The simplest way to pay for shares of stock in a new company is with cash. In the earliest stages of a company, the price per share of a company’s stock is usually equal to its par value. When par value is low, such as $0.00001 per share, a founder can usually purchase shares for a total of a few hundred dollars. Sometimes, founders may want to pay for shares with their existing intellectual property (IP). Paying for shares with IP is possible, but more considerations come into play.
IP refers generally to creative works including copyright, trademark, patents, and other inventions. It can also include business plans, models, software code, and product prototypes. Founders may choose to assign relevant IP to their new company as payment for shares in addition to or in lieu of cash payment.
When assigning IP to a company, founders should work with legal counsel to ensure that the assignment (the transfer of IP rights) is properly documented. Not having the correct documentation may result in the company not having proper ownership of important IP, which can be problematic when the company is raising money or negotiating an exit.
IP should be properly and fairly valued at the time of the transaction
IP that is valued too highly at the time of transfer may cause the fair market value of the stock to increase, which would have a negative impact on other early purchasers of the stock (e.g. other founders, early employees). On the other hand, IP that is valued too low at the time of transfer may be found later (e.g. in an audit) not to have covered the purchase price of the stock. Founders need to have a reasonable basis to value their IP. In situations involving complex IP, this may mean obtaining an independent valuation of the IP.
Structuring for a tax-free exchange
An IP-for-company-stock transaction also needs to be structured properly alongside other founders’ purchases of stock (including for cash), in order to be considered a tax-free exchange. Section 351 of the Internal Revenue Code, which covers tax-free exchanges, requires that: (1) the exchange be solely for stock (i.e. the individual can’t receive both stock and cash), and (2) immediately after the exchange, the founders need to have control of the company, which means they hold at least 80% of the combined voting power of all classes of stock entitled to vote, and at least 80% of the total shares of each class of stock.
Delaware corporate law issues may come into play. When a Delaware corporation issues stock, it must receive consideration with a value of at least the par value of the issued shares. This is so that the shares may be considered “fully paid.” If there is any question about the value of the IP being contributed, it is advisable to pay at least the par value of the shares of stock in cash.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.