Why is understanding equity so important?
Equity is ownership in the economic returns from a business and a measure of influence over how it conducts its affairs. Founders and employees of startups should understand how equity functions because it forms an important part of how voting power is distributed within companies and how returns are structured throughout the startup ecosystem. Bluntly: if you don’t understand how equity works, you will work for people who do.
By the end of this guide, you’ll understand:
- how to purchase stock as a founder of a newly incorporated company
- how vesting works and whether your company should adopt it
- why IP assignments are important in connection with stock grants
- why 83(b) elections are so impactful for startup founders
There are many places where you can innovate with your company, but legal practices are rarely one of the most fruitful places to spend your risk budget. Just do what your startup lawyers advise you to do. Details and timing really matter here.
Founders who start their company with Stripe Atlas can use our tool to issue stock to founders—for free—with legal templates from Orrick and terms that are standard among many tech startups and top investors.
This guide is most relevant for startup founders, immediately after they have incorporated a company. We’ll cover the treatment of equity for investors and for startup employees at a later date.
What is equity?
There are a variety of vehicles for equity; the most common is shares, which are simply units that represent pieces of the company.
A company will authorize a certain number of shares when it is incorporated (and, perhaps, authorize additional shares from time to time thereafter) and issue them periodically, in return for money, labor, or other valuable things.
Perhaps counterintuitively, founders of a company do not automatically own equity in it. Instead, they purchase their shares (often described as founder stock) from the company shortly after incorporation. As the company has almost no value immediately after incorporation, the shares will be very, very inexpensive. They are assigned a very low price (par value), perhaps on the order of $0.000001 per share. As long as the founder buys shares before any additional value is added to the company, the founder can buy those shares at par value without tax consequences for the founder and the company. It is in founders’ interests to purchase shares when it is obvious that the shares are still valued at par, as soon as possible after incorporation.
Then the founders, and future employees, go about the hard, necessary work of building the business. In addition to creating value in the world and satisfying customers, one goal of the enterprise is to make the business more valuable. This results in the equity in the business becoming more valuable, which provides a substantial portion of the economic returns to founders and employees.
Eventually, if the business is successful, it can be acquired (with each equity owner being compensated, generally in proportion to their ownership interest) or its shares can be traded publicly. These are called liquidity events, because equity in private companies is otherwise illiquid—it cannot be conveniently converted into money.
Equity is recorded on a capitalization table (or cap table), which is a spreadsheet showing who owns how many shares of the company. The cap table lists all founders, investors, employees, advisors, and ex-everything who own a stake in the company.
Since equity is generally awarded via contracts, it can carry terms with it (like vesting, described below) which materially impact how it will function for you.
How do you get equity?
You get equity by buying it from someone who is selling it on mutually acceptable terms.
In the special case where the someone who is selling it is a corporation you just created, you might have substantial latitude for what those terms are. If shares are purchased at the time of or immediately following incorporation, you’ll generally be purchasing at par value, a number which is very, very low relative to future values of the stock in any successful outcome.
Companies extract a few terms in return for selling equity to you and any co-founders. One is an IP assignment. This is generally a contract which clarifies that any intellectual property you create over the course of your employment with the company, and potentially related intellectual property you have already created related to the company, is the property of the company rather than you. The IP assignment for IP created during your employment is often formally called a Confidential Information and Invention Assignment Agreement, or CIIAA for short. Stripe Atlas has templates which include IP assignment in the Common Stock Purchase Agreement (to cover IP which predates the company) and a CIIAA for IP created during employment with the company.
Startups often condition purchasing any equity on execution of IP assignments. This is because IP assignment is extraordinarily important for startups to document correctly, as otherwise when a movie is eventually made about your company, it will likely include a subplot about how expensive fixing that problem was. Since founders and employees of startups generally very much want to receive their equity, gating it on IP assignments being signed means that the company reliably collects the signatures needed to establish IP ownership. It also means, by construction, that anyone owning equity in the company is unlikely to have an unresolved IP issue to later use as a negotiating lever against the company.
