Founder Vesting

Posted by Dave Broadwin on June 05, 2012

A couple of quick observations resulting from a quick read of a “standard” founder vesting agreement. 

(1)  Be wary of “standard.”  There are some items legal things that are truly “standard” but not as many as some lawyers may imply. 

(2)  You can under most circumstances get some up front vesting from VC type investors.  My experience is that for many startups in which the founders have invested some sweat, investors will give you some credit in the form of fully vested stock.  So, a typical arrangement (again depending on the facts) might be 10% to 25% fully vested at the Series Seed (or Series A, as the case may be) closing with the remaining amount vesting ratable on a monthly basis over three years.

(3)  The notion of a “cliff” seems out of place for founders who have been working on a startup for some months (or longer).

(4)  I see a lot of so-called double triggers (as opposed to full acceleration upon a sale).  So, sometimes you see everything that is unvested vest upon a sale (a liquidity event other than an IPO).  More often, however, I see something along the lines of half of the unvested vests with the remainder subject to the “old” vesting schedule provided that (and here is the second trigger) if the founder is terminated by the acquirer in the liquidity event (or the founder quits for good reason) within some agree upon time after the liquidity event (say six months, but sometimes more) then the remainder vests. 

(5)  Vesting stops when the founder ceases to work for the company.  The notion that unvested shares might vest immediately upon termination other than for cause has some appeal to founders, for obvious reasons, but you may need to come to a parting of the ways with one of your co-founders.  If you do, that fully vested block of shares (typically a big percentage of the common stock) may loom very large.

Founder Agreements - Vesting, vesting and more vesting....

Posted by Prithvi Tanwar on April 28, 2010

A quick shout out to my co-blogger David Broadwin for his recent guest post on Sim Simeonov's (of FastIgnite) blog High Contrast, on the subject of founder agreements and the importance of including vesting. 

 In other words....how not to give away too much of your company to slackers and flakers who don't deserve it.

Every aspiring start-up founder and founding team should give this a quick read.   Click here for the full post.

The Options for Options

Posted by Dave Broadwin on February 04, 2010

Sim Simeonov has a nice post on the subject of what is the best option vesting schedule. Options are a topic that has received a lot of attention in the blogosphere. A while back there was a lengthy discussion of options on Fred Wilson’s blog that, as I recall revolved around the need to think of option grants as percentages of the equity of the issuer (rather than in numbers of shares.  The EEC blog has many posts on options (and the related topic of restricted stock). All these posts tend to focus on some discrete aspect of options that came up in the author’s business. For a more general discussion, you can go to the Emerging Enterprise Center web site under "Ask the Start-up Lawyer." There you will find a general overview of the basics.

83(b) Elections

Posted by Dave Broadwin on August 21, 2009

83(b) elections seem simple but can be tricky. The general rule is that the recipient of restricted stock (stock subject to vesting) has 30 days from the date of issuance of the stock to file her 83(b) election. Unfortunately, ambiguity often creeps in. For example, what if you sign the contract for the restricted stock on day 1 but the stock is not issued until day 10? What happens if the stock is issued without restriction on day 1 and restrictions are imposed (that is a contract providing for vesting is entered into) by an investor on day 2? And is the result different if the restrictions are imposed on day 15? Day 30? Day 365? Often facts intervene to make life complicated. You need to talk to your accountant, lawyer or tax professional to make sure you get it right. The consequences of getting it wrong can be really unpleasant.

Reverse Vesting and S Corporations

Posted by Dave Broadwin on July 17, 2009

I recently ran into this interesting question: If you want to use reverse vesting and take advantage of 83(b) in an S Corporation what do you do about (1) tax distributions and (2) built up after tax profits?

In the case of tax distributions, once the shares are issued, the holder will have to pay tax (to the extent that there are taxable profits) pro rata in accordance with his ownership. So, it seems logical that any distributions made to help stockholders pay this tax should also go to the holder of restricted stock on a pro rata basis. If they do not, then the holder of restricted stock will have taxable income and no cash to pay it. Moreover tax regulations require that “S” corporations make all distributions pro rata to all shareholders, including holders of restricted stock (if they have made 83(b) elections), otherwise the IRS could treat the corporation as having an impermissible second class of stock, resulting in loss of the “S” election."

Now, what about the build up of after-tax value in the corporation? A pro rata amount of that build up belongs to the holder of restricted stock. By way of example, if the company makes $1mm of profit and distributes $400K to the stockholders to pay tax liability, there will be $600K of post tax dollars in the company. If the company were dissolved, these post tax dollars would go pro rata to the stockholders. (In the case of an option holder in an “S” corporation, there would be no ownership and no tax burden.) So, when it comes time for a distribution, even if the option holder exercises his options, he does not get the benefit of the after tax dollars – that is to say, he does not take the dollars out tax free. (Nonetheless, the tax regulations described above require that an option holder who exercises his options must share pro rata in any distributions. In this example, if the company distributes the $600K of accumulated post-tax profits, a pro rata portion of the $600K would go the option holder who had exercised his options, even though none of the $600K has been taxed to him. This, of course, reduces the amounts distributable to the other stockholders, so that they would not receive their full pro rata portion of the $600K based on their ownership prior to the option exercise.) Compare this to a holder of restricted stock with reverse vesting. The holder of restricted stock will have incurred taxable income, will have received cash from the company to pay the tax, and will then get a distribution of post tax dollars equal to (in our example) his pro rata share of the $600K.

