Founder Equity Split: Rebalancing Cap Tables

Starting a company often involves an initial rush to get things off the ground, and that often means splitting equity quickly based on originally envisioned splits. But as the company grows and roles evolve, the founding team might realize that the original equity split doesn't reflect everyone's contributions and responsibilities. Or perhaps there is a need to add a new “Co-Founder” at some point after the initial founders’ stock is divied up. These realization can prompt a need to rebalance the cap table to ensure fairness and proper motivation for all founders. 

Let's dive into how these adjustments can be made. We’ll use the following scenarios to explain how rebalancing cap tables should be addressed..

Scenario 1: A startup incorporates with 10M shares authorized. Founder 1 is issued 4.7M shares, while Founder 2 is issued 4.3M shares (each with a standard 4-year vesting schedule with a 1-year cliff). Additionally, an equity incentive plan (EIP) with 1M shares is set up. 

Thirteen (13) months later, the company is finally starting to get some traction and starting conversations with investors. However, by that time Founder 2 has taken a job and is moonlighting for the startup for only about 25% time of what was originally envisioned. In addition, a new person joined the team 6 months into the process and is contributing such that they deserve a Co-Founder title and significant equity (Founder 3). 

At that time, the three agree that the split should be as follows:

1. 55% to Founder 1
2. 12% to Founder 2
3. 23% to Founder 3
4. 10% to EI

Scenario 2: Same as Scenario 1 except that 3 months after incorporation, the company has raised $4M of funding and then Founder 2 takes a job and then Founder 3 joins a few months later. 

Primary Considerations Driving the Rebalancing of Cap Tables

Fair Market Value Issues

When issuing stock or options to service providers, it's essential to do so at the current fair market value (FMV). If the stock is undervalued, the difference between the FMV and the amount paid is treated as taxable income by the IRS. This rule applies even if the stock is transferred between shareholders. For example, if Founder Two transfers stock to Founder One for free, and Founder One is a service provider, the IRS would consider the FMV of the stock as taxable income for Founder One.

QSBS  Requirements

To qualify as Qualified Small Business Stock (QSBS), the stock must be originally issued by the company, meaning it can't be acquired through secondary transactions (transfers between stockholders). 

Additionally, certain repurchases of stock by the company could be considered "significant redemptions," which can disqualify the stock from QSBS status for the holder involved, as well as other stockholders who bought stock within one year before or after the redemption.

The Intuitive (But Usually Wrong) Approach Startups May Consider

Founders might consider simply having Founder 2 transfer some of their shares to Founder 1 and Founder 3. While this is possible, it's not ideal for a couple of reasons:

1. The transferred shares won't qualify for QSBS treatment because they don't meet the "original issuance" requirement.
2. Any difference between the fair market value (FMV) of the shares and the amount paid by the recipient is considered taxable income to the recipient. If the recipient is an employee, this could also create withholding obligations for the company.

The Better Approach

In this type of scenario, we typically see the following steps as the best approach:

1. Founder 2 surrenders (i.e. forfeits) the number of shares needed to get them down to the target (3.1M shares are forfeited in our examples). The company may consider getting a release signed from the Founder to ensure that investors conducting due diligence down the line will not be concerned about this surrender.
2. The company directly issues the 3.1M shares to Founder 1 (800k shares in our example) and Founder 2 (2.3M shares in our example) as new stock issuances. A stock restriction agreement or amendment to the original stock purchase agreement for Founder 2 may be put in place to reset or clarify the vesting schedule for Founders 2’s remaining shares. The vesting schedule for the newly granted shares for Founder 1 and Founder 3 should be set forth in their new stock purchase agreements. 

In scenario 1, step 2 above is straightforward and the company should be able to issue these new stock grants for nominal value since the company has not yet raised any money. Additionally, no material events for the company have occurred yet. However, they should quickly get this done before an investor comes to them with a term sheet or another form of definitive investment offer, which would typically be considered an event that increases the FMV of the company.

In scenario 2, step 2 is more nuanced because the company has raised a meaningful amount of money. With that cash in hand, the company should have a 409A valuation completed (if they have not already done so following the $4M round). The new equity for Founders 1 and 3 would be granted either as options or restricted stock. 

If the stock is issued as restricted stock, Founders 1 and 3 would either need to pay FMV or receive their stock in exchange for their services. If they do not pay FMV (and they just receive the stock in exchange for their services), then the value of the stock is taxable income to the Founders receiving stock and the company would have a withholding obligation (assuming the founders are employees, which they probably should be at this point). 

If the stock is issued as options, then they would not need to pay up front. However, they will not hold the stock until they exercise the options, and the holding period for QSBS purposes and long term capital gains does not start until they exercise the options. This scenario is one where we often see early exercisable options granted.

In addition, if the goal is to get the stock in the hands of the founders quickly without paying out of pocket out the gate, the company could consider offering the founder a promissory note such that the purchase price is paid in the future (often set with a long term repayment period or a requirement to pay upon an acquisition of the company). There are nuances to using a promissory note in this way, but it is an approach to consider.

What If A Departing Founder Wants Payment for Stock?

If Founder 2 wants $50k to give up his stock and the company wants to provide that, the company should not just repurchase the stock from him for $50k. That would likely be a “significant redemption” under QSBS rules and all 3 founders’ stock (and the investors’ stock in Scenario 2) would no longer be QSBS. This would be a bad outcome.

Instead, the parties could consider the following approaches:

1. The company pays no more than $10k for a portion of the stock (and often there is a desire for the company to pay no funds to the founder for the repurchase), which keeps the repurchase below the significant redemption threshold. Then Founder 1 and Founder 3 pay the remaining $40k to Founder 2 and purchase a portion of the stock directly from Founder 2. Note that this portion would not be QSBS because of the original issuance requirement. 
2. An alternative approach could be for the company to pay the Founder $50k as a bonus run through payroll such that the Founder pays ordinary income taxes (as opposed to capital gains) on the $50k and the company has a corresponding withholding obligation.  

Unfortunately, this is a tricky situation and one that requires discussion to strategize on the best approach. In our scenario, if Founder 2 is not willing to be helpful then presumably Founder 1 could consider just removing Founder 2 and ideally the stock held by Founder 2 is subject to vesting such that the company gets back the unvested stock.

For personalized support in structuring founder equity for your startup, contact us today. Our attorneys have decades of experience in helping startups like yours.