Founder Stock Vesting

Have questions about founder stock vesting? then read on to learn more about what it is and what market terms look like.

What is founder stock vesting?

When we say founder’s stock “vests”, we typically mean that the founder or founders of a company have granted the company a “repurchase right” to their stock that diminishes over time in exchange for the founder’s continued employment or association with the company.  Note that stock options can also vest, but here I am only discussing the vesting of actual stock, rather than options.

It might work like this: A founder purchases 1 million shares of stock in the newly formed corporation subject to an agreement that gives the company the right to purchase the shares back if the founder leaves the company. If the founder remains associated with the company, after one year from the date of purchase the repurchase right has diminished so that it only extends to 75% of the originally-purchased stock, after two years it only extends to 50%, three years 25%, and after four years the repurchase right is extinguished and the founder owns the shares free and clear. What “vests” over time is the right of the founder to leave the company and keep the purchased stock.

The effect is to incentivize the founder to stay with the company, and to make sure that if the founder leaves, he or she does not leave with a significant portion of equity that hinders the company’s ability to move forward.

Should founder’s stock vest?

If there is more than one founder, or if you expect to seek investment in the next year or two, in most cases it should.

Founder’s stock should vest when there are multiple founders because that assures each founder that their co-founders won’t simply leave and take a large chunk of equity with them.

Even if there is only one founder, the stock should vest if the company plans on seeking investment from venture capitalists or other sophisticated investors, because the investor will likely require vesting as a term of their investment. If the original vesting terms are reasonable, investors are likely to accept those terms.

What are reasonable terms for founder stock vesting?

Typically founder’s stock vests over four years from the date of the start of operations, even if that date is before the incorporation or purchase of shares. Also, there is typically a one-year cliff, meaning that the founder has to remain with the company for at least a year before any shares are owned free and clear, and after that the shares vest in equal monthly or quarterly installments.

Many founders include “double trigger” acceleration, which means their vesting will be accelerated if two things occur: first, there is  a change in control or acquisition of the company, and two, the founder is dismissed without cause in connection with the sale or for a period of time thereafter. This protects the founder from the company being acquired and losing her or his stock because the acquiring company lets him or her go. Typically the acceleration is for only a portion of the remaining stock remaining to vest (for example, it accelerate 50% of the unvested stock, or a year’s worth of vesting).

“Single-trigger” acceleration (acceleration on a change in control OR a dismissal without cause)  is rare and not recommended as it might affect the potential to attract investment or be acquired.

What are the tax consequences to the founder of founder stock vesting?

When a founder’s stock vests, the founder is essentially trading labor (by working for the company over a period of time) for the stock. Normally, stock that is earned in exchange for labor is taxed as income when it is earned. Therefore, if a founder agrees to a vesting arrangement and does nothing else, the founder will have to pay tax on the fair market value of the stock every time a portion of the repurchase right diminishes. Most founders like to avoid paying this tax as the stock vests (however, in a small amount of cases it may be beneficial to pay tax this way, so check with your tax adviser).

In order to avoid having to pay tax as the stock vests, it is very important to file an 83(b) election with the IRS within 30 days of purchasing stock subject to a vesting agreement. By making this election, the founder there are two tax effects:

  1. It freezes recognition of gain to the date of the purchase, such that the founder does not need to pay tax on the increase of the FMV of the stock as the repurchase right diminishes; and
  2. It starts the clock on the one-year holding period for long term capital gains treatment.
Bottom line

When incorporating a startup company, you probably want to:

  1. Make sure the founder’s stock vests;
  2. Vest it over a four year period with a one year cliff;
  3. Grant the founders double-trigger acceleration rights; and
  4. Make sure the founder files an 83(b) election within 30 days!