In the last post I wrote about the basic mechanics of vesting. Now I would like to explain why it is indispensable for every healthy startup to have founders’ shares subject to vesting.
The reasons for vesting.
Getting shares later rather than sooner is sometimes, counter-intuitively, actually better and this is definitely the case here. Founders themselves benefit from vesting as it locks their partners in the enterprise and guarantees that they will work hard to push the business forward. Founders usually perform dual roles in startups, as they are both their shareholders and employees. This may theoretically result in a situation where a founder quits working and moves to Bahamas but, as a shareholder, continues to reap off profits of the company’s growth. This is why vesting is useful, as it makes sure that co-founders will be incentivized to work hard on the development of the firm. It is also important for the investors as they want to be certain that the people who are masterminds behind the startup and know it inside out will not stop working or sell their stock on a whim. In fact, our experience shows that getting financing for a startup which founders are not vested may be really difficult.
Can’t we do it differently?
One may ask why not simply prevent all the problems pointed out above by using the stock as a salary and simply issue it every month. It seems to be more simple, transparent and intuitional than the somehow complex vesting structure. Firstly, it is inconvenient as board’s resolution is required every time stock is being issued. Secondly, because of the tax issues. Making long story short, when a company is formed, stock usually is given to founders practically at no value what decreases the taxable income to almost zero. However, as the startup starts operating, the actual share value increases over time what makes the subsequent acquisitions of shares more and more burdensome. That is why founders want to make sure that the IRS considers the shares, both vested and unvested, to be acquired at the moment of their grant. In order to do that, IRS requires an additional 83 (b) election to be filed within 30 days after the grant. It has to be emphasized that, barring exceptional circumstances, not filing of the 83 (b) election is a major mistake.
Vesting is beneficial for the startup as it provides necessary incentives for the founders and prevents “free rides” at each other’s expense. Additionally, it makes the startup look more stable in the eyes of potential investors. Finally, vesting benefits the founders as they can optimize their tax liability by taking advantage of the 83(b) election.