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Do Founders Really Need a Restricted Stock Purchase Agreement for Founder’s Shares?

fortunecookieOne of the basic issues founders are confronted with is whether they should take their founders’ shares of the startup subject to a restricted stock purchase agreement, or outright with no restrictions on the shares.

What is an RSPA? What’s it good for? Is it really necessary? Here are some thoughts to help answer questions that founders typically have.

RSPA. A restricted stock purchase agreement is a document by which founders take their initial shares of a startup they have founded. It is not limited to founders’ and founders’ shares — RSPAs can accompany any stock issuance. A general matter, however, investors take equity in a company differently than founders.

Common Provisions.  The typical Restricted Stock Purchase Agreement will include a number of provisions, including a vesting schedule, a right of first refusal to purchase the founder’s stock before it is sold to a third party, a repurchase option for the company if the founder leaves before all shares are vested, and a lock-up agreement not to sell stock within 180 days of an IPO.  Other common provisions include transfer restrictions, prohibiting any founder from transferring stock to third-party except in certain circumstances, for example, if they should pass away.

Vesting. Most founders have heard of vesting. What is vesting and why does any founder take stock shares vested over a period of time? Well, mostly because of investor comfort.  Founders would never let employees take equity in their company without attaching some sort of vesting schedule. Investors generally feel the same way. The risk is that a founder will work for the company for very short period of time and then walk away with a massive piece of equity. To fix this problem in a way that keeps the company attractive to investors, founders take equity in the company over a period of time, which is the term referred to by “vesting.” The common practice is for stock to vest monthly over a four-year period, meaning that over the course of the four years, each month the founder  receives 1/48th of the total equity being promised under the RSPA.  Under some circumstances, there is a “cliff,” which refers to the period of time in the past before any of the stock vests. If the vesting schedule is not used, the cofounder or founder receives all of the equity in the company on the date the stock grant is made. This basically means that if the cofounder or founder changes his or her mind and no longer wants to work with the company a day after receiving equity in the company, the individual still remains a shareholder and is entitled to all of the benefits associated with being a shareholder, including voting for directors and receiving dividends declared on behalf of the company. Generally, this is a scenario that is very unattractive to investors.

Tax Elections. If founders take their stock subject to vesting periods, it is important to make certain arrangements to avoid a large tax bill received later on when the company becomes profitable and shares are valued much higher than at the start. This is where the famed Section 83(b) election comes into play. The tax problem  arises because the IRS doesn’t consider restricted stock to have been received by founder until it no longer has a substantial risk of forfeiture. So if the company issue stock to the founder subject to vesting schedule, the founder is not actually taking the stock without a substantial risk of forfeiture…until the shares being invested over a period of time actually vest. As the restricted stock vests according to the vesting schedule set forth in the RSPA, the founder would be subject to taxation based on the value of the stock at the time of vesting, at the recipients ordinary income tax rate, and the value of the stock as of the vesting date. Assuming the vesting schedule is over a four year period, and the company does well, the founder may be subject to dramatically increasing tax liability as the founders equity vests. To cure this problem, a section 83(b) election is necessary.   Section 83(b)  refers to a paragraph in the Internal Revenue Code that allows a person acquiring restricted stock to elect to be taxed on the value of the stock up-front at the time of the issuance, rather than when the shares actually vest (and when the company may be much more profitable).  The tax benefits are usually much more favorable, but there are certain scenarios in which making a Section 83(b) election would not be appropriate. To make this election, the founder simply has to file a simple form with the IRS within 30 days after issuance of the equity.

Alternatives.  If an RSPA is not workable for your company, an alternative is a nonqualified stock option. The option allows the holder to exercise an option, but not the obligation, to buy equity in the company at a particular set price during a stated time period. Stock options are generally valued at stock price minus exercise price, and vest over a few years, subject to the option’s vesting rules and requirements.   They are the most common form of stock options, especially for early stage companies.

AXIS Legal Counsel’s Business and Corporations Practice provides legal advice to numerous startups at the pre-seed, seed and growth stage, including investor-backed ventures.  AXIS  can help with formation matters, governance, co-founder’s agreements, insurance, licensing, and assist with investment agreements, convertible notes, tax elections, and numerous other matters that startups deal with, including startup formations, contracts, deals, and transactions, business administration, corporate governance, operations, risk management / insurancelabor/employment matters, intellectual property, healthcare, crisis management, directors/officers, private/data security, technology, statutory/legal compliance, and business litigation. AXIS represents California and Delaware startups, C Corps, S-Corps, LLCs, LLPs, Partnerships with a wide variety of legaltasks. AXIS represents businesses, corporations, LLCs, LLPS, partnerships, and startups in need of a corporate lawyer, for business legal matters as well as business litigation, such as disagreements, non-solicit agreements, non-competes, trade secrets, cyberlaw, intellectual property, and others. We are also experienced in providing assistance to business clients concerning business contracts, corporate formation matters, contracts and transactions, business litigation, business legal advice for Corporations, LLPs, LLCs, Partnerships, Small Business, Startups, and others involving corporate law.

For information on retaining AXIS Legal Counsel to represent your startup in connection with any legal matter, contact [email protected] or call (213) 403-0130 for a confidential consultation. Axis’ managing attorney Rabeh M. A. Soofi is ranked as one of the “Top Women Lawyers of Southern California” by SuperLawyers Rising Stars, and is a Los Angeles Startup Lawyer representing businesses and start-ups throughout Los Angeles and California.