Founders’ Stock – File Your 83(b) Election
Simple rule to follow: If your founder’s stock “vests” (and I recommend that in most cases it does), you should file an 83(b) election with the IRS to avoid some very unpleasant tax consequences.
Section 83(a) of the Internal Revenue Code provides that a founder will not recognize income until the founder’s stock subject to vesting actually vests (income in this case being the difference between the price paid for the founder’s stock – presumably a fairly low price – and the fair market value of the founder’s stock on the date of vesting). Vesting in most cases occurs over an extended period of years, resulting in the likelihood that the spread between purchase price and fair market value will increase (perhaps, significantly) over the vesting period. Let’s look at a quick example to help quantify the potential problem.
Founder A purchases 100,000 shares of common stock of the startup at formation, pays $0.01 per share (determined to be roughly equal to fair market value on formation, since the startup is merely a business plan with no valuable contributed or developed assets on formation), and has his stock subject to four year vesting with a one year initial cliff (i.e., no vesting of any stock until the one year anniversary of the grant date, with monthly vesting thereafter). On the one year anniversary of the purchase date, let’s assume that the common stock of the startup is worth $.50 per share. 83(a) of the Code provides that in such case the founder recognizes $0.49 per share of income on the one year anniversary of the purchase date (25,000 shares vested x 0.49 = $12,250 of income on such anniversary), and the founder will continue to recognize income thereafter on a monthly basis equal to the difference between the fair market value of the stock vesting in such month and the original $0.01 purchase price. Yes, the founder needs to pay ordinary income taxes and the employee’s share of FICA taxes on these amounts as if the founder received such amounts in cash. In addition, the startup is required to pay the employer’s share of FICA tax on such income and to withhold the employee’s applicable taxes. Ouch!
This problem is solved, however, if the founder makes a voluntary Section 83(b) election with the IRS. A Section 83(b) election taxes the founder on the difference between purchase price and fair market value of the founder’s stock on the date of grant, instead of taxing the founder on the spread as the founder’s stock vests. Since founders will typically set purchase price for founders’ stock at fair market value (both typically being nominal at the formation stage of a business), there is no recognizable income. Problem solved.
Critical Timing: For an 83(b) election to be effective, the founder must file his Section 83(b) election with the IRS within 30 days of the purchase date. There is no extension period here – this is a use it or lose it election and it must be timely and properly filed to be effective.
Preparing the election. An 83(b) election need not be on any special form – you simply need to incorporate the right information into an organized format and send the information to the right people. The necessary information includes: (i) taxpayer name, address and social security number, (ii) a statement that the taxpayer is making an 83(b) election, (iii) a description of the stock received, and the nature of the restrictions on the stock, (iv) date of receipt of the stock and the tax year for which the election is applicable, (v) the amount, if any, you paid for the stock, (vi) the fair market value of the stock on the date received, and (vii) a statement that copies of the election form have been provided in accordance with applicable treasury regulations. An example of this form is set forth below:
Election to Include in Gross Income in Year of
Transfer of Property Pursuant to Section 83 (b)
of the Internal Revenue Code
The undersigned (the “Taxpayer”) hereby makes an election pursuant to section 83 (b) of the Internal Revenue Code with respect to the property described below and supplies the following information in accordance with the regulations promulgated thereunder:
- The name, address and taxpayer identification number of the Taxpayer are:
Name: Mr. John Founder
Address: 1 Startup Way
Princeton, NJ 08540
Taxpayer I.D. No.: XXX-XX-XXXX
2. Description of property with respect to which the election is being made: 100,000 shares of Common Stock, par value $.01 per share (the “Shares”), of Startup Inc. (the “Company”).
3. The Shares were transferred to Taxpayer on [April 1], 200[9].
4. The taxable year to which this election relates is calendar year 200[9].
5. Nature of restrictions to which the Shares are subject:
Termination. If, on or before [April 1], 20[12], the Taxpayer is terminated as an officer of the Company, or the employment or consulting services of the Taxpayer is terminated by the Company, for “Cause”, or if the Taxpayer voluntarily resigns, for reasons other than “Good Reason”, the Company has the option to repurchase from the Taxpayer a specified percentage of the Shares for $.01 per share.
6. The fair market value at time of transfer (determined without regard to any restrictions other than restrictions which by their terms will never lapse) of the Shares is $.01 per share.
7. The Taxpayer paid $.01 per share for the Shares.
8. A copy of this statement has been furnished to the Company.
Dated: _________ __, 200[9] ___________________________
Signature of Taxpayer
Filing the election. As mentioned above, the key consideration on filing the election is that is must be made within 30 days of the purchase of the founder’s stock. After the election form is prepared, you will need to (i) send the election to the IRS office where you file your individual tax return (the instructions to Form 1040 provides guidance on this mailing requirement), (ii) provide a copy of the election to the startup company that granted you the stock, and (iii) attach a copy of the election form when you file your income tax return for the applicable year of the election.
Important Note: Section 83 of the Internal Revenue Code applies to the receipt of restricted stock and other securities subject to forfeiture restrictions after the initial formation of a startup. In such situations, the analysis regarding whether to file an 83(b) election is likely to be more complex depending on the then current fair market value of the securities received and the nature of the forfeiture provisions. The analysis above is only focused on the typical founders stock situation.
Founders’ Stock – Dividing the Pie
I am often asked by founders to help provide some guidance in connection with dividing up the initial equity of a startup among the founding group. Here are some thoughts.