This is important to both have done and to be able to conveniently demonstrate you have done. Investors and acquirers do not want to take on the risk of working with a company with unclear IP assignments; that invites ruinously expensive lawsuits into their operations years after the fact. If you do not have a well-documented paper trail on IP, when they check your documents during due diligence (routine pre-transaction investigation into you and your company), fixing the paper trail will either cost you a lot of money and stress or it will kill the deal entirely. Don’t let this happen to you; get the contracts your lawyers give you signed, and then keep them in an organized and accessible fashion forever.
Equity generally isn’t simply awarded, it is traded, and it is important to document that an exchange of value for equity actually happened (to avoid unpleasant tax consequences). For founders at the company, who purchase shares at the time of incorporation, this will generally be an exchange of a nominal amount of money (par value times number of shares received) for the shares and/or an assignment of any relevant IP generated prior to the time of incorporation. (Founders that use Stripe Atlas to issue stock purchase their shares with a combination of money and IP.)
What is vesting?
Ownership in startups, both for founders and employees, vests over time; it isn’t awarded immediately on joining but rather accrues according to a pre-agreed vesting schedule.
There are a variety of reasons why startups choose issue equity subject to vesting. Mostly, it is about aligning incentives between the company, the person receiving the equity, and all other owners of the company. Value is created over a very long period of time; ownership of the company should be earned over that period, and not instantly. Otherwise, someone might leave early with substantial ownership that was not earned by producing substantial value.
Imagine a company with three founders. One of them leaves after 3 months. (This happens extremely frequently.) The other two work for the next six years and eventually build the company into a massively successful business that can be sold. Is it a fair or just outcome for each of those three founders to earn the same amount from the sale? No, it is manifestly unfair to the founders who stayed with the company. It is, in fact, so unfair that the depth of the impending unfairness might kill the company as soon as the first founder leaves.
This is an outcome that no one wants. The company would prefer to continue existing; its customers would prefer to continue being serviced; its employees would prefer to continue having jobs; its remaining founders would prefer to continue owning an equitable portion of it; and its departing founder would prefer to not see their work go to naught. Vesting might have prevented the collapse.
Vesting is a contractual right between a company and a person, and is as configurable as any other contractual arrangement.
It is frequently implemented in two parts for founders: awarding the founder shares upfront and, simultaneously, specifying conditions when the company may repurchase some or all of those shares at the cost the founder paid for the shares. The founder’s risk of losing some of the shares generally decays over time according to a vesting schedule, eventually reaching a point where none of the shares are at risk. The individual is then “fully vested.”
For founders, Silicon Valley companies often use vesting schedules where a portion of the shares vest after a fixed period and the remainder vests in equal amounts over a longer term. The standard vesting schedule among companies in the tech industry is “4-year vesting; 1-year cliff.” (This is also the default term for using Stripe Atlas to issue stock for a multi-founder company.)
The fixed period is referred to as the cliff: none of the shares are vested until the cliff date, at which point a significant number of the shares vest. Typically, the fraction of the shares that vests is equal to the fraction of the total vesting period represented by the cliff. Accordingly, under 4-year vesting; 1-year cliff, 25% of the shares vest upon the first year of service being complete.
The remainder of the shares typically vest in equal monthly increments over the remainder of the vesting period. With 4-year vesting; 1-year cliff, the remaining 75% is divided into 36 equal installments that vest monthly over the ensuing 3 years.
Some companies use variations on this vesting schedule, for example, lengthening the vesting period to 5 or 6 years or having the number of shares awarded per month be back-weighted (to incentivize staying at the company for an extended period). It’s important to read your legal agreements very carefully. Vesting math, including edge cases, generally has to be agreed upon in advance; fixing mistakes after a schedule has been agreed upon can be very, very expensive, particularly in the case where the relationship between the founders is strained, as it often is when they have parted ways and a substantial amount of money is on the line.
