While equity distribution in startups can be complicated, it sets the stage for a company's future. Approximately 40% of startups with 2 founders and only 3% of startups with 5 founders choose a simple, equal split, while the rest opt for more complex allocation strategies. Founders must consider many factors when devising an equity distribution plan, including tax implications, control dynamics and future investment rounds. These choices can significantly shape the company's ability to attract talent, raise funds and ultimately realise its vision.

Beyond how much equity each founder gets, they must also decide how that equity will be structured and distributed. The mechanisms of issuing this stock can range from direct issuance to complex financial instruments, such as convertible notes. The issuing method doesn't just affect the founders, but also future employees, investors and potential acquirers.

In this article, we'll discuss what startup teams need to know about issuing stock to founders, including direct stock issuance, restricted stock, stock options and convertible instruments. We'll also cover the tax implications and governance issues associated with each issuing method. With diligent research and support from tax advisors, creating a plan for issuing this stock can maximise long-term benefits for founders and their companies.

What's in this article?

• What is stock in a startup?
  
• Startup stock allocation: what do founders get?
  
• How to issue stock to founders
  

What is stock in a startup?

Stock in a startup is made up of shares that represent ownership in the company. This ownership provides potential financial gains and determines how decisions are made within the company. It incentivises stockholders – from founders to employees – influencing immediate actions and long-term plans. Each type of stock has specific rights and responsibilities that affect control and valuation. The initial distribution sets the stage for all future financial and operational adjustments.

Startup stock allocation: what do founders get?

How ownership is distributed among founders is more than a simple division of equity. It establishes the governance structure and sets a precedence for future financial engagements, such as fundraising rounds and acquisitions. It also creates a roadmap for how decisions will be made, as well as how rewards and responsibilities will be shared.

Founders typically receive common stock, along with associated voting rights and claims on future earnings or sales of the company. However, the rights attached to these shares can differ based on agreements among the founders. Certain elements, such as vesting schedules, can come into play, incentivising long-term engagement with the startup. Vesting usually takes place over a period of years and may include a "cliff" – a set period before any shares vest – to ensure commitment to the venture.

There are several methods to determine how much stock each founder receives. One common method is the "contributions evaluation", where each founder's percentage of ownership corresponds to what they bring to the company – whether that's capital, intellectual property or specialised skills. Another popular method is "dynamic equity", where ownership is adjusted over time based on ongoing contributions. This is usually determined by pre-approved metrics.

Equity dilution is another factor that founders need to consider. As the startup progresses through the various funding rounds, the introduction of external investors will usually dilute the ownership percentages of the founders. However, this dilution is often accepted willingly in exchange for the capital needed to scale the business.

Agreements detailing the allocation of founder equity should be well-documented and should address various scenarios, such as exits, additional fundraising or changes in roles. These documents serve as the guiding framework for the company's internal operations and external engagements. While legal and financial advice is always recommended, the ultimate decisions will be made by the founders, who must balance their immediate needs with the future goals of their startup.

How to issue stock to founders

The process of issuing stock to founders starts with determining how much equity each founder will hold, which we've discussed previously. But there are several more elements to consider.

Factors to consider

Type of stock

Here are the major types of equity that startups tend to use:

• Common stock: this type of equity is often allocated to founders and employees, offering them voting rights and a portion of dividends or proceeds from a sale of the company.

• Preferred stock: these shares usually go to investors and offer various advantages, such as first entitlements on dividends and assets if the company is liquidated. They may also feature anti-dilution provisions.

• Stock options: these give employees the opportunity to buy shares at a set price within a designated period, often requiring certain conditions to be met for exercising the option.

• Restricted stock units (RSUs): these represent a promise to award a certain number of shares at a future date, dependent on meeting specific conditions, such as staying with the company for a set amount of time or achieving performance targets.

• Warrants: these are similar to stock options but are typically given to investors, allowing them to purchase shares at a specific price.

• Convertible notes and SAFEs: these financial documents are turned into equity during future fundraising rounds, usually under terms that are more favourable to the holder. A Simple Agreement for Future Equity (SAFE) grants the investor the right to receive shares at a later stage, while convertible notes are company loans in which the debt converts to shares instead of being repaid.

While common stock is often the first choice for founders, it's worth considering whether to issue other types of equity, such as restricted stock or stock options. Restricted stock usually comes with vesting schedules, which encourage more sustained commitment to the startup. Stock options, although less straightforward, can offer tax advantages and enable more flexible planning in the long term.

Voting rights

Voting rights should reflect the balance of power among the founders, and they are usually documented in the company's bylaws or a separate voting agreement. When making these arrangements, consider each founder's role, level of involvement and desired influence over governance matters. You can create special voting shares to give certain founders extra voting power, but this could complicate future investment rounds or potential exits.

Tax implications

The timing of the stock issuance, as well as the type of stock issued, can affect the tax burden for founders. Most founding teams consult tax advisors who are familiar with their industry and corporate structure before making decisions about equity. These advisors can explain the implications of different equity scenarios and provide a better insight into tax strategies related to stock issuance. For example, an advisor might consult on whether to file an 83(b) election in the United States, which allows founders there to lock in a lower valuation for tax purposes when receiving restricted stock.

Documentation

Founders should have comprehensive shareholder agreements in place that outline the terms of the stock issuance, from vesting schedules to what happens if a founder exits the company, or even if the company is acquired. These legal documents govern the startup's equity structure, providing clarity and preventing future disputes.

Intellectual property

Finalise any third-party agreements – such as intellectual property transfers – before issuing stock. If a founder is bringing in pre-existing intellectual property, they need to transfer it officially to the company to avoid any future conflicts.

Ways to issue stock to founders

There are several methods for issuing stock to founders, each with its own implications for tax treatment, governance and dilution risk. Here are some of the most commonly used methods:

• Direct stock issuance
  This is the simplest form of stock issuance. The company issues new shares directly to founders. A stock purchase agreement is drafted, specifying various terms, such as purchase price, vesting schedule and any restrictions. Although a straightforward option, it requires clear documentation to avoid future disputes or ambiguities.

• Restricted stock
  This type of stock – also referred to as "RSUs" – has a vesting schedule, meaning that founders earn their shares over time. If a founder leaves the startup before their RSUs are fully vested, the company has the right to repurchase unvested shares, often at a cost.

• Stock options
  These are options to buy shares at a fixed price, known as the strike price. Stock options are not actual shares, but they offer the potential to own shares in the future. Often subject to vesting, these can be beneficial in situations where a founder's future involvement is uncertain.

• Convertible instruments
  These financial vehicles, such as convertible notes or SAFEs, do not issue shares immediately, but instead convert into equity at a later date – usually during a funding round. They can be a good fit when the company's valuation is hard to determine.

• Phantom stock and stock appreciation rights (SARs)
  These are contractual agreements that grant the right to receive either cash payments, shares of stock or a combination of both. Based on the value of a stated number of shares, these are paid out at a future date. Companies often use these to reward certain founders without diluting the equity pool.

• Warrants
  These long-term options to buy shares can be a strategic tool for startups, particularly when issued to founders who are also investors or strategic partners. They usually have a much longer life compared with stock options.

Each method requires a different set of documents, so the chosen method will dictate the complexity and volume of legal paperwork needed. For example, in the US, restricted stock usually requires a restricted stock purchase agreement and often an 83(b) election form. Stock options necessitate an option grant agreement and a stock option plan under which to issue the options. Convertible notes require a convertible note purchase agreement, as well as the note itself.