My advice starts with the need for the founders to understand that there are no rigid rules in allocating equity among founders – the best approach is one that (i) balances the pre-formation and anticipated future contributions (cash, property, IP, intellectual capital and effort) of each founder, (ii) provides each founder with incentives for hard work and retention over an extended period of time, (iii) recognizes other opportunities that founders may have given up to participate in the startup, and (iv) divides the anticipated future awards of the business “fairly.” Key point: don’t be greedy. Each founder has an interest in balancing the factors above in a way that all founders feel is “fair,” with the result being a founding group that is motivated and aligned in their interests and in their desire to work together in a highly collaborative manner. Importantly, note that “fairness” does not necessarily mean each founder gets the same ownership percentage – it just means that the all founders “feel good” about how the group balanced the factors above to get to the final allocation of stock among the founders.
Best to have this discussion as early as possible in the process of developing a business so that misalignments among the founders, if any, can be identified and addressed. Such a discussion should also include a discussion about vesting of the founders stock (see my post on the importance of vesting of founders stock). The objective here is to get all founders on the same page (from an ownership standpoint) as early as possible in the business development stage. Importantly, addressing these matters early helps to avoid the “lost founder” problem – namely, a person who materially contributed to the development of the business but was cast aside or voluntarily departed before the startup was formed and the equity was allocated. Such a person carries with him or her the potential to bring a claim against the startup at some point in the future (as you might imagine, this will often occur at the worst of times, such as when the company is closing a venture round or proceeding towards a sale or IPO) alleging that such person “earned” a piece of the company by virtue of his/her material contributions to the business prior to formation. Obviously, this is a problem to be avoided.
Consideration should also be given by the founders as to how they intend to incentivize future employees with an ownership stake in the business. At the outset, the founders will collectively own 100% of the capital stock of the startup (obviously, there being no other owners of the business upon formation other than the founders). Shortly thereafter, however, the startup will need to bring on additional key employees and will likely need (and want) to incentivize them with an ownership stake in the startup. An option or other form of equity plan is often established upon formation that anticipates the equity to be granted to these key hires and sets aside a portion (often between 15-30%) of the ownership of the business for this purpose. As equity is allocated out of this plan to key hires, the founders’ ownership interests in the company become diluted. As a result, the founders should consider how such dilution will impact the founders’ initial ownership allocation – again, with the goal of making sure that all founders fully understand their ownership stakes in the startup and the fact that such ownership stake will be diluted over time by new hires and, of course, in capital raising transactions.
Founders’ Stock – The Importance of Vesting
For most startup companies, vesting of founders’ equity – whether over time, based on achievement of defined business milestones, or some time/milestone combination – is a necessary means to properly align the interests among the founders and between the founders and the company’s future investors.
Simply put, “vesting” means that the founders must continue to earn their founders’ equity after the startup company is formed and the slices of equity pie are initially divided up among the founders. Typically, this is accomplished by the company retaining a right to repurchase the founders’ equity at a nominal price (presumably, the same nominal price paid by the founders for their equity) with such repurchase right lapsing in portions over a period of 2-4 years and/or, in somewhat less common cases, upon achievement of certain business milestones (e.g., launch of beta version of website; development of initial product prototype; etc.). Why is this important? Let’s take two simple examples:
Example 1: Four founders start a company and split the equity in equal portions – 25% each. All four founders contributed a fair amount to the development of the business plan and the company’s technology platform prior to formation, but as is always the case there is an enormous amount of work still to be done before the company can hope to be funded. Six months after formation, one of the founders leaves for a different opportunity (or any variety of other reasons). Should that founder retain the same 25% ownership as the other founders who, presumably, will continue to work long hours in an effort to add value and build the startup? Obviously, not. The departing founder, as with the other founders, should be subject to vesting and a portion of the departing founder’s equity should be repurchased by the company, effectively reallocating the equity among the founders to achieve a different ownership allocation that reflects the continuing investment of time and effort by the founders who remain with the startup.
Example 2: Same four founders as above, with the same initial ownership allocation but nobody has left. An angel investor is considering providing a few hundred thousand dollars of seed financing to the startup company 9 months after formation. Should the angel investor make this investment if the founders are not subject to vesting and, in a highly unlikely but still possible scenario, one or all of the founders can depart with their initial equity stake intact leaving the angel investor with holes in the business team he invested in? Obviously, not. The angel investor has similar interests to the founders when it comes to vesting of founders stock. At this early stage of development, the angel investor is investing much more in the founding team and their future efforts to effect a business plan and much less in what has been developed so far. The angel investor will want, and will often demand, that the founders’ equity vest over some extended period of time to help ensure that the founders remain committed to the startup for years to come.
I kept the two examples above fairly simple to make the point, but even when the facts are fairly nuanced the point remains true – in most cases when there is more than one founder and/or when a startup will seek investment capital, vesting of founders stock is an important tool to properly align the incentives and interests of the key players in a startup company.
For Princeton Entrepreneurs…
As you can quickly read from my bio, I have spent a fair amount of time working with the entrepreneurial community in and around Princeton. As a lawyer, I have been asked and have answered many questions over the years relating to startup company matters and have had to address and resolve a significant variety of issues. My goal with this blog is to build a resource that will hopefully answer many of these questions and resolve or avoid many of these issues, all in an effort to help empower entrepreneurs.
I am just getting started, so stay tuned as I build.
