Ten Things You Should Know about Founder Equity for C-Corporations

Many founders decide on forming a C-corporation as the legal entity of choice for their company. When forming a C-corporation, founders are issued equity in the C-corporation, often referred to colloquially as “founder shares” or “founder stock.”

While there are many existing tools and services (such as Stripe Atlas and Clerky) that quickly and inexpensively allow for the incorporation of a company, these tools and services don’t always provide guidance into the issuance of founder stock. While the issuance process is generally straightforward, there are some considerations that founders should think about with respect to the issuance of their initial equity, which may affect how the company is initially structured.

What is “founder stock”?

Simply put, “founder stock” are shares of stock of a corporation that is issued to one or more founders, typically at the time of the initial incorporation.

Stock issued to founders is always in the form of “common stock” of the company, for reasons as further explained below, although the specific type of common stock may differ.

These shares of common stock are typically “purchased” by the founder(s) pursuant to a stock purchase agreement. Because this issuance is occurring at the initial formation of the company (and typically before any outside money is raised by the company), the initial value for these shares is generally very low (referred to as “par value”, typically set at $0.0001 or $0.00001 per share).

Is founder stock different from other kinds of stock of the company?

At formation corporations typically only have one class of stock – “common stock”. This is the class of stock that is typically issued to founders at formation.

While some founders believe that “founder stock” is legally different from other kinds of stock, there is no formal definition of “founder stock.” As such, standard common stock issued to founders is NOT necessarily different than common stock that might be issued to employees and consultants.

That said, common stock issued to founders may be treated differently in certain ways:

While the common stock purchased by founders may be the same as other common stock, the stock purchase agreement under which the founder purchases such stock will be subject to the terms and restrictions specific to that agreement. These may be different from the terms and restrictions that other common stock issuances may be subject to.

Shares issued to founders are typically NOT issued pursuant to an employee stock plan. Stock or options issued under an employee stock plan may have different (and sometimes more onerous) restrictions than stock issued to a founder.

Finally, in certain cases, founders can decide to create a different class of stock for founders (sometimes referred to as “founder preferred” or “class F common stock”). This different class of common stock will often define special rights that the holders of such class of stock may have.

Why don’t founders get preferred stock?

Typically only investors receive preferred stock in exchange for investment in a corporation. While there is no legal requirement that investors receive preferred stock, due to custom and practice, most knowledgeable investors will insist on receiving preferred stock rather than common stock.

Preferred stock gives holders of preferred stock certain rights and privileges that holders of common stock do not have. One of the most important rights that preferred stock has is something known as a “liquidation preference” – in a sale, merger or shut down of a company, to the extent any cash or assets remain (that aren’t owed to someone with a more senior right like a debt holder), the preferred have the right to get a return on their original investment before common stock holders get a return.

Since founders typically don’t pay a significant amount for their founder stock, other than the extremely low “par value” at the time of formation, it doesn’t make sense to grant founders preferred stock with a liquidation preference. Moreover, generally investors do not like to invest in companies where founders hold shares with special preferred rights, given that founders (as a group) typically already manage the company, hold a majority of the board seats and hold (as a group) majority voting power, even without preferences.

What is “founder preferred” or “class F common stock”?

As noted above, typically only investors receive preferred stock with certain rights (eg “preferences”) that provide investors special rights in exchange for their investment.

However, while still relatively uncommon, in the last decade an increasing number of founders have created a special class of common stock that do give the holders (typically only founders) certain rights and preferences. Often referred to as “founder preferred” stock or “Class F Common Stock”, this special class of common stock must be defined in the company’s Certificate of Incorporation and issued separately from “normal” common stock.

While the special rights given to “class F common stock” vary depending on the company and founders, one of the most common rights these class of shares have is “supervoting”, where each share of “class F common stock” is given the same voting rights as 10 or 20 shares of Common Stock (sometimes referred to as 10X or 20X voting power). Given the potential for future share dilution, some founders issue themselves these “supervoting” shares to ensure they maintain voting control over the company through successive future financings.

However, class F common stock (or similarly defined common stock) with special rights/preferences are still relatively rare. Many investors do not like to invest in companies where founders hold such shares, or if they do invest, specifically request removal of such rights as a condition to investing. That said, some high-profile private companies (typically companies that have leverage over investors) have been able to maintain shares with such rights, such as WeWork and Pinterest.

Who (should) get founder stock?

As noted above, except in the instance of “class F common stock”, “founder stock” in most cases is simply common stock and is not legally different from other common stock. Therefore, in most cases, founder stock is simply stock that those who are deemed “founders” have received.

Usually those individuals who are considered “founders” is pretty obvious and straightforward. In other instances, a company or set of founders may want to bring on another person as a “co-founder” well after the company has formed, and ask whether the company can still “issue founder stock” to that new co-founder.

How equity may be granted to a later arriving co-founder often has more to do with the valuation of the company at the time of issuance and tax considerations. In many cases, it may be more tax-optimal to grant equity to a later arriving co-founder in the form of an option, as the per-share valuation may make outright purchase of shares too-expensive, and issuing shares for a nominal purchase price will give rise to tax obligations for the company and the new co-founder.