Why do companies choose to vest founders?
Founders may be reticent about accepting vesting, because it is a mechanism by which they can lose ownership interest in their own company. Investors and savvy co-founders, however, will generally require you to do it as a condition of doing business with you.
Vesting is particularly important for companies with multiple founders.
Founder relationships can be very intense because startups are intense. Your company will grow in new and unpredictable directions over the next few years, and founders may find themselves growing in ways that are incompatible with the direction of the company. Even best friends sometimes need to separate over the course of doing a company. Vesting gives a pre-agreed, orderly structure to deciding how that breakup happens. Without vesting, arguments over ownership and control after a founder leaves can result in the company disintegrating, leaving everyone (the company, founders who remain, and the founders who leave) worse off than if the company had divided interests in the fashion contemplated by a vesting arrangement.
Vesting is less important for solo founders, since it is unlikely the founder could leave the company and have it survive and be valuable. That said, you may want to consider adopting it anyway – investors will likely require it as a condition of investment (though you can negotiate the exact terms with them). You will also be able to show potential future employees that you are being equitable with regards to vesting their own equity grants; you were willing to do it to yourself, after all. If you choose not to impose vesting at the outset, you can always subsequently impose vesting on your shares with a stock restriction agreement.
Vesting agreements additionally protect the interests of founders and the company from the eventual desires of people who might take the founder’s seat at the table (often without the company’s permission). You might have total trust in your co-founders to optimize for the company’s interests at all times. Even if you do, if tragedy were to strike, their seat at the proverbial table could fall to their heirs or lawyers. Those new parties might not be as automatically supportive of the company’s interests or the wishes of the co-founders as the co-founder they replaced was. Vesting allows you to give an appropriate level of protection to both the future of your company and the rights of all stakeholders, including the new party, in the event someone joins the cap table unexpectedly.
You have limited bandwidth for hard conversations with your co-founders… and preparing contingency plans for every possible failure scenario would result in a lot of hard conversations. Silicon Valley standard terms account for experience with deaths, divorces, lawsuits, and acrimonious founder breakups, sometimes with billions of dollars on the line, and are robust against them, so why reinvent the wheel? Strongly consider adopting industry-standard vesting terms so you can spend your bandwidth on things which will actually make your company more successful.
What happens if a founder leaves before fully vesting?
In most cases, the company will elect to exercise the remaining portion of its repurchase right against any unvested shares the departing founder has purchased. It will do this in the manner specified in the relevant contracts; this may involve giving the founder written notice of the intent to repurchase their unvested shares and then paying back the price they paid for those shares.
Note that the amount paid to repurchase shares or options is not the current value, but the price originally paid for the shares—the repurchase won’t lead to a gain or loss. This means, for a founder who leaves before being fully vested, if their shares are repurchased, they will generally receive only a nominal amount of compensation for the shares.
For example, if a founder owns 4 million shares acquired at a par value of $0.00001 per share, and only 25% of them are vested, the company will repurchase 3 million shares for $30.
Companies should be very, very certain that payment is actually made for repurchased shares, even though the amounts will often be negligible. One very much would not want to discover during due diligence for an IPO that the company was light 3 million shares worth several hundred million dollars because someone forgot to write a $30 check six years ago.
What is acceleration?
Just as contracts can define vesting schedules, they can also define criteria under which the vesting happens faster than otherwise scheduled. This is called acceleration.
The most common variant of this among sophisticated entrepreneurs results in a percentage of unvested equity vesting upon an event, called a trigger.
There are two main flavors:
Single-trigger acceleration: The founder immediately vests some percentage of their unvested shares after a single event occurs. Typically the triggering event is a change of control, such as an acquisition.
