The concept of founders’ stock is as simple as the name implies. It denotes the ownership stake that the firm’s founders or creators have in the enterprise. Contrary to common assumption, a startup’s founders do not automatically gain proprietary interests in the firm. Instead, they earn their ownership rights through founders’ shares allotted to them over a vesting schedule.
Fundamentals of Founders’ Stock
Founders’ stock is the firm’s equity issued to its founding members and early investors who have contributed to getting the business off the ground. The word itself is not a legal term, and the firm’s bylaws may not include it as such.
Nevertheless, the founders’ stock is an important component of the firm’s shareholding structure. Fair division of founders’ stock can serve as the basis for an efficient and simplified distribution of equity among the firm’s other stakeholders.
Some General Features
Technically, founders’ stocks are a class of common stock issued at the time of the firm’s incorporation. These stocks typically have very low valuations as the firm is still in its embryonic stage and has not yet produced any value. Some other characteristics of founders’ equity include the following:
1. A Means of Raising Capital and Compensating Initial Contributors
Generally, a startup receives first investments from its founders and co-founders. Founders typically bootstrap their business until it has grown sufficiently to accept outside funding.
Other than investing initial funds, founders also contribute to managerial efforts, bring in technical know-how & technological assets, and undertake risks for business growth. Founders are paid back for their contributions through ownership in the firm.
2. Issued at Face Value
Founders’ shares are always issued at face value (or par value), as listed in the company’s account books and its share certificates. Beneficiaries pay less tax because of lower valuation.
3. Governed by a Vesting Schedule
Usually, these shares are not issued to the beneficiaries upfront. The allotted stocks are vested over a period of time, typically in three to five years. The vesting schedule determines how much ownership is granted to founders and when.
4. Ordinary Shareholders Receive Return on Investment on Priority
Typically, dividends are not paid to the company’s founding shareholders until all the common stockholders are paid first.
5. Subject to Restrictive Conditions
In addition to vesting schedules, founders’ stocks may be subject to other restrictions related to the sale and/or transfer of shares. Common conditions include the ‘Right of First Refusal’ (ROFR) and co-sale/tag-along rights.
ROFR requires that a founder wanting to sell his shares must first offer them to the company for repurchase. Similarly, if a potential buyer is interested in purchasing the founder’s shares, they may also be obliged to buy shares from other shareholders on the same terms.
Significance of Vesting Schedule for Founders’ Stock
Much like the vesting schedule for other types of share grants, it serves an important role in founders’ equity. Vesting schedules for founder’s stocks have the following advantages.
1. Incentivizes Founding Team Members to Keep Promoting the Business
A vesting schedule ensures the continued participation of the shareholders in the company’s progress. The beneficiaries will receive ownership of the shares only after the vesting is complete. A founding team member parting ways with the company before the completion of the vesting schedule will have to surrender the unvested shares awarded to him.
2. Safeguards the Interests of Remaining Founders if Any Founder Quits the Business
A vesting schedule eliminates the risk of an early team member later becoming a ‘free-rider’ for the company. The departure of a co-founder is not always peaceful. If the person who leaves has full ownership of the shares allotted to him, the company risks having an outsider with substantial control over its managerial process and rights to its future profits.
A proper vesting schedule ensures that the co-founders only receive shares proportionate to their contribution at any given time.
3. Helps Improve Investor Confidence in the Future of the Company
Having a vesting schedule in place for founders’ shares simplifies further negotiations with potential investors. Vesting restriction on founders’ stock provides assurance to venture capitalists or angel investors on the founding members’ long-term commitment.
Potential investors may be hesitant to fund a company if the founders have very few unvested shares, thus, less vested interest in the company.
What Is Vesting Acceleration?
Typically, a co-founder who leaves the company before the vesting period ends must forfeit his unvested shares. However, there could be some unique circumstances, like the acquisition of the firm or the termination of a founder before the equity has fully vested.
Vesting is expedited in such situations to safeguard the interests of the shareholders by the following means:
A. Single Trigger Provision
This method accelerates the vesting of unvested stock at the time of sale/acquisition.
B. Double Trigger Provision
This method requires two events to take place back-to-back for shares to vest before the scheduled date. First is the sale of the company, followed by the termination of the co-founder without cause within a set period after the sale.
Founders’ stocks provide early founders with a share of ownership and profit entitlement in the company. During the firm’s incorporation, shares are distributed to founding members in such a way that they collectively own a majority stake in the company.
Founders’ equities get diluted as the startup progresses through different funding rounds, which affects the founders’ voting power in the company. Firms also add control provisions to their founders’ stock to protect the founders’ control rights.
One such provision is to give the founders’ shares special voting rights. Such classes of stocks are called super-voting stocks; they hold multiple voting rights per unit, giving their votes more weightage compared to other common shareholders. Another method is to grant hybrid characteristics to the founders’ common stock such that they resemble a preferred stock.
Equity Management in a Startup With trica
Managing different types of equity in a startup can be quite challenging, even with the help of a cap table. Startups can benefit from using cap table software to record and track their shareholding pattern.
trica’s Cap Table Management Tool aids fast-growing startups. It is equipped with features to generate customized views of your cap table, communicate relevant information with your shareholders, and model how future rounds of funding will impact the firm.
Contact us today to schedule a free demo of the innovative cap table management.