[Startup Guide to US Market Entry] Founder's Equity and Vesting

This article is a contribution by attorney Seong Ki-won. If you would like to share quality content for startups in the form of a contribution, please contact the Venture Square editorial team at editor@venturesquare.net.

(Disclaimer: The information below is for general information purposes only and is not intended to be legal advice for any specific client. You should always consult an attorney before taking any action based on this information.)

Is vesting really necessary?

During the startup establishment phase, shares issued to founders are typically granted without restrictions. Especially for sole founders, a vesting schedule may seem unnecessary. However, in practice, it's generally preferable to establish a vesting schedule for founder shares from the outset. These can be broadly categorized into two categories.

First, there are cases where there are multiple founders. If a founder leaves the company, and there's no vesting schedule, former co-founders who no longer participate in management will still hold significant shares, potentially burdening the remaining founders' management rights and business operations. On the other hand, if there's a vesting schedule in place, the company can reclaim the departing founder's unvested shares or repurchase them at a lower price, protecting the remaining founders.

Second, there are cases where investors request it. Venture capitalists and institutional investors typically require a vesting schedule for all or part of a founder's equity if it hasn't vested at the time of investment. If the founder and company have already established vesting arrangements in the early stages, investors are more likely to recognize the existing vesting schedule and reflect the founder's contributions up to that point. This can provide the founder with an opportunity to negotiate more favorable terms.

General structure of vesting

Vesting schedules are typically set for two to five years, with equal vesting periods of monthly, quarterly, and annual installments. At each vesting date, the founder must remain with the company and provide services.

Vesting schedules typically include a one-year cliff. This means that shares do not vest for the first 12 months, and after that 12-month period, all shares accumulated during that period vest in one lump sum. This ensures that employees must provide at least one year of service to the company before they are eligible to receive shares. After that, vesting occurs at an equal rate monthly (or quarterly or annually).

The most common structure for startups is a combination of four-year vesting, monthly vesting, and a one-year cliff. In this scenario, 25% of the total shares vest in one year, followed by a 1/48th vesting period each month for 36 months.

Accelerated Vesting

Founder's stock agreements often include accelerated vesting provisions. These provisions allow founders' unvested shares to vest early in the event of a company sale or change of control. There are two main methods for accelerated vesting: (1) single trigger and (2) double trigger.

• Single trigger: Shares that have not yet vested at the time of a change in control are immediately vested.
• Double trigger: This structure allows for accelerated vesting only when (i) a change in control occurs and (ii) the founder involuntarily resigns within a certain period. Involuntary resignation, as used herein, includes resignations for "good cause" (e.g., salary cuts, job demotions) or "dismissals without cause." This means that even if a change in control occurs, if the founders' employment is still guaranteed, vesting will not be deemed complete simply due to a change in control.

In practice, the double trigger approach is more common, and investors also prefer this approach to retain talent after an acquisition.

The Meaning of Vesting in Investment Negotiations and Tax Considerations

Vesting conditions are not fixed simply because they are unilaterally determined by the company and founder. During the process of attracting external investment, investors often renegotiate the vesting conditions of the founder's shares. Therefore, establishing an appropriate vesting schedule between the founder and the company at an early stage can be a crucial strategic tool to avoid unfavorable terms and secure leadership in subsequent negotiations.

However, it's dangerous to simply assume that vesting founders' stock is always advisable. If founders' stock is subject to a vesting condition, it's considered stock with a substantial risk of forfeiture for tax purposes. Therefore, under U.S. Internal Revenue Code §83, the taxation of the stock is deferred until the actual vesting date. In this case, as the stock value increases over time, the founders recognize taxable income based on the market price at each vesting date. Consequently, they risk incurring significant taxes even when there's no cash flow.

To prevent this, an option is the 83(b) election. If a founder makes an 83(b) election within 30 days of receiving the stock, the difference between the fair market value (FMV) of the entire stock and the actual paid-in value (usually par value) is recognized as taxable income only once at the time of grant. No additional tax is imposed upon subsequent vesting.

However, caution is required as the 83(b) election also carries the following risks:

• If a founder leaves the company and loses his or her shares before vesting is complete, any taxes already paid will not be refunded.
• Additionally, if the stock value does not increase over time, the founder may be unnecessarily taxed early.

Therefore, establishing a vesting schedule for founders' shares is crucial for fair distribution, investor negotiating power, and company stability. However, it's also crucial to consider whether an 83(b) election is required under tax law. Because shares have little value in the early stages, most founders benefit from early taxation through an 83(b) election. However, this can vary depending on each founder's circumstances and the company's valuation outlook, so it's always advisable to consult with your tax professional.

---

• See more related columns