Ground Rules for Founders
If you are running a company, thinking about starting your own business, or are just curious about the topics founders, boards, and lawyers think about, this article is for you. Below are some ideas and best practices to consider as you set up your stock plan and issue Stock Based Compensation (SBC).
Early Exercise Provisions
If you permit early exercise, you allow those with options and restricted stock to exercise their SBC when it is granted as opposed to when it vests. While they are still subject to vesting schedules, early exercise can be highly advantageous from a tax perspective for employees, founders, and anyone else on your cap table – that is, the table which breaks down who owns what in any company.
There is a great video here from the Head of Executive Compensation & Benefits at JP Morgan. He references a medical device company that he advises. The founder has Incentive Stock Options (ISOs) which were granted at an exercise price of under $1.00, and the Fair Market Value (FMV) of each share is now north of $60.00. The spread there is so large that exercising options would create a taxable event via the Alternative Minimum Tax (AMT). You can read more about the AMT here. This example is one of many in which allowing early exercise could have solved this issue. Had the founder early exercised his or her options for under $1 per share when the grant initially occurred, the cost of exercising would have been significantly lower, and there would have been no taxable event under AMT.
If you permit the early exercise, make sure to remind folks that they need to file their 83(b) election with the IRS within 30 days of exercise. You can read more about early exercising and 83(b) elections here.
Working with Qualified Legal Professionals
It should go without saying that you should work qualified legal professionals, but we are surprised how often this occurs. Your legal professional can help you see around corners, especially as you draft your equity plan. Your equity plan governs SBC and is what everyone will reference as your company scales. Therefore, you need to consider edge cases – that is, those situations that are highly unlikely to occur but should be spelled out in writing. As your company grows, edge cases will occur more frequently than you may realize. You should have considerations for:
- Share repurchases after departure
- What happens in the case of death or disability?
- Transferability of options
- Separation with cause
- Separation without cause
These topics are just a handful of what should be covered in a stock plan. Amendments to stock plans are possible, but they do require a shareholder vote. It is far easier to specify policies in a stock plan early in a company’s life as opposed to several years later when you may have many new shareholders on your cap table, each with its own opinion and set of interests. When you engage with a professional, they should know where problems can occur, and if they don’t, you should find someone who does.
Your stock plan will not only govern SBC issued to future employees. It will also specify what happens to you in the event there is a change of control or if the board decides you are unfit to serve in your position. You should ask your legal counsel who they have worked with in the past and speak to references if possible.
Intra-Family Transferability Provisions
Including this provision is another recommendation described in this video. The idea here is that options are often given at a discount to what they may be worth in the future, so it is best to take advantage of this discount prior to any share price appreciation. Early exercising unvested options is one such strategy, and transferring shares is another. Transferring shares may help avoid the $100,000 limit on the amount of Incentive Stock Options, or ISOs, exercisable in any given year. In addition, there is no added cost on the part of your company. You can read more about ISOs and other types of SBC here.
When to Use Certain Types of SBC
We encourage you to ask your legal counsel, advisors, and investors about when to use certain types of SBC. They have hopefully seen companies at many stages and can tell you what types of compensation was used. Prior to a seed or a Series A round, you may want to award restricted stock with its own vesting conditions.
In other cases, ISOs and NSOs are also a common form of compensation at the seed through the pre-IPO stage. Please note that ISOs can only be given to full-time employees. NSOs, on the other hand, can be given to full-time employees, contractors, board members, and anyone else indirectly involved in the company. As a company matures and sees a public listing or sale on the horizon, forms of SBC such as RSUs or restricted stock become more common.
If any of this is confusing, we would encourage you to read our article on the basics of SBC.
Qualified Small Business Stock (QSBS)
If you are a founder, early employee, or early investor, your shares may qualify for a tax exemption of up to $10 million. QSBS tax treatment is one of the most underrated benefits that exist today, and many do not know they qualify for it.
The basic qualification for QSBS is that you must hold stock in a C corporation for at least five years prior to a liquidation event. Those holding actual stock, not ISOs, NSOs, or RSUs, can qualify for QSBS. Here lies another reason why allowing early exercise may be a good idea. You help those on your team, including yourself, start the clock on qualifying for QSBS tax treatment. It also justifies having a priced round early on instead of a note, as again you want to start the clock for QSBS treatment. If you are looking for more information on QSBS, you can read our article on QSBS. It is always best to discuss QSBS with professional tax help.
