Being a founder can be fun, but there are a lot of responsibilities that come with it. From running the daily operations to managing staff, things can add up pretty quickly. In addition to these things, it’s important that you setup the share structure of the company properly, starting with the founder’s stock.
The founder’s stock will set the basis for your company’s shareholders, and how the rest of the shares are structured. This knowledge-based article will help you learn more!
What is Founder’s stock?
Founder’s stock is the equity offered to the early founders of the company. This stock is different from the common stock that you may find in the secondary market. The main difference is that founder’s stock can only be issued at face value, and often comes with a vesting schedule over time.
Despite this, founder’s stock itself is not a separate legal term. It is used to describe the shares issued to the early participants of the company. These participants can be anyone from a founder who helped grow the company, to an investor who put in funds. Keep in mind though that the bylaws of the company would have not such terms.
How to allocate Founder’s Stock?
The main principle of dividing equity amongst the stakeholders is fairness. This part is the most crucial, as its different in principal from just getting the largest stake in the company. So, how should the founder’s stock be split up?
To begin with, the early shareholders have to keep in mind that as the company expands, so would the number of participants involved. This can be described as adding individuals in “layers”. These layers would help identify the different shareholders of the company during its business lifecycle.
This is explained more as below:
- The uppermost layer would hold the early founders of the company. This can be one or more founders. But the basic idea is that all of these individuals began working at the same time. This means that these people (including the founder) incurred the same risk of leaving their jobs to experiment with this new business idea.
- The second layer is filled with the first employees. These employees can be the secretaries, customer service, HR personnel, accountants, IT specialists, or anyone else. The time you decide to get in other professionals to run your business, it is mostly because you see some money flowing in and out of the business. This can be from the investors or even from the initial clients. The employees do not take any risk like the founders did and are guaranteed a salary as soon as they join.
- The third layer has the employees hired much later when the company is in the stage of growth. By this time, the company would be stable and earning enough profit to support the business and growth in the future.
For the majority of startup companies, each layer takes about a year to be formed. So, by the time the company grows to the point where it can go public, it would have about five or more layers.
With this in mind, when the equity is being distributed in the first layer, the initial founders should get at least 50% of the company ownership. After this, the next subsequent layers would receive about 10% of the company, which would then be divided among the employees in that layer.
Practical Example of Founder’s Stock
Let us take an example to explain a way to distribute the founder’s stock. Assume there is a company with two early founders, where both of them receive 2,500 shares each with 5,000 shares outstanding in the company. Now, if the company hires four employees during the initial year, each of these employees would get 250 shares. This would bring the total number of outstanding shares to 6,000.
And as the company moves to the second layer, it hires 20 more workers in the second year. They would be issued 50 shares each, for a total of 1,000 shares split amongst them. Now the company would keep moving ahead and grow until it reaches the sixth layer. Up until now, the company would have issued a total of 10,000 shares. This would leave each founder with 25% of the company, while the rest of the shares would be allocated equally among the employees in each layer.
Not every owner has to follow the same formula from above for allocating the founder’s stock. This is just a simple example as to how things could be and how the hierarchy would be set. In short, the initial founders are the ones who would get the majority ownership of the company, as compared to the additional shareholders that come in the subsequent layers.
Considering Vesting Schedule for Founder’s Stock
One of the main characteristics of the founder’s stock is that it typically comes with a vesting schedule. This schedule tells the date when the shareholder would have the power to exercise their stock options (or receive company stock for vesting share plans). For example, when an individual owns the options vested over a 5-year time, it means that they become exercisable after 5 years.
The shareholder would have to stay with the firm until the time the stock would be exercised and beyond (if the shareholder wants to continue with the firm). But why would anyone want a vesting schedule for a founder’s stock? Well, there are two reasons for this:
- If one of the early founders decides to leave the company before time, the vesting schedule would protect the other founders from the “free-rider” problem. (Although this rarely happens, it is done so that the other founders can be safe.)
- A vesting schedule is created in case the company would be taking in future investments. In such a time, the investors usually ask for the vesting restrictions and the individual may decide to wait up to the time of the investment to address the issue.
Knowing this, you might feel that vesting schedules are unfair for the founders because you would not have the equal allocations made even after you started the company. But once you learn more about this, you will realize that it is a good idea. It keeps both you and the company safe. This is also important later on if the founder decides to transfer their stock.
Before we jump ahead to transferring founder’s stock, we should cover an important aspect of vesting schedules called the “cliff”.
What is a “Cliff”?
In a vesting schedule, there is usually a one-year cliff. This means that the individual has to stay with the company for at least a year before a part of the shares is offered to them. While a one year is common for most companies, you can set another time frame for the vesting schedule’s cliff.
What Happens to My Unvested Stock if the Company is Sold or I’m Fired?
Vesting provisions on founder’s stock can provide the acceleration of vesting following the sale of the company. In this, there are two main kinds of variations:
- A “single trigger” provision accelerates the vesting of any unvested shares as at the time of the sale.
- A “double-trigger” provision accelerates the vesting of any unvested shares if the company is sold and the employee is terminated without cause within some time period following the closing of the sale.
With the single-trigger provision, the protection is lifted at the time of the sale and it depends on the buyer to figure out how to motivate and retain the team of the company acquired afterwards. On the other hand, the double-trigger provision keeps the protection in place. But it also secures the employee from being terminated without cause by the buyer by accelerating the vesting of the unvested shares.
At times, the acceleration of vesting also takes place in case the buyer considerably changes the responsibilities of the employee or moves the place of work, for example over 100 miles away. All these “Good Reason” provisions accelerate vesting of the unvested Founder’s Stock in case the employee elects to leave after the “Good Reason” event takes place.
It is common for the founder to inquire about the acceleration of vesting if the founder is terminated without any cause (which would not be in connection with the acquisition of the company). And even though this may not be a major concern, it is better to be careful to agree to accelerated vesting for a termination without cause. The vesting restrictions don’t usually distinguish among the many reasons why a founder and a company might part ways, although it is possible to provide that it applies only in the case of a termination without cause or voluntary termination.
Many of the legal definitions of the “cause” focus on bad behavior like theft, dishonesty or a felony conviction. However, it doesn’t cover more subjective assessments of effectiveness like poor management or weak leadership skills. In fact, during the early days of the company, an ineffective team member can easily jeopardize the entire company. And if the person is terminated and didn’t satisfy the cause definition, the person might walk away with a significant part of their stock in an unintended result. That is why its important to have well planned provisions in place to protect the company.
Transfer of Founder’s Stock
A founder’s stock is usually subjected to the “right of first refusal” .This gives the company and the other founders the chance to buy the shares that the other founder proposes to sell to a third-party. This right is normally requested by investors. In fact, the “right of first refusal” is a part of the company’s bylaws and is automatically applied to the company’s issued shares after the Bylaws are finalized.
This right is useful for controlling the ownership of stock only to the extent where the person that has the right and is willing to spend the needed funds to finance the purchase. Otherwise, the shares would be sold to the third-party buyer. Moreover, it has become more common for the bylaws to include the requirement of the Board to approve a stockholder to transfer stocks. This is because companies have become more concerned in handling their shareholder base and the flow of the confidential information.
All-in-all, the Founder’s stock is the shares issued to the first shareholders of the company. Usually, the company does not get returns to the point that a dividend is payable in determining when the shares are exercisable. Additionally, a vesting schedule is important as it protects the founders from the free-rider situation when one of the founders decides to leave.
Now that you know all about Founder’s stock, you can start off your company with your partners and divide the shares accordingly. To know more about how many shares you can authorize in the company, check out the next knowledge-based article here!