Startup Law 101 - FAQ 006

Startup Law 101 Series - What is restricted stock and how is it used in my startup?

What Is Restricted Stock?

Restricted stock is the main mechanism by which a founding team will make sure that its members earn their sweat equity. Being fundamental to startups, it is worth understanding. Let's see what it is.

Restricted stock is stock that is owned but can be forfeited if a founder leaves a company before it has vested.

The startup will typically grant such stock to a founder and retain the right to buy it back at cost if the service relationship between the company and the founder should end. This arrangement can be used whether the founder is an employee or contractor in relation to services performed.

With a typical restricted stock grant, if a founder pays $.001 per share for restricted stock, the company can buy it back at $.001 per share.

But not forever.

The buy-back right lapses progressively over time.

For example, Founder A is granted 1 million shares of restricted stock at $.001 per share, or $1,000 total, with the startup retaining a buy-back right at $.001 per share that lapses as to 1/48th of the shares for every month of Founder As service tenure. The buy-back right initially applies to 100% of the shares made in the grant. If Founder A ceased working for the startup the day after getting the grant, the startup could buy all the stock back at $.001 per share, or $1,000 total. After one month of service by Founder A, the buy-back right would lapse as to 1/48th of the shares (i.e., as to 20,833 shares). If Founder A left at that time, the company could buy back all but the 20,833 vested shares. And so on with each month of service tenure until the 1 million shares are fully vested at the end of 48 months of service.

In technical legal terms, this is not strictly the same as "vesting." Technically, the stock is owned but can be forfeited by what is called a "repurchase option" held by the company.

The repurchase option can be triggered by any event that causes the service relationship between the founder and the company to end. The founder might be fired. Or quit. Or be forced to quit. Or die. Whatever the cause (depending, of course, on the wording of the stock purchase agreement), the startup can normally exercise its option to buy back any shares that are unvested as of the date of termination.

When stock tied to a continuing service relationship can potentially be forfeited in this manner, an 83(b) election normally needs to be filed to avoid adverse tax consequences down the road for the founder.

How Is Restricted Stock Used in a Startup?

Restricted stock usually makes no sense for a solo founder unless a team will shortly be brought in.

For a team of founders, though, it is the rule as to which there are only occasional exceptions.

Even if founders do not use restricted stock, VCs will impose vesting on them at first funding, perhaps not as to all their stock but as to most. Investors can't legally force this on founders but will insist on it as a condition to funding. If founders bypass the VCs, this of course is not an issue.

Restricted stock can be used as to some founders and not others. There is no legal rule that says each founder must have the same vesting requirements. One can be granted stock without restrictions of any kind (100% vested), another can be granted stock that is, say, 20% immediately vested with the remaining 80% subject to vesting, and so on. All this is negotiable among founders.

Vesting need not necessarily be over a 4-year period. It can be 2, 3, 5, or any other number that makes sense to the founders.

The rate of vesting can vary as well. It can be monthly, quarterly, annually, or any other increment. Annual vesting for founders is comparatively rare as most founders will not want a one-year delay between vesting points as they build value in the company. In this sense, restricted stock grants differ significantly from stock option grants, which often have longer vesting gaps or initial "cliffs." But, again, this is all negotiable and arrangements will vary.

Founders can also attempt to negotiate acceleration provisions if termination of their service relationship is without cause or if they resign for good reason. If they do include such clauses in their documentation, "cause" normally should be defined to apply to reasonable cases where a founder is not performing proper duties. Otherwise, it becomes nearly impossible to get rid of a non-performing founder without running the risk of a lawsuit.

All service relationships in a startup context should normally be terminable at will, whether or not a no-cause termination triggers a stock acceleration.

VCs will normally resist acceleration provisions. If they agree to them in any form, it will likely be in a narrower form than founders would prefer, as for example by saying that a founder will get accelerated vesting only if a founder is fired within a stated period after a change of control ("double-trigger" acceleration).

Restricted stock is normally used by startups organized as corporations. It can be done via "restricted units" in an LLC membership context but this is more unusual. The LLC is an excellent vehicle for many small company purposes, and also for startups in the right cases, but tends to be a clumsy vehicle for handling the rights of a founding team that wants to put strings on equity grants. It can be done in an LLC but only by injecting into them the very complexity that most people who flock to an LLC seek to avoid. If it is going to be complex anyway, it is normally best to use the corporate format.

Conclusion

All in all, restricted stock is a valuable tool for startups to use in setting up important founder incentives. Founders should use this tool wisely under the guidance of a good business lawyer.

G.G.

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Question or comment about this topic? Was it helpful? Can it be clarified? Email George Grellas at gg@grellas.com

 

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