Founder's Stock - Explained
What is Founder's Stock?
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Table of ContentsWhat is Founders Stock?Characteristics of Common StockCharacteristics of Founder’s EquityValuing Founder's StockVesting of Founder's SharesManufactured Forms of Founder’s EquityOptions for Early Employees (Nearly Founders)
What is Founder's Stock?
Founder’s equity or founder’s stock is a class of stock issued to founders or early members of a company. In reality, founder’s stock is simply common stock issued to founders. Common stock is the basic form of stock issued by every corporation.
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Characteristics of Common Stock
All for-profit corporations are required to issue at least one class of stock shares to owners. At the time of incorporation, common stock may be the only stock authorized under the articles of incorporation or it may be issued in conjunction with other classes of shares. The corporation will issue additional classes of shares if necessary for a particular purpose, such as an equity financing round.
Stock is a power tool for the corporation. It is the method by which a corporation receives initial financing. Further, it may comprise a significant portion of the compensation paid to early company employee. Interesting, common stock is often referred to as founder’s stock when it is issued to the individuals comprising the company’s leadership at the time the company forms or reorganizes as a corporation. The name seeks to identify the time period at which the common stock is issued.
The number of shares authorized in the articles of incorporation will vary depending upon the nature and objectives of the companies. A company that plans to use stock as form of compensation will issue more shares than a company that does not. Common stock is generally issued at a very low par value. There are numerous tax reasons for this fact. Issuing stock at a low par value indicates that the shares are not valuable at the time of award. If awarded as compensation, this can avoid a situation where employees receiving the stock are forced to recognize much income upon receipt. Often, existing shareholders or third parties will continue to use the term founder’s stock with the intention of purchasing common stock at the price (generally very low) and under the conditions (discussed below) that it was granted to company founders. Tax law generally profits this, but the phrase continues to be used in this way anyway.
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Characteristics of Founder’s Equity
Often, common stock issued to founders will be made subject to specific restrictions. This is normally carried out by placing limiting provisions in the stock grant agreement or by requiring founders to enter into shareholders’ agreements. The purpose of these agreements is to make the common stock similar in nature to preferred stock, which is generally issued to later investors in the company.
Commonly, founder’s stock will be subject to various conditions, as follows:
Restricted Shares - Restriction refers to a shareholder’s ability to sell or otherwise transfer the equity for a specific period. The restrictive provisions generally require that the shareholder offer the company the right to repurchase the shares before they can be transferred to any third parties. This is known as a “right of first refusal”. Also, if the company issues additional shares, the shareholder generally has the right to sell her shares along with the issuance. This is known as “co-sale rights”.
Vesting Schedule - A vesting schedule states that time period or period in the future when shareholders become full owners of the stock granted to them. The vesting term is generally 4 years, with no stock vesting until 12 months after the grant. Granting stock to shareholders subject to vesting makes certain that the shareholder remains loyal to (or perhaps remains an employee of) the company. If the shareholder leaves the company prior to shares vesting, she forfeits her ownership interest. To protect the shareholder, the stock grant generally provides for accelerated vesting if the company is sold, goes through a later equity financing, or the shareholder is an employee and fired without cause.
Super-voting Rights - This is where the class of stock grants the shareholder more than one vote per share. This is extremely important for early founders who wish to retain control of the company.
Valuing Founder's Stock
At the time of formation, founders issue the stock at a very low valuation (e.g., .01 or .001). This is permissible, as the company is simply a shell at the time of formation. It technically has not value until it is funded. Once the company is funded and as the company grows the stock will become more valuable.
Founders who receive the early stock face little or no taxation due to the low value. If the founders receive the stock after it has appreciated, then it would be a higher tax liability. Because the stock is awarded very early at a low valuation, the holders are not taxed on the appreciation in stock until it is sold.
Vesting of Founder's Shares
Often times, the founders will not receive all (or any) of their shares of equity at the initial issuance. Rather, the award of stock will vest over an extended period of time, known as restricted stock. This is the case when the founder receives her ownership interest in exchange for continued work for the corporation.
In this fashion, the corporation is protected from having to repurchase all of the shares in the event the founder/office leaves the corporation. As long as the stock is subject to a substantial risk of forfeiture, it is not taxed at that time. Founders can, however, recognize the value of the stock as compensation before it vests. This allows them to pay a much lower tax rate if the stock rises in value before it vests.
Manufactured Forms of Founder’s Equity
While founder’s stock is simply common stock, it is not uncommon to authorize a specific class of common stock with hybrid characteristics. That is, the company authorizes a second class of common stock that takes on characteristics commonly associated with preferred stock.
One example is class B common stock, sometimes called class F stock. This is a form of common stock with numerous protective provisions including super voting rights (often 10 votes for each share).
Another example is series FF stock. This is a second class of common stock that takes on numerous preferred characteristics. Most notably, this class of stock is convertible into a future class of preferred stock if specified conditions are met. The interesting aspect about these dual-class forms of common stock is that they are almost always issued in startups with a view toward future equity financing.
Next Article: Class F Stock
Options for Early Employees (Nearly Founders)
Once the startup begins to increase in value, most startups cease issuing common stock (Founders shares) to new employees. Awarding shares to employees constitutes compensation, which is subject to income tax.
To avoid taxation and achieve tax deferment, the startup issues options to purchase the common stock at the current price. Since the stock option has no value at this point, it is not taxable.
The employee will defer recognition of any appreciation of stock until the option is exercised. At that point, the value of the stock will be subject to taxation at that income tax rate. Options may vest immediately or over time.
The founder has the option of recognizing the award of the stock option as taxable income at the time of issuance. This means that the value of the underlying stock will be treated as income to the employee and the value of the stock at that time will be immediately taxed at ordinary income rates.
The benefit to this option is that, when the option is later exercised (i.e., receives common shares for the option), the appreciation in the value of the stock will be treated as capital gains.
Capital gains are generally taxed at a lower tax rate than the ordinary income tax rate. An employee would make this immediate tax recognition election when the value of the stock is expected to rise greatly in the future.