Yet More on Restricted Stock

Posted by Dave Broadwin on January 28, 2009

Here is the disclaimer: 

There is a lot of downside to failing to make the correct filings in the context of restricted stock. You need to seek appropriate advice whenever you get restricted stock.

Here is the post:

A situation that commonly arises in connection with venture financings is when a founder is required to subject some or all of his or her shares to vesting as a condition to obtaining funding. Folks in our tax department note, and I agree, that:

there may be some confusion as to whether a protective 83(b) election should be filed in the situation where a founder receives company stock that is not subject to vesting, and vesting is subsequently imposed at the request of investors. 

Based upon Rev Rul 2007-49, our tax department's position is that:

 such an election is not required, as a general matter, where vesting is imposed on already-owned founders stock. 

But, our tax folks note that:  

A potential exception to this general rule is the situation where vesting is imposed shortly after the stock is first transferred.

In this situation, you need to consult your tax attorney. Our tax folks further note that:

the Rev Rul expressly holds that an 83(b) election is required (in order to avoid tax at the time of vesting) where stock is exchanged for unvested stock of the acquirer in either a tax-free reorganization or a taxable acquisition.

More on Restricted Stock and 83(b)

Posted by Dave Broadwin on December 15, 2008

I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

Continue Reading

Restricted Stock versus Options

Posted by Dave Broadwin on October 09, 2008

One thing that I find many entrepreneurs (particularly first time entrepreneurs) struggle with is the distinction between options and restricted stock and why one would use restricted stock instead of options.  See also the following link:  Stock Options and Restricted Stock.

I think it is fair to say that most, perhaps all, entrepreneurs have heard of options.  But, just in case, options are contractual rights to purchase shares of stock (usually common stock) at a fixed price.  In the employment context, options typically vest over time.  For example, four year vesting is a common provision in a venture financed company.  A typical arrangement would be for options to vest 1/4 on the first anniversary of employment  and 3/4 ratably (monthly or quarterly) over the subsequent 3 years.  This is the arrangement included in the National Venture Capital Association form of Term Sheet. Vesting refers to the right to exercise the option and purchase stock at the option price.  Since the employee cannot exercise options unless they are vested, to the extent that options have value, the employee is motivated to remain with the company and realize that value.

Restricted stock is actual stock (as opposed to options which are a right to acquire stock).  Restricted stock can be made to provide an incentive similar to that of options by requiring, as a condition to the grant of restricted stock, that the employee receiving the restricted stock enter into an agreement providing for "vesting."  In the context of restricted stock, it is often referred to as "reverse vesting" and it works like this:  The employee is granted shares of common stock subject to the condition that the company will have the right to buy back the shares at a trivial price (often par value).  The concept of reverse vesting comes in because the company loses its repurchase rights over time.  So, on the first anniversary of employment the company may loose the right with respect to 1/4 of the shares and so on.  In this way restricted stock mimics options.

Having said all this, there are important tax differences between options and restricted stock.  Options can be incentive stock options or non-qualified options.  Incentive stock options are options that meet certain requirements set forth in the internal revenue code and, if all conditions are met, can provide the option holder with capital gains treatment (as opposed to ordinary income treatment) upon the sale of stock acquired through the exercise of these options.  Among the requirements are that the options be held for at least one year and that the stock acquired upon exercise of the options be held for at least one year.  Since most option holders commonly sell the stock they acquire promptly upon exercise of the option, they rarely achieve capital gains on the excess of the sale price of the stock over the exercise price of the option.  Non-qualified options do not provide the possibility of achieving capital gains treatment on the excess of the sale price of the stock over the exercise price of the option (although you might, depending on how long you hold the stock, achieve capital gains on the difference between the fair market value on the date of exercise of the non-qualified option and the eventual sale price of the stock).

With respect to restricted stock, the holding period for capital gains treatment begins upon the date of grant, if the holder files a so-called 83(b) election under Section 83 of the Internal Revenue Code.  As a result, most employees who are granted restricted stock will achieve capital gains treatment.  The dark lining on this silver cloud, however, is that when you file an 83(b) election you must take the then fair market value of the stock into income (for purposes of income tax) without regard to whether or not it is vested.  So, if the stock has a high value, the employee receiving the stock will have a lot of income and no cash to pay the tax.  If the 83(b) election is not made, then the employee has to take into income the fair market value of each share of stock at the time that it vests.  If the value of the stock is increasing (as with the customary hockey stick projections) you can imagine that the income to be realized could become substantial.  To avoid these situations, use option grants.  However, early in the life of a company, its stock may have little value, with the result that using restricted stock and increasing the odds of getting capital gains upon a sale of the stock may make good sense.