Double-trigger acceleration: The founder immediately vests some percentage (commonly 100%) of their unvested equity after two events occur. Typically, the first event is a change in control (e.g. acquisition), and the second event is the termination of the founder’s employment by the new owner of the company (or a “constructive termination”, where the new owner makes it untenable for the founder to work in their new job).
Both flavors of acceleration protect the interests of founders in the event of acquisitions. There are a variety of reasons for this. One is that surrendering control over one’s employment to the new owners shouldn’t also surrender control over one’s upside due to the value one has created at the acquired company.
Single-trigger acceleration is often preferred by founders / employees relative to double-trigger acceleration, since acceleration is a thing one wants and it is easier to qualify for single-trigger than double trigger. VCs in Silicon Valley generally prefer double-trigger acceleration over single-trigger acceleration. Single-trigger acceleration is not standard in Silicon Valley, though some companies do provide it.
The exact specifics of what constitutes a triggering event are very important and are set by the terms of the stock purchase agreement. It’s important to scrutinize the documents closely and get legal advice.
An excellent reason to provide double-trigger acceleration for founders is to signal that it will also be provided to top employees, who are more at risk of involuntary separation in an acquisition and have very limited ability to extract favorable terms from the acquirer without backing from the founders.
Why don’t companies immediately issue all authorized shares?
Generally, companies will authorize a certain number of shares when they incorporate but only issue a portion of them initially, dividing them between founders as per their mutual agreement. For example, a company might authorize 10 million shares but only issue 8 million, splitting them evenly between two co-founders.
Those two million are held in reserve for future people to receive them, most commonly employees. Why pre-authorize shares you intend to give to employees? Because authorizing shares requires boring, expensive legal work and filings with the state, but issuing authorized shares can be done relatively easily. Authorizing more shares than you plan to issue upfront will often save you costs and headaches over time; if you don’t end up needing the shares that are authorized but not issued, that’s fine; shares that aren’t issued yet don’t dilute any owner of the company. (Issuing shares that you haven’t authorized, on the other hand, is a recipe for a huge, expensive legal mess.)
You might wonder what dilution is. Basically, as the number of shares in a company increases, each share accounts for less of the ultimate economic value of the company. If you own 4 million shares out of 8 million at the time the company is founded, but need to authorize and issue 2 million shares to employees and 30 million shares to investors, you end up owning only 10% of the company, not the 50% you started with. That is fine and natural! 10% of a meaningfully successful business is likely worth a lot more, as a dollar figure, than 50% of a dream is. But you should be cognizant that dilution happens to you, and every other owner of the company, every time you issue shares to anyone.
Consider the stylized case of a company with 10 million authorized shares, of which 8 million are issued equally to two co-founders. Each founder owns 50% of the company as of today but has indicated that they’re on board with being diluted down to 40% in the case where all shares are issued (likely to employees).
Each additional new issuance, such as in exchange for investment, dilutes the founders (and other owners of the company) further. Dilution is not intrinsically a bad thing, it is simply a price—at some prices it is beneficial to buy things (for example, the participation of an employee or money from an investor) with the hope of providing greater value to the company than the price paid.
What is an 83(b) election?
You might be curious as to how founder’s equity is taxed. You will almost certainly want to consult professional advisors about it.
If you acquire property (such as stock) at a price below its fair market value, you will have taxable income on the difference between the fair market value and the price you actually paid for the property. One reason founders often purchase their stock immediately after incorporation is so the shares can be purchased when fair market value is par value. They can pay for a large number shares up front (at a nominal price) and have no income on the purchase. They will eventually owe income tax if they sell shares at a gain, but that is likely years down the road.
Shares which are subject to vesting have the substantial risk of being forfeited; they’ll generally be repurchased at a nominal price if the founder leaves the company. The default position under U.S. tax law is that a founder has earned the shares (from a tax perspective, not a legal one) as of when that risk goes away, i.e., when the shares vest. This means that the “spread” between fair market value of shares and the price paid is calculated every time some of the shares vest. If the shares have increased in value before vesting, the shareholder might have enjoyed a paper gain on the difference between par value and the fair market value of the shares. This founder would ordinarily owe income tax on the income that that difference is assumed to represent… even if they cannot actually sell the shares yet.