Reverse Vesting Plans
Founders often receive what is known as “founder’s shares” or “founder’s stock,” which is simply stock issued to the originators of the company. Despite our initial thoughts, founder's stock is not a special class of stock but instead describes stock distributed at the point in time in which the company was formed. With founder’s stock, it is common to see a reverse vesting schedule – that is, a repurchase schedule in the event a holder of founder’s stock departs the company within a defined period.
Reverse vesting plans address a situation in which a large percentage of shares are given to an individual who soon after leaves the company. You generally do not want 25% of your company held by someone who worked on the company for a year and then departed.
With a reverse vest, you set out repurchase rights for founder’s stock, which includes the share price the company will purchase shares at before the vesting ends. This share price will usually be at cost. If holders of founder’s stock remain with the company for several years and vest, the repurchase never occurs.
In place of a reverse vest, you may also see a traditional vesting schedule for founders, so their shares will vest over four years with a one-year cliff and then vest monthly afterward. The difference between the reverse vest and the traditional vesting schedule is that in the first situation, you are given all of your shares upfront and have them repurchased if you depart early, while in the second scenario, you earn the shares over time.
Any professional investor, whether they make minority investments in private companies, acquire majority stakes in companies, or buy public stocks has an expectation on what returns they want to generate. If an investor finances a business and typically expects to make 3x their money over 5 years, any future employee is going to be skeptical when you tell them that the company is going to grow 100x from here. When you take on an investor, you should understand their return expectations and make sure the strategy you are pursuing is somewhat in line with their goals.
Other Topics to Consider
1. There are different classes of stock in a company.
At venture-backed companies, it is normal to have a class of stock held by co-founders, employees, and advisors called common stock. In addition, you might have preferred stock, which is held by investors who contribute capital to finance the company's operations. At venture-backed businesses, preferred stock is inherently more valuable than common stock because it typically has rights which common stock does not have (covered in the next paragraph). We are careful to specify venture-backed businesses because preferred stock at public companies is quite different.
Each company has different sets of rights to its preferred stock if preferred exists at all. One of the most common is a liquidation preference, which governs the way in which proceeds flow back to shareholders. Other rights include anti-dilution provisions and the right to appoint a board seat. There are other nuances to the distinction between common and preferred stock, which we cover in our article here. Multiple financings often bring on multiple classes of preferred stock. As a company raises more money and issues more preferred stock, you will frequently see your preference stack or liquidation overhang grow. This figure is the amount of money that must get paid back to investors before the common shareholders see any proceeds. We write more about how to think about preference here.
Some companies have only one class of stock. This is common among companies that:
- Have not raised outside capital and are known as bootstrapped companies,
- Are public because preferred stock tends to convert into common stock at an IPO, or
- Are owned by a Private Equity (PE) firm
You may see multiple classes of stock at any of the above but you will most frequently see it among venture-backed companies.
2. Be thoughtful about your cap table.
Your cap table lists the shareholders in your company and how many shares each owns. You can manage your cap table digitally. Our preferred cap table management software is Carta.
SBC is used to attract talent and retain talent, so when you give out stock, ask yourself what type of contribution you expect from this person or this team. Then you should compare the value of what you are giving out with the value you expect to be created. If you are giving too little in comparison to what you expect in return, then do not be surprised if someone asks for a larger stock package.
3. SBC should be granted at the Fair Market Value (FMV) of your common stock.
Early on, SBC granted to early employees is given at a valuation determined in good faith since there is not much to value the company on. There may also have been no investment round to give the company an explicit value. As a company matures and potentially raises a round or two of outside financing, it will begin to conduct an annual 409A valuation by a third party. This exercise establishes the FMV of your common stock which is used to set the exercise price of your options or tax deduction stemming from the use of RSUs or restricted stock. You can read more on 409As and FMV here.
You may be tempted to give out options that are at a massive discount to the current value of your company, or you may want to use the same exercise price which you used last year. We strongly recommend against these types of actions because it could raise the red flag of auditors and draw resentment from existing employees who are being diluted by more than anticipated.