1. What Is Founder's Stock?
2. Tax Considerations

Updated November 2, 2020:

What is founder's stock? This is the equity interest issued to a company's founders at or near the time the company is created.

What Is Founder's Stock?

Typically, the company issues founder's stock for a nominal cash payment. This may be as low as $0.0001 per share. The company may also issue founder's stock for assignment of intellectual property.

Founder's shares are common stock shares. In most cases, startup companies issue them at the time they incorporate. The shares are issued at very low prices and are normally allocated to the initial players or founders. The amount of shares they receive is commensurate with their role in the company and/or the amount of their investment.

While the shares are allocated and committed, they're not actually issued and owned (vested) until a later date. Startup companies often put some stock restriction agreements in place with each founder in order to ensure that the stock issued to the individuals is properly “earned” by these founding stockholders.

In most cases, founder's stock is set on a vesting schedule. This provides the company the chance to buy back unvested stock shares in the event a founder leaves the business before his or her shares are fully vested. Usually, vesting in startup companies occurs every month over a four-year period, beginning with the first 25 percent of founder's stock vesting only after an employee has stayed with the company for a minimum of 12 months — known as a one-year “cliff.”

When an employee leaves the business, vesting always stops.

Whether founder's stock has the same rights as other equity interests in a business depends on the agreement between the company and the founder, made either when the stock is issued or at a later date.

The rights may include the following:

  • Vesting and co-sale provisions
  • Right of first refusal
  • Accelerated vesting upon the sale of the business
  • Super-voting rights
  • Lock-up agreement

It's common to find special clauses because the involved parties want to minimize the dilution of shares.

Tax Considerations

Unfortunately, many founders make a mistake in waiting until an investor shows a serious interest in the company before they decide to incorporate it. This can cause a significant tax issue when founders start a business very close in time to raising capital.

For instance, say founders issue stock to themselves for a penny per share when they start the business. Shortly after that, outside investors come in at $1 or more per share. An IRS audit may make it appear that the founders issued stock to themselves at a price set far below the fair market value.

The government may consider the value difference between the fair market value (based on what outside investors paid) and what the founders paid for it to be compensation income. This income can present the founders with a significant tax liability.

Founders can avoid this tax risk by filing an "83(b) election" within 30 days of purchasing shares. They should also pay taxes early on those shares. Many founders fail to file this election, and this common mistake can be costly.

For founders who invest more of their own money at any time, there shouldn't be any tax concerns, as these concerns relate to outside investors who come in soon after the company is created.

Until outside investors come on board, valuation has little meaning.

Startup companies tend to be dynamic entities because people constantly come and go. Their responsibilities and roles constantly evolve. Because of this environment, founders should consider these stock provisions at the very start of the company.

As soon as they begin real work on forming the business, they should incorporate and allocate founder's stock. Ideally, they'll do this at least half a year before anticipating outside investors. However, it's important to not incorporate too early because investors measure the company's growth and process beginning from the incorporation date. Outside investors will consider it problematic if several years of seeming inactivity have passed since incorporation.

Tax and finance issues can be complicated when starting a company. Having trusted financial and legal professionals on your side can help you effectively manage your business.

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