Avoid Founder Equity Missteps That Can Cause Long-Term Headaches

By Dustin Rickett

For many new businesses, startups especially, equity grants are often the primary method of compensating founders for their hard work building a business in its earliest stages. Given the importance of these grants, it is paramount that founders ensure they comply with applicable corporate, securities, tax and other laws to avoid headaches that may not surface until far later in the company’s development.

Below are a few non-exhaustive pieces of advice to founders to avoid key mistakes that can be difficult and costly to fix down the road:

1.       Ensure that equity grants are approved by the board of directors. The board of directors must approve every issuance of a company’s securities, full stop. So make sure that there are either clearly drafted resolutions or written consent approving founder grants. On a related note, also make sure that there is clear evidence of who the initial directors are (this is typically done through a consent by the incorporator of the company during its incorporation).

2.       Make grants pursuant to written stock purchase agreements. A well-written stock purchase agreement clearly outlines the terms of founder stock grants, including the consideration paid for the stock, vesting provisions, and a company right of first refusal. Founders will typically want to pay at least a small amount for their initial grants, and they typically also assign their intellectual property to the business. Note that merely providing future services to the company is not a valid consideration in many jurisdictions. Having clear and binding vesting schedules is extremely important for early-stage companies. The reason is that if a founder leaves shortly after the company’s incorporation, the company and other founders will want the ability to claw back most, if not all, of such departing founder’s stock.

3.       File an 83(b) election for vesting stock. If a founder’s stock is subject to vesting, then by default, they will be taxed on the difference between the price they paid for the stock and the value of the stock as it vests. The more successful the company becomes, the more of a tax obligation this will create for founders. To get around this potential problem, founders can file an 83(b) election with the IRS to be taxed on the entirety of the grant on the date it is issued. During the very early stages of a company, this will likely create de minimis tax obligations. Note, however, that you only have thirty (30) days from the date of grant to make the filing. If you miss that deadline, you are generally out of luck. Make sure to consult with your attorney and/or CPA for assistance with making the filing. 

4.       Ensure that the company is still complying with applicable labor laws. Many founders believe that employment laws, such as the Fair Labor Standards Act (FLSA), do not apply to them since they are the company’s owners, not employees.  This is not always the case. If founders provide services to the company, they may still be classified as employees even if they own stock. If a founder owns less than 20% of the company or is not actively engaged in its management, the minimum salary requirements in the FLSA can still apply, and not all states have similar exemptions.

5.       Be cautious when bringing on new founders. It is not uncommon for the initial founders to bring in a new person as a “founder” after the company’s incorporation to fill in skill gaps. However, be aware that granting equity to “future founders” requires a more complicated analysis of securities laws, and future founders may be “taxed out” of receiving grants if the company already has a sizable valuation.

It is always in the best interests of founders to hire a knowledgeable attorney to assist them with the incorporation of the company and its initial organization. There are many aspects of the law that founders are unaware of, and certain mistakes can lead to the grants being void, which means that founders might not own any stock of the company at all. Most, though not all of these mistakes can be fixed, it almost always costs magnitudes more than having an attorney set up the company correctly at the outset.