How to Issue Founder Stock and Why it's Important | Cooley LLP Partner, Sally Kay J.D.

So founder stock. Those of you that formed entities already, have you issued founder stock yet? Anybody? Yes. Okay. So this is probably one of the biggest bones of contention in the formation of a company when you have more than one founder or you start on your own and then you decide you need to bring in a technical co-founder or more of an operational person 'cause that's not your strength. You wanna issue equity. You wanna do it as cheaply as possible because you wanna have the lowest possible tax basis in the stock that you give yourself. And then you need to figure out how you carve up the pie. Right. So, the way that it works, and typically in a startup, is that you sign an agreement, a founder stock purchase agreement, where the company says, we're gonna give you X number of shares of stock in the company. And in exchange, you're paying for that by signing this assignment agreement that then assigns all the work that you've done on that company into the company. And so at that point, you now have stock and the company owns all of your hard work. All of the IP that you've developed, all the customer lists you've come up with, all the beautiful drawings that you've done, all your market analysis, every single thing that you've done in furtherance of the company, you're signing it away to the company. In exchange, you get your stock. If you have co-founders, you figure out how you're gonna split them up, right? I get half, you get half. I get half, you get less than half, and you get what's left over. That, I think, is probably one of the hardest conversations to have. And I think on my first slide I talked about Three Musketeers syndrome, right? So it's 3 of you, we're all for one, we're one for all. This probably predates all of you who didn't ever see The Three Musketeers. But you know, you and your bros, there's 3 of you, you're gonna make this company, and man, we're all gonna work hard, and it is gonna be the best thing ever. But that is also the point in time where the 3 of you have to have a very candid conversation about whether we're really all on the same page. We're all gonna be contributing an equal amount to this company. We're all gonna be contributing an equal amount of time to this company. We are all committed to seeing it through. Because if you split everything in third, third, third, and one of you is still working a day job, and he's only working on this new company 2 nights a week and part of Sundays, The 2 of you that are working 100% time on this are gonna really start hating that guy. And then you're gonna say, well, why do we give him a third? He's not doing a third worth of work. But you've already issued him a third. And then you get in a dilemma. Well, now what do I do? Do I fire the guy? Do I not fire the guy? How do we fire the guy? But this is our bro. This is our friend. We've been friends with this kid since childhood. Now what do we do? And so it's important to have a candid conversation before you've issued the stock to make sure that you're all on the same page. What you don't wanna do is, first of all, you don't wanna ruin a lifelong friendship. And that gets into a whole separate conversation about whether you form a company with your friends or not. But a lot of people do. But secondly, what is everybody really willing to put into this? Are we really on the same page? Are we all investing the same amount of time? Are we all taking the same amount of risk? We wanna make sure that we know what— we wanna know what it is up front. Because if you try to fix it later, that's much harder. Because it will normally involve extracting one of those people from your company, and that's not very pretty because they'll fight and say that they've worked really, really hard. Um, founder stock. You guys know what vesting is of stock? Okay, so some companies, um, the founders just don't make their stock vestible at all. They say, I own 100% of my stock, it's 100% vested. Um, that can become really problematic in the scenario that I just talked about, right, where you got 3 co-founders, they all own their stock outright, 100%, And then one of them isn't holding up his end of the bargain or he decides, you know what, I really need to keep my day job. I need to back out of here. I'll leave the two of you. You guys go run with it. Go make me some money. Well, you don't want him to own 100% of his stock. He hasn't done 100% of the work. And so, again, creates a problem. So, it is generally a smart idea to have your stock vesting from day one as opposed to waiting to see if a potential investor is gonna force you to make your stock vest. It also, in my kind of concept of pigs getting fed and hogs getting slaughtered, if you go through a due diligence process with a prospective investor and they see that your founder stock is not subject to vesting, they think, well, A, these guys are kind of crazy because they should have known this was coming. B, they maybe really think highly of themselves if they think that the contributions they've made so far have earned them all of the stock up front. And C, then they're gonna suggest to you what they think your vesting should be, which potentially could be far more punitive than what you originally set up for yourselves. So, it makes sense to kind of do something reasonable and realistic. So, most companies, in a very typical, typical vesting scenario, 25% vests at the end of 1 year. The rest of it vests in equal monthly increments over the next 3 years. So. That means that if you all start the company together and 6 months from now one of you decides to leave, he hasn't invested in any of his stock. You get to take stock back. You get to pay him what he paid for it, which is probably a tenth of a cent a share. Something really, you know, you write him a check for $9. And then you part company, his shares come back, it's done, and then it just leaves the other founders. If he leaves 15 months in, He's earned 25% plus 3/36. And he leaves, and you can feel pretty decent about the fact that he's made 15 months' worth of contribution. He gets to keep 15 months' worth of stock. But he doesn't get to keep 100% of it while the rest of you still