Founders’ Equity: Vesting, Dilution, and Other Common Issues

1. Founders’ Equity:
Vesting, Dilution, and Other
Common Issues
PRESENTED BY BOSTON UNIVERSITY SCHOOL OF LAW STARTUP LAW CLINIC
JAMES BLACK & KEITH NEMETH

2. Founders’ Equity:
Overview
WHAT IS FOUNDERS’ EQUITY?
WHY IS IT IMPORTANT?

3. Overview - What is Equity?
▶ Ownership of a company
▶ It takes different forms depending upon the entity:
▶ Corporation
▶ Common Stock (shares)
▶ Limited Liability Company
▶ Member Interest (percentage or units)

4. Overview - Why is Equity Important?
▶ Compensatory
▶ Attracting and retaining employees
▶ Incentives for founders and employees
▶ Replace cash compensation with non-cash benefits
▶ Fostering an ownership mentality
▶ Employees have a stake in the well-being of the company
▶ They will have a greater incentive to help the company succeed.

5. Founders’ Equity:
Categories
DIFFERENCE BETWEEN
AUTHORIZED AND ISSUED
SHARES
WHO RECEIVES EQUITY
WHAT TO CONSIDER
WHEN TO ALLOCATE EQUITY

6. Authorized Shares v. Issued Shares
▶ Authorized shares are the number of shares a company is legally allowed to
issue.
▶ Located on the certificate of incorporation.
▶ We recommend authorizing a smaller amount as it lowers taxes.
▶ Issued shares are authorized shares sold to and held by the shareholders of
the company.

7. Authorized Shares v. Issued Shares
(Continued)
▶ Hypo 1:
▶ Company authorizes 5,000 shares
▶ Founder 1 owns 1 share and Founder 2 owns one share
▶ Founder 1 and Founder 2 each own 50% of the company.
▶ Percentage of ownership is based upon the number of issued shares, not
authorized shares.
▶ Hypo 2:
▶ Company authorizes 10,000,000 shares
▶ Founder 1 owns 20 shares, Founder 2 owns 20 shares, and Founder 3
owns 10 shares.
▶ Founder 1 and Founder 2 own 40% of the company and Founder 3
owns 20% of the company.

8. Equity Allocation
▶ Create three categories to allocate authorized shares into:
▶ Founder group
▶ Investor Group
▶ Option pool group (directors, advisors, and employees) (will remain
unissued)
▶ Pre-series A funding share allocation
▶ Founders: 50-70%
▶ Investors: 20-30%
▶ Option pool: 10-20%
▶ Post-series A funding share allocation
▶ Founders: 20-30%
▶ Investors: 50-70%
▶ Option pool 10-20%

9. How Much Equity Should They Receive?
▶ Founders
▶ Original, innovate ideas?
▶ Intellectual property
▶ Capital
▶ Commitment to company
▶ Skill sets
▶ Advisors
▶ Providing guidance or strategic vision?
▶ Key employees
▶ Incentivizing early key hires with points of equity

10. When To Split Equity?
▶ Splitting equity early
▶ Lower stake negotiations
▶ Helps to attract quality team members
▶ Lower value of equity grant
▶ But risks making grants to employees who are not as committed as
expected
▶ Splitting equity later
▶ Greater incentive to perform at a higher level
▶ Team dynamics have formed
▶ Roles are established
▶ But equity may have appreciated

11. Founders’ Equity:
Categories
EQUITY IN DIFFERENT ENTITIES
TYPES OF EQUITY INTERESTS

12. Entities and Their Equity Interests
▶ Corporations
▶ Shareholders
▶ Common
▶ Non-Voting
▶ Preferred
▶ Share of profits and losses through dividends
▶ Double taxation
▶ Corporation is taxed
▶ Dividends are taxed

13. Entities and Their Equity Interests
▶ Limited Liability Companies
▶ Membership
▶ Capital contribution
▶ Can be made in cash or non-cash
▶ Share a percentage of profits and losses
▶ May choose to be taxed as either a partnership or corporation

14. Founders’ Equity:
Compensation
WHAT IS EQUITY
COMPENSATION?
TYPES OF EQUITY
COMPENSATION
ISSUES WITH EQUITY
COMPENSATION

15. Equity Compensation: Overview
▶ Non-cash compensation that offers an ownership stake in the company
▶ Otherwise known as “Sweat Equity”
▶ Reasons:
▶ Attract and maintain employees
▶ Cash is in short supply
▶ Most Common Types:
▶ Restricted Stock
▶ Stock Options

16. Restricted Stock
▶ Shares that are subject to legal restrictions
▶ Certain conditions must be met before the recipient can to sell shares
▶ Time-based or performance-based
▶ Actual shares issued by the company
▶ Therefore holder has voting and other ownership rights from grant date
▶ Subject to forfeiture
▶ Restricted stock becomes unrestricted once any conditions are met
▶ Generally, this occurs incrementally rather than all at once

