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What entrepreneurs need to know about Founders’ Stock September 15, 2008

Posted by jeremyliew in Entrepreneur, financing, founders, start-up, startup, startups, VC, Venture Capital.
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This is a guest post by John Bautista. John is a partner in Orrick‘s Emerging Companies Group in Silicon Valley. John specializes in representing early stage companies.

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When entrepreneurs start a company, there are four things they need to know about their stock in the company:

• Vesting schedule
• Acceleration of Vesting
• Tax traps
• Potential for future liquidity

VESTING SCHEDULE

The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not vesting until the employee has remained with the company for at least 12 months (i.e. a one year “cliff”). Vesting stops when an employee leaves the company.

Even Founders’ stock vests. This is to overcome the “free rider” problem. Imagine if you start a company with a co-founder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for much of the hard work. Founder vesting takes care of this issue.

Even if you’re the sole founder, investors will want to see your founder’s stock vest. Your ability and experience is one of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company’s development and funding process, want to make sure that you are committed to the company long term. If you leave, the VCs also want to know that there is sufficient equity to hire the person or people who will assume your responsibilities.

However, many times vesting of founders’ shares will follow a different schedule to that of typical startup employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history working with each other, and know and trust each other. In addition, most founders will start vesting of their shares from the date they actually started providing services to the company. This is possible even if you started working on the company prior to the issuance of founders’ stock or even prior to the date of incorporation of the company. As a result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.

This vesting is balanced by investors’ desire to keep the founders committed to the company over the long term. In Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the three or four years following the date of a Series A investment.

ACCELERATION OF VESTING

Founders often worry about what happens to the vesting of their stock in two key circumstances:

1. They are fired “without cause” (i.e. they didn’t do anything to deserve it)
2. The company gets bought.

There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if they both occur (double trigger acceleration).

“Single Trigger” Acceleration is rare. VC’s do not like single trigger acceleration provisions in founders’ stock that are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s services are terminated then the founders’ stock should not continue to vest. This is the “free rider” problem again.

In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the company’s headquarters are moved). However, under most agreements, there is no acceleration if the founder voluntarily quits or is terminated for “cause”. A 6-12 month acceleration is also usual in the event of the death or disability of a founder.

VC’s similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the company to a buyer. Acquirors typically want to retain the founders, and if the founders are already fully vested, it will be harder for them to do that. If founders and VC’s agree upon single trigger acceleration in these cases, it is usually 25-50% of the unvested shares.

“Double Trigger” Acceleration is more common. While single trigger acceleration is often contentious, most VC’s will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the enterprise from the acquiring company’s perspective. It is arguably in the acquiring company’s control to retain the founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event of involuntary termination by the acquiring company. In Orrick’s experience, it is typical to see double trigger acceleration covering 50-100% of the unvested shares.

TAX TRAPS

If things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests, and before you have the cash to pay those taxes.
There is a 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. One of the most common mistakes I’ve encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company.

Fortunately, over the years, I’ve developed a number of work-arounds (depending on the circumstances) and we can many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed. Nevertheless, this is one of the first things that your lawyer should check for you.

Of course, you’ll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I’m sure you’ll be able and happy to pay!

POTENTIAL FOR FUTURE LIQUIDITY

Founders’ stock is almost always common stock because VC’s purchase preferred stock with rights and preferences superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new security for founders which we call “Founders’ Preferred” which enables founders to hold some of their shares in the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale.

The “Founders’ Preferred” is a special class of stock that founders can convert into any series of preferred stock sold by the company to VC’s in a future round of financing. The founders would only choose to convert these shares when they plan to sell those shares to VC’s or other investors in that round of financing. This special class of stock is convertible into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock is identical to common stock.

The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price.

Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as opposed to common stock.

“Founders’ Preferred” can usually only be implemented at the time of the first issuance of shares to founders. Therefore, it is important to address the advantages and disadvantages of issuing “Founders’ Preferred” at the time of company formation. I normally recommend for founders who want to implement “Founders’ Preferred” that such shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance of “Founders’ Preferred” remains a new development in company formation structures. Therefore, it’s important to consult legal counsel before putting this special class of stock into effect.

