Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

Founders often ask how they can keep a co-founder who leaves the company shortly after formation from taking his founders’ stock with him. The remaining founders typically feel that the departing founder should not be able to share in the company’s future upside value. Similarly, investors typically want to prevent a founder from leaving with his stock shortly after making an investment.

Like employee stock options, founder stock can be subject to vesting based on service to the company. This is accomplished by the founder granting the company an option to repurchase his stock for the nominal price paid by the founder if he leaves the company before the stock vests. The stock “vests” periodically when a partner is released from the repurchase option. This is often referred to as “reverse vesting.” Note, investors sometimes give vesting credit for time a founder spent building the company’s value by exempting a portion of the founder’s stock (e.g., 25%) from the repurchase option.

For example, three founders could each agree on a repurchase option with quarterly vesting over two years with respect to their founders’ stock for which they paid $0.001 per share. In this example, 12.5% of the stock held by each founder would be released from the repurchase option quarterly such that at the end of two years all of the stock held by each founder would be free of the repurchase option and a founder would be free to leave the company with such stock.

When using a repurchase option, a founder should seek tax advice as to whether to file an 83(b) election with the IRS. Such an election enables the founder to include in income at the time of original issuance the value of the stock that is subject to repurchase. 

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 "Section 409A"--Section 409A of the Internal Revenue Code requires the inclusion in income of deferred compensation paid pursuant to a deferred compensation plan that fails to meet certain requirements, or that is not operated in accordance with certain requirements.  

If a deferred compensation plan fails to meet the Code's requirements, or is not operated in accordance with the Code's requirements, then all compensation deferred under the plan for the taxable year and all preceding years must be included in gross income for the tax year to the extent not subject to a substantial risk of forfeiture or not previously included in gross income.

If compensation is required to be included in gross income under Section 409A, the tax imposed by 409A for the tax year is increased by interest and an amount equal to 20% of the compensation which is required to be included in gross income.

Compensatory stock options and compensatory warrants are subject to Section 409A, and under Section 409A all such options must be granted at fair market value on the date of grant.  If a compensatory option is granted at below fair market value, the amount that must be included in income is the spread between the fair market value and the exercise price upon vesting, plus 20% of that amount, plus interest.  

Non-compensatory warrants, such as those received in connection with making a loan, are not subject to Section 409A, although they raise other tax issues.

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The alternative minimum tax (the AMT), is an alternative tax regime Congress originally enacted to prevent high income taxpayers from not paying any income tax at all.  The AMT is calculated by first calculating regular, ordinary taxable income, and then adding to that tax base items excluded from the regular tax base to determine alternative minimum taxable income (AMTI).  Then, after an exemption amount is applied, AMTI is subject to a flat tax--whichever tax is higher, the ordinary income tax, or the AMT, the taxpayer owes.

Most importantly to early stage startup companies is this--that the spread on the exercise of an incentive stock option is an AMT adjustment.  Meaning, that even if the option was granted at FMV, so that there is no income on grant, nor ordinary income on exercise--there is potentially a dramatic AMT impact on exercise.  Beware!

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"Reverse Vesting" is an expression used to describe a situation in which an employee or independent contractor or consultant receives stock subject to repurchase by the company at an at-cost purchase price, which repurchase right lapses over the vesting period.  Thus, it is the reverse of the typical situation, where the service provider receives a right to purchase stock (an option) which right is not exercisable until the service providers vests.

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