammer is, without a doubt, a great company name. Despite how much noise there is in the marketplace, the name Yammer stands out from the crowd. It’s memorable, it catches people’s attention instantly, and it makes people want to learn more. However, coming up with a striking company name is far from easy. I come across many names that are pretty flat and forgettable. Take Facebook, for instance. Although Facebook is a great name, the company’s original name was TheFacebook.com, which was awkward. Despite some initial resistance, Zuckerberg eventually agreed that “The” was not good for branding.

  Company names are crucial, so make sure you spend a lot of time thinking of the right name for your venture. What’s more, make sure you can secure the URL of your company’s name, as well as the URL of any of the typical misspellings that might crop up. True, many URLs are already taken, which means you’ll probably have to pay off a squatter, (a person who has no plans to use the URL for a website but is only interested in finding a buyer for it) but the purchase of it should be worth it in the end. Facebook had to pay $200,000 for facebook.com and, well, I’d venture to say that the expense was well worth it.

  You also need to make sure you can protect your company’s name. If not, you may be forced to change it if you lose a trademark dispute, which can be a disaster. It’s true that if you start using your company name with an Internet service you start to accrue some rights to the name in what is known as a common law trademark; however, these types of trademarks are extremely limited and you are better off filing for a trademark registration with the United States Patent and Trademark Office (USPTO). When you are granted a trademark by the USPTO, you receive presumptive ownership of and protection for the name on a nationwide basis. You also obtain the right to bring an action in federal court to protect the trademark.

  There are two types of trademark applications you can file: an in-use application or an intent-to-use application. Many technical startups choose the latter of the two because their Web service typically has not hit the market by the time they file their trademark application. Keep in mind that you can also obtain a trademark for a symbol. Facebook, for example, has a trademark on its logo and the Like button.

  Here are some other tips for dealing with trademarks:

  Before applying for a trademark, do a trademark search to determine whether another trademark conflicts with your intended trademark. This process should be conducted by someone who specializes in intellectual property law.

  A trademark cannot be descriptive. Thus, if you create a medical social network, you cannot get a trademark for “Medical Social Network.”

  Enforce your trademark. If another company is infringing on it, insist that it cease its infringement. In many cases, companies accomplish this by sending the offender a cease-and-desist letter—a strategy that Facebook has used several times throughout the years. If you fail or choose not to protect your trademark against infringement, you could lose your legal protection for your trademark.

  Adhere to Government Regulations

  As a social networking company, Facebook deals with many complex laws and regulations, enforceable at both the federal and state levels, involving privacy, data protection, content, protection of minors, and consumer protection. Because Facebook is a global company, it must also deal with the laws of the other countries in which it operates—laws that are often vague and subject to change. All these layers of legal complications can make it tough for Facebook to understand its liability exposures and to operate within the constraints of the law. To this end, Facebook assembled a top-notch legal team. In October 2008, the company hired Theodore Ullyot as its general counsel. Prior to joining Facebook, Ullyot was a partner at Kirkland & Ellis. He was also the chief of staff at the U.S. Justice Department and deputy assistant to then-President George W. Bush. He was even a law clerk for Supreme Court Justice Antonin Scalia. Facebook also brought on a key board member to help with its complicated legal issues: Erskine Bowles. Besides enjoying a successful career in the financial services industry prior to joining Facebook, Bowles also served as White House Chief of Staff from 1996 to 1998.

  Of course, it’s impractical for a fledgling startup to hire such high-caliber personnel early in its development. However, it is important to be mindful of some of the key regulatory problems that can occur when running a Web or mobile service, especially when dealing with data on consumers. If you do not follow the letter of the law, you may be subjected to severe legal liabilities. But the law is specialized and is evolving. This is why it is important to hire an experienced attorney.

  For example, in late 2011, Facebook struck a 20-year settlement with the Federal Trade Commission regarding the company’s publishing of its users’ information, which violated their privacy rights. The terms of the agreement involved meeting certain ongoing requirements and biannual, independent privacy audits—which, let me tell you, is no walk in the park. It’s not clear why Facebook violated the regulations but it shows that there are consequences to misusing user data. You should also be aware that, depending on the platform on which you build your technical service, you may also be subject to that platform’s privacy rules. One mobile app company—Path—learn
ed this the hard way. David Morin, a former Apple employee and early employee at Facebook, created Path to allow users to build a private social network of no more than 150 friends. As it turned out, however, the app actually sucked up each user’s personal information, such as e-mail addresses, names, and phone numbers. The platform that Morin used, Apple iOS, prohibits developers from creating apps that violate its users’ privacy rules. Needless to say, an app that allows its developer to access users’ contact lists is clearly in violation of Apple’s privacy rules.

  Apple’s CEO Tim Cook was livid and demanded that Morin come to his office, where he got balled out. Interestingly, Path was not the only offender. Other notable companies were doing the same thing, like Yelp, but Path became the “poster boy” of the offense and was used by Apple to set an example. Although these companies continue to operate their services and are highly successful, they are certainly more mindful of Apple’s privacy rules. A platform operator like Apple can ban any third-party app it chooses, which could render a company’s business model obsolete in an instant.

  Consider Other Protections

  Bear in mind that patents and trademarks only serve as protection for specific areas of intellectual property. Computer code is usually protected as a trade secret, and to qualify your code as a trade secret, your company must take certain measures. For example, your company should have confidentiality agreements for employees, contractors, and partners. It should also make invention assignment agreements a standard part of its practice. And have a process in place to secure documents.