Issues with Typical Founders Equity Structures
For young companies that come through our doors looking for legal advice on formation and structuring, vesting is among the most requested, yet least understood legal concepts. Moreover, typically when vesting is discussed, it is within the lens of minority stakes dolled out to employees as an incentive and to make up for the relatively modest compensation that start-ups can offer their employees and contractors. The concept of founder vesting in particular is rarely considered by clients, and takes some persuasion from us for new companies to even consider the concept.
There is a good reason for this. Everyone involved in a start-up company is optimistic, founders are in a honeymoon period where they are forward-facing and the notion of their harmony turning to acrimony seems far-fetched and impossible. A good attorney, on the other hand, is well-versed in the actual probability of worst-case scenarios. If they are doing their job properly, they will persuade their clients to consider these worst-case scenarios. After all, coming up with agreements and a structure to deal with these scenarios is far easier when they remain hypotheticals, as opposed to hammering out a solution when the situation is contentious and the players involved are far from neutral in their positions.
Among our start-up clients, perhaps the most arrangement are two founders coming in with a fifty-fifty arrangement. Again, at this initial stage, everyone is committed to the project, and if our individual founders even entertain the notion that things can change down the road, they rarely voice it, deeming it improbable and deciding that such a discussion is therefore unnecessary and only likely to introduce undue contention. But imagine a hypothetical.
Our two founders, Bill and Ted, incorporate their new company — AustinTech. They give themselves each a million shares, each becoming a 50% shareholder of the company. Their first six months are a slog, and they find little traction for their product. With their financial runway rapidly coming to an end, Ted quits working on the start-up and takes a cushy developer job at a large software company, with a large salary and benefits. Bill continues the work at AustinTech.
Three years later, Bill’s hard work has paid off. He has worked without a salary for the majority of that time, and afterwards largely took only the bare minimum salary he could survive off of. He has bootstrapped the company, and reinvested profits back into its growth. Accordingly, AustinTech has grown precipitously, and now has 50 full-time employees. Bill is now being paid a respectable salary. Soon after, the company is sold, for $100mm. Yet, when the dust settles, you would never know that Bill has been working non-stop and Ted has had absolutely no involvement in the company while he enjoyed his cushy salary. Because, with their initial 50/50 arrangement, Bill and Ted are both about to receive $50mm.
Vesting Repurchase Agreements (with Acceleration)
The issue here should be obvious: though 50% of a company with a near-zero valuation did not seem like a big deal for our forward-looking founders when they were in start-up mode, years later it becomes clear that what was actually being awarded, in a big chunk and all at once at the beginning, was worth a whole lot. The notion is not entirely different than paying an employee three years of their entire salary on their first day working at the company.
However, while a vesting structure or stock options — where shares, or the option to purchase them, are given out incrementally — solves some of this, it comes with its own issues. In particular, as the company’s valuation grows steadily, the tax impact of those grants gets worse and worse. If an option agreement is used, the strike price will increase with time as well.
Instead, we often suggest a vesting structure in which the founders get all their equity up front, but the company (or other founder) has the right to take it back for a some relatively low-value through a repurchase agreement. As time goes on, the company has the right to buy less and less of the founders’ shares, which makes sense — they put the time in, and they have earned those shares. These rights will be further secured by including an acceleration clause whereby certain triggers (the company selling, the founder being removed without cause, etc.) will cause some or all of their shares to vest. The end result is that the founders:
- Are incentivized to keep working on the company.
- Keep ownership of their stock, right from the start.
- Enjoy favorable initial tax treatment.
- Can exercise their full voting rights.
- Are allowed for long-term capital gains.
Contrary to popular belief, founder vesting works in favor of the founders when paired with reasonable acceleration.