17. Stock Options
▶ Right to purchase a set number shares in the future at a fixed price
▶ No shares issued at the time of a stock option grant
▶ Therefore, no voting or other rights exist until the option is exercised
▶ However, the company must keep shares available for the option period
▶ Any benefit realized to the option holder depends on the difference
between the value of the stock over the option price
▶ If stock’s value is equal or less than the exercise price, stock options are
worthless
▶ Typically have an expiration date (can be months or several years)
▶ Types:
▶ Incentive Stock Options
▶ Non-qualified Stock Options

18. Stock Options: Types
Non-qualified Stock Options (“NQSOs”)
▶ Preferential tax treatment
▶ Only for Employees
▶ No income tax owed when the option is exercised, as long
as IRS holding requirements are met
▶ Makes ISOs eligible for more favorable capital gains treatment
Incentive Stock Options (“ISOs”)

19. Equity Compensation: Issues
▶ Disappointing Performance
▶ Early founders may lose focus or dedication as months or years go by
▶ Burdensome and complex securities law compliance
▶ Phantom Income
▶ Lack of Transferability
▶ Particularly a concern for private companies and restricted shares

20. Founders’ Equity:
Vesting
WHAT IS IT
VESTING SCHEDULES

21. Vesting
▶ Vesting is the process of gaining full legal rights to shares or options
▶ Unvested shares are subject to forfeiture back to the company
▶ Shares that vest are not subject to forfeiture or lapse
▶ Addresses concerns discussed previously regarding shareholders who begin
to disappoint or decide to leave the company early
▶ E.g. Free Rider Problem
▶ Vesting requires founders to earn equity
▶ Two models:
▶ Time-based
▶ Performance-based

22. Time-Based Vesting
▶ Time-based vesting schedules give the holder full legal rights over
incremental amounts of shares according to a set schedule
▶ Shares typically vest either monthly or quarterly over 3-4 year period
▶ Will often include a “cliff”
▶ A designated length of time before any shares vest at all
▶ For example, Employee is granted 4,000 shares subject to a 4-year
vesting schedule and a 1-year cliff
▶ Employee will receive 1,000 shares after 1 year
▶ And, no shares if they leave after 11 months
▶ The remaining 3,000 shares will be evenly distributed over the
remaining three years

23. Performance-Based Vesting
▶ Vesting that occurs upon the achievement of specified milestones
▶ Shares vest upon the occurrence of key events in the future
▶ Examples include:
▶ First shipment to a customer
▶ Achievement of certain sale/revenue figures
▶ Threshold number of users
▶ Development of first prototype
▶ Structure will be closely tailored to the type of business and stage of
development
▶ Milestones should be clear, easy to measure, and unambiguous

24. Vesting Schedules: Acceleration Events
▶ Acceleration events cause all unvested shares to automatically vest, subject
to the occurrence of one or more defined events
▶ Types
▶ Single Trigger
▶ Double Trigger
▶ Common Acceleration Events:
▶ Sale of company
▶ Merger
▶ Termination
▶ Change in control

25. Founders’ Equity:
Restrictions on Sale
WHAT IS IT
COMMON TYPES

26. Restrictions on Sale: Overview
▶ Limit on a shareholders ability to freely dispose of his or her shares
▶ Restrictions enforced after one gains full legal right to vested shares
▶ Common Examples:
▶ Right of First Refusal  Company, Founder, or Other Shareholders
▶ Drag Along Rights  Primarily benefits majority shareholders
▶ Co-Sale Right  Primarily benefits minority shareholders
▶ Lock-up Agreement  Primarily benefits new investors

27. Founders’ Equity:
Dilution
WHAT IS IT
WHAT TO BE AWARE OF

28. Dilution
▶ Typically, founders’ equity is diluted as additional shares are issued to new
founders, employees, or investors
▶ As the number of outstanding shares increases, the percentage ownership of
each shareholder goes down if the number of their shares remains constant
▶ Good Dilution:
▶ Occurs where equity percentage decreases, but outside investment
increases the overall value of the company and the price per share
▶ Bad Dilution:
▶ Occurs where new shares are issued to employees who neither pay for
the shares, nor add any value to the company

29. Questions?
▶ Set up an appointment with the Clinic for more information.
▶ https://sites.bu.edu/startuplaw/
▶ What can we do to help?
▶ Advice regarding equity allocation
▶ Drafting founders’ equity agreements
▶ Reviewing investment offers
▶ And more

30. Appendix

31. Vesting: 83(b) Election
▶ Important for companies whose par value per share is very small today
▶ Beneficial Tax Treatment:
▶ Ordinary Income vs. Long-Term Capital Gains
▶ Allows recipients to pay taxes on current (rather than future) value of the stock
▶ Employee receives 1,000 shares with a par value of $0.01, subject to a 4-year
vesting schedule with a 1-year cliff. One year from now, shares valued at $1,000
▶ If 83(b) election is filed, employee will be recognize $10 of income today.
Shares sold in the future will be taxed at capital gains rate when sold
▶ If no 83(b) election is filed, employee will recognize $0 of income today. One
year from now, when shares vest, employee will recognize $1,000,000 of
income that will be taxed at the ordinary rate
▶ Must file within 30 days of purchasing shares