Key Takeaways

  • A stock restriction agreement (SRA) governs the allocation and transfer limitations of shares, typically to founders or key employees.
  • These agreements protect companies from founders who leave early but retain ownership stakes.
  • SRAs often include repurchase rights, vesting schedules, and restrictions based on continued employment or milestones.
  • Making an 83(b) election can provide tax advantages by recognizing income at grant rather than vesting.
  • Founders usually receive common stock, while investors may receive preferred stock.
  • SRAs can help retain control, protect confidential information, and incentivize performance.
  • Legal counsel is vital to ensure SRAs comply with securities laws and protect both company and founder interests.

A stock restriction agreement or SRA refers to the agreement made between a company and its founder for allotment of stock that places certain restrictions on its transfer.

What Is a Stock Restriction Agreement?

The founders of a new company are usually compensated through cash and stock. Since most new companies do not have enough cash, they often partially pay the founders with the stock of the company issued over a certain period of time. This is typically done under a stock restriction agreement (SRA).

If the founders are allotted all of their shares outright, investors may find it unattractive and may refuse to invest in the company. Hence, most founders execute a stock restriction agreement in order to protect the interests of the company and appease the investors. Under an SRA, the total amount of stock allotted to a founder is kept aside. A vesting schedule is prepared, and the shares are distributed in installments according to this schedule.

An SRA usually requires a founder to maintain a business relationship with the company until all of the stock is vested. If the founder leaves the company or is terminated before completion of the vesting schedule, the remaining unvested shares are forfeited.

The objective of an SRA is to provide an incentive to the founders to continue working on the company's product or service and contribute toward its success. Founders looking to enter into an SRA should consider retaining a lawyer because such agreements involve important aspects of tax and securities regulations.

Why Stock Restriction Agreements Matter

Stock restriction agreements serve as a foundational tool to align the interests of founders, employees, and investors. Without such an agreement, a departing founder could retain significant equity while no longer contributing to the company—potentially disrupting fundraising and decision-making.

By clearly defining when and how stock vests or can be repurchased, these agreements ensure equity is earned through continued commitment. This alignment is particularly critical during early fundraising rounds when investors seek assurance that key team members will remain engaged.

Section 83(b) Election Under the IRC

Section 83(b) of the Internal Revenue Code (IRC) allows a founder to include the allotted stock in his personal tax return at the time of allotment instead of the time when it vests. This protects the founder against any increase in tax liability if the stock value goes up during the vesting period. The founder can claim all of the stock under the agreement in a single financial year. Any increase in the value of stock can be computed as capital gain at the time of actual sale. Note that 83(b) election must be made within 30 days of allocation of stock.

Importance of Timely Filing the 83(b) Election

Failing to file the 83(b) election within 30 days of stock issuance can result in severe tax consequences. Without this election, the IRS treats each vesting milestone as a separate taxable event—potentially leading to high tax bills if the stock’s value increases over time.

Founders should:

  • Consult tax advisors immediately after stock grant.
  • File Form 83(b) with the IRS within 30 days.
  • Send a copy to the company and retain proof of mailing.

This simple proactive step can yield significant long-term tax benefits.

What Type of Stock Do Founders Receive?

When a company allocates stock to its founders, they typically receive shares in the ownership or common stock of the company. Therefore, all the rules under the state statute applicable for stock transfer usually apply to such allocation. As the company grows and expands its investment base, it may decide to issue preferred stock with additional rights, making it more attractive to investors compared to the common stock.

Differences Between Common and Preferred Stock

While founders generally receive common stock, investors typically receive preferred stock with additional protections such as:

  • Liquidation preferences: Priority in receiving payouts upon company sale.
  • Anti-dilution provisions: Adjustments to maintain ownership percentages during future fundraising.
  • Dividend rights: Entitlement to fixed or cumulative dividends.
  • Conversion rights: Ability to convert into common stock under predefined conditions.

Understanding these distinctions is vital during equity negotiations to ensure fair and strategic capitalization.

The Benefits of Vesting Agreement for Founders

When two or more people found a company and split up the common stock equally without any stock restriction or vesting agreement, they may inadvertently expose themselves to certain risks from each other. For example, one of the founders may abandon the company while still retaining his ownership interest. When other founders make the business a success, the abandoning founder may reappear to claim his ownership in the company.

Even if things don't reach this extreme, other similar issues may crop up. For instance, one of the founders may not show the same enthusiasm or not work with same dedication as the others. Executing a vesting agreement protects other founders from such potential risk.

How Does a Restricted Stock Agreement Work?

A typical restricted stock agreement works as follows:

  • A founder is allocated unvested shares outright.
  • A vesting schedule is prepared for the issuing of shares over a period of time.
  • The company retains a right to repurchase the unvested shares for a certain amount if the founder terminates his relationship with the company.
  • As shares vest, the company automatically loses the right to repurchase the vested shares, giving an exclusive ownership to the founder.

What Is a Vesting Schedule?

A vesting schedule is the period over which the unvested shares of a founder would vest. This period is decided by the company depending upon the role and contribution of each founder. A vesting schedule typically includes the date of installment along with the number of shares to be granted. Instead of a pure time-based schedule, companies may also tie the vesting to performance milestones.

A company should come up with its own vesting schedule to suit its investors. In its simplest form, a vesting schedule could be a four-year period with 25 percent of the total shares vesting each year.

Common Terms Found in Stock Restriction Agreements

Stock restriction agreements typically include the following terms:

  • Vesting Schedule: Outlines the timeline or milestones required for stock ownership.
  • Right of First Refusal (ROFR): Gives the company or existing shareholders the option to purchase shares before they can be sold to outsiders.
  • Repurchase Rights: Allows the company to repurchase unvested shares if a founder or employee departs.
  • Forfeiture Provisions: Defines what happens to unvested shares if the holder is terminated for cause.
  • Acceleration Clauses: Allows for immediate vesting upon certain events like acquisition or involuntary termination.
  • Transfer Restrictions: Limits who can hold or purchase shares, helping maintain control over ownership.

Each provision reinforces the company’s ability to retain equity among active contributors and avoid external dilution or legal entanglements.

Risks of Not Having a Stock Restriction Agreement

Startups without a stock restriction agreement risk:

  • Loss of control: Departed founders may retain voting rights or equity influence.
  • Investor hesitation: Venture capitalists are less likely to invest in companies with unclear equity arrangements.
  • Internal disputes: Misaligned equity stakes can lead to resentment and legal conflicts among co-founders.
  • Diluted ownership: If unvested stock isn’t repurchased, it may remain on the cap table and dilute active members’ equity.

Having a comprehensive SRA in place helps mitigate these risks and ensures all parties are rewarded based on contribution.

Frequently Asked Questions

  1. What is the purpose of a stock restriction agreement?
    It aligns the interests of founders, employees, and investors by placing conditions on share ownership, typically through vesting and repurchase rights.
  2. When should a startup implement a stock restriction agreement?
    Ideally, it should be implemented at or before the time of the initial stock issuance, especially for founders and early team members.
  3. Can a stock restriction agreement be amended?
    Yes, but any amendment typically requires consent from the parties involved and may also require board or shareholder approval.
  4. What happens if a founder leaves the company early?
    The company can usually repurchase any unvested shares, preventing the founder from retaining full equity without continued contribution.
  5. Is filing an 83(b) election mandatory?
    No, but it is highly recommended for founders receiving restricted stock to avoid increased tax liability as shares vest.

If you need help with a stock restriction agreement, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.