Founder Stock Grants and Vesting

Founders leave companies for all sorts of reasons.  As such, it is critical for investors to understand founder stock grants and vesting, in order to ensure that incentives are aligned.

Founder Stock Grants

In general, founders should issue to themselves, in aggregate, between half and two-thirds of the amount of shares initially authorized, with the remaining shares held in reserve for investors and employees.  The only number to consider when looking at the division of equity is the percentage — not the raw number of shares, the price of the shares, the strike price of options, or the percent of the outstanding options pool.  These numbers are all meaningless for a young company — it is just the percent of the company that matters.

Splitting the Pie Between the Founders

Usually there is more than one founder — and thus the founders’ equity allocation must be divided.  While arguments taking a different point of view are widespread, the easiest and most straightforward way is to split equity equally among the founding team.  This approach is most likely to preserve the founders’ relationships with each other and keep everyone feeling like their work is fairly rewarded.

Certain situations may warrant a deviation from equal sharing (for example, when one founder is primarily responsible for most of the early work — or is working full-time while others are still part-time), but founders should examine carefully whether their situation really does demand a departure from equal allocation.

Too often, a founder feels like he or she “had the idea” and therefore deserves most of the equity.  Those founders forget that ideas are cheap and it’s the execution that truly counts.

All of that said, there are many who make the case that founders should receive equity based on a host of factors, including who pitches investors, who pays for basic expenses, and who does which pieces of the work.  There is one “co-founder equity calculator” at foundrs.com, which attempts to turn all of this into an objective formula.  Nevertheless, any uneven division, no matter how objective, will almost certainly lead to some founders feeling underappreciated — and undercompensated.

Vesting Schedules

A four-year timeframe with a one-year cliff is typical.  What that means is that one-fourth of a founder’s allocation will vest 12 months after the grant date and the remainder will vest in equal monthly installments over the next three years.  The one-year cliff — meaning nothing vests before a full year has passed — ensures that every founder commits a minimum amount of time to the company before owning any shares.

There are sometimes provisions that accelerate vesting if there is a change of control — an acquisition (see next section below) — or a founder is terminated without cause.  There are also sometimes provisions that allow some of the stock to immediately vest, especially if a founder has put up capital for the company or donated valuable intellectual property.  Contributions like these can justify a fraction of the stock vesting immediately, since they are not contingent on work going forward.

[su_pullquote] The Importance of Vesting. Without a vesting schedule, each founder can hold the company hostage: a founder leaving with a substantial chunk of the company’s equity early in the process makes it difficult for the startup to succeed, because the available equity pool is significantly reduced. Vesting ensures that every founder contributes not simply to the idea, but to the execution. Moreover, a founder who leaves early with his or her ownership intact may severely demoralize the remaining founders. Finally, founders without vesting schedules risk losing credibility in the eyes of their employees: why should employees abide by a system that the founders do not? Having everyone subject to the same vesting schedule instills a sense of being in it together.[/su_pullquote]

Acceleration Upon Change of Control

In the case of acceleration upon a change of control, there are a couple of different options that are important to understand:

Single trigger acceleration means that 25% to 100% (depending on the particular provision) of unvested stock vests immediately when there is a change in control. The length of the vesting period for the remainder of the stock is not reduced — it just means that less stock remains unvested.

Double trigger acceleration means that 25% to 100% of unvested stock vests immediately — but only if the individual is either fired (terminated without cause) or resigns for a good reason (acceptable reasons are usually spelled out in the initial documents, but mostly involve material changes in job titles or duties, being forced to move, or having compensation lowered by more than a certain percentage).

Vesting Start Date

The vesting schedule is often adjusted to take into account work prior to the initial stock grant.  Founders often spend significant time on a company before formally incorporating and want to receive credit for it.

One rule of thumb is that vesting should begin once a founder begins working on a project full-time.  The hours that founders spend talking after school or after work generally shouldn’t count when it comes to vesting – the clock starts when commitments are serious and hit 40+ hours per week.  Why?  It goes back to ideas versus execution: the former is easy; the latter generates the value.

The Company’s Right to Repurchase

Equity that has not yet vested generally has a repurchase option for the company, if the person’s service to the startup ends before the equity vests.

Typically, the startup can repurchase the equity at the same (usually nominal) price that was paid.  This is almost certainly a much better deal for a company than a buy-out of vested equity — which requires a fair market value calculation at the moment in time that the equity is bought back.

It is common for a startup to hold unvested equity in escrow, just in case the relationship between the company and the ex-founder turns sour, and for the founder to sign an assignment of unvested equity back to the company for the company to hold just in case it needs to execute the repurchase option.

 83(b) Election

Founders are often surprised that vesting stock is treated by the tax code as compensation, and must be recognized as income based on the value of the stock at each vesting date.  If the company grows to a high valuation, the tax bill can end up quite large, even though no gains have yet been realized.

Founders can avoid this problem by filing an 83(b) election with the IRS, which treats the stock as if it will not vest, meaning there is no tax issue upon vesting.  However, this election must be filed within 30 days of the initial stock grant.

Restricted Stock vs. Options

The above pertains to restricted stock grants — but some companies choose to use stock options, which allow founders to purchase a certain amount of stock during specified windows of time.

There are a number of reasons that restricted stock is the preferred approach over stock options.  Among them: (1) the IRS requires that options be valued by a professional valuator, which can be quite costly; (2) options can become worthless even when the company — and its stock — still has value (in the case where the strike price of the option is higher than the value of the stock); and (3) restricted stock encourages the founder to think long-term, since he/she will own these shares regardless of current value, as opposed to merely wanting the short-term value of the company to rise so that options hold more worth.

Stock Grants for Employees and Officers

Founders aren’t the only ones receiving stock in a young company.  Employees and officers also typically receive some stock.  Much has been written on this topic, but the general rule for early employees who are not founders is that, in terms of fully diluted ownership range, an early-hired CEO will end up with between 5% and 8% ownership, a COO between 2% and 5%, and other key early employees, particularly the engineers making the product come to life, will end up with something in the range of 0.2% to 1%.  These numbers fall as the company grows more mature – the above ranges pertain to companies with valuations below $15 million.

In closing, stock grants and vesting are important items to diligence before investing in an early-stage company.