What is Founders Stock?

What is Founders Stock?

Typically, the company issues founder’s stock for a nominal cash payment. This may be as low as $0.0001 per share. The company may also issue founder’s stock for assignment of intellectual property.

Founder’s shares are common stock shares. In most cases, startup companies issue them at the time they incorporate. The shares are issued at very low prices and are normally allocated to the initial players or founders. The amount of shares they receive is commensurate with their role in the company and/or the amount of their investment.

While the shares are allocated and committed, they’re not actually issued and owned (vested) until a later date. Startup companies often put some stock restriction agreements in place with each founder in order to ensure that the stock issued to the individuals is properly “earned” by these founding stockholders.

In most cases, founder’s stock is set on a vesting schedule. This provides the company the chance to buy back unvested stock shares in the event a founder leaves the business before his or her shares are fully vested. Usually, vesting in startup companies occurs every month over a four-year period, beginning with the first 25 percent of founder’s stock vesting only after an employee has stayed with the company for a minimum of 12 months — known as a one-year “cliff.”

When an employee leaves the business, vesting always stops.

Whether founder’s stock has the same rights as other equity interests in a business depends on the agreement between the company and the founder, made either when the stock is issued or at a later date.

The rights may include the following:

  • Vesting and co-sale provisions
  • Right of first refusal
  • Accelerated vesting upon the sale of the business
  • Super-voting rights
  • Lock-up agreement

It’s common to find special clauses because the involved parties want to minimize the dilution of shares.

Why Consider a Vesting Schedule for Founders Stock

As already mentioned, one unique characteristic of founders stock is that it comes with a vesting schedule. The schedule determines the exact time that shareholders are allowed to exercise their stock options. For instance, if an individual owns shares vested over a five-year period, it means that they become exercisable after five years. As such, the shareholder would need to work for the firm during that period, or simply wait out that period, before they are allowed to exercise their stock options.

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But why would an individual consider a vesting schedule for their founders stock? Two reasons: one, if one of the early founders chooses to leave or is asked to leave when the company is still young, a vesting schedule helps to protect the other founders from the “free rider” problem.

Although most founding teams remain united at least to the point of, for example, an IPO, it is not unusual for one or more of the founders to part ways. When such an event happens, a vesting restriction ensures that the departed founder does not get any more benefits resulting from the efforts of those who remain to build the firm.

Secondly, a vesting schedule is prepared if the company is expecting a future investment such as venture capital or angel investors who usually ask for these kinds of vesting restrictions. An individual may decide to wait up to the time of investment to address the issue.

The drawback for the founders playing the “wait and see” game is that it puts them at risk of not getting fair allocations of company equity. The investors who put their money into the firm later may come up with a more onerous proposal of how to divide equity, as compared to the one that the founders would’ve created if they were on their own.

Why is Founder’s Stock Issued?

A point to note is that founders stock is not a legal term in itself. Therefore, one won’t find any such things in the corporate code or any other legal document. Instead, the term has come in use to describe the shares given to the early participants in the formation of a company.

Thus, the company’s founders could include initial founders, early directors, partners, and first investors. Basically, these are the persons responsible for transforming the idea of a company into a reality. To compensate such people, a company issues founders stock to them.

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As said before, the company issues such shares at a very low value, and each founder gets a significant percentage of shares. A company is able to do so because when it issues such shares, it hasn’t yet started the business.

After the start of the business, a company may give new team members stock with the same characteristics. Such stocks are also often called “founders.” However, it gets difficult for a company issues these shares at par. Therefore, after incorporation, companies normally close the “founder” class of stock.

Characteristics of Common Stock

All for-profit corporations are required to issue at least one class of stock shares to owners. At the time of incorporation, common stock may be the only stock authorized under the articles of incorporation or it may be issued in conjunction with other classes of shares. The corporation will issue additional classes of shares if necessary for a particular purpose, such as an equity financing round.

Stock is a power tool for the corporation. It is the method by which a corporation receives initial financing. Further, it may comprise a significant portion of the compensation paid to early company employee. Interesting, common stock is often referred to as founder’s stock when it is issued to the individuals comprising the company’s leadership at the time the company forms or reorganizes as a corporation. The name seeks to identify the time period at which the common stock is issued.

The number of shares authorized in the articles of incorporation will vary depending upon the nature and objectives of the companies. A company that plans to use stock as form of compensation will issue more shares than a company that does not. Common stock is generally issued at a very low par value. There are numerous tax reasons for this fact. Issuing stock at a low par value indicates that the shares are not valuable at the time of award.

If awarded as compensation, this can avoid a situation where employees receiving the stock are forced to recognize much income upon receipt. Often, existing shareholders or third parties will continue to use the term founder’s stock with the intention of purchasing common stock at the price (generally very low) and under the conditions (discussed below) that it was granted to company founders. Tax law generally profits this, but the phrase continues to be used in this way anyway.

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Features of  Common Stock

  • It is generally a large percentage of stock that each individual founder gets.
  • A company issues such stocks at a nominal price, usually at the par value.
  • These represent the initial compensation to the founders.
  • Such stocks come with a vesting schedule.
  • A company may buy back unvested stock at cost if the founder leaves the company for any reason.

Different From Common Stock

Apart from the fact that a company issues such shares at a very low price, there are more differences between the common stock and founders stock. These differences are mostly in terms of dividends and other rights.

Such shares receive dividends after paying the common stockholders. However, such shares usually have the right to all the profits after paying the dividends to the ordinary shareholders. But, this is not always the case.

Whether or not the founder’s stock gets the same rights as other common stockholders depends on the agreement between the founder and the company. Some of the exclusive rights that such shares may get are super-voting rights, right of first refusal, lock-up agreement, accelerated vesting upon the sale of the business, and co-sale provision.

Under the ‘right of first refusal,’ a founder must offer their shares to the company first before selling it to a third party. In ‘co-sale provision,’ the founder gets the right to add their shares if the company is issuing additional common shares.

Under super-voting rights, founders get more than one vote per share. This is important if early founders plan to retain control over the company. A “lock-up agreement” limits the sale of the stock for some time after the IPO. The lock-up is usually for 180 days.

A company may include other special clauses after the discussion with the founder.