Martin Zwilling, in his blog Startup Professional Musings, provides some solid advice for start-up founders on how to protect their shares in the company as it begins to bring in outside investors. These so-called “founder’s” shares, he explains, are nothing more than common stock, issued at the time of incorporation, for a very low price. They are typically allocated to the initial players commensurate with their investment or role. “But that’s only the beginning of the story,” Zwilling notes.

Founder’s shares are allocated and committed, but not really issued and owned (vested) until later. “Typically, vesting in start-ups occurs monthly over 4 years, starting with the first 25% of such shares vesting only after the employee has remained with the company for at least 12 months,” a feature known as the “one-year cliff,” he explains. Vesting ends when an employee leaves the company.

Founders can – and should — negotiate special vesting and other terms as part of their stock restriction agreement as venture investors sign on. Zwilling offers these typical special terms to consider in your agreement:

• Negligible real value. Since founder’s shares are usually issued at the time the company is incorporated, they essentially have no real value. As the company builds value, shares allocated later for employees or partners will have an appropriate price.

• Vesting with no cliff. Most founder vesting is not subject to the one year cliff because partners should already know and trust each other. Thus, most founders will start vesting their shares from the date they actually started providing services to the company.

• Right of repurchase in favor of the company. This clause gives the founder the first right of refusal to buy shares back from a partner who decides to leave early, or otherwise makes a troublemaker out of themselves. This right usually “lifts” over time, meaning that as time goes on, fewer shares are subject to this repurchase agreement.

• Accelerated vesting conditions. Founder can ask for special terms in the case of termination or demotion that accelerate vesting. “These have less to do with the type of stock and more to do with who the person is and how strategic they are to the organization,” Zwilling says.

• Stock dilution control. While most employees would see their vesting rest when the “Series A” round closes, a founder might retain some percent of their shares. Everyone wants to minimize dilution of shares, so this special clause is common.

A common error made by founders, he says, is waiting until they have received a strong indication of interest from an investor before they incorporate — a delay that Zwilling warns “can create a significant tax issue.” He illustrates: “If founders issue themselves stock for one cent per share when they form the company, and then within a short period of time outside investors jump in at $1 or more per share, it might appear in an IRS audit that the founders issued themselves stock at significantly below the fair market value per share.” That windfall will be treated as compensation income, potentially resulting in a huge tax liability to the founders.

This problem can be avoided, he adds, by filing an “83(b) election” with the IRS within 30 days of purchasing your founder’s shares and paying taxes early on those shares. “Failing to file the 83(b) election is common mistake of founders that you should avoid,” Zwilling offers.

“My advice is to incorporate and allocate founder’s stock as soon as you are starting real work on the company, but at least six months before you anticipate any outside investors. But don’t incorporate too early, as investors will measure your growth and progress since the incorporation date. Several years of apparent inactivity since incorporation will make it look like there is a problem with you or with the company,” Zwilling concludes.

Source: Startup Professionals Musings

Posted January 30th, 2013 under Tech Transfer

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