Not all founders are created equal.
INTRODUCTION
When there is more than one founder of a new venture, the issue of an equitable division of the equity pie should be at the forefront of their planning. The bottom-line is that not all founders are created equal. As such, these inequalities should be reflected in the way founders’ shares are distributed. Nevertheless, this only addresses part of the issue brought about by the distribution of founders’ shares. All founders should consider what would happen if one (or more) of their co-founders departed the new venture for a better opportunity?
VESTING BASICS
Vesting is to secure the immediate right of ownership and enjoyment to a thing (options, shares, etc.). Before the moment of vesting, however, the grantor of the right may extinguish the unvested right. In order for a co-founder’s shares to fully vest, she must remain with the startup in some capacity until the end of a particular vesting period (or the complete vesting cycle for 100% vesting of all shares). In the context of startup companies, vesting seeks to align the incentives of the enterprise (i.e., the company), the individual co-founders who remain with the company and the co-founders who leave the company before a liquidity event. For example, if a co-founder is granted 4,800 shares of founding stock, with a four-year vesting cycle and a monthly vesting period, 1/48th of that founder’s shares vest each month (this example assumes no vesting cliff). In this case, 100 shares will vest each month. If the co-founder leaves after eight months, she will have 800 vested shares, and 4,000 shares will be subject to forfeiture.
THE IRS, INCOME AND VESTING
The IRS defines income in Section 61 of the Internal Revenue Code (IRC 61, 26 U.S.C. §61). Section 61 states that “except as otherwise provided in this subtitle gross income means all income from whatever source derived.” That has a few implications for vesting. First, unvested shares are not considered as purchased or “earned” until they are no longer subject to forfeiture. Second, if a co-founder obtains shares for a price lower than the stock’s fair market value, then the difference between the stock’s fair market value at the time the stock vests and the purchase price is income to the co-founder. In the example above, each issuance of 100 shares would be considered income. In addition, as the value of the shares increase, the income to the co-founder would cause an increasing tax liability (with no realization of cash to offset the income tax bill from the IRS). Reverse vesting, in correlation with a Section 83(b) election, seeks to soften the blow of the adverse IRS treatment.
REVERSE VESTING
The obvious solution to the foregoing would be to issue all of the shares to the co-founder, but reserve an eroding right for the company to repurchase the shares at an agreed upon, negligible price (via a repurchase agreement). Over a period of time, the company has the right to repurchase fewer and fewer shares. The co-founders’ effective, fully vested stake in the company grows over time, while still letting the co-founder keep ownership of the stock from a legal standpoint as it appreciates, allowing long-term capital gains treatment, favorable initial tax treatment, voting rights, etc. Following the example set forth above, the co-founder would receive all of her 4,800 shares at or about the time of the company’s formation. However, the company’s right to repurchase lapses with respect to 100 shares each month for 48 months. The shares are said to vest at a rate of 100 shares per month. Therefore, after eight months, 4,000 shares are subject to the company’s repurchase and 800 shares are fully vested with the co-founder.
THE SECTION 83(B) ELECTION
From an income tax perspective, the IRS reasonably acknowledges that reverse vesting is simply a fiction created to avoid the adverse tax consequences related to issuing shares that are of an increasing value. However, if a co-founder makes a voluntary Section 83(b) election, the co-founder recognizes income upon the purchase of the stock (i.e., at the time of the initial grant of shares). Generally, the stock value is at its lowest point, hence a relatively low purchase price. If the entity is formed relatively early in the process, and shares are granted at that time, one might argue that the value of the stock is zero (or thereabouts) and there is no income taxable event. Needless to say, a co-founder who is purchasing unvested stock, should consult his or her tax advisor to fully understand the consequences of purchasing unvested stock and filing (or not filing) an Section 83(b) election [1].
ACCELERATION OF VESTING
The astute reader is wondering what happens to a co-founders’ shares that are subject to forfeiture upon a change of control event (i.e., merger or acquisition). An acceleration provision provides for accelerated vesting in certain events. Acceleration comes in two flavors: single-trigger and double-trigger. A single-trigger means that some or all of one’s stock vests upon a change of control event. A double-trigger means that some or all of one’s stock vests upon a change of control event and their firing. Each acceleration feature has its own advantages and disadvantages for the company and the shareholder that should be discussed thoroughly with an attorney when accelerated vesting is being considered.
CONCLUSION
Vesting of founders’ shares often makes co-founders uncomfortable. However, the consequences of failing to address this issue can be catastrophic to a company. With the appropriate bells and whistles, vesting can be made palatable to all concerned. If you would like to discuss this or related topics further, please feel free to contact me directly by clicking here.
[1] The Section 83(b) election applies equally to “regular” vesting and “reverse” vesting. The only requirement is that equity be issued subject to either (1) forfeiture or (2) repurchase by the company at cost, in each case prior to when the vesting requirements are met (generally the service time).