A Manatt for Entrepreneurs Resource
Founder’s stock refers to the equity granted, typically in the form of common stock, to founders of a company for their preformation efforts in building the company. This common stock is sold to founders at a nominal value at or immediately after formation, when the fair market value of the stock is low; the founders typically pay cash for the equity or acquire the equity in exchange for their contribution of intellectual property to the company. The equity is typically subject to certain restrictions, including a vesting schedule, which allows a company to repurchase unvested shares when a founder departs. Allocating equity between founders and whether to subject such equity to restrictions are fundamental issues that need to be addressed with care at the time of formation.
We encourage founders to subject their founder’s stock to a vesting schedule with some level of acceleration, particularly when the founders expect to seek funding from outside investors.
Vesting Schedules
Vesting schedules, which outline how a founder’s stock will vest over a period of time, are important mechanisms that protect the company and its stockholders by requiring a founder to continue providing services and to remain motivated and focused on the growth of the business. Should a founder depart before his or her equity vests, the company will have the option to repurchase such founder’s unvested equity, typically at the lower of fair market value or the original purchase price.
Factors to consider in creating a vesting schedule include the length of the schedule, whether all the shares granted will be subject to the schedule and how often the shares will vest. The most common vesting schedule is four years with a one-year “cliff.” Under this structure, 25% of the equity subject to the vesting schedule vests at the end of year one and the remaining equity continues to vest in monthly increments over the remaining 36 months. The purpose of the cliff is to delay commencement of vesting until the founder completes one year of service with the company. Despite this industry-standard schedule, we sometimes see vesting schedules that differ between founders of the same company based on the founders’ respective roles with the company and their contributions to the business.
It is important to note that vesting schedules may be renegotiated and/or re-upped in future financing rounds by investors as a condition to their investment, a method used to assure investors that founders are sufficiently incentivized to remain with, and perform on behalf of, a company. We encourage founders to subject their founder’s stock to typical vesting schedules from the outset since future investors may be willing to honor those schedules rather than seek to impose new, restrictive vesting arrangements.
Acceleration Provisions
Most founder vesting schedules include an acceleration provision that permits full acceleration of a founder’s unvested equity upon the occurrence of certain events. The two most common acceleration provisions are known as “single trigger” and “double trigger” acceleration.
Single-trigger provisions allow for accelerated vesting upon the occurrence of a single event, usually a change in control of the company or, in rare cases, upon termination of employment without cause. Under more frequently utilized double-trigger provisions, vesting is accelerated only upon the occurrence of two events: (1) a change in control of the company and (2) where the founder is terminated without cause or leaves for good reason during a period following the change in control transaction. The definitions of “cause “and “good reason” are heavily negotiated in the founder’s stock purchase agreement and are beyond the scope of this article.
Single-trigger acceleration provisions are founder favorable and generally not accepted by outside investors. Given the current economic uncertainty, we expect to see an increased usage of double-trigger acceleration provisions.
Section 83(b) Tax Elections
General tax law requires that taxes be paid on the fair market value of shares at the time the shares vest; if the fair market value of the shares increases over time, so will the tax liability of the stockholder. A Section 83(b) election provides stockholders the ability to pay tax at the time equity is issued rather than on the date equity vests, permitting equity holders to pay tax on the nominal value of shares at the time of acquisition rather than on any increase in value when such shares vest. The 83(b) elections must be filed with the IRS within 30 days of the date of acquisition of the shares subject to vesting. We strongly recommend that founders consider and discuss 83(b) elections with their individual tax advisors.
Overall, in order to strategically position the company for success from the outset, when incorporating, we encourage founders to carefully balance their own interests and the expectations of potential investors by ensuring that equity grants include appropriate vesting and acceleration provisions.