Many VCs do not like to see Founders’ Preferred in a capital structure.

CONCLUSIONS

As discussed above, there are a number of issues to address when issuing founders’ stock. In addition to business terms associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate important legal and tax considerations. My advice to founders is to make sure to “get it right” the first time. Although here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it is important that founders get the right business and legal advice, and not just use pre-packaged forms.

This advice should begin at the time of company formation. A little bit of advice can go a long way!

Comments»

1. Dave Spencer - September 15, 2008

Naive question, but isn’t one solution to the free rider problem is that you can issue more stock and then dilute the free rider?

Scenario:
– company starts
– 1 year later a founder leaves prematurely and “unfairly”
– remaining founders, investors, etc, create more stock and pass it out to those still with company

….or can shares not just be created like this?

thx,
Dave

2. John V. Bautista - September 15, 2008

Dave,
A company can easily sell shares. However, if the sole purpose is to dilute the other founder and if the shares are not sold at fair market value, then that founder could have a claim of breach of fiduciary duty. He would argue that the shares are not being sold for value and that the sale is unfair and he would probably prevail. This is why it is important to have an agreement up front dealing with the circumstances in which one of the founders may leave the company

3. ProjectX Blog » Blog Archive » Xlinks Digest - 16 / 09 / 2008 - September 15, 2008

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4. Conrad Hametner - September 15, 2008

Enjoyed the post, thanks for sharing some of the many considerations for creating a solid foundation to grow a startup. If I have learned anything in my experiences in start-ups it is to get good qualified advice, especially in areas where I do not have an expertise. It is however always a balancing act, between this, “getting things done” quickly and cost. But as John points out, it is always better to “get it right” the first time if you can.

5. Mike D - September 15, 2008

Great post John. Thanks. In regards to the single trigger for sale of company, you write that the acquiror wants vesting to retain the founders (and therefore so do the VCs)…makes total sense…of course. However, in today’s world where the average exit is about 6 years, the founder in the majority of cases has already fully vested by then which would make this issue largely moot, no?

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8. yokum - September 16, 2008

John,

Among other things with respect to founders preferred stock (which I have blogged about at http://www.startupcompanylawyer.com/2007/12/22/what-is-series-ff-stock/), are you 100% comfortable that:

1. the IRS wouldn’t treat the conversion of the Founders Preferred into later round preferred stock as the exercise of an NSO, with the holder recognizing ordinary income and the company having a withholding obligation; or

2. the IRS wouldn’t take the position that the purchase of Founders Preferred as the purchase of preferred stock subject to a substantial risk of forfeiture, with failure to file an 83(b) election resulting in ordinary income on the spread between purchase price and FMV upon conversion; or

3. the IRS wouldn’t take the position that the Founders Preferred includes an NSO to purchase the later round preferred stock and is therefore a deferred compensation arrangement subject to 409A issues; or

4. that whatever pricing scheme for the Founders Common versus the Founders Preferred (with presumably the Founders Preferred being issued at a higher price than the Founders Common) in the absence of a valuation report would be upheld if challenged by the IRS?

Yokum

9. jenslapinski - September 16, 2008

This is a good post. Thanks for that. I have two comments:

1) To entrepreneurs: Do not accept the above as gospel! It is up to you to negotiate your vesting schedule. Obviously, you want the schedule to be in your favor as much as possible. Negotiate the best deal you can. A three years vesting schedule with quarterly vesting and full acceleration in case of a sale is not unusual at all. For me personally, not having accelerated vesting in full in the case of sale would be a deal breaker. For example, read this article as to why you want cash in the bank when you sell your company: http://venturebeat.com/2008/09/01/when-selling-your-company-beware-of-earnouts-you-may-lose-your-shirt/
If a company acquirer wants to retain you, then this will be solved contractually at the time of sale. They may also offer you additional earn-outs. In the case of an IPO, the underwriter will restructure the shares anyway.
When a VC comes to you and asks that you not have accelerated vesting in the case of a sale, ask them whether they would be happy to be on the same vesting schedule as your are, without the accelerated vesting on a sale. You could explain that this is designed to ensure that the company is as high quality as advertised at the time of sale and that the buyer gets a good deal. When the VC firm tells you that you are nuts, ask them why you think it is unreasonable to ask this of them, when they are asking this of you.
You get my point…

