From day one, it’s crucial to put your company on the right path. With proper planning, you can avoid a number of common problems that would make investors run for the doors, such as co-founder disputes, tax issues, and cap tables. Startup equity is one of those things that most founders struggle with unless they have an MBA. But as with all of life, founders’ paths may grow apart for different reasons. It’s one thing when the “divorce” is peaceful, but sometimes situations become very complicated. In a blink of an eye, you’re fighting over the “custody” rights with someone who was previously on your side.
With the added stresses of the pandemic—working from home or working from anywhere—and the pivots required for businesses to adapt their models and work styles to the new normal, we are seeing significant pressure placed on the relationships between founders and other founders, between boards and founders, and between investors and founders.
Founder equity splits. When considering how to initially split founder equity among the various co-founders, some of whom may be present, and some of whom are merely a twinkle in your eye, startups should think long term.
First, consider the relative contributions each person will make. While everyone says they are “all in” at the start, are they quitting their jobs? Have they invented something? Is their role critical to fundraising or engineering? Who is adding the most value now, and who will add value later? What cash is available? Get clear on these issues from the start and understand that they will evolve over time.
Types of startup equity. As to the types of startup equity, they are generally structured as common stock at formation. The price per share is usually insignificant, or what is referred to as “par value,” a “peppercorn,” or close to zero. This is referred to as “sweat equity,” which is vested over time.
Founder stock terms can also include some of the elements typically found in preferred stock, such as governance rights, liquidation preferences, and super-voting rights. Special founder terms can be a red flag for venture capital investors, and for that reason, particular consideration should be given as to whether such terms are reasonably obtainable.
At formation, cash investors typically receive a convertible note, a simple agreement for future equity, or series seed preferred stock. Some founders put in cash at the formation and structure the cash investment in one of these instruments.
Who gets what? There are four groups of people who typically get equity in the early stages: founders and co-founders, advisors, investors, and employees, and consultants. Who gets what is more art than science, and there is no simple answer. Numerous websites offer purported “co-founder equity split” calculators and practical advice.
Equity incentive plans. Stock options are the typical currency for employees, consultants, and advisors of startup companies. Restricted stock units, restricted stock awards, phantom stock, and a large assortment of hybrid instruments may also exist. In early-stage and venture-backed startups, the currency is usually a stock option. Stock options can be structured in a number of ways for tax purposes. Typically, they can be “incentive stock options” or “ISOs.” If options do not qualify for ISO status, they are referred to as “non-qualified” stock options, or “NSOs.” An ISO gives an employee the right to buy shares with the profit taxed at the capital gains rate, not the higher rate for ordinary income.
Vesting. Founder equity, like stock options, typically vests over time. Founder equity is usually subject to repurchase by the company, with one-fourth of the equity ceasing to be subject to repurchase, or vested, after a one-year cliff. After that, founder equity vests monthly or quarterly until the culmination of four years from the formation. Sometimes, repeat entrepreneurs can obtain equity without offering the right of repurchase or reverse vesting, or with reduced vesting, but four years is the standard.
Stock options are not actual ownership, and there is no cash outlay upon grant. These options become exercisable after one year from the initial vesting date, which is usually the date of grant, and they vest in monthly or quarterly installments until four years have transpired from the initial vesting date. In order to exercise stock options, the holder pays the exercise price, which for tax purposes must correspond to fair market value upon the date of the grant. Unless the option has ISO status, upon subsequent exercise and sale, it would be taxed at ordinary income tax rates.
Cap tables. Founders are well served to ensure that their companies use a technology-enabled vendor to store the company’s capitalization records in an automated, secure, and cloud-available format.
409A valuations. In a nutshell, Section 409A of the Internal Revenue Code provides a safe harbor. It suggests that the IRS will not challenge an exercise price as being below fair market value if a third-party independent valuation firm established the fair market value, and that value was approved by the board of directors, all within the prior year of the grant. While there is much fine print and some exceptions, a 409A valuation is generally important to obtain once a year and after each financing round. This risk of doing nothing is that the IRS could argue that the option was granted below fair market value and impose a higher tax rate on the income or gain.
When things change. After your company’s formation is complete, the founder equity has been divided, the equity incentive plan approved, and stock options doled out, life goes on. The world turns, and things change. Co-founders join, co-founders leave, co-founders fight, key employees join and depart, venture capital is raised, and M&A transactions come and go.
Founder roles adjust over time. It’s only natural. So, as well, should their salaries, bonuses, commissions, downside protections, and equity stakes. These are all easy to adjust when things are going well, but what about when things go sideways? Management carve-out plans can provide incentives for people to struggle through a tough spot.
Founder break-ups and departures. When founders leave, the first questions asked are whether the equity is vested and what happens to it. If unvested, the company should repurchase it at the issue price. For vested equity, founders will want it bought back at fair market value, and investors won’t want precious dollars going out the door to provide liquidity to someone who is leaving. Deals are struck where founders have something that investors want, like super-voting rights, board control, and exit rights. When the parties can’t agree, founders who push the envelope too far risk getting recapitalized and diluted, being terminated for cause, undergoing investigation, and having their information rights clipped. Does the founder have the right to severance? Is it enough to buy peace? Non-competition agreements post-termination of employment are generally not enforceable in California, so this can be another carrot that departing founders can dangle in exchange for a buyout of their shares. Will the remaining team know where the bodies are buried, or is a consulting agreement with the departing founder required to make sure her or his services are available when needed? Was there a bonus due? A commission? Inevitably, companies and departing founders will need to get along to ensure a good exit.
Mergers and acquisitions. It is not uncommon for companies to be put up for sale when a founder departs, and market participants expect it. So for boards and founders in a deadlock, is it the right time to bring things to a boil? Who constitutes the universe of potential strategic and financial buyers? Is it feasible to raise a growth equity round or “minority recap” with primary and secondary capital to reshuffle the C-suite and the cap table? Is a management carve-out plan needed? A new retention plan? Or restructuring? Potential scenarios abound…
What happens next. Invariably, after a founder divorce, the parties need to find a way to get along…in the board room…to raise capital…to help sell the business…to market the message…to evangelize the mission.
Things sometimes fall apart. Founders have to know how to keep things together until the next off-ramp is in sight.
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Louis Lehot is the founder of L2 Counsel. Louis is a corporate, securities, and M & A lawyer, and he helps his clients, whether they be public or private companies, financial sponsors, venture capitalists, investors or investment banks, in forming, financing, governing, buying and selling companies. He is formerly the co-managing partner of DLA Piper’s Silicon Valley office and co-chair of its leading venture capital and emerging growth company team.
L2 Counsel, P.C. is an elite boutique law firm based in Silicon Valley designed to serve entrepreneurs, innovative companies and investors with sound legal strategies and solutions.
