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Why Startups Need A Founder Vesting Schedule

(Photo credit – David Paul Ohmer)

Every startup needs to have a founder vesting schedule because things don’t always go as per the plan. When you team up with close friends or co-workers as founders of a startup, the future seems bright and mapped out all the way to a successful IPO or buyout.

But, if one of the co-founders suddenly wants to bail and head for bigger and better pastures, it shouldn’t rock the boat.

Apart from the loss of that founder’s vision, leadership, industry connections, hard work and expertise, there’s also the little matter of what happens to the stock that founder owns.

Both sides will have to spend endless hours with lawyers and accountants to figure out all the possible scenarios. They will have to sit down and negotiate an acceptable solution that satisfies the founder bailing out as well as the interests of the startup and remaining founders.

Then there are the tax implications of a transfer of shares from one founder back to the company or one of the other founders. It could happen that 50% or more of the company stock is owned by a person no longer associated with the company. If you leave things as they are, then how do you explain to a prospective investor that a huge chunk of the company is owned by a former founder who has nothing to do with the startup anymore?

All said and done, it is a costly, messy and time-consuming affair. This is where founder vesting comes into the picture. Actually, it has to be worked out during startup formation, when stocks are authorized and allotted to the founders. Founders don’t get the lion’s share of the authorized stocks just for the idea and/or property (intellectual or otherwise) created or invested.

They are also expected to stay at the helm and work hard until such time as the company is in a position to hire a replacement, and this is where the vesting restrictions work as an incentive. Also note that investors like VC funds mandate founder vesting restrictions, so most startups these days have no choice but to agree for a vesting schedule.

At the very least, a standard VC agreement will include a buy-back vesting clause for a 3-4 year period. If a founder wants to quit before that, then the startup gets the option to buy the shares back. As a general rule, all startup employees and the founders should only be able to fully vest 4 years from the start date, with a one-year cliff for employees. This means they get nothing if they quit within the first 12 months.
The most commonly followed vesting schedule is that founders get 25% upfront and employees get 25% after a year. The rest (for both founders and employees) should be spread out monthly or quarterly over the 3 year period following the one year cliff.

From the founder’s view point, this may seem a bit extreme. To sweeten the pill, lawyers can provide the founders with a change of control clause. To completely safeguard your rights as a founder, put in full acceleration upon a double trigger. This means you can fully vest your stocks if the company is acquired and you get fired.

A single trigger where the company gets acquired but keeps you on merits at least some acceleration. For example, let’s say your company gets acquired a year after startup. This leaves you twiddling your thumbs for 3 more years. In this case, your vesting could be hastened up to 12 months after the acquisition. This gives the buyer a reasonable year of your services before you can vest and part ways with your startup.

Assuming you now fully agree that founder vesting restrictions are a must for every startup, there are a few things you should know about. First of all, you need to file a form called Section 83b election with the IRS. It has to be done within 30 days after you get the stock if you don’t want Uncle Sam to walk away with a big chunk of your fortune.

The way it works is that the restricted stock you get is not considered as taxable income. But when it vests, you have to report it as income. Even worse, you have to report any rise in the value of the stock during the interim vesting period as income and not capital gain.

This horror scenario can be avoided if you file an 83b election. You simply pay tax on the stock when you get it and nothing when it vests. Any increase or decrease in the stock value when you sell it can be reported as capital gain or loss, and taxed accordingly. Of course, founder vesting doesn’t always work out to everyone’s advantage. But it is definitely better than not having a vesting schedule.

 

(Photo credit – David Paul Ohmer)