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Founder’s stock is simply the common stock of the corporation issued to founders at the time of formation. 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.
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.
Options for Early Employees (Nearly Founders)
Once the startup begins to increase in value, most startups cease issuing common stock (Founder’s 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.