What should the vesting terms of founder stock be before a venture financing?
July 19, 2007
I think that founders stock before a venture financing should be subject to the same general vesting terms as one would expect after a venture financing. A typical vesting schedule is four year vesting with a one year cliff. This means that 25% of the shares will vest one year from the vesting commencement date, with 1/48 of the total shares vesting every month thereafter, until the shares are completely vested after four years. The vesting commencement date can be the date of issuance of the shares, or an earlier date, in order to give the founder vesting credit for time spent working on the company prior to incorporation and/or issuance of the shares.
Some founders want to accelerate vesting upon a termination without cause or a constructive termination. (I will get around to defining these terms in future posts.) I’m not sure that this is really in the best interest of the founders. It is extremely difficult to terminate someone for cause, so termination of a founder will generally result in his/her shares being vested. For founders that have never worked with each other, I would generally counsel against acceleration of vesting upon a termination without cause or a constructive termination. If personalities clash or things don’t work out and a founder needs to be forced out, the remaining founder(s) will kick themselves for allowing the departing founder to leave with a significant equity stake.
If there is acceleration upon a termination without cause or constructive termination, I think the amount of acceleration should be similar to the amount of severance that a person may receive in the same situation. If six to 12 months of severance might be justified if a person is terminated without cause, then six to 12 months vesting acceleration seems reasonable. Of course, the typical norm in technology companies is that there is no severance in any situation.
In addition, some founders may want to accelerate vesting upon a change of control. Single trigger change of control vesting means that the shares accelerate upon a change of control. This isn’t in the best interest of investors because the fully vested founders have little incentive to continue to work for an acquiror after a change of control. In order to incentivize these people, additional options may need to be granted, which increases the cost of the acquisition to the acquiror, potentially to the detriment of the investors. Double trigger change of control vesting means that the shares accelerate upon a change of control AND the founder is terminated without cause or a constructive termination occurs within 12 months of the change of control.
The amount of shares that accelerates upon these events can be 100%, or written as a certain number of months of vesting, such as twelve. I’ve had one VC express a strong opinion that the amount of vesting upon one of these events should not be 100%, but rather 12 to 24 months of vesting acceleration, due to the fact that it is extremely difficult to terminate someone without cause. I think that double trigger 100% acceleration for founders or certain executives is fairly accepted among investors. However, extending that protection to rank and file employees is not common.
In any event, VCs are likely to impose their own vesting terms and acceleration upon a Series A financing, so it may not matter what terms are implemented when the initial founders shares are issued. However, reasonable vesting and acceleration terms may survive the Series A financing, especially if it would be difficult to renegotiate with a critical founder in a team with multiple founders.
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A key to remember if service-based vesting will be imposed up on the founder stock is that the tax rules provide that it is taxable at vesting on the value of the stock at the time of vesting. These rules will be overridden if the founder elects within 30 days of the issuance of the founder stock to be taxed on the value of the stock at the time of issuance (less anything paid for the stock, which can include the value of IP contributed to the business) [this is an “83(b) election”]. The 30 day limit is extremely strict and the 83(b) election has to be filed with the IRS within that 30 day period, so if service-based vesting will be imposed, it is important to be very careful to consider making an 83(b) election and filing it with the IRS within the deadline.
What kind of stock or equity and at what value should we offer a founder/board member when the stock is of no value in a start up company and no investment is made by the Founder.
The founder/board member should be offered common stock. The number of shares should be determined as percentage of fully-diluted shares.
Yokum,
If founders are issued restricted common stock instead of options, can I include both employment-based schedule and performance-based schedule into the restricted stock agreement? Let’s say 50% of stock is subject to 4 year release schedule, and remaining stock is released while company reaches certain milestone? For the performance based stock, a term should be specified, right? such as 10 years?
The reason for me to ask this question is, I see most company grant options for performance based stocks instead of restricted stocks, even for their initial founder.
While it is possible to have performance-based vesting with respect to founders’ stock, it’s not common. When a company is initially formed, the founders of the company hold all of the capital stock. Many founders don’t subject their stock to any vesting criteria. These founders often find that when they raise their first round of financing the investors want to impose some vesting with respect to their stock. Investors do this to motivate founders to continue increasing the value of the business and so that the founders will remain focused on the current venture rather than potentially focusing on other interests or ventures. To retain some control over the vesting provisions of their stock, founders will often subject their founders’ stock to vesting prior to the first round of financing so that investors have less incentive to revise or impose their own vesting provisions.
If founders are going to impose vesting onto their stock, most impose time-based rather than performance-based vesting criteria. It’s often difficult to ascertain appropriate performance-based vesting criteria for a start-up company as the company can grow quite fast and the environment can change quickly often making what was originally thought to be an appropriate goal obsolete or unattainable. Performance criteria related to raising capital might be a viewed as a negative milestone to an outside investor as they may believe the founder’s goal is to raise financing to fund their lifestyle or a way to recoup forgone salary rather than a means of promoting the company and increasing the value of the business. While performance-based vesting can be an appropriate motivator and incentive, performance-based vesting is usually imposed after investors have invested their capital in the company and can help design appropriate and objective performance goals that can best help motivate the founder, as well as promote and increase the value of the business.
[Thanks to one of my employee benefits colleagues for pondering this with me.]
What are the tax implications of the grant to initial founders of common stock who bring the IP and business plan, and others invest the dollars. There is no vesting schedule.
@LJ. Assuming it is structured properly, the contribution of assets for stock and contribution of cash for stock should be a tax-free transaction under Section 351 of the IRS Code.
How to structure properly to be tax-free for founder’s stock?
Thanks!
I don’t understand the question. There is no tax on the issuance of the founder’s stock if it is issued at fair market value. There will be tax on the subsequent sale of the stock if there is gain.
Thank Yokum! I don’t quite understand this:
@LJ. Assuming it is structured properly, the contribution of assets for stock and contribution of cash for stock should be a tax-free transaction under Section 351 of the IRS Code.
What document needs to be filed? Need to file 83b election? or it’s autumatic?
In short, how to achieve a tax-free transaction?
Yokum, I mean even though “There is no tax on the issuance of the founder’s stock if it is issued at fair market value. ” Does it mean all the stocks are vested already also at the same time?
If not, what if the price is higher when the stocks are vested?
What if 83b election isn’t filed within 30 days?
If I just started a C Corp and authorized 10M common shares. I want to pay $6000 to get 6M shares. What time the transaction shall happen? Do I need to file 83b election to make this tax free?
I’m really not following the questions.
If you contribute assets in return for stock, then you need to comply with the requirements of Section 351 of the IRS code. If the transaction is not structured properly, then it will be taxed as if you sold the assets. You should discuss this with an attorney.
If you buy the stock for cash, then there is no Section 351 issue and there is generally no tax on the purchase as long as the purchase price is fair market value.
The 83(b) election has nothing to do with Section 351 and an assets for stock transaction. The 83(b) election is important if the company has the right to repurchase the shares. Please read the 83(b) post for more details.