Regardless, once a company has established an equity pool (various called an option pool or an employee stock option plan or ESOP or “Plan”), it generally makes more sense for a company to issue equity out of a Plan, vs issuing shares directly (outside of the Plan) as in many cases companies have not authorized enough shares to grant to individuals outside the Plan, and such issuances may require thought into the appropriate securities exemption to issue such shares.

How do we decide how to split founder shares amongst founders?

Founders occasionally ask for feedback on how to split initial equity ownership. The pat answer is there is no hard and fast rule. In some cases, founders split equity equally amongst the founders. In other cases, one founder in particular holds more equity, for instance where the founder is seen as the driving force and/or the company’s CEO. While there is no right or wrong answer to how to split founder equity, there are a few things to consider:

Voting Power: Founders that grant equity equally amongst 2 or 4 founders sometimes run into impasse when a dispute occurs amongst the founders, especially where the board seats are also equally distributed. Founders may want to consider whether one founder (perhaps the CEO) should have more shares to tip the scales.

Vesting: With the large number of shares founders typically hold, vesting becomes important for voting and control reasons when one or more founders leave. As noted above, most standard incorporation documents provide for vesting, but if they don’t, founders should always consider subjecting shares to vesting so that co-founders who leave early do not retain their full allotment..

Future Contribution: However founder equity may initially be split, issues often arise where one or more founders end up contributing more time and energy to a company, yet hold fewer shares than other founders who may be more passive participants. It is not easy to change the allocations after the fact, so regardless of past contributions, founders should think about the likely future efforts and contributions of the founders in framing the appropriate equity split.

Why do I have to buy my founder shares?

All shares of company stock must be paid for in order to be validly issued. Payment must be at fair value, and may be made in cash, by a promissory note, or in exchange for property (including IP) or services. However, because the issuance of founder shares typically occurs at initial formation of a company (often before any outside money is raised by the company), the initial value for these shares is very low. As a result the “purchase price” is often nominal and it is normally not a problem to pay the purchase price with cash.

However, purchase of these shares does not have to be for cash – it can be in the form of assets or intellectual property. Thus, even if structured as a purchase, the out of pocket cost to the founders is generally minimal. Founders generally avoid paying for stock by providing services as this gives rise to tax issues for the company and the founders.

Why are founder shares typically subject to vesting?

Subjecting founder or employee equity to vesting is standard and typically expected.

The usual vesting terms for venture backed private companies is 4 year vesting with a 1 year cliff (no equity vests until the one year anniversary of the vesting start date, after which 25% vests on that one year anniversary and the balance vests monthly pro-rata for the remaining 3 years of the 4 year vesting term).

The reason is in part custom – institutional venture investors typically expect founder and employee equity to be subject to this 4 year vesting/1 year cliff, and most standard financing documents contractually require companies to adhere to this vesting standard. Venture investors typically want to see that the founder has “skin in the game” in the form of ongoing future vesting.

It also can be to the advantage of founders to be sure that all founders be subject to vesting. This is especially the case with a departing founder – if a founder leaves before the 4 year vesting term, for ownership and voting purposes it is typically to the advantage of the non-departing founders that the leaving founder stops vesting post departure.

Will I be taxed when I receive my founder shares? What is an 83(b) Election?

Yes and no.

As noted above, where founder equity issuances are structured as a purchase (and assuming the purchase price is equal to the fair market value of the shares at the time of purchase), then the purchase is generally not subject to tax.

However, where such founder shares are subject to vesting, then such shares WILL be subject to ongoing tax reporting (and payment of taxes) based on the increase in the value of such shares as they vest over time. To prevent this ongoing tax reporting and payment obligation with respect to shares subject to vesting, founders should always file an 83(b) Election with the IRS. This should always be part of any incorporation package that issuances founder shares to founders, and MUST SENT TO THE US IRS TAX OFFICE (POSTMARKED) WITHIN 30 DAYS OF ISSUANCE OF STOCK (no exceptions or extensions).

Assuming a founder has purchased his/her founder shares at fair market value and assuming the founder has sent an 83(b) Election to the IRS within the required 30 days of issuance, then the founder generally should not expect to be taxed on the issuance of the shares, but will still incur tax upon the sale of such shares (the specific timelines and tax treatment of such future sale of shares is outside the scope of this particular blog).

Can I sell or transfer my founder shares?

Generally speaking, no, subject to some specific exceptions.

As private, non-publicly listed securities, founder shares can only be sold pursuant to specific securities exemptions (generally only to accredited investors, and generally not pursuant to a general solicitation or advertisement).

Moreover, most founder stock purchases are subject to various transfer and other restrictions that are built into the founder stock purchase agreement. These typically subject such shares to vesting, and also subject vested shares to transfer restrictions (which usually grant the company a right to buy such shares pursuant to a right of first refusal and/or an outright transfer restriction). Some companies also have restrictions against transfers in the company’s bylaws, and if the company has entered into a financing with an investor, the investor (or investors) may also have certain rights to purchase such shares from founders (or approve/deny a sale) pursuant to investment documents.

These restrictions or approval rights will typically have to be waived before any transfer, even if compliant under securities laws.