Founder's Stock can be an Important Start-Up Tool
If you are an entrepreneur starting a Chicago business, you are probably interested in attracting talented people to help run your venture. One way of doing this is by granting founder's stock at the start-up stage. This will save you a lot of money since you will pay very little, if anything at all, to whomever you issue such stock. The stock's recipient will also acquire a high earning potential over the long term. If you want to take advantage of such a win-win situation and issue founder's stock, then you should keep the following three considerations in mind: 1) the vesting schedule; 2) the acceleration of vesting; and 3) tax traps.
The vesting schedule is a key consideration in granting founder's stock. First of all, what does it mean for a stock to "vest?" Vesting refers to the amount of time necessary for a founder or employee to actually acquire the right to own the shares they have been issued. The longer you have the stock, the greater your earning potential. If a founder's stock does not vest, then there is the possibility for free-riding. For example, pretend you begin a Chicago business with a co-founder yet the co-founder abandons it after 4 months while you continue working for the company over the next few years before it is sold. It would clearly be unfair for you and the absentee co-founder to be paid the same. Founder vesting ensures this does not happen. When considering vesting, it is important to keep in mind that founder's stock is the inverse of a stock option since founder's stock is subject to repurchase or transfer back. Such a right is, however, discretionary rather than automatic. This means that a company may reserve the right to repurchase but that it does not have to.
Founders are frequently concerned about what will occur to the vesting of their stock if the company is bought or if they are fired without cause. These two situations are usually considered in the context of single or double trigger acceleration. Single trigger acceleration occurs if the founder's stock agreement provides for the acceleration of vesting in one of these two situations while double trigger acceleration occurs if the agreement provides for the acceleration of vesting in both of these situations. It is generally not favorable to have single trigger provisions associated with the end of employment since equity within a startup should be earned. The argument is that if a founder no longer provides services for the company, his or her stock should not continue vesting. Some founders may stipulate having a part of their stock accelerate if the founder leaves the company for good reason or if he or she is involuntarily terminated. Generally, however, if a founder is terminated for cause or voluntarily quits, there is no acceleration.
Although vesting is a key consideration when issuing founders' stock, it is also important to not forget about the tax consequences of issuing such stock. It is expected that stocks will increase in value. As the owner of a business, you must monitor your taxes to ensure that you do not owe taxes on this increased stock value. Since an "83(b) election provision" means that the founder recognizes income on the value of the stock at the lower purchase price, it is important to include an 83(b) election in your stock purchase agreement. You must, however, file an 83(b) election with the IRS within 30 days of purchasing your founder's shares.
Typically, there are important contractual aspects of issuing founder's stock. Each recipient will have to sign a confidentiality, non-competition, and non-solicitation agreement. In addition, each recipient will also have to sign a stock purchase agreement governing the terms and conditions surrounding vesting and the repurchase of stock.
If you are starting up a new business, it is important for you to consider founder's stock as a possible option. It provides a way to obtain talent while conserving cash for other purposes during critical development needs.
This item was prepared by summer research assistant Yelena R. For your equity or other start-up business law question, please contact Chicago business lawyer Jeremy Gibson.