Tales From The Trenches: Founder Equity And Founder Agreements In The Pandemic by Louis Lehot
Palo Alto, CA (PRUnderground) October 1st, 2020
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, such as cofounder disputes, tax issues, and cap tables that would make investors run for the doors. Startup equity is one of those things that most founders struggle with unless they have an MBA. But just like in life, founders’ paths may grow apart for different reasons. It’s one thing when the “divorce” is peaceful, but sometimes things can become very complicated, and in a blink of an eye you’re fighting over the “custody” rights with someone who was previously on your side.
With all of the added stresses of the pandemic, working from home, working from anywhere, and the pivots required for businesses to adapt their models and work styles to the new normal, we are seeing significant stresses placed on the relationships between founders and other founders, between boards and founders, and investors and founders.
On September 9 and 16, elite boutique law firms L2 Counsel and MBL Counsel partnered with leading accelerator 4thly to produce a two-part webinar series on founder equity and founder divorce, hosted by L2 Counsel founder Louis Lehot, MBL Counsel founder Brian McAllister, and 4thly CEO and legendary “Silicon Valley guy” Bret Waters. As usual, there was a lively discussion (available on the #askasiliconvalleylawyer YouTube channel here and here) with slides to help follow along here and here.
Founder equity splits. When considering how to split founder equity initially among the various co-founders, some of whom may be present, some of whom may be a twinkle in your eye for down the road, startup founders should think about the long term.
First, they should consider the relative contributions that each person will be making. While everyone says they are “all in” at the start, are they quitting their jobs, have they invented something, or 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? These are all items to get clear on 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”, that you vest into over time.
Additional terms of founder stock can include some elements of what is typically in a 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 so special consideration should be given as to whether such terms are reasonably obtainable.
Cash investors at formation typically receive a convertible note, a simple agreement for future equity, or series seed preferred stock. Some founders put in cash at formation, and structure the cash investment in one of these instruments.
Who gets what. There are four groups of people that can typically get equity in the early stages: founders and co-founders, advisors, investors, employees and consultants. Who gets what is more art than science, and there is no simple answer. Numerous websites abound with 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. There can also be restricted stock units, restricted stock awards, phantom stock and a large assortment of hybrid instruments. In early stage and venture-backed startups, the currency is typically 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 would be 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 vest over time. In the case of founder equity, it 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, and then vests monthly or quarterly thereafter until the expiration of four years from formation. Sometimes repeat entrepreneurs can obtain equity without 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, and they 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 the expiration of four years from the initial vesting date. In order to exercise them, the holder pays the exercise price, which for tax purposes must correspond to fair market value upon the date of 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 are using 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 allows a safe harbor that the service would not challenge the exercise price being below fair market value (and the negative tax consequences associated therewith) if a third party independent valuation firm established the fair market value, and this was approved by the board of directors, all within the prior year of grant. While there is a lot of 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 challenge that the option was granted at below fair market value, and impose a greater level of tax on the income or gain.
When things change. After your company’s formation is complete, the founder equity has been cut up, 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 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 are going sideways? Management carve-out plans can help incentivize people to struggle through a tough spot.
Founder break-ups and departures. When founders leave, the first question that gets asked is whether the equity is vested and what happens to it. If unvested, the company should repurchase it at 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 give 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, investigated and 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 out 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 probably need to get along in order 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 are the universe of potential strategic and financial buyers? Or 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 a 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.
While sometimes things fall apart, you have to know how to keep things together enough to get to the next off-ramp.
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.
Disclaimer: The views, thoughts, and opinions expressed in this press release belong solely to Louis Lehot. By using this site you confirm that there is no attorney-client relationship. This website should not be used as a substitute for legal advice and is not a substitute for seeking advice from a licensed attorney in your jurisdiction. The news site hosting this press release is not associated with Louis Lehot. It is merely publishing a press release announcement submitted by a company, without any stated or implied endorsement of the lawyer, information, product or service.
About L2Counsel
Louis Lehot is the founder of L2 Counsel, P.C., an elite boutique law firm in Palo Alto, California, established to serve a gap in the market for innovators, disruptors, entrepreneurs and their investors with strategic solutions that make sense. Whether your company is two people just getting off the ground, or a large publicly traded company, Louis Lehot’s team has the experience and expertise to serve your interests. L2 Counsel specializes in representing high growth, innovative companies, helping them at all stages of development. From assisting with formation to financing, from seed or venture capital investors, to preparing for an exit, a public financing on a major international joint venture, Louis takes pride in assisting companies as they grow. Helping a business get big, go public, or get acquired, is his specialty. Louis has worked across sectors, from artificial intelligence, cybersecurity, fintech, enterprise software, real estate, life sciences, to clean energy technologies and projects. His broad experience uniquely positions him to provide tailored advice to drive outcomes for his clients. Louis is widely known for his expertise in cross-border transactions and has been a prominent business and legal leader in Silicon Valley. L2 Counsel is positioned to serve innovators across a wide range of sectors and Louis welcomes conversations to help ideas reach their growth objectives.