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Founders' stock...

What entrepreneurs need to know about vesting, acceleration, tax traps, future liquidity

Financial trends and news by John Bautista
September 16, 2008 | Comments (6)
Short URL: http://vator.tv/n/40d

 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!

(Vator is a client of Orrick. Also see Lightspeed Ventures blog for other great posts!
Image source: blogs.guardian.uk)

Comments

Thom Calandra
Thom Calandra, on September 16, 2008

Terrific article. Rarely have I seen someone dissipate so precisely the clouds that swirl around the mysteries of F-stock. (Must be a lawyer.)

thomcalandra.com


David Gehring
David Gehring, on September 16, 2008

hmm, maybe I should be an Orrick client!


David Saad
David Saad, on September 16, 2008

Your article is good and covers the main points typically found in a well-drafted Stock Option Plan. However, you seem to be too consumed by what VCs like. Maybe you ought to be a bit more concerned of what entrepreneurs need?!! Entrepreneurs need to be equally protected by the potential abuse, negligence, or sheer incompetence of their VCs. For example, in the case of a down-round caused by a failed strategy imposed by the VCs on the entrepreneur, the VCs manage to enrich themselves at the expense of the entrepreneur who finds his/her equity evaporates. There is indeed lack of accountability. VCs are not just innocent bystanders. They are an integral part of the decision making. They reap the rewards when the venture succeeds but take no blame when it fails even though, more often than what they like to admit, they are the main culprit. So maybe the same type of vesting schedule ought to apply to VCs, don't you think? In an era where entrepreneurs can bootstrap and grow their business on a dime, venture capitalism is about to be reformed. For the lack of a better term, I call it Venture Capitalism 2.0.


David Saad
David Saad, on September 16, 2008

I do appreciate your effort in proposing the Founder Stock, but very soon, investment agreements are going to look like the IRS tax code. We had Common Stock which everybody understood, then Preferred Stock came about to protect investors, and now Founder Stock show up to negate some of the shortcomings. I won't be surprised if "VC Stock" are soon introduced to negate the Founder Stock. Let me be blunt: I want to get rid of the Preferred Stock because of the inequailty and complexity that they create. Before you know it, the closing cost would skyrocket if we continue this escalation. I realise of course that complexity pays the bills for a service provider. As an entrepreneur, I like KISS (keep It Simple Stupid). I also want every dime to go towards building my business and not paying service providers. As a result, I am a big proponent of standardizing and simplifying agreements, getting rid of brokers, and eliminating the need for professional services, especially the legal ones, for startups. Sorry to be so brutal, but it's about time to defend the single most important constituent who creates real value - the entrepreneur. Finally, considering your legal expertise, the most important and nobel contribution that you can make to entreprneurship is to reduce, if not eliminate, the need for your services. I know, it's not gonna happen!!!


Ryan Roberts
Ryan Roberts, on September 16, 2008

Great article.

I think Founders Stock (aka "Series FF") is a great idea for the entrepreneur. If a founder has racked up debt getting his or her startup to the financing, selling these shares can be a blessing. Of course, selling Founders Stock at a financing could end up being expensive (in the long run) to the founder if the company increases in value post-funding.

Unfortunately, Founders Stock is a bit new to the space so there may not be some clear cut answers re (a) tax issues upon its sale, and (b) its long-term viability (i.e. acceptance by VCs).


Christian Karl Kameir
Christian Karl Kameir, on September 30, 2008

Vesting over four years seems long for the typical start-up. Personally I have not seen a lot of monthly vesting schemes. Seems rather cumbersome.


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