When a new company's formed, the potential breakup is typically the last thing discussed, because let's face it, it's uncomfortable. Unfortunately, though, it happens often, and it can be quite problematic. Founders might leave the company for greener pastures, new opportunities, or they may simply graduate college and move on. In the world of fast-rising startups, an experienced attorney can save your high-potential ideas from a disappearing cofounder with an understanding of two critical concepts: vesting and the 83(b) election.First, vesting is the process of granting equity that's subject to a risk of forfeiture (either as an outright claw-back or by way of a repurchase right in favor of the company) that goes away over time, or upon certain events or milestones. The most common structure is simple time-based vesting where a co-founder’s equity (or a portion of it) will be surrendered in the event they leave the employ of their new company within “X” amount of years. This creates an incentive for the cofounder to stay active and diligent in the new company’s pursuit. It can also alleviate having to have an awkward conversation with a potential investor about your inactive 50% shareholder cofounding roommate that left in the second week of the company’s infancy.
Next, a direct consequence of vesting is the importance of timely filing an 83(b) election with the IRS. What is an 83(b) election, you ask? Section 83 of the U.S. tax code requires taxpayers to include as income any equity grants at the time the equity becomes transferable or no longer subject to a substantial risk of forfeiture, at its then-current fair market value. Great! In other words, vesting means a founder does not have to claim equity as income until it vests, often several years after it’s granted.
Now comes the good part: recipients of equity that vests over time can choose to accelerate the recognition of that income under Section 83(b) and incur all of those income tax consequences at the time of the grant. Awesome! You can choose to pay your taxes early (thanks, America).
Here’s why this is critical: when founders’ equity is granted it often has a nominal value, which may be entirely offset by the purchase price paid in consideration to capitalize the company. That means, the value of income to the founder when it's granted is often nominal or $0. Paying taxes on $0 doesn’t sound that bad. Now, if a founder does not file an 83(b) election within 30 days of the grant of equity subject to vesting, she would be taxed as the equity vests, at her ordinary income rates, and at the market value at the time of vesting. In high growth companies, this is not a small thing. As a modest example, if 25% of your 50% ownership vests one year from grant, and the company has been successful enough to require a $5,000,000 valuation, the IRS is going to expect the founder to pay ordinary income taxes on $625,000 (around $220,000). It doesn’t matter that she didn’t receive any cash by which she could actually pay that amount.
So what's the big takeaway here?
Vest founder’s equity and file an 83(b) election within 30 days of the equity grant date.
We're always happy to assist entrepreneurs in their pursuits. If you want to discuss company formation, equity compensation, or fundraising, please don’t hesitate to reach out. I can be emailed at: Brian.Casserly@gutwinlaw.com.