Key Takeaways:

  • Founder Shares Overview: Founder shares are low-cost common stock allocated during a company's inception and often tied to a vesting schedule to ensure commitment.
  • Vesting Schedules: Typically, vesting is spread over four years with a one-year cliff to protect long-term contributors and ensure equity aligns with ongoing contributions.
  • Sale of a Company: Unvested shares may accelerate their vesting through single-trigger or double-trigger provisions during company acquisitions.
  • Tax Implications: Founders should consider filing a Section 83(b) election to mitigate tax liabilities on unvested stock.
  • Risk Mitigation: Clear agreements on vesting schedules and shareholder rights help prevent disputes and protect equity in cases of dilution or co-founder disagreements.

Founders shares are low-priced common stock issued when a startup company is incorporated. The shares are typically spread among initial parties, proportionate to their role or investment in the company. The shares are allocated at this point, but do not become vested, or owned, until a later time.

Shares for a startup company are often vested monthly, over a period of four years. The first 25 percent of shares are typically vested after the employee has passed the one-year cliff, meaning they have remained with the company for more than one year. When an employee leaves the company, vesting of the shares stops.

Although they are common stocks, founders may negotiate special vesting terms or other options as part of their agreement for venture investment. Since the stocks are issued to the originators of a firm, they do not typically receive any return until dividends are paid to all common stockholders. These shares are still entitled to all remaining after-tax profits, regardless of the amount.

The shares are usually issued for a nominal cash payment and/or assignment of intellectual property. Typically, founders shares are subject to a vesting schedule which gives the company the right to purchase the unvested shares back from the founder if they leave the company before their shares become fully vested.

Vesting Schedule in Founders Shares

The vesting schedule for founders shares should be agreed upon when the stock is first issued but may be decided at a later point, as a stipulation of the investment by an outside investor. 

There are a few reasons a founder might agree to have their shares fall under a vesting schedule during the inception of a company.

  • It is fairly common for some founders to leave a startup during the first few years, so the vesting schedule protects those who stay by eliminating the parties who leave from being able to reap the benefits of the employees who stay with the company.
  • Having the expectation of future investments by the company; if the founder waits until after investors are involved, they may receive a stricter vesting schedule.

Often, founders may be given some vesting acknowledgment that is retroactively dated for the work they completed prior to the company becoming incorporated. Vesting provisions regularly include a safeguard for the employee being terminated without proper cause, as a result of the company being sold. When founders consent to such vesting limitations, it is typically good business practice to file special tax elections, which are recognized as Section 83(b) elections.

Tax Implications of Founder Shares

Founder shares come with potential tax implications that founders must carefully address. Filing a Section 83(b) election is one way to manage tax liabilities. This filing enables the founder to pay taxes on the shares' initial valuation rather than their appreciated value during vesting. Key points include:

  • Filing must be done within 30 days of the shares' issuance.
  • Without an 83(b) election, taxes will be levied annually as the shares vest, potentially at a higher valuation.
  • Consulting with a tax advisor is critical to ensure compliance and minimize financial burdens.

What Happens to Unvested Stock if the Company Is Sold

The vesting provisions for founder's stock might provide for speeding up of vesting after the sale of the company. There are a couple main variations of these provisions: 

  • A single-trigger provision, which expedites the vesting of shares that are not yet vested, effective at the time of the sale. With this provision, starting at the time of the sale, the buyer is responsible for understanding how to preserve and inspire the team members of the company that has been acquired.
  • A double-trigger provision, which expedites the vesting of shares that are not yet vested, if the company is sold and the employee is fired without cause, sometime after the sale has closed. This type of provision protects the employee from being fired without cause by the buyer, by increasing the time of vesting for the existing shares that are not yet vested.

Vesting restrictions are not usually a part of the reasons why a company and a founder decide to go their separate ways. However, it is certainly a possibility that it applies in the case of being terminated without proper cause or voluntarily leaving the company. 

Often, a founder may request a time reduction for vesting if they are terminated without cause, even when not in connection to a company acquisition. This may not be an entirely unreasonable request, but you should be very cautious about agreeing to an acceleration of vesting. This can become an issue if the person was terminated, but did not fully satisfy the definition of cause — they may end up walking away from the company with a large portion of the company's stock.

Mitigating Equity Dilution Risks

Equity dilution occurs when new shares are issued, reducing existing shareholders' ownership percentages. Founders can mitigate this risk through:

  • Anti-Dilution Provisions: Protect initial ownership stakes by adjusting the conversion rates or issuing additional shares.
  • Careful Fundraising Strategies: Raise capital without excessive dilution by valuing the company appropriately and negotiating fair terms.
  • Equity Agreements: Clearly outline the terms of dilution and equity retention in shareholder agreements.

Addressing Co-Founder Disputes

Disputes among co-founders can threaten a company's stability and equity structure. To prevent conflicts:

  • Establish clear roles, responsibilities, and equity splits from the start.
  • Implement a shareholder agreement that defines decision-making processes, dispute resolution mechanisms, and exit strategies.
  • Regular communication and alignment on the company's vision can also minimize misunderstandings.

FAQ Section

  1. What are founder shares?
    Founder shares are equity issued to a company's founders during incorporation, often subject to a vesting schedule to ensure long-term commitment.
  2. What is a vesting schedule for founder shares?
    A vesting schedule determines when a founder fully owns their shares, typically over four years with a one-year cliff.
  3. What happens if a founder leaves before shares are vested?
    The company can repurchase unvested shares, preventing early leavers from benefiting disproportionately.
  4. Why is the Section 83(b) election important?
    Filing an 83(b) election allows founders to pay taxes on shares based on their initial value, reducing potential tax burdens as shares appreciate.
  5. How can founders prevent equity dilution?
    Founders can use anti-dilution provisions, fundraise strategically, and clearly define dilution terms in agreements to protect ownership stakes.

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