Founders Equity Vesting Dilution and Other Common Issues

Founders’ Equity: Vesting, Dilution, and Other Common Issues PRESENTED BY BOSTON UNIVERSITY SCHOOL OF LAW STARTUP LAW CLINIC JAMES BLACK & KEITH NEMETH

Founders’ Equity: Overview WHAT IS FOUNDERS’ EQUITY? WHY IS IT IMPORTANT?

Overview - What is Equity? ▶ Ownership of a company ▶ It takes different forms depending upon the entity: ▶ Corporation ▶ Common Stock (shares) ▶ Limited Liability Company ▶ Member Interest (percentage or units)

Overview - Why is Equity Important? ▶ Compensatory ▶ Attracting and retaining employees ▶ Incentives for founders and employees ▶ Replace cash compensation with non-cash benefits ▶ Fostering an ownership mentality ▶ Employees have a stake in the well-being of the company ▶ They will have a greater incentive to help the company succeed.

DIFFERENCE BETWEEN AUTHORIZED AND ISSUED SHARES Founders’ Equity: Categories WHO RECEIVES EQUITY WHAT TO CONSIDER WHEN TO ALLOCATE EQUITY

Authorized Shares v. Issued Shares ▶ ▶ Authorized shares are the number of shares a company is legally allowed to issue. ▶ Located on the certificate of incorporation. ▶ We recommend authorizing a smaller amount as it lowers taxes. Issued shares are authorized shares sold to and held by the shareholders of the company.

Authorized Shares v. Issued Shares (Continued) ▶ ▶ ▶ Hypo 1: ▶ Company authorizes 5, 000 shares ▶ Founder 1 owns 1 share and Founder 2 owns one share ▶ Founder 1 and Founder 2 each own 50% of the company. Percentage of ownership is based upon the number of issued shares, not authorized shares. Hypo 2: ▶ Company authorizes 10, 000 shares ▶ Founder 1 owns 20 shares, Founder 2 owns 20 shares, and Founder 3 owns 10 shares. ▶ Founder 1 and Founder 2 own 40% of the company and Founder 3 owns 20% of the company.

Equity Allocation ▶ ▶ ▶ Create three categories to allocate authorized shares into: ▶ Founder group ▶ Investor Group ▶ Option pool group (directors, advisors, and employees) (will remain unissued) Pre-series A funding share allocation ▶ Founders: 50 -70% ▶ Investors: 20 -30% ▶ Option pool: 10 -20% Post-series A funding share allocation ▶ Founders: 20 -30% ▶ Investors: 50 -70% ▶ Option pool 10 -20%

How Much Equity Should They Receive? ▶ ▶ ▶ Founders ▶ Original, innovate ideas? ▶ Intellectual property ▶ Capital ▶ Commitment to company ▶ Skill sets Advisors ▶ Providing guidance or strategic vision? Key employees ▶ Incentivizing early key hires with points of equity

When To Split Equity? ▶ Splitting equity early ▶ Lower stake negotiations ▶ Helps to attract quality team members ▶ Lower value of equity grant ▶ But risks making grants to employees who are not as committed as expected ▶ Splitting equity later ▶ Greater incentive to perform at a higher level ▶ Team dynamics have formed ▶ Roles are established ▶ But equity may have appreciated

Founders’ Equity: Categories EQUITY IN DIFFERENT ENTITIES TYPES OF EQUITY INTERESTS

Entities and Their Equity Interests ▶ Corporations ▶ Shareholders ▶ Common ▶ Non-Voting ▶ Preferred ▶ Share of profits and losses through dividends ▶ Double taxation ▶ Corporation is taxed ▶ Dividends are taxed

Entities and Their Equity Interests ▶ Limited Liability Companies ▶ Membership ▶ Capital contribution ▶ Can be made in cash or non-cash ▶ Share a percentage of profits and losses ▶ May choose to be taxed as either a partnership or corporation

Founders’ Equity: Compensation WHAT IS EQUITY COMPENSATION? TYPES OF EQUITY COMPENSATION ISSUES WITH EQUITY COMPENSATION

Equity Compensation: Overview ▶ Non-cash compensation that offers an ownership stake in the company ▶ ▶ ▶ Otherwise known as “Sweat Equity” Reasons: ▶ Attract and maintain employees ▶ Cash is in short supply Most Common Types: ▶ Restricted Stock ▶ Stock Options

Restricted Stock ▶ Shares that are subject to legal restrictions ▶ Certain conditions must be met before the recipient can to sell shares ▶ ▶ Time-based or performance-based Actual shares issued by the company ▶ Therefore holder has voting and other ownership rights from grant date ▶ Subject to forfeiture ▶ Restricted stock becomes unrestricted once any conditions are met ▶ Generally, this occurs incrementally rather than all at once

