You and your friend have the next big business idea. Together, with your technical expertise and your friend’s business acumen, you believe you can make this a success! You both decide now is the right time for you to bring your idea to life. You incorporate your business, and your friend and now co-founder suggests issuing Founders Stock. Wait…You have not a clue what that is…Well, do not fret, were here to help – below are the 6 things you need to know about Founders Stock!
What is Founders Stock?
The term “founder” and “founders stock” are not legal terms, rather, they are terms of art describing a certain class of early participants of a company and their ownership interests.
Founders Stock are common shares issued to the founders of the company (typically at a nominal price), and unlike common shares sold on the secondary market, Founders Stock can only be issued at face value. Also, Founders Stock comes with a vesting schedule, which we will explain in more detail shortly.
How to allocate Founders Stock among the founders?
There is no one way to allocate Founders Stock to the founders of a company. However, when allocating these shares, it is important to note that equitable does not necessarily mean equal.
According to David Beisel, a seed-stage investor and co-founder of NextView Ventures, founders should not start a zero-sum negotiation around specific figures, the dialogue should begin with a conversation about how you’d like to decide, not just what you’re going to decide.
He recommends the following criteria to consider in his article, “How to Divide Founders Equity: 4 Criteria to Discuss”:
- Experience/Seniority/Role. Founding splits usually acknowledge that more senior-level founders will have a larger equity stake than more junior level co-founders.
- Capital Investment & Sweat Equity. Co-founders will sometimes provide capital to fund the company at its inception. As a result, they usually assume a larger portion of the founders’ common shares. This is also the case for those co-founders who forgo a salary early on and build what has become known as “sweat equity”.
- Prior & Ongoing Involvement. A co-founder’s equity should also reflect their on-going involvement with the company. The co-founders who are there for the long haul working full-time hours should have a larger chunk of equity – typically multiple times that of co-founders not working full-time on the venture.
- Ideation/IP. Sometimes a portion of founders’ equity splits is attributed to “who came up with the idea” or to actual IP that is brought to the business. However, most successful startups are based on execution and not merely idea, so be careful as to how much weight you attribute to this factor.
The process here is what matters most, in terms of people feeling good about where they resulted, despite what can be a contentious discussion, with the hope that everyone will look back years later without regretful feelings.
It is therefore critical for founders to have a clear and open discussion with a process and framework in place at the company to reduce the risk of future conflict.
How to allocate stock as the company grows?
Issuing equity at the company’s infant stages is more of an art than a science. It is worth noting that as the company grows, shares are typically allocated at different levels. The founders make up the first level and are naturally issued the highest percentage of shares (typically at the cheapest price). As the company recruits new employees, they obtain shares at later levels and usually at a higher price. As levels increase, the number of employees at each level also increases. Thus, the stock ownership of each individual employee is diluted. This is because new employees take much less risk as compared to the ones that come earlier! A typical allocation would involve the founders getting 50% of the company and then each subsequent level would get 10% of the company. This 10% then gets divided between each employee at that level.
Let us explain by using an example. Assuming you and your friend decide to share the stock equally and take 5,000 shares each, the company has a total of 10,000 outstanding shares. If the company hires 2 new employees in its second round, the entire level gets 2,000 shares i.e. each new employee gets 1,000 shares. Now if the company hires 4 more employees at its next level, each employee would get 500 shares each. Notice how as the levels and the number of employees in each level increase, the number of shares issued to each employee reduces. By the sixth level, the company will have issued 20,000 shares with 50% i.e. 10,000 shares belonging collectively to the founders. So, each founder owns 25% of the company. And, the rest 50% is divided between all the employees.
It’s important to note that this is only one method of allocating stock. Some companies use a formula where they preplan that the founders receive 51%, first employees receive 10% (in total), advisors would be issued 5%, and 34% would be open for investments. Once again, there is no way of doing this and it should be a case-by-case assessment of the situation.
What is a Vesting Schedule?
Founders Stock will typically have a vesting schedule attached to it. A vesting Schedule outlines certain terms that have to be met by the shareholders before getting full rights to their shares. Basically, what this means is until these terms have been satisfied, the founders cannot sell their shares. However, they still retain voting rights. If you’d like to learn more about vesting, check out our article on “Startup Equity 101 – Why You Need to Vest and How it Works”
Let us continue the previous example where each founder was issued 5,000 shares. With the typical schedule of shares vesting every month over a span of four years, each founder will get the right to 1,250 shares each year.
Why is it important to have a Vesting Schedule for Founders Stock?
There are two main reasons why it is important to have a vesting schedule when talking about Founders Stock. One, a vesting schedule discourages the founders to leave the company in its early stages. If the founders leave before the shares fully vest, the company has the right to buy back the shares at a nominal price. But if the shares have fully vested, the company forfeits the right to buy back the shares. Second, venture capitalists and angel investors often ask for vesting restrictions. So, if the company anticipates VC or angel investors’ investments, it is helpful to have a vesting schedule.
Can companies issue Founders Stock to employees joining later in the game?
Companies can issue Founders Stock to these employees, but they generally choose not to because of tax considerations. After the company is beyond its start-up phase and has started operations, the fair market value of the stock increases. But if the employees are offered shares at the nominal price that the founders received, there is now a significant difference between the fair market value and the nominal price. Canada Revenue Agency (CRA) categorizes this difference as an ‘employment benefit’ on which income tax is payable.
Companies often issue stock options to avoid the risk of having to pay the deferred tax liability. Stock options are an instrument that provides the holder with the right to buy shares at a particular price within a specified period of time. There is no tax liability when the options are received. However, tax liability still exists if and when the options are exercised.
All in all, Founders Stock is just a fancy name for the shares issued to the founders of a company. What makes it special is that they are issued at a very nominal price and they come with a vesting schedule. And, if you want to issue Founders Stock to an employee joining, later on, do not forget to consider the tax implications!
A special thank you to Spandana Unnava for her help and contributions to this article!
The content of this article is written for general information purposes only and does not constitute specific legal advice. This article should not be used as a substitute for competent legal advice from a licensed lawyer. Please contact us at 416-238-5527 if you’d like to speak to an Emerge LLP lawyer.