When you start a business, there are a million and one things swirling around in your head, with endless questions that you need answers to. Who will your investors be? What will your business model look like? Will people actually buy into your business idea? On top of these common questions, there are a number of questions that should be thought about but aren’t, including what is founders’ stock?
Founders’ stock is related to equity within a startup, but this is something that’s often overlooked because shareholders are constantly changing. It’s also commonly ignored in favour of discussions surrounding investor and employee equity. Despite this, it’s imperative that you understand what founders’ stock is because it can have a huge impact on your business overall moving forwards.
Understanding what it is, how it works, and the role it plays in your business will serve you well in the future with regards to minimising time and money wasting, and it can also help you attract new investors. So, with this in mind, here’s your essential guide to founders’ stock.
When can founders' stock be issued?
As we’ve already mentioned, founders’ stock is issued when your business becomes newly incorporated. If this is something your business is looking at, you need to make sure you issue founders’ stock as soon as possible, typically before your company is valued by an investor.
The reason for this is if your business is valued and is given a high value on founders’ stock, you will be liable to pay a higher rate of equity holding tax. If you issue founders’ stock immediately after your company becomes incorporated but before you receive an investor valuation, you can file for an election which enables you to pay taxes on the founders’ stock at the time they were issued, typically when they’re not worth much at all.
To put this into context, if you issue founders’ stock as soon as your company becomes incorporated when it’s not worth much, you’ll pay a lower amount of tax because it will be based on how much the stocks were worth at the time. If you make the common mistake of issuing founders’ stock later on when your company has grown in value and your stocks are worth more, you’ll be taxed based on the value of the founders’ stock at the time you issue it, which in this case will be considerably higher.
To avoid paying an unnecessarily high tax bill, you should issue your founders’ stock as soon as your company becomes incorporated.
Should you have founders' stock?
If you’ve never really heard of founders’ stock, you’re likely wondering what the point in it is and whether it’s worth having. Well, in short, it’s definitely worth having for two main reasons, the first of which being that it establishes the leading authoritative figures who will be responsible for making important business decisions and having the final say.
Realistically, not everyone involved in a startup can make all the big decisions because it’s not efficient or viable in most senses. With this in mind, issues founders’ stock makes it clear who plays what role and what level of authority they hold within the business on the basis that those with a higher level of stock own more of the business, meaning they have more of a say.
This is why founders’ stock is particularly useful for startups with bigger teams, such as tech startups where there may be several different people involved, but not all of whom play an equal role in the business.
The second main reason you should have founders’ stock is because it encourages the founding members and original team to stick with the business. Startups can go incredibly well, or they can go completely downhill. Typically speaking, those that go downhill are the ones with teams that got bored and lost their passion.
If your team stands to make a profit from their involvement in the company, they’re more likely to want to stay on and make it work. After all, if you own something, you’re far more likely to look after it and give it your all compared to if you don’t own it and stand to gain nothing from your hard work and commitment to it.
Outside of these two main advantages of founders’ stock, there is one more reason why you should consider it. People come and go, especially in the early stages of a company. It’s entirely possible that a majority shareholder may choose to leave your startup, leaving you with an important decision to make about whether your business can keep running.
If founders’ stock is issued, a plan will typically be drawn up alongside it detailing how it will be split (more on this later), but essentially, majority shareholder stock will be divided amongst the other members. The person who has the most shares has the most ownership of the business and is effectively the person in charge, meaning as soon as they get the stock, they can keep the business running as normal. This is essential for avoiding any hiccups or issues in the day to day running of your business, further adding to the need to issue founders’ stock.
Is founders’ stock important?
Due to the fact so many companies issue founders’ stock, if at all, it’s no wonder you may be wondering whether it’s important. Well, the answer is yes, it’s hugely important. Not only does it determine who holds authority within a startup, but it can also attract more investors if the stocks go up in value.
Interested in learning more about what can attract investors and what they’re thinking during a startup investment pitch?
Learn more about how investors operate and what you need to know about pitching by watching our School of Startups Investor Insights webinar with Gian Seehra.Watch now
What is a vesting schedule?
It wouldn’t be possible to answer the question ‘what is founders’ stock?’ without exploring vesting schedules. This is because vesting schedules and founders’ stock go hand in hand, with this being a unique aspect of this particular type of stock.
Essentially, a vesting schedule is an established timeframe that must elapse before a founder is entitled to fully own their founders’ stock. Generally speaking, there is what is referred to as a one year cliff which means anyone who has been allocated founders’ stock has to stay employed for at least one year before they actually own their allocated shares.
Some companies may choose to have a five-year vesting schedule which means for a person to truly own their founders’ stock, they need to work at the startup for five years. This is to protect against former employees and shareholders profiting when they may have left the company years beforehand but retained their stocks.