2) If you want to read more about how to negotiate your term sheet (including stock vesting), then I highly recommend this site (I have no connection to it): http://venturehacks.com

10. John V. Bautista - September 16, 2008

Dave,
In response to your question regarding the duration of founder vesting. You are right that average liquidity periods have lengthened since the “bubble” burst in 2000. In fact, the liquidity periods we see today are similar to what they were before the internet bubble in 2000. Nevertheless, 4 years of vesting for all employees is the norm, including founders. There are 2 principal reasons why vesting is not longer. First, the most critical stage for a company is the early stage, and thus vesting during the first 4 years of a company’s growth is most important for founders shares. Presumably, the founder will add the most value to the company during these beginning years. Second, CA securities laws used to impose minimum vesting requirements on stock and options, i.e vesting couldn’t be less than 20% per year. There are exceptions now to this rule. However, the precendent has remained and with the vast majority of companies adopting 4 year vesting for employees, it will be hard to change this practice.

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12. Peter S Magnusson - September 17, 2008

john, founded stock can also avert the risk of founders ending up w zero dollars on an exit due to liq prefs. Correct?

13. Peter S Magnusson - September 17, 2008

*founder’s (dumb iPhone)

14. Peter S Magnusson - September 17, 2008

*founders’ (wtb edit button)

15. Sam - September 17, 2008

I thought ‘founders stock’ could be bought up front by the founders (when the corporation is formed), but bought back, based on a vesting schedule, if the founder leaves. You’d essentially be vesting, but you’d avoid the tax implications that occur when exercise the option to buy a stock below it’s appraised value. I’m a software developer considering a venture as a founder and would love to have some more insight into this.

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18. John V. Bautista - September 19, 2008

Yokum,

We don’t know exactly what the IRS’ position is on founders’ stock since it has not been test in an audit or litigation. So, our tax analysis is based on similar cases. With this, we believe with reasonable certainty that there would be no tax on conversion of the founders stock into the round of preferred stock that is issued, assuming the founders stock is set up as a separate class of stock at or near the time of formation of the company. Another reason to do this early. Also, it is important that founders stock be fully vested and no 83(b) election is filed. Finally, the founders stock should be done either at the time of first issuance of shares or in a recapitalization where all then existing stockholders are treated the same and on a pro rata basis. This should avoid any compensation charges.

19. John V. Bautista - September 19, 2008

Peter,
Yes, founders’ stock provides a mechanism by which founders can convert a portion of their holdings into a later round of preferred stock. This usually occurs at the time of that later round and most VC’s will want to be sure that the conversion occurs then. But, that is negotiable. If you can negotiate to have the right to convert at any time in the future, then you would achieve the objective of protecting a portion of your ownership in the downside scenario you explain.

20. John V. Bautista - September 19, 2008

Sam,
For tax reasons, founder’s preferred stock needs to be vested upfront. Since usually only a portion of a founders holding is in the form of founders’ preferred, it is normally not an issue that this portion is vested at the time of a venture round. The remainder (in the form of common stock) can be subject to whatever vesting is agreed to with the VC’s.

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22. Rick - November 19, 2008

What advice do you have for founders in the situation below?

– 2 founders start a company
– they find friends and family to invest a small amount
– they use that amount to get freelancers to build the product
– they find their angel investor who comes aboard full time and they hire all the people who helped build the product
– over time, they bring on people who are “A” class people to help drive this company to greater levels and they take on larger amounts of investment and adds new board members
– if the board at some point feels that one of the founders has more stock than other members of the team who are more experienced than the founder and suggest a recapitalization so that the founder can be on the same level playing field as the other experienced team members, how should the founder handle this?

What are young inexperienced founders to do when only they are asked to give some of their stock to other experienced team members so that the cap table doesn’t look unfair?

