This is one of the first, and most consequential, questions that founders of a new startup have to answer: how are we going to divide company equity amongst ourselves, new employees, and future employees? Although this question has to be answered in light of the unique circumstances of your particular startup, there are a few current trends and best practices that can provide guidance.
What is Founder Equity?
The terms “founder stock” or “founder equity” is used to refer to the shares of the startup stock allocated to founders of a new startup. However, it is important to note that, from a legal perspective, founder equity is, simply, common stock. In other words: it is standard shares in the company, without any special preferences or privileges attached to them.
Some founders have tried allocating preferred shares to themselves, allowing for special voting rights or dilution protection, for example. As a general rule, however, such stock grants will not survive a first round of funding: investors usually insist that founders, like employees, have common stock.
Current Trends in Startup Stock Allocation
Trends in compensation and equity grants tend to shift as the startup industry and investor expectations change. For example: recent years have seen increases in the cash compensation, and along with that decreases in the equity compensation, of VPs of Engineering and Product.
In terms of founder equity, current trends are heading in the exact opposite direction. Startup valuations have increased whilst investors have been keeping their investments relatively constant, leaving founders with more shares in their startup’s stocks.
Another observable new trend is that post termination exercise (PTE) periods have been increasing. A PTE is the amount of time after employment at a startup is terminated in which that employee can exercise his or her employee stock options. Generally, PTEs tended to be around 90 days. This means that an employee has 90 days after the day on which his or her employment was terminated to exercise stock options. As startup valuations have increased, the cost of exercising employee stock options have skyrocketed. As a result, some big startups have increased their PTEs to five or even ten years.
Finally, given the recent slowdown in IPOs, startups have also increasingly performed tender offers as a way to allow employees and/or founders to sell their options and earn lump sum compensation. This helps alleviate the relative illiquidity that equity compensation burdens employees and founders with.
Industry Standards for the Allocation of Startup Stock
Although there are no hard and fast rules when it comes to the allocation of your startup’s stock, it can help to take some guidance from industry standards. Your first step when deciding on the allocation of startup stock, is to divide company equity (100%) among three groups: founders, investors, and the option pool (for employees, advisors, and directors).
The standard amount of equity allocated before Series A investment is typically: 50%-70% to founders, 20%-30% to investors, and 10%-20% for the option pool. After Series A investment, it is usually: 20%-30% to founders, 50%-70% to investors, and 10%-20% to the option pool.
Once you have decided on the percentage that will go to founders, you have to decide how to divide company equity among founders. As a general rule of thumb, it is not advisable to simply divide startup stock equally among founders. Each founder brings something unique to the table, and therefore adds different amounts of value to the venture. One approach is to use the so-called founders’ pie calculator. This approach involves dividing a founder’s value contribution into five categories: idea, business plan preparation, domain expertise, commitment and risk, and responsibilities. Give each value contribution a weight, and determine the founder stock allocation accordingly.
Best Practices to Keep in Mind When Allocating Startup Equity
All Founders Should Sign a Subscription Agreement
A subscription agreement, or stock purchase agreement, determines all the terms that accompany the allocation of startup stock to founders (as well as employees and investors, of course). For founders, this agreement usually stipulates a nominal purchase price, as well as standard provisions in which the founder assigns any intellectual property or other relevant assets that he/she owns to the startup.
In addition, a subscription agreement should include a lock-up clause. This prevents founders from selling their shares within a certain time period following an IPO. Usually, this time period is set at 180 days. This is to ensure that the stock price is not depressed by founders and employees selling their stock en masse directly after an IPO.
File an 83B Election
As soon as founders receive stock options, they should file an 83B Election with the IRS. A Section 83B Election is a form you send the IRS notifying it that you’d like to be taxed on your equity on the date the equity was granted to you instead of the date the equity vests. You must make this election within 30 days of receiving ownership of the vested stock interest. It almost always makes sense for a Section 83B Election when the restricted stock is worth a nominal amount, as this dramatically lowers the tax burden associated with the stock grant.
Decide on, and Stipulate, Vesting Schedules
Vesting periods are almost always included with startup stock grants. This incentivises founders and employees to stay with the company. The industry standard is a four year vesting period, during which vesting usually occurs on a monthly basis. If the founders do not know each other well, they often also include a cliff: providing that the first tranche won’t vest until the end of the cliff period (usually a year).
Usually, founders stock vests completely upon sale of the company, although this is not the case for employee stock options.
Include a Right of First Refusal in Your Startup’s Bylaws
A right of first refusal gives the company or its other stockholders the right to match any offer to purchase company equity. In practice, this means that, if one founder decides to sell his or her shares, the company and/or the other founders have the option to match the offer and prevent the shares form going to an unknown outsider. Right of first refusal terms should be included in your startup’s bylaws and therefore decided upon at your startup’s incorporation.
Hire a Startup Attorney Today
At LawTrades, we get startups. You need expert legal advice, and you need it at your fingertips. We are here to help. For to all your questions and concerns about startup equity: we have the answer. Talk to one of our experts today!