Founder Stock: Everything You Need to Know
Many novice startup founders are excited to get their idea off the ground but are unfamiliar with the logistical side of creating a startup. Creating a business model, seeking out funding from investors, and creating a product that is desirable, are all things a founder must deal with.
While these are important, a very important and frequently forgotten aspect of a startup is the equity within a startup. During the early days of a startup, founder stock is what is given to the founding team of a startup. As the funding rounds begin, investors are given preferred stocks in exchange for funding.
As the business progresses and is looking for new talent, a startup can utilize its common stock to attract talent. Each utilization of equity has its own set of rules and regulations and understanding the regulatory guidelines can keep a startup out of financial repercussions.
Founders stock specifically has many different dimensions to consider.
From understanding the basics of founder stock to understanding the differences between it and other equity opportunities, founders need to be aware of the main asset they have throughout their business’s formative years.
Investor and employee equity are items that are more frequently discussed, however founders stock is not typically highlighted in information regarding startup equity.
Founder stocks face challenges that need to be addressed right at the beginning of the business’s establishment. As such, having advanced knowledge of the requirements for founder stock can save a founder time, money, and frustrations.
Below is a discussion of founder stock and everything you need to know.
What is Founder Stock?
To adequately understand what founder stock is, it is important to have an underlying knowledge of what equity is.
Equity is any portion of business ownership that is bought and sold. The most commonly known example of equity is within the stock market. Each stock represents a percentage of ownership of the publicly traded corporation and has a value that is assigned to each stock. Fluctuations in the stock price correlate with the business and the economic landscape.
For example, during the recession in 2008, stock prices dropped across the board because consumer confidence and the economy had its worst downturn in decades. With a decrease in consumer spending across the board, many stock prices fell because this created a dip in sales and revenue for the publicly traded businesses.
Shareholders buy and sell stocks to achieve a profit. Buying stocks at a low price and then selling at a higher price is how this is accomplished. Founder stock and startup equity act in a very similar manner to the stock market as the prices of these shares fluctuate with the condition of the market and startup. As the startup grows in value, the founder's stock increases in value alongside the business.
Founder stock is the very first stock issued by a newly incorporated business. These stocks are divided between founders and are key in understanding the split of ownership of a startup.
For example, a founder's stock can be divided between multiple people but typically there are only a few that hold a majority stake which is what enables them ownership over a startup.
Ownership divided during the issuing of founder stock is a topic in its own right as there are many ways in which a startup's equity can be divided amongst a founding team.
When is Founder Stock Issued?
As described previously, the issuance of founder stock should be when the startup first becomes incorporated. Many startups fail to understand the importance of this and can face unnecessary taxation on their founding stock. Being aware of this common mistake can allow founders to avoid a costly mistake.
The main reason a startup needs to issue founder stock as soon as possible is that in the beginning, the stock is not worth much of anything. Issuing founder stock when it is valued at a low price is advantageous because founders can file an election that allows them to pay taxes on the deferred amount at the time they were issued rather than as they vest at a higher value.
Issuing stocks at this low rate is perfectly legal as long as the business was just incorporated and little effort has been put into the business. If the founder stock is not issued before the first valuation by an investor, this could result in the founder’s stock being valued highly, and as such founders would need to pay the taxes associated with this high valued equity holding.
As an example to illustrate the point, let's say that there are two startups that are just being incorporated. One has founders that issue stocks immediately while the other decides to do it at a later date. The one that issues founder stock immediately will only pay taxes on what the initial price of the stock was at incorporation. The longer the other startup waits to divide up founder stock, the more valuable the stocks become, and the more income tax that will need to be paid.
This information is not common knowledge and highlights a reason a startup should look to M13. Providing seed to series A funding in addition to guiding startups along the way, M13 gives entrepreneurs the best chance at navigating complex issues like that surrounding equity.
What is the Reason for Founder Stock?
With a general understanding of what founder stock is, the question becomes: what is the reasoning behind issuing founder stock? There are many reasons why a startup should issue founder stock but the two main reasons are to establish who has majority ruling and to incentivize founding team members to stick with the startup.
Startups are each very unique in their organizational structure but the one thing that they all have in common is that there are typically a select few majority shareholders who have the final say-so during business decisions. Issuing founding share percentages at the beginning of a startup allow for clear-cut authoritative figures that have the power to make business decisions.
An added bonus to the founder share system is that a startup can continue on even if the majority shareholders leave the startup. Whoever owns the majority of shares becomes the new majority shareholder and is able to resume business as usual.