have to do the work to move the company forward. This is the same concept with stock options later when you bring on employees. You want to make them vest because people need to earn them. You don't want to just give them equity right out the gate. Um, Like I said, the price of your stock, you want to keep it for your founder stock as low as possible. For multiple reasons. But you want to be able to say that your basis in that stock is very, very low because you don't want to have any gain. And you also don't want to have to issue stock options later or sell stock to outside investors at a really high price. You want to be kind of reasonable as you go. The important thing in founder stock, the one thing that you cannot fix If you wait more than 30 days to do it, is to file an 83 election with the IRS. And for those of you that are gonna form your companies here, this is the only thing about tax law that I actually know. So an 83 election is where you say to the government, I got all this stock today and its value is a tenth of a cent per share. It vests over 4 years, but I only want to take the tax consequences of it today. Well, if you do that at that time, there's no spread. So you have no gain. You paid a tenth of a cent for it. It's worth a tenth of a cent. And so over the course of the next 4 years as it vests, you don't have any taxable events in there because you've declared them all upfront. But you only have 30 days. And if you miss the 30-day window, you're in trouble because you can't do it. The effect of that, especially when you're a founder in a company where you're not taking any income, or very little income is that you do not want a big old huge tax hit as your stock starts to vest. And I'll give you an example. So I have a client, we formed a company, we issued the founder stock at a hundredth of a cent per share, right? So 3 zeros, 3 zeros and a 1 after the decimal, right? Guys gotta file your A-3Bs. Guys gotta file your A-3Bs. Guys gotta file your A-3Bs. 2 of the 3 did. I mean, like, they signed them and sent them back. We sent them to the IRS for them. Third guy didn't do it. You know what? It's not a big deal. I don't need to do it. Okay, fine. So what happens? 25% of his shares vest after a year, but they got financed 9 months in. After that, they did a 409A valuation to determine the fair market value of their common stock after that based on the valuation of the financing. It's a whole bunch of another IRS mumbo jumbo thing that I don't understand. But the fair market value of the common stock determined by the board after 9 months was $1.07. So at the end of year 1, the one guy that didn't file an 83 had to pay the spread between $0.01 per share and $1.07 on 2 million shares of stock. That was taxable gain to him in that year. And then every month, if it went up, the next incremental part of your stock that vested is another taxable event. And when you don't have any money, when you have to look at paying tax on that much, it's, it's not good. So remember, 83, 30 days. If you take nothing else away today, don't forget that part. Okay. Um, the other component to vesting with regard to founder stock is around acceleration. So you say, okay, I'm here, I'm working really hard, I'm doing everything I can But what happens if my co-founders push me out? What happens if somebody buys my company? What happens if somebody buys my company and then they fire me? Under what circumstances? Like, I should be able to keep my stuff. I should be able to get some entitlement to this because I didn't work this hard for nothing and I don't want some event to happen to take everything away from me. There are certain things that you generally include in a founder stock purchase agreement that provide for some acceleration of your vesting. 2 concepts, single trigger and double trigger. So, in a single trigger acceleration clause, only one thing has to happen to make your shares vest. And it can be 100% vesting, 50% vesting, lots of variables and you guys can kind of toy with that. Single trigger. Either somebody buys my company or I get fired. Okay. So, you have your stock. You're vested about 50% of it. and your co-founders decide they're done with you and they're gonna let you go. If you have a single trigger acceleration provision, when they fire you, the remaining 50% of your stock vests. Okay? Same scenario. Somebody buys your company. At that point, your stock vests 100%. Single trigger. Nobody likes single trigger in the investment world. And acquirers also don't like single triggers. Because to an acquirer, if you become 100% invested in your stock, At the date that they buy you, what is your incentive to stay? You don't have any skin left in the game, right? You own everything that you were given, everything that you owned before you got there, 100%, nothing left for you to vest in. So acquirers don't like that, and they'll oftentimes try and get you to waive that or amend it. Your investors don't like it if you've got a single trigger on termination because you're getting terminated because you're not doing a good job. So why should you get to keep the stock that you haven't earned? Right. So, also sets off alarm bells and will also generally cause your prospective investors to say, all right, we'll put in money, but you guys need to change your vesting terms. But it is very, very typical to see a double trigger acceleration clause in the founder stock purchase agreement. And that requires 2 things to happen. That requires your company to be acquired and the acquirer needs to fire you within some period of time. 6 months, 12 months. of the acquisition date. So, you still get the benefit of the stock that you worked so hard to build this company with if you stay after the acquisition. You still have some skin in the game there. Or if you're perfectly willing to stay on in this new company and they decide that they don't want you, then you still get the full benefit of it. And in a double trigger acceleration, I have never seen anybody I've never seen anybody in a term sheet stage where the prospective investors come back and ask them to get rid of that. Single trigger, many, many of those they've asked have amended so that it's just a double trigger and not single. Thank you.