Rick

23. John V. Bautista - December 8, 2008

Rick,

I’ve had this happen before and generally discourage it. Certainly, after a venture round has occurred, a deal is a deal if if they founders have negotiated their equity up front and the VC invested in the company based on that capital structure, then there are few arguments post-funding to restructure the capital structure. However, if the company has not yet completed a venture round (i.e. no significant professional investors yet), then I’ve seen restructuring of cap tables. The principal objective is to ensure that all members of the team are motivated to create value for everyone, and to have the capital structure looks right to a VC. Founders nevertheless almost always have more stock than other members of a team to take into account that they are founders and that they invested time and effort prior to the venture taking off. In general, my experience is that founders have (at the time of a VC financing) about 2X ownership what a new hire would receive. In one instance where a founder’s stock was restructured post VC financing, it was due to the fact that one of the founders was not performing at the level expected by the board and represented to the VC’s. The company had to hire another executive to fill the role.

24. Martin Zwilling - February 1, 2009

This is an excellent post on founder’s stock, especially with all the comments. I recently tried to clarify the beginning founders stock issues on http://blog.startupprofessionals.com for my clients, but it is still a source of questions.

Marty Zwilling, Founder & CEO, Startup Professionals, Inc.

25. rick rodgers - August 17, 2010

Jon,

This might be worth reading. I do recommend that you do the Section 83(b) election (based on what I read).

Rick

26. brendadronkers - September 14, 2010

Hi there. I was wondering if anyone can help me. I am a founder, and am looking to sell some or all of my non-voting shares in a large franchise system that is going international.

I need liquidity, and am looking to sell my shares. I can’t seem to find the right type of broker to handle this. Any suggestions?

The other investors and VC firm are not interested..

27. Andrew Payne - September 23, 2010

Great article!

Here’s some additional info I wrote on the same topic that might be helpful as well: http://www.payne.org/index.php/Startup_Equity_For_Employees

28. Bern - October 22, 2010

Great article –another reason to avoid VCs “as long as possible.”

29. Dan Marshall - October 25, 2010

If a corporation is formed and common stock is issued immediately (say 30% to one of the founders) at a negligible price then a month later a 30% interest is sold for $1M to an investor (neat trick if you can do it). My understanding is that the IRS will step up the basis of the founders stock and tax the stepped up amount at regular income rates. That would mean the founder with 30% of the issued stock would be immediately taxed on ~0.3 x $1M or on $300,000 gain. Is this correct? I understand taxation of restricted stock and the 83(b) Election rules. Is there any legitimate way around up front taxation of founder’s stock (when investment capital is received early on)?

30. MP - April 20, 2012

Very helpful article. I have a few questions: can we have different vesting schedules for the different founders? How do we record the founders shares, are they a separate class of shares altogether, or do the conditions attached to them only show in the shareholders agreement.
Thanks
MP

jeremyliew - April 29, 2012

You can have different vesting schedules for the different founders. They would be a separate class of shares. You should consult your lawyer for more advice

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33. Fletcher Whitney - July 11, 2012

Question: Founder works on a company for 18 months. After 18 months he brings on someone with business and possible fundraising capabilities. No agreements on paper, but verbal discussions centered around a 70/30 split with the new person. One year passes and the new person leaves on their own. The startup has not received any funding to date. The person who left states that they ‘vested’ 10% by the time they left. Wants to hold onto that percentage to ‘see how things go’.
If someone on the team leaves prior to funding…and there isn’t a hard, written agreement with regards to exact vesting schedules, etc, what should the person leaving expect? There is no ‘treasury’ to buy back that 10% the leaving person feels they own. Do people that leave startups get to keep their shares indefinitely? Thanks.

jeremyliew - July 23, 2012

Any situation where there isn’t a written agreement are very difficult. I would defer to “norms” and given a norm in silicon valley of a four year vest with a one year cliff, I’d apply that to the current situation to see what ownership that implies (ie given a verbal agreement of 30% for the cofounder, then it would be 7.5% at the first year anniversary and then the rest vesting equally over the next 36 months). For founders, there is often no cliff, so you’ll have to decide if that applies.

And yes, they would keep shares indefinitely unless there was some agreement to buy the shares back in the future

34. H lee - August 3, 2012

Do these principles apply to startups in China? Cofounder is saying that equity allocation is determined at the end by the investor, so founders don’t currently know how much they own.


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