The term, “founders’ stock” is often used in the start-up world. Founders’ shares are typically shares of common stock issued to founders and initial employees of a company very early in the process of forming and organizing the company. These shares can be issued fat a low valuation if the company has no business or assets at inception, which means that the tax consequences to recipients of these shares will be minimal. The number of shares that founders receive is usually commensurate with their position or expected contribution to the company. Some companies also issue founders’ stock when employees or founders assign their intellectual property over to the company.
A common strategy is to issue shares subject to vesting over time. Shares that are not vested can be repurchased by the company if the holder of the shares ceases to perform services for the company (or for other reasons). However, by issuing the shares early in the organization of the company, the tax consequences to recipients of the shares are minimized because the shares have a very low value. Vesting also ensures that founders and initial employees demonstrate longevity and loyalty in order to “earn” their founders’ stock.
In this article, we’ll walk you through some of the aspects of founders’ stock and what to look out for if you are granting or receiving founders shares.
Characteristics of Founders’ Stock
Vesting
In many cases, the receipt of founders’ stock will be subject to a vesting schedule. This allows the company to issue a significant number of shares when the tax consequences are favorable but also buy back unvested shares if a founder leaves the business or is terminated sooner than expected. When an employee leaves the business or is terminated, vesting stops and unvested shares can be re-purchased by the company. If you hold founders’ shares subject to vesting, and you separate from the company, review carefully the provisions of your stock purchase agreement/subscription agreement or award agreement (depending on how the shares were issued). If you have stock options as well as founders’ shares, you may have rights that expire shortly after, or just prior to, your separation date.
Rights and Restrictions
When reviewing the rights and restrictions applicable to founders’ stock, you should not be surprised by any one or more of the following characteristics:
- Rights of first refusal that prevent you from transferring your shares without first offering them to the company or other shareholders,
- Other prohibitions on transfer,
- Accelerated vesting upon certain conditions such as a sale of the company or a change in control,
- Super-voting rights granted to key persons but not all persons receiving founders’ shares, and
- Lock-up agreements which come into effect if the company undertakes a public offering.
This is not an exhaustive list, and there may be other rights and restrictions attached to your founders’ shares. There may also be special clauses aimed at minimizing the dilution of a founder’s share position.
Founders Stock vs. Preferred Stock
Preferred Stock
Preferred shares of stock are typically issued to investors who bring money – venture capital investors and angel investors who finance a company’s early funding rounds. This stock is a different “class” of stock from the common stock. Preferred stock often carries a higher priority claim on a company’s assets and provisions aimed at giving the preferred holders a specified return before any return is paid on the common shares. In other words, if a company is sold, goes bankrupt or enters into a merger transaction, preferred stock is structured to give preferred shareholders their investment back, plus a specified return, before common stockholders see any return. In recent years, an uptick in the contractual returns given preferred stock has made the terms of preferred shareholder distributions a more prominent issue that must be completely understood by all parties to a financing.
Tax Considerations for Founders
The premise of issuing founders’ shares early in the life of a company is that the company’s shares have little or no value. At inception, the company typically does not own anything and has no business. It has plans and intentions. As a result, while shares issued to founders and employees are considered taxable income, the income is very low or negligible. This low valuation may be challenged, however, if outside investors invest based on a substantially higher valuation shortly after the founders’ shares are issued. This can give rise to an unexpected tax liability for the founders.
Founders can control tax exposure as shares vest by filing an IRS Code § 83(b) election within 30 days of purchasing the founders’ shares. They should pay whatever tax is due on the shares when the filing is made, based upon the low valuation. But they will not be subject to taxable income as the shares vest in the future (hopefully at higher valuations).
Other Issues
The capitalization table established early in the life of a company is always a work in progress if the company expects to raise money by issuing equity. Professional investors will not be shy about specifying the percentage of the equity they require and the degree of control they expect. Founders have to expect dilution, recognizing that they will have a smaller slice of a larger pie when the company takes in money and the business grows. A few general principles bear stating.
- The interests of common shareholders versus preferred shareholders can be dramatically different, depending on the situation, especially where preferred shareholders are looking for an exit that does not support a payout to everyone.
- The interests of preferred shareholders as between classes of preferred stock also can be different. Expect that your Series A investors are baking in protection against the Series B and Series C investors to come.
- Professional investors are keenly attuned to these inter-share-class issues.
- We always recommend strategizing at the early stages of a company’s growth. Founders cannot anticipate everything, but often they know the path they would most want to take. Lay the groundwork and build some defenses for the challenges that will come. It is always easier to defend protections that you have put in place than to introduce them in the context of negotiating with an investor.
- Many founders are doing things in this arena for the first time with lots of people offering advice. There is no set playbook for capitalizing a company. Choose your advisors and screen out the “noise.”