Allocation of equity is one of the first and most significant topics that arises when forming a company. In fact, how founders split their equity in the initial stages essentially determines who will control the major decisions of the company – that is, until a voting agreement is negotiated, which typically does not happen until investors come in and potentially tip the balance of control.
Some factors to consider when allocating equity to founders include:
- How long has the individual been working on the product or service that the company provides?
- How much time has that individual devoted, or how much time will such individual devote, to building the product or service?
- What type of value will this individual bring to the company? Is it connections, funds, name recognition, technical skills, niche expertise, etc.?
- If there is intellectual property involved, did this individual contribute to or create that intellectual property?
- What prior experience does this individual have? Has he/she built successful companies in the past?
- What is market for the particular industry in allocating equity if there are multiple founders with various skill sets or levels of contribution?
From the company’s perspective, it is widely considered as best practice to impose a vesting schedule on founder shares rather than issuing unrestricted (i.e., fully vested) equity. “Founder vesting” means that, for a set period of time, some or all of the founder’s shares would be forfeited back to the company (or be subject to repurchase by the company at a nominal price) if the founder ceases to provide services to the company. A key purpose of founder vesting is to keep founders incentivized to continue working for the company to grow the company’s value and increase its changes for success. Without a vesting arrangement, a founder could quit the day after receiving their equity, keep all of their shares in the company, and receive the benefit of any growth in the company without the founder’s continued contribution. This could create significant inequities to the remaining founders who stay committed to the company and now feel undercompensated.
The imposition of founder vesting also has tax implications and may require certain tax filings such as an 83(b) election, which we discuss in a separate blog, and should be considered carefully prior to entering into vesting agreements.
Many similar factors apply when considering the allocation of equity to directors and advisors. However, because new directors and advisors are generally not engaged until a later time when the company has significantly increased in value, it is often more advantageous from a tax perspective to issue options to purchase equity (for corporations) or profits interests (for LLCs).1 With that said, the same vesting considerations still apply.
In sum, allocation of equity and the structuring of equity incentives come down to two critical considerations: value creation and taxes. What value will an individual bring to the company, how can the company best incentivize the individual to realize that value, and how can this equity be issued without causing a negative tax impact on the company and the recipient?
If you are a company considering offering equity as compensation for services, or a founder or service provider about to receive equity in exchange for services, do not hesitate to reach out to any member of our team to discuss.
1 Issuing options to purchase equity (for corporations) or profits interests (for LLCs) are both covered in a separate blog.