Five Things You Should Know About Founder Stock Vesting

• 10.5.2015

In our initial meetings with entrepreneurs, we frequently spend a significant amount of time advising on founder stock vesting. Those discussions can be much shorter—not because we don’t want to spend the time with you, but because in most the cases, the best thing to do is what’s standard. As a founder, your time is better spent building your company.

Here are five tips you can read in five minutes (as an alternative to having a one-hour meeting with your lawyer) to help you understand vesting and how it affects you and your startup.

Founder stock should be subject to vesting. Generally, this should not need discussion. Vesting is a commitment device—investors will want to see that you have such a commitment device in place, but more importantly, co-founders should want one. In the absence of vesting, a co-founder could walk away from the company, as early as day two, with his or her stock, and without the company being able to repurchase the stock, leaving you with a more complicated cap table. Stock vesting creates an incentive for founders to continue working with the startup. Also, if a founder leaves with all stock vested, you will need to grant additional equity to a replacement, resulting in further dilution to you and those who are still around.

Use a standard vesting schedule. Follow the industry standard—a four-year vesting schedule with a one-year vesting cliff (i.e., 25% of the stock vests after one year) and month-to-month vesting for the remaining three years—unless you have a specific reason for changing it. It is also powerful when recruiting to tell your potential employees that everyone has the same terms, including the founders.

Founders typically get restricted stock, which is stock that vests over a period of time (four years, usually), and the company has the right to repurchase any unvested shares at their original issuance price upon termination of employment. It is important to understand the term “vesting commencement date”—this is the date from which vesting begins. For example, with standard four-year vesting, the vesting commencement date is the date on which the four-year period begins (and not the date on which the vesting cliff is reached, which is the anniversary of the vesting commencement date).

We have seen instances where one of the founders is temporarily part-time (usually before the company gets funding) while the other co-founders are full-time. Here, the cliff or the total vesting period for the part-time founder may be based on when the founder will join full-time, which is fair to the other co-founders and full-time employees. If you opt for a milestone cliff or milestone vesting, rather than time-based vesting, make sure to define the milestone (the event that results in vesting) very clearly.

And if you’ve been working on the company for some time before incorporation (read more about why you should incorporate soon), founders will often decide to start vesting earlier than incorporation, or to provide that a portion of the founders’ share are vested on the date of incorporation, effectively providing “credit” for service to date.

Make an 83(b) election within 30 days. Founders should make an 83(b) election within 30 days of the restricted stock grant. Negative tax consequences can result if the recipient has not made an election under Section 83(b) of the tax code within that time period. In the absence of a timely filed 83(b) election, restricted stock is taxed as it vests (based on the amount equal to the fair market value of the vested shares on the date of vesting minus the original purchase price paid for such vested shares). Therefore, if the value of the stock increases over time, a founder who has not filed an 83(b) election by the deadline could owe a significant amount of tax. By filing an 83(b) election, the founder elects to be taxed at the time of grant, rather than as the stock vests, based on the difference between the fair market value and the purchase price at the time of grant. Because founders typically pay fair market value for their restricted stock, there will be no tax paid at the time of grant (and thanks to the 83(b), no tax paid in the future when the stock vests). Learn more about 83(b) elections.

Double-trigger acceleration is typically most appropriate. Double trigger acceleration of vesting means 100% of the founders’ stock (or some lesser pre-agreed percentage) vests if there is a change in control (usually acquisition of the company), and the founder’s employment is terminated by the acquirer without cause or by the founder for good reason after the acquisition (typically within 12 months of the acquisition).

Founders often ask us about single-trigger acceleration, which means one of two things: (1) vesting occurs upon a change of control (without termination) or (2) vesting occurs upon termination without cause (without a change of control). While single-trigger acceleration of vesting can be put in place, it is generally not advisable. An acquirer who wants to provide additional incentive to keep founders with the company following an acquisition may reduce the purchase price because the acceleration of vesting (particularly, when a significant percentage vests) diminishes those incentives (and the acquirer may have to provide additional incentives). Investors, of course, don’t like a reduction in purchase price, so they’ll often object to the single trigger acceleration upon the change of control, too. Co-founders should not want to put in place single trigger acceleration where the trigger is termination without cause; “cause” is usually defined as commission of a felony, which is unlikely to occur in practice, or significant misconduct, which may be hard to prove or too expensive to litigate over, meaning that co-founders will likely end up terminating a team member without cause, resulting in the acceleration.

Investors may renegotiate. The more creative you are with vesting, the more time and money you could end up spending at the time of your first institutional round negotiating vesting terms with investors. If they believe the terms are not typical or do not provide adequate incentives for founders to remain with the company, investors might insist upon resetting the cliff or extending the vesting schedule. Reduce the likelihood of this occurring by following the industry standards—most of which are fair and reasonable—unless you can explain why you chose to do things differently.

Be sure to check out this related video: The Need for Vesting on Shares Held by Founders