This math can get brutal. For example, in a stylized example, a co-founder who is vesting 4 million shares of a company worth $20 million with 10 million shares issued will vest 1 million shares a year, or about 83,000 a month. Each is worth $2, so the co-founder would be seen as earning income of about $180,000 a month. This money is not cash—there does not yet exist a market for those shares—but the IRS demands payment as if the founder had actually received $180,000 a month in cash from the company (and similarly, the company owes payroll taxes on that amount).
Enter the 83(b) election: if you file the appropriate paperwork with the IRS within 30 days of acquiring stock, U.S. tax law will instead deem you to have acquired all of your shares when you paid for them. Thus the spread between the fair market value and the purchase price of your shares is calculated and taxed up front (when the shares still have minimal value), rather than as they vest, which will typically result in little or no tax liability.
This is one of the critical housekeeping tasks for early startups. Do. Not. Forget. Your. 83(b). Election. Talk to an accountant or lawyer to see if you should file one and how to file it correctly. This issue has bankrupted very smart, honest taxpayers whose only mistakes were working for a company which got valuable and neglecting to send in a one-page piece of paper by a deadline. Every tax accountant in Silicon Valley can tell you cautionary stories. Don’t become one of them.
What about tax and securities requirements?
When American companies that are publicly traded sell stock, they register those sales with various government agencies. When private companies issue stock to founders, they are almost always exempt from federal registration requirements. It’s generally not necessary to file anything with the U.S. government to qualify for this exemption. But each U.S. state has its own requirements, and companies may need to file for exemptions from registration depending on the states in which the founders are based. Other countries may also have rules that create legal and tax obligations for non-U.S. founders.
It’s important to talk with your attorney to understand if any of these obligations apply.
How does Stripe Atlas help with founder equity?
Stripe Atlas provides a tool that enables founders to generate and sign legal documents to authorize and issue stock to the founding team, using templates provided by Orrick. These templates include standard terms used by experienced entrepreneurs and investors. The tool is available immediately after incorporation (for only 30 days) to companies who have not done anything to increase the value of the company since incorporation - in other words, the fair market value of shares in the company is still par value.
The standard terms used in the tool are:
Vesting schedule: 4-year vesting; 1-year cliff, with even monthly vesting over the 3-year post-cliff period.
Acceleration: Double-trigger acceleration (founders vest immediately if they are fired or constructively fired after a change in control).
Number of shares issued: The number and allocation of authorized shares is up to the founding team; at least 20% of authorized shares will remain unissued so they can be issued to employees or investors in the future.
Price per share: The tool uses the par value chosen at incorporation.
Using these defaults, most Stripe Atlas founders should owe no more than tens of dollars for their founder stock.
If you’d prefer to consult with lawyers to customize these terms, we can give you templates provided by Orrick to work on with your legal advisors to save you some time.
Talk to a lawyer
You should always speak with an attorney before issuing equity in your company for the first time; if you don’t have an attorney, we’d be happy to introduce you to attorneys who have helped other Stripe Atlas users.
If you’re not a Stripe Atlas company, we encourage you to receive advice specific to your situation from a qualified attorney in your jurisdiction.
A sampling of issues associated with issuing stock to be aware of: many U.S. states have regulatory requirements to register issuances of shares with them. If you are located outside of the United States, treatment of equity grants or equity vesting can be materially different than described here; you will want to have a qualified local accountant or lawyer explain the implications and help you choose a structure which is appropriate to the founders’ and company’s needs. There may also be additional tax consequences associated with issuing shares. There are other issues, and they are very specific to your circumstances. Seek qualified professional advice.Back to guides