Should founders take restricted stock?

First off, we need to distinguish two definitions of restricted stock.  The term restricted stock also refers to stock that is restricted from public transfers under the securities laws because it has not been registered with the SEC and state securities agencies.  This post is about founder stock that is restricted in the sense that the company has the right to buy the stock back if the founder leaves the company.  Founder restricted stock typically has the following characteristics:

  • It is issued pursuant to a Restricted Stock Agreement between the founder and the company.
  • At least part of the stock is subject to repurchase by the company at the original purchase price if the founder leaves.
  • The restrictions on the stock, or in other words, the company right of repurchase, usually lapses according to a vesting schedule over two to four years, similar to stock options.
  • For tax efficiency, stock is ideally issued at the earliest stage of the company, when the value of the stock is low.
  • The founder makes an election under Internal Revenue Code Section 83(b) to include the value of the stock (in excess of the price paid for it) in the founder’s gross income for that year, which allows the founder to have capital gains treatment on the appreciated stock when it is later sold.
  • Although the stock is not vested (it is still subject to the buy-back right) it has all the rights and privileges of issued stock, including voting and distributions.

Although it may be deemed burdensome, restricted stock serves at least three purposes that are mutually beneficial for founders:

  1. It motivates founders and other key employees to stay with the company and do their fair share.
  2. It establishes a pre-agreed protocol for easing out founders who have lost interest or underperform.  (If a founder is perceived to be at higher risk than average to be tempted away to other projects, it is also possible to impose on the vested stock a buy back right at fair market value – as opposed to original purchase price for unvested stock.)
  3. Investors appreciate 1 and 2.  In some cases, investors have required founders to accept buy-back restrictions on their stock

Restricted stock can be particularly useful in early stage companies where one or more founders are not working full time on the project.  In such cases, rather than termination of employment, it is failure to contribute the minimum amount of service to the company that triggers the buy-back right.  A clause like the following in the founders’ mutual restricted stock agreements seems to work well to keep founders doing their share of the work:

Service” means at least an average of 20 hours of weekly service to the Company if Founder is not otherwise compensated (e.g., as a full or part-time employee).  Founder will be assumed to be performing Service for the Company unless he receives a written notice from the other two Founding Shareholders that, in their view, Founder is not meeting the service requirement, in which case Founder will have 30 days to cure the failure.

If you decide to use restricted stock, it is wise to consult with an attorney or accountant, particularly with respect to the tax aspects and the 83(b) election.  The 83(b) election must be filed with the IRS within 30 days of when the stock is originally issued.

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