The other main reason a startup utilizes founder stock is to provide dynamic compensation for the founding team that works tirelessly to help create a startup. By offering ownership of the business, it makes it more worthwhile that founder employees work to make the business successful. The more successful the business, the more money they can get paid out.
An additional part of founder stock is that they typically utilize what is known as a vesting schedule. The vesting schedule is a predetermined time frame in which an employee or founder stock becomes truly theirs. Vesting schedules prevent a founder or employee from signing a contract for the shares and then not giving anything in return. Many vesting schedules have what is known as a one-year cliff where the shares are not given until a year of employment has lapsed and after one year the vesting schedule for the shares is typically transferred on a more regular basis.
What is Founder Stock Worth?
When founder stock is granted at the beginning of a startup, the shares tend to be worth very little. The actual worth of the founder's stock is in the future potential they hold.
Since founder stock is the very first stock holdings of a business, they have the potential to give the most return out of any other subsequent award of equity. For a successful startup, the founder’s stocks have the largest profit since they were initially the cheapest of any other equity holdings. In this scenario, founder stocks can be worth millions depending on the success of a startup.
Another key point about founder stock is that when it is distributed into a vesting schedule, it is initially worthless to the recipient. When equity is given in a vesting schedule, the recipient has no power over these holdings until the vesting period has elapsed. In this scenario, a founder that received 20% of a startup will actually not own 20% on day one but will rather earn it over time through the predetermined vesting schedule.
Determining the worth of founder stock over time can be accomplished through yearly 409a valuations that determine the fair market value of the common stocks in a private institution.
Founder stock and common stock are really the same and the only distinction between the two is that founder stock was issued to the founding team while common stock is typically utilized to lure in new talent.
What Are the Regulations?
Equity in a startup has become a fairly regulated field. Since the inception of the regulations about non-qualified deferred compensation, startups have had to adjust accordingly to ensure they avoid hefty tax penalties. There are two main regulations that should be considered when founder stock is being issued. These are the 409a and 83(b) election issued by the IRC.
409a is a subset of a regulatory guideline that calls for independent business appraisers to create a valuation to determine the fair market value of the common stock. This regulation is in place to ensure that the undervaluing of stocks is not taking place when distributing shares to employees in the form of a deferred compensation plan such as a vesting schedule. For founder stock, 409a only comes into play when a startup decides to distribute founder stock later down the road.
For example, if a startup is seeking seed funding and an investor appraises the startup at 2 million dollars, the founders would be unable to distribute shares amongst one another for a low value. If the founders in this scenario valued their common stock below the fair market value, they would face the taxation penalties of 409a and would be forced to include the share value in their federal income tax for that year.
The 83(b) tax election allows founders to pay the income tax for their shares the year they were issued. The reason a founder would want to do this is that fewer taxes will need to be paid.
For example, let's say a founder files for 83(b) right after getting their shares and incorporating the startup. While the founder has to pay the taxes associated with their shares immediately, the value of the stock is relatively low. Without an 83(b) election, the founder would end up paying much more in taxes because when the shares vest, as they will be worth a lot more money, and as such will result in more money being taxed.
What is the Difference Between Founder Stock and Preferred?
A common misconception is that all equity shares are the same but this is not the case.
When looking at a startup there are typically two classifications of stock and those are preferred stock and common stock. Founder stock is considered a subset of common stock while the stock typically given to investors is considered preferred stock.
The main differences between common stock and preferred stock are the number of privileges and control they have to offer. Preferred stock has advantages in that they have precedence in the case of liquidation, where they are entitled to their money back before common stockholders.
Additionally, preferred stock can have other built-in safeguards that can protect an investor. Common stock typically does not have any of these additional stipulations, however, common shares do typically carry voting rights and are typically cheaper than preferred stocks. Common shares tend to be utilized when a startup wants to build a team of well rounded individuals that facilitate a strong startup culture.
Overall, founder stock is a way to repay founders for their hard work and dedication.
Knowing the ins and outs of founder stock can save founders from headaches down the road. Issues like unnecessary taxation, tax penalties, and many more can be avoided with a general understanding of founder stock. Knowing the regulations, worth, and unique qualities of founders stock can allow a founder to be better prepared for receiving their equity share.
Creating a business is hard enough, don’t let misinformation and ignorance come between the hard work and compensation for a startup. With a clear understanding of founder stock and how it works, a founder can focus more energy on making the business the best it can be. Founders that are given the tools to succeed are the ones that are able to create the best and most profitable businesses in the long run.