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)