Stock Options ▶ ▶ ▶ Right to purchase a set number shares in the future at a fixed price No shares issued at the time of a stock option grant ▶ Therefore, no voting or other rights exist until the option is exercised ▶ However, the company must keep shares available for the option period Any benefit realized to the option holder depends on the difference between the value of the stock over the option price ▶ If stock’s value is equal or less than the exercise price, stock options are worthless Typically have an expiration date (can be months or several years) Types: ▶ Incentive Stock Options ▶ Non-qualified Stock Options

Stock Options: Types Incentive Stock Options (“ISOs”) ▶ Preferential tax treatment ▶ Only for Employees ▶ No income tax owed when the option is exercised, as long as IRS holding requirements are met ▶ Makes ISOs eligible for more favorable capital gains treatment Non-qualified Stock Options (“NQSOs”)

Equity Compensation: Issues ▶ Disappointing Performance ▶ Early founders may lose focus or dedication as months or years go by ▶ Burdensome and complex securities law compliance ▶ Phantom Income ▶ Lack of Transferability ▶ Particularly a concern for private companies and restricted shares

Founders’ Equity: Vesting WHAT IS IT VESTING SCHEDULES

Vesting ▶ ▶ Vesting is the process of gaining full legal rights to shares or options ▶ Unvested shares are subject to forfeiture back to the company ▶ Shares that vest are not subject to forfeiture or lapse Addresses concerns discussed previously regarding shareholders who begin to disappoint or decide to leave the company early ▶ E. g. Free Rider Problem Vesting requires founders to earn equity Two models: ▶ Time-based ▶ Performance-based

Time-Based Vesting ▶ ▶ Time-based vesting schedules give the holder full legal rights over incremental amounts of shares according to a set schedule ▶ Shares typically vest either monthly or quarterly over 3 -4 year period Will often include a “cliff” ▶ A designated length of time before any shares vest at all ▶ For example, Employee is granted 4, 000 shares subject to a 4 -year vesting schedule and a 1 -year cliff ▶ Employee will receive 1, 000 shares after 1 year ▶ And, no shares if they leave after 11 months ▶ The remaining 3, 000 shares will be evenly distributed over the remaining three years

Performance-Based Vesting ▶ Vesting that occurs upon the achievement of specified milestones ▶ Shares vest upon the occurrence of key events in the future ▶ Examples include: ▶ First shipment to a customer ▶ Achievement of certain sale/revenue figures ▶ Threshold number of users ▶ Development of first prototype ▶ Structure will be closely tailored to the type of business and stage of development ▶ Milestones should be clear, easy to measure, and unambiguous

Vesting Schedules: Acceleration Events ▶ Acceleration events cause all unvested shares to automatically vest, subject to the occurrence of one or more defined events ▶ Types ▶ ▶ Single Trigger ▶ Double Trigger Common Acceleration Events: ▶ Sale of company ▶ Merger ▶ Termination ▶ Change in control

Founders’ Equity: Restrictions on Sale WHAT IS IT COMMON TYPES

Restrictions on Sale: Overview ▶ Limit on a shareholders ability to freely dispose of his or her shares ▶ Restrictions enforced after one gains full legal right to vested shares ▶ Common Examples: ▶ Right of First Refusal Company, Founder, or Other Shareholders ▶ Drag Along Rights Primarily benefits majority shareholders ▶ Co-Sale Right Primarily benefits minority shareholders ▶ Lock-up Agreement Primarily benefits new investors

Founders’ Equity: Dilution WHAT IS IT WHAT TO BE AWARE OF

Dilution ▶ ▶ Typically, founders’ equity is diluted as additional shares are issued to new founders, employees, or investors As the number of outstanding shares increases, the percentage ownership of each shareholder goes down if the number of their shares remains constant Good Dilution: ▶ Occurs where equity percentage decreases, but outside investment increases the overall value of the company and the price per share Bad Dilution: ▶ Occurs where new shares are issued to employees who neither pay for the shares, nor add any value to the company

Questions? ▶ Set up an appointment with the Clinic for more information. ▶ ▶ https: //sites. bu. edu/startuplaw/ What can we do to help? ▶ Advice regarding equity allocation ▶ Drafting founders’ equity agreements ▶ Reviewing investment offers ▶ And more

Appendix

Vesting: 83(b) Election ▶ Important for companies whose par value per share is very small today ▶ Beneficial Tax Treatment: ▶ ▶ Ordinary Income vs. Long-Term Capital Gains Allows recipients to pay taxes on current (rather than future) value of the stock ▶ Employee receives 1, 000 shares with a par value of $0. 01, subject to a 4 -year vesting schedule with a 1 -year cliff. One year from now, shares valued at $1, 000 ▶ ▶ ▶ If 83(b) election is filed, employee will be recognize $10 of income today. Shares sold in the future will be taxed at capital gains rate when sold If no 83(b) election is filed, employee will recognize $0 of income today. One year from now, when shares vest, employee will recognize $1, 000 of income that will be taxed at the ordinary rate Must file within 30 days of purchasing shares