Founders’ Equity: Vesting, Dilution, and Other Common Issues

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

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

3. 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)

4. 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.

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

6. 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.

7. 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 10,000,000 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.

8. 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%

9. 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

10. 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

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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. Stock Options: Types Non-qualified Stock Options (“NQSOs”) 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

19. 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

20. Founders’ Equity: Vesting WHAT IS IT VESTING SCHEDULES

21. 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

22. 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

23. 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

24. 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

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

26. 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

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

28. 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

29. 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

30. Appendix

31. 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 $1,000,000 of income that will be taxed at the ordinary rate • Must file within 30 days of purchasing shares