Thoughts on startups by investors that
fund them & entrepreneurs that run them

Founder’s Stock Is Gold, If You Know The Rules

Image via Flickr by BullionVault

Image via Flickr by BullionVault

In reality, so-called “Founder’s” shares are simply common stock, issued at the time of startup incorporation, for a very low price, and normally allocated to the multiple initial players commensurate with their investment or role. But that’s only the beginning of the story.

These shares are allocated and committed, but not really issued and owned (vested) until later. Typically, vesting in startups occurs monthly over 4 years, starting with the first 25% of such shares vesting only after the employee has remained with the company for at least 12 months (one year “cliff”). Vesting always stops when an employee leaves the company.

Even though the class is common stock, Founders can negotiate special vesting and other terms as part of their stock restriction agreement upon venture investment. Here are some typical special terms and considerations for Founder’s stock:

  • Negligible real value. Since Founder’s shares are usually issued at the time the company is incorporated, they essentially have no real value. As the company builds value, shares allocated later for employees or partners will have an appropriate price.
  • Vesting with no cliff. Most Founder vesting is not subject to the one year cliff because partners should already know and trust each other. Thus, most Founders will start vesting their shares from the date they actually started providing services to the company.
  • Right of repurchase in favor of the company. This clause gives the Founder the first right of refusal to buy shares back from a partner who decides to leave early, or otherwise makes a troublemaker out of themselves. This right usually “lifts” over time, meaning that as time goes on, fewer shares are subject to this repurchase agreement.
  • Accelerated vesting conditions. They might also have special terms in the case of termination or demotion that accelerate vesting. These have less to do with the type of stock and more to do with who the person is and how strategic they are to the organization.
  • Stock dilution control. While most employees would see their vesting rest when the “Series A” round closes, a Founder might retain some percent of their shares. Everyone wants to minimize dilution of shares, so this special clause is common.

Unfortunately, Founders often make the mistake of waiting until they have received a strong indication of interest from an investor before they decide that it is time to incorporate. Forming a company so close in time to raising capital can create a significant tax issue.

For example, if Founders issue themselves stock for one cent per share when they form the company, and then within a short period of time outside investors jump in at $1 or more per share, it might appear in an IRS audit that the Founders issued themselves stock at significantly below the fair market value per share.

The difference in value between what the Founders paid and the fair market value of that stock based on actual sale to outside investors will be characterized as compensation income resulting in what could be significant tax liability to the Founders.

The way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your Founder’s shares and paying your tax early on those shares. Failing to file the 83(b) election is common mistake of Founders that you should avoid.

There should be no tax concern for a Founder investing more of his own money any time in the process. All the tax concerns relate to “outside” investors coming in shortly after incorporation. Valuation has very little meaning until an outsider invests.

So my advice is to incorporate and allocate Founder’s stock as soon as you are starting real work on the company, but at least six months before you anticipate any outside investors. But don’t incorporate too early, as investors will measure your growth and progress since the incorporation date. Several years of apparent inactivity since incorporation will make it look like there is a problem with you or with the company.

Of course I have to add my caveat that I’m not a lawyer, and these comments do not constitute a legal opinion. See a qualified business attorney if you anticipate multiple investors or a complex company structure. Don’t let a positive investor decision take the joy out of your future.

Written by Martin Zwilling

user Martin Zwilling Founder and CEO,
Startup Professionals

Martin is a veteran startup mentor, executive, blogger, author, tech professional, and angel investor. He is the Founder and CEO of Startup Professionals, a company that provides products and services to startup founders and small business owners.

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