How to Exchange IP for Shares of Stock in your Startup
Founders of technology startups typically pay for their shares at incorporation by contributing intellectual property (“IP”) they have developed and that relates to the business of the startup. This IP might consist of business plans, source code, domain names, websites, sketches or drawings, algorithms, processes, ideas, concepts or any other tangible or intangible property that relates to the business. This article will discuss the key concepts around transferring IP into the company — and how to structure the contribution in a way that is generally tax free to the company and the founder.
To License or to Assign?
This question is asked quite frequently by startup founders. The difference between licensing and assigning property to the company lies in who owns the property after it has been “contributed” to the company. If the founder licenses the IP to the company, the founder retains legal ownership of the IP. In an assignment, however, legal ownership of the IP is transferred to the company, with the founder forfeiting all ownership rights to the IP.
The gut instinct of many founders is to simply retain ownership of the IP and license it to the company. That said, in the overwhelming majority of cases the IP doesn’t get licensed to the company but rather, it gets assigned. This is because for most technology companies, the primary value of the company lies in its technology. If a license to a critical piece of technology isn’t renewed or the founder who owns the licensed technology becomes disgruntled or leaves the team, the company risks losing an asset that comprises a significant amount of its value. That being the case, investors and acquirers typically want the company to own all of its key technologies free and clear. Thus, most technology startup founders end up assigning the company all of their IP that relates to its business.
Structuring the Transaction for Tax-Free Treatment
Section 351 of the Internal Revenue Code provides that company founders may transfer cash and property into the company in exchange for stock (tax free) as long as two conditions are met:
- The property must be transferred solely for stock (i.e., transaction is not tax-free if founder exchanges IP for stock and cash); and
- Immediately after the transfer, the founder(s), (including those transferring cash) must own (i) stock comprising at least 80% of the combined voting power of all classes of stock entitled to vote, and (ii) at least 80% of the total number of shares of each class of stock
If there is more than one founder, the contributions do not need to be simultaneous, but must be made at or around the same time as the other founders in order to be deemed part of the same “transaction” for purposes of satisfying the 80% tests.
Other Considerations for Transferring IP
It should be noted that founders are typically only asked to contribute IP that relates to the business. Therefore, it would be entirely acceptable for a founder to specifically exclude any IP that he or she has developed that does not relate to the business. This leads to the issue of how to define which IP to assign into the company. Special attention should be paid to ensure that the scope of what is being contributed into the company is properly defined so the company receives all the IP it needs to successfully conduct its business. Care should also be taken to ensure the transfer of the property is perfected where required (e.g., assignments of patents and trademarks are properly documented with the United States Patent and Trademark Office).