Startup stock value is an important issue to be mindful of, particularly when it comes to taxes. If someone receives stock for less than its fair market value, they receive a taxable gain. Therefore, when issuing common stock, whether it be the initial purchase by the founders during incorporation, or even with employee equity compensation, it is often good practice to ensure that the fair market value of the stock does not greatly exceed the assigned value of the stock — and they are not necessarily the same thing!
Oftentimes, when the “payout” of the stock is several years after when the stock is received it is possible to accelerate the payment of tax (such as is the case with restricted founder’s stock and a Section 83(b) election); even then, a difference between the assigned value of the stock and the fair market value of the stock can create a tax liability.
So what is the fair market value of a company’s stock? Before you get financed, and upon your first financing, it can largely depend on what someone pays for the stock. This is why financings are often done as convertible debt/preferred stock, since it is reasonable to claim that preferred stock can have a higher value than the common stock. After financings, once the company gets an established valuation, the fair market value of stock often ends up being determined according to formulas in the Internal Revenue Code.
In any event, entrepreneurs should be careful not to let the fair market value of their company’s common stock appreciate too much, otherwise they end up increasing their tax liability (and by extension the value of their stock) when it comes time to pay.