In this second installment of our 2020 First Time Founder Series, we’re going to discuss founder equity: what it is and how you get it.
What is founder equity?
Your startup company needs owners. The first owners are you and your co-founders. Your equity represents your ownership of your startup. In corporations, equity is called stock or shares. In limited liability companies (LLCs), it can be called units or membership interests.
Startups have two basic types of equity: common and preferred. Equity issued to founders is almost always common. Equity issued to your investors will almost always be preferred.
What’s the difference? Common equity is plain vanilla ownership. Preferred equity will have additional rights and preferences, which can vary depending on your investors and your development stage. We’ll discuss investors and preferred equity in the next installment in this series.
About a decade ago, the startup community got excited about a sort of hybrid founder equity that had features of both common and preferred. Search for “Series FF Stock” or “Class F Stock” for more background. The excitement around this equity was both good and bad. Some founders loved it, some lawyers questioned it, and some investors hated it. This is an ongoing debate, and its use remains limited. We are therefore going to ignore it and assume common equity for your founders.
Who should get founder equity?
This is the million (and maybe billion) dollar question. Think very carefully before doing equal splits between you and your co-founders. Founder contributions are rarely equal. Do not pretend they are. You will regret it later. Instead, be honest with yourself and your co-founders. Who is bringing what to the table? Who came up with the seeds of your brilliant technology? Who figured out how to make that technology a business? Have these difficult conversations now, before the startup takes off and before your friendships are tested by the stress of running a startup. Then grab one of the many publicly available pro forma capitalization tables and start modeling your proposed ownership splits.
How do you pay for founder equity?
Founder equity is typically issued for a nominal (low) price. The rationale is that, at this stage, the equity is not worth very much because your business is still extremely risky.
You can write a check, transfer intellectual property, or do some combination of both to cover the purchase price. Once you transfer technology to your startup, your startup (not you) owns that technology. This is key and, ideally, every founder is transferring all intellectual property related to your startup’s business (including know-how and fledgling concepts) into the startup in exchange for equity. As you grow and seek outside investment, it is critical that you can prove ownership of (or the right to use) all intellectual property used by your startup. Having the founders transfer their intellectual property rights to the company in exchange for founder equity is the first step.
What about vesting?
At this point, you understand what founder equity is. You have appropriately (and honestly) divided it up between you and your co-founders. And you and your co-founders have paid for your equity. Your ownership is all set, except what happens if someone leaves?
This is where vesting comes in. If your equity is subject to vesting, and you leave the company before it vests, then the startup has the right to buy back your unvested equity. The startup typically does this with cash, and the price it pays is typically your original (low) purchase price. If you transferred intellectual property into the startup, that all stays with the startup. If the price of the equity has gone up, you likely will not see that value when the company buys back your unvested equity.
So why would you ever agree to vesting? Two main reasons:
- This is your deal with your co-founders. They are fine acknowledging your significant contributions and giving you 55% ownership. But they do not think it is fair for you to continue to own 55% if you walk away.
- Your investors will expect vesting. They are investing in both you and your startup. They want you committed to the startup. If you didn’t impose vesting on yourself, your investors might be inclined to impose onerous vesting terms. But, if you have imposed some reasonable vesting, many (but not all) investors will leave your self-imposed vesting alone.
The most common vesting schedule is a four-year vesting schedule with a one-year “cliff.” Under this schedule, 25% vests after one year (the cliff) and the balance then vests monthly over the remaining three years. At the end of four years, your equity is fully vested. Vesting should start when you started on your startup journey. If that was two years ago, the vesting start date could be two years ago (even if the startup didn’t exist as a formal entity yet).
You can also add acceleration terms to any vesting schedule. This means that certain events will accelerate the vesting. There are two main types of accelerated vesting:
- Single Trigger, which means the occurrence of a single event will accelerate the vesting of some percentage of your equity. Typical examples are acceleration if you are fired without cause, or if the startup is sold.
- Double Trigger, which means the occurrence of two events is required to accelerate vesting. The typical example is acceleration only if both the startup is sold and you are fired.
It is not uncommon for founder equity to have double trigger acceleration. That is acceptable to most (but not all) investors. Some startups like to give double trigger acceleration rights to all employees, or at least their early employees. We’ll discuss that in a later installment in this series.
With most startups, once your equity is fully vested, neither the startup nor your co-founders have the right to buy it back. It’s yours. For some startups, especially those that plan to stay small and not seek outside capital, you may want additional buy-back rights in certain situations (such as death, disability, and certain departures). Buying back vested equity is more complicated and can raise questions about price and process. Talk to your advisors before doing this.
Finally, some formalities.
If your startup is a corporation, your founder equity must be formally approved by the corporation’s board of directors. Your handshake deal with your co-founders is not sufficient. (There are also formalities for LLCs, which will depend on how you set up the LLC.)
Also, founder equity is a security, subject to both federal and state securities laws. The good news is that, in most states, founder equity will qualify for an exemption to filing requirements. The bad news is that to qualify for that exemption, you need to get it right, and, in some states, filings are still required.
Bottom line: talk to your advisors about these topics before issuing your founder equity. We did not cover everything here, and there is a wealth of knowledge out there, with differing opinions. Get informed and make the best choices for you and your startup.
The next installment of this First Time Founders Series will discuss raising outside capital.
Originally posted on the Galvanize blog.