McStartup

This next question comes from Brian, who has had a problem in the past with a member of the founding team getting cold feet after the venture was started, and then refusing to give up the equity he had been given.  In this particular case the founder in question hung around with substantial equity, held bitter feelings toward the rest of the team, and made funding awkward and difficult.  His question pertains not to his current situation, but how to avoid it in the future.

Brian writes:

How should we structure the founders equity so that we don't get stuck in a situation where a founder leaves and keeps all his or her stock?

This is an area that many startups, especially when founded by first time entrepreneurs, don't even think about.  They decide how the company should be split up, dole out the shares of stock, and proceed down their happy path.

This is great, until someone decides to leave early, or otherwise makes a troublemaker out of themselves.

The solution is really quite simple, but isn't obvious unless you've dealt with it before.  You can create "Founders Shares" which are really just common shares but are subject to certain restrictions you would not have as a simple shareholder.

These shares are made subject to a "right of repurchase in favor of the company" which is a fancy way of saying that, if you leave, the company has the right, at its sole discretion, to buy the shares back.  These restrictions then "lift" over time, meaning that as time goes on, fewer shares are subject to this repurchase agreement.

For example, lets say that Bill has 1,000 shares of common stock, subject to the founders stock agreement.  Under this agreement, all of his shares are subject to repurchase at any time if he leaves the company (or is fired).  At the same time, 250 shares per year will have their restrictions lifted, provided old Bill here is still with the company.

Ok, so in month 26 of his tenure with the company, Bill has an epiphany, decides to become a ninja, and moves to a monastery in a remote part of Japan to begin his studies.  Good for Bill.  In this case, Bill has been with the company for just over 2 years, so he has 500 shares (250 for each year) free and clear of any founders restrictions.  He keeps those, and the company buys back, at the current share price (or at a previously agreed upon price, maybe what he paid for them) the remaining 500 shares.  Bill is happy with his new ninja friends, and the company is happy to have parted ways in a fair and amicable fashion.

Basically, the founders shares end up working like employee stock options that vest over time (and if you aren't' clear on that, then just ask and I can go into it).  There are two key advantages, however, that favor the founders using this restricted stock format.  One, the founders agreement should state that the owner of the restricted stock can vote their shares as though they were not under any kind of restriction.  That means that, so long as Bill is still with the company, he can vote all 1,000 of his shares even though most or all of them might still be subject to restrictions.  The second is that, because Bill actually bought the shares, his holding period of tax purposes begins at the company's founding, as opposed to (if he held employee stock options), when he exercised those options.  

While most founders are hardly worried about tax consequences at day 1, this is still something worth considering.  If the company is purchased and cash is given for the shares, then you'll be much happier to be in the 15% long term capital gains bracket than at the much higher short term capital gains bracket.  

Finally, founders agreements will often contain accelerators in the event of a liquidation or sale of the company.  For example, say that in year one, Google comes along and buys your company.  From our example, Old Bill had 1000 shares, yet all of them are still subject to repurchase by the company.  Is the evil board of directors going to fire Bill immediately prior to the acquisition, so that it can purchase his shares back for cheap, pocket the cash, and leave Bill hung out to dry?  Unlikely, but it could happen.  This can be addressed by including accelerators stating that, immediately prior to an acquisition or liquidation, or upon termination immediately preceding such an event, all restrictions (or a portion of them) lift.  With this little gem, even if they give Bill the axe (they didn't like his infatuation with ninjas anyway), he'll get to keep his shares because of the accelerators.

You can also do with with your employee stock options if you like, however you need to be careful because a company that acquires you isn't going to want all your employees bailing on day one because they've all received their stock.  Again, employee stock option structuring is probably for another question, but you have to balance what you give to your employees vs. what you can actually make work in the real world.  They are many examples of mergers that didn't go through because the stock options were structured in a way to put all the risk on the acquiring company, and it's just not worth it.

I hope this is helpful.  As always, if there are follow-up questions, ask away.