There is no such thing as Founder Stock (legally speaking)

Matt Bartus —  April 8, 2013 — 3 Comments

I often have a discussion that goes like this:

New employee:  “I want Founder Stock”

Me:  “I see, you want to buy Common Stock”

New employee:  “No, I want Founder Stock, just like the founders received.”

Me:  “There is no such thing as Founder Stock, you are talking about Common Stock.”

New employee: “I’m confused.”

Just to clear up the confusion, legally speaking, there is no such thing that is commonly known as “Founder Stock.”  

For all practical purposes with startups, stock in a corporation is either Common Stock or Preferred Stock.  Let’s ignore Preferred Stock for now, as that is primarily issued to investors.[1]

When a company is set up, the founders purchase Common Stock.  The price of that Common Stock is typically very low (almost zero) because the company has just been set up and presumably has very little value – for example, $0.0001/share.  If the founder is issued 5,000,000 shares, the purchase price would be $500.

Why does this matter?  Because often times when later employees say they want “Founder Stock,” what they really mean is that they want to receive Common Stock at the same price that the founders paid.  However, there is a basic rule in tax law that says that if you are a service provider to a company and you receive property (stock), then you have compensation income equal to the excess of the fair market value of the stock on the date of grant over what you paid for that stock.  So, let’s assume the new employee is receiving 250,000 shares six months after the founders bought their Common Stock, and because of growth in the business and its prospects, the company’s value has increased such that the fair market value of the Common Stock has increased to $0.05/share.  The value of those 250,000 shares is $12,500, so the employee would have to either pay $12,500 to buy the shares, or if the shares are issued without payment, she would have taxable income of $12,500 (and there is a related withholding obligation on the part of the Company for that income, which can be complicated if cash is tight).  This problem gets worse over time as the company gets more valuable, which is one of the reasons that companies issue options.[2]

So-called Founder Stock is also a way that people sometimes refer to stock with different vesting or acceleration terms.  For example, the Common Stock issued to the founders might vest over 4 years monthly without a cliff, while stock to employees typically vests over 4 years with a 12 month cliff (i.e., no stock vests before the first year of employment).  It might have different “acceleration terms”, meaning rights to accelerated vesting upon the occurrence of certain events such as an acquisition of the company.

So the next time you are joining a company and think that you want to acquire Founder Stock, remember that you are actually either going to acquire Common Stock or an option to acquire Common Stock.[3]  And if you’re hiring your first employees and trying to figure out your company’s approach to stock-based compensation, make sure to factor the tax consequences to the company and the new employees in making the decision to issue stock vs. options.

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[1] This is to be distinguished from so-called “Series FF Stock” which is a hybrid between Common Stock and Preferred Stock.  I have also purposefully ignored infrequently implemented two-tier common structures, Class F stock and other cap table engineering designed to vest disproportionate control in a subset of stockholders.

[2] If the new employee doesn’t want the $12,500 of income (or the $12,500 payment obligation), she could be issued an option to purchase 250,000 shares with an exercise price (or purchase price) per share of $0.05/share.  However, options do not put the individual in the same position as stock, as both have their pros and cons and differing tax treatment, which is beyond the scope of this post.

[3] Some later stage companies, such as Facebook and Zynga, have issued “Restricted Stock Units” (or RSUs) in advance of their IPO.  These rights to acquire stock are highly tax driven and are beyond the scope of this post.

Thanks to my partners Peter Werner and Craig Jacoby for reviewing this post in advance.

 

  • http://blog.teamly.com/about Scott Allison

    Thanks for the clear explanation of this tricky subject!

  • http://www.cookstream.tv/ Vladimir Vityuk

    Very informative post. Thanks Matt! Would be very interesting to hear you opinion about “Series FF Stock”. From your experience, how many startups have implemented this? And is this the only mechanism that allows founders to receive liquidity without increasing the common stock FMV?

    • Matt Bartus

      I don’t really have any numbers for how many companies implement this, but probably less than 10% of my new companies request it. I doubt that this is the “only” mechanism around, but it’s certainly one of the more common ones.