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Many startups develop technologies that are potentially applicable to fields unrelated to their businesses. Commercializing these technologies often requires significant additional management time, expertise and funding and may attract different investors and customers than the start up’s main business. Creating a subsidiary of the startup — a new company to which the startup can license its technology for a specific unrelated field — may seem like the perfect solution to this need for separate focus, funding and management. But beware — these second-generation startups involve legal, tax and practical issues that you may not have anticipated. This article outlines some of those issues. Being aware of them in advance can make them easier to surmount. TRANSFERRING IP FROM THE PARENT TO THE SUBSIDIARY Can the original startup (the parent company) transfer its intellectual property to the subsidiary on a tax-free basis? That depends on two things: (1) whether the transfer constitutes a transfer of “property” for purposes of � 351 of the Internal Revenue Code (the Code); and (2) whether the transfer is in exchange for at least 80 percent of the shares issued by the new corporation. Regarding the first issue, most tax practitioners take the position that an exclusive perpetual license for intellectual property for a particular field of use qualifies as a � 351 transfer. The tax counsel and accountants of both the original startup company and its subsidiary should be involved in analyzing whether the terms of the transfer satisfy these criteria. The second issue is important because, unless the shares issued to the parent company in exchange for its intellectual property represent at least 80 percent of the shares issued by the new corporation, the intellectual property will not qualify as property for purposes of � 351. Whether this 80 percent test is met depends on how many other shares the subsidiary issues initially and for what consideration. If, when the subsidiary is established, more than 20 percent of its equity is issued to the management and employees of the parent and the subsidiary in consideration for services rendered or to be rendered, � 351 will not apply to the license. As a result, the parent company will have a taxable gain equal to the difference between the value of the intellectual property at the time of transfer and its tax basis in the intellectual property (usually zero or close to zero). ISSUING THE SUBSIDIARY’S SHARES TO ENTITIES OTHER THAN THE PARENT At what price and with what tax consequences can the subsidiary issue shares to its founders (other than the parent company) and early stage employees? In the typical startup scenario, two or more founders form a company by contributing ideas, nascent technology or a prototype and a few dollars (typically the par value of the shares they acquire). Because the technology is in an early stage and no significant money has been invested in developing the technology, the employees who join post-formation and pre-financing often can acquire shares or receive options at the same low “fair market value” per share as the founders. Moreover, because they paid “fair market value,” these employees likely will have elected to incur the tax liability up front on any unvested shares (which liability is zero) pursuant to � 83 (b) of the Code, rather than be taxed on the difference between the price they paid and the fair market value at the time their shares vest. Contrast this with the second generation startup scenario, in which the parent company has expended a significant amount of money on a system that, even if it has to be substantially redeveloped to meet the subsidiary’s needs, may be worth several million dollars. Suppose that, when the original startup was formed, the technology license to the subsidiary was worth $2 million. If the individual founders of the subsidiary receive 10 percent of the subsidiary’s equity for a nominal purchase price, their tax liability will be almost $200,000. The only way to issue “tax-free” stock to these individuals would be for the subsidiary to pay them grossed-up bonuses equal to their tax liability. This is not a realistic option for most growing companies. Granting options in lieu of issuing shares outright will postpone tax liability, but only if the option exercise price is not de minimus. Tax practitioners generally consider this threshold to be somewhere between 25 percent and 40 percent of fair market value. PROVIDING EQUITY TO THE PARENT COMPANY’S EMPLOYEES What is the appropriate level, if any, of equity participation in the subsidiary by the parent company’s management and employees? If the original startup feels that certain of its employees have made significant contributions to the “birth” of the subsidiary, it may want the subsidiary to issue vested founders’ shares to these individuals for services already rendered. This raises the same valuation and tax problems discussed above. Also, the parent company may wish to encourage its employees to continue to support the subsidiary by issuing unvested shares or options in the subsidiary, to be earned in the future. This, however, would result in adverse accounting consequences for the subsidiary because, unlike the issuance of restricted shares or options of the original startup to its own employees (which, if issued for fair market value, generally do not result in a compensation expense), the issuance of restricted shares and options in the subsidiary to employees of the parent corporation will require the subsidiary to recognize a compensation expense based on the Black-Sholes method or another fair value method for valuing the options or shares over the service period. The issuance of unvested shares or options to the parent corporation’s employees also raises the business question of how many hours and what period of time the parent corporation’s employees should devote to the subsidiary’s business (remember that the subsidiary was set up separately because of the need for separate focus, funding and management). SERVICES PROVIDED BY THE PARENT What level of management, facilities and development support should the original startup provide to its subsidiary? The terms of the license agreement between the parent and its subsidiary and any services agreements between them should be clearly documented. If the parent company is going to house its subsidiary initially, the term, allocated space, and the systems and facilities support that it will receive should be specified in writing. The time period and extent to which management, research and development and any other personnel services will be provided also should be detailed. If the parent company is not going to own 100 percent of its subsidiary, the parent’s board of directors has a fiduciary duty to its stockholders not to provide services without adequate consideration, whether the consideration consists of additional equity in the subsidiary, cash or other consideration. Furthermore, if the subsidiary is going to seek outside financing, it will be important to its prospective investors to be able to identify clearly the field in which it is licensed to conduct business and the services that the parent company has agreed to provide, as well as their cost. EXISTING INVESTORS’ OPPORTUNITIES TO INVEST IN THE SUBSIDIARY Many companies would welcome financing in a new subsidiary by their existing investors. However, if the original startup feels that, for strategic or other reasons, it does not want to offer this to its stockholders, does it nevertheless have an obligation to do so? Absent a contractual obligation to offer shares of a subsidiary to its stockholders (preemptive rights provisions do not typically cover a subsidiary’s shares), the parent company typically would not be required to offer its stockholders the opportunity to invest in the subsidiary. Some venture capital firms and other institutional investors, however, require in their financing agreements with their portfolio companies that their consent be obtained prior to the creation of a subsidiary or at least a subsidiary that will not be 100 percent owned by the parent company. This effectively gives them the right to negotiate their participation in the subsidiary’s financing in exchange for the requisite approval. It also may be the case that the parent company wants some, but not all, of its stockholders to participate in the subsidiary’s financing. While there may not be any contractual requirement to offer this right to all stockholders, it would serve the parent company well to consider an offering to all stockholders if it plans to make the investment available to any of them. THE PRINCIPAL CONSIDERATION The principal consideration underlying a number of the issues described above is the value of the subsidiary when it is organized. This, in turn, depends principally on the value of the technology license and any services agreement. Although the value of a startup business may be far from clear, the more objectively and thoughtfully the value has been determined, the more likely it will be given credence by the accountants of both companies, as well as by the IRS. The most prudent course of action is for the parent company to have an outside valuation of the subsidiary conducted in connection with the subsidiary’s formation. It is important to remember that this valuation cannot be conducted by same accounting firm that will audit the subsidiary’s accounts. Under the rules of the accounting profession, the subsidiary’s accounting firm cannot act as the subsidiary’s independent auditors if it has performed the outside valuation of the subsidiary’s options. Ellen B. Corenswet is a partner in the Business & Technology Department in the New York office of Brobeck Phleger & Harrison LLP.

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