These heady, entrepreneur-friendly times have led to a resurgence of companies issuing founder-friendly stock to their founders. What is founder-friendly stock? Should you consider issuing it to yourself?
Here at Capshare we have seen quite a few companies issue founder-friendly stock like the “Series FF” stock invented by the Founder’s Fund or other kinds of stock with control benefits. Founder-friendly stock can confer significant benefits on the founders of a company.
Some view this trend as a bubble-induced excess that could lead to disastrous consequences. Others see this as a long-term trend that might wax and wane with entrepreneurial cycles but will eventually take root as a common feature of the entrepreneurial landscape.
So which is it? Should you care? It turns out that decisions you make around this issue can have very significant positive or negative impacts on your company’s experience, your rights as a founder, and your own personal pocketbook.
So you should go in with a solid understanding of the issues. Let’s start with a basic understanding of founder-friendly stock.
Defining Founder-Friendly Stock
Founder-friendly stock is equity with early liquidity provisions, better vesting terms, enhanced control rights, or a combination that is designed to provide valuable benefits to founders without harming a company’s other employees or investors. Let’s look at each of these rights in more detail.
Early Liquidity Stock
Stock with early liquidity rights contains a built-in right for the holder to sell shares in any future fundraising events. This allows the holder to get cash in exchange for stock often much earlier and much easier than is usually the case.
Before the advent of founder-friendly stock, founders selling shares at high prices would often cause problems for new optionees. New optionees receive stock options with a strike price that has to be set by law at the fair market value of the company’s common stock (according to a US Internal Revenue Code section called409A). When a founder sells common stock at a high price it can affect the valuation of the company’s common stock. This in turn makes the price of all new stock options more expensive.
An example might help. Let’s assume that the fair market value of common stock in a company is $5.00. When founders sell their common stock at a certain price, say $10.00, this becomes a very important indication of the fair market value of all common stock in the company. So let’s assume new stock options would need to have a strike price of $10.00 as opposed to $5.00.
This makes new stock option grants less valuable to new employees because they cost more to exercise. Put another way, the company would have to be worth a lot more before it would make sense for these new option holders to exercise their shares. So one founder selling some shares might make stock options less valuable for all future optionees.
At the end of 2006, The Founders’ Fund created a new type of security that is typically called Series FF. They hoped to design stock that would allow founders to achieve liquidity more easily and do so without increasing the cost of stock options for new employees.
This stock has become the model for all other forms of early-liquidity stock.
Series FF typically has the following features:
- The stock is designated “preferred”
- However, the stock is actually more like common stock with one important exception: It is convertible at the option of the holder into the same series of preferred stock issued in a subsequent funding round
- A sale of the stock can only happen if the buyer is willing to pay the same price per share for Series FF as for the new preferred series
So these features allow Series FF holders to sell their stock at the same price as preferred stock in subsequent rounds. This design seemed brilliant at the time because it allowed founders to sell shares early with minimal transaction costs and it wouldn’t increase the price of common stock.
Why wouldn’t it increase the price of common stock? Great question. At the time, most valuation experts believed:
- Series FF would not be a good proxy for common stock because it has some significant differences compared to common (mainly its liquidity rights)
- Because Series FF can’t be used a proxy for common, you could in theory sell it for whatever you want and it shouldn’t affect the price of common
More recently some valuation experts have questioned
whether or not this kind of stock really protects the common from increased valuations. However, setting up stock like this from the beginning definitely has benefits:
- Signals to investors that you are interested in liquidity but don’t want to do it in a way that harms the company
- Gets everybody on the same page about liquidity options
- At least somewhat minimizes other negative impacts of early selling on the fair market value of options
Vesting is extremely common among founders. Not using vesting with founder shares is one of the biggest equity pitfalls we regularly see here at Capshare. It is very common to see one or more founders leave a company before it is successful. This “founder churn” often occurs when it becomes clear that the road to success is longer and riskier than originally thought.
If founders all start with an equal, fully vested stake in the business, then those who leave could receive just as much reward in a successful exit as those who spend years working late nights at half pay to get to the exit. Preventing this is as simple as giving yourself and your co-founders vested equity.
Four years with a cliff means that you will generally vest no shares until after you have worked for the company for 1 year. At this point you receive 1/4th of your total share grant and you will vest monthly for the remaining 3 years. You receive 1/48th of your total share grant each month for the next 3 years. So the total period of vesting is 4 years.
Most vesting has either a single trigger or a double trigger. In the vesting world, triggers cause your unvested shares to vest. This is a good thing for entrepreneurs because you can sell vested shares but you cannot sell unvested shares until they vest.
Single trigger vesting means that as soon as your company sells (or goes public) your shares fully vest no matter how much had previously vested. Double trigger means that two things have to happen before you vest:
- Your company sells or goes public
- You are let go as an employee
The second trigger may seem strange but it protects the recipient because they will still receive the value of their equity after a company sells even if they are fired.
Some founders want better terms than these so they push for shorter vesting periods like 3 years or even 2 years. They also ask for single trigger vesting.
The second kind of founder-friendly stock is stock that grants founders control rights in a permanent or semi-permanent way even if their ultimate percentage of the company drops well below 50%. Mark Zuckerberg famously used this strategy to maintain control of Facebook to this day.
There are several ways to accomplish enhanced control. Founders can establish control through a board structure or through separate classes of voting stock. You can consult with your lawyer to see which might work for you.
Generally founder-friendly terms are investor-unfriendly. So keep in mind that there is a natural tension between founder-friendly (or company-friendly) terms and investor-friendly terms. Often deals get done “up-the-middle” where terms are neither too founder-friendly nor investor-friendly.
Most founders who receive founder-friendly terms have earned it by being a successful serial entrepreneur or by creating a company that is already massively successful.
Founder-friendly stock can make a big difference for founders looking for early liquidity, smaller vesting periods, or control. However, you will need to balance your appetite for founder-friendly terms with you desire for outside investors. Outside investors will generally only grant these terms when you have already created something of significant value.