Essentially, founders’ stock is a reward for taking the risk and starting the business, but a vesting schedule ensures the stock needs to be worked for through commitment and dedication.
Is a vesting schedule worth considering?
If you are going to be instigating founders’ shares, you absolutely need to implement a vesting schedule to protect your assets and your team members. Startups are hard, things don’t always go to plan, and sometimes, people just don’t see eye to eye. Vesting schedules mean if a shareholder leaves before the permitted vesting schedule, they won’t actually own their shares and therefore can’t profit from work they may not necessarily have done.
For example, you might have a shareholder who has been allocated founders’ stock but who leaves after eight months because they’ve decided to work elsewhere rather than see the startup through to success. If a vesting schedule isn’t in place, this shareholder could still hold a majority of the stock and keep it for years to come, by which point the company will likely be profitable and therefore the person stands to make money from selling the shares, even though they haven’t contributed to the work that has resulted in the company becoming profitable.
A vesting schedule could stop such a situation from cropping up, ensuring those who work the hardest are the most fairly compensated for their efforts. It’s also something investors may ask for later down the line, so if you’re looking to gain investment, you may find that investors ask for a vesting schedule to be put in place if it isn’t already, It’s in your best interests to do this yourself before investors request it as you may find the way you want to share your stock is different to how investors want it to be shared.
How is founders’ stock divided?
Any type of equity needs to be divided fairly and equally in line with best practices, and founders’ stock is no exception to this. Generally speaking, where shares and stocks are concerned, there will usually be talk surrounding ‘layers’ of employees. This is relevant in deciding who is entitled to founders’ stock – or any other type of stock for that matter.
Regardless of the business, the first layer is always the same: the early founders. These are the people who had the initial business vision and who risked their livelihoods to make the plan a reality, generally by leaving their jobs to start a brand-new business with no guarantee of success or viability. Founders’ stock rewards this layer of people for their bravery and commitment to early doors, and so it is these members who founders’ stock is divided amongst.
Typically speaking, a year after conception, the second layer comes in and comprises what can be considered as the first set of proper employees. They didn’t necessarily take a risk by joining the company and weren’t involved in the initial startup phase, meaning founders’ stock should not be divided amongst these employees. That being said, there may not be as much security when these employees were hired compared to when the third layer is hired a year later.
Again, third layer employees are not issued founders’ stock because they didn’t start the business and therefore aren’t entitled to compensation as such.
Generally speaking, a business offers public shares after it reaches five layers. There’s a general rule of thumb that founders in the first layer should be issued with 50% of the entire company amongst them, typically evenly split. If shares are offered beyond that, 10% is generally issued equally to every employee in each of the following layers, for example, 10% divided amongst all the employees in layer two, and 10% amongst all the employees in layer three.
The majority held in founders’ stock is a direct representation of the risks taken by the first layer of employees to start the company in the first place and grow it to the subsequent layers, hence these members are entitled to greater monetary rewards when the company becomes profitable.
Founders stock vs preferred stock
Founders’ stock and preferred stock often get confused, but they are very different things. Firstly, founders’ stock is classified as a type of common stock, and this is a separate classification to preferred stock.
The main difference comes in the form of preferred stock offering more of a safety net to the shareholders (investors). For example, if a business goes into liquidation, preferred stock members will be able to retrieve the money they invested before the common stockholders (including those with founders’ stock) can get theirs.
That being said, common stockholders (founders’ stockholders) tend to have more of a say in how the business is run day to day, with one major benefit being that they can often vote on business-related matters where preferred stock members can’t.
Common stock tends to be cheaper than preferred stock, but in the context of founders’ stock, it may well be worth less. This is because, as mentioned above, founders’ stock tends to be the biggest chunk of all the stocks available, though this could change over time.
Another key difference is that founders’ stock comes with a vesting schedule, whereas preferred stock doesn’t. As mentioned, though, preferred stockholders may dictate a vesting schedule if you don’t already have one in place, so it’s important you have one established before opening your business up to preferred stock shareholders.
Founders’ stock is an often-overlooked aspect of a startup company, but it’s one of the most important aspects for rewarding the first employees and attracting future investors. The goal of any startup is to attract attention in the way of investment so that it can grow and go on to become more profitable and successful, with founders’ stock playing a role in this.
How Accountancy Cloud can help you with attracting investors
Startup finances can be complicated at the best of times due to the volatile nature of starting a business. With so much going on, attracting investors can seem like a monumental task and is often the biggest hurdle businesses face. Accountancy Cloud can help you on your path to growth by providing expert financial and accounting services, as well as advice regarding investors.
Our award-winning accountancy software can help you get a grip on your finances from the get-go, including helping you with taxes relating to founders’ stock.
To find out more about how we can help you, please contact us and one of our financial experts will be more than happy to assist you with everything you need to know about founders’ stock and our accounting software solutions.
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