Restricted Stock in Startups

Authored by Bryan Springmeyer
The information on this page should not be construed as legal advice.

"Restricted stock" is generally common stock that is subject to repurchase or forfeiture based upon certain contractual conditions being met. Most often, these conditions are that the stockholder continue to be an employee or officer of the corporation that issues the stock.

The two focal points of entering into restricted stock agreements are: (1) among the founders of a startup; and (2) at the insistence of the investors.

Founders use restricted stock to ensure that each of the other founders continues to contribute to the corporation.  Imagine, for instance, that a corporation is split between five founders.  After the first six months of the bootstrapped venture, one of the founders decides he can no longer survive on Ramen noodles and live in his mother-in-law’s living room.  He decides to find a paying job and leaves the company and the other founders.  Three years later, the company has gone through a couple of venture capital rounds and the other four founders have built its worth up to the tens of millions of dollars.  The founder that bailed in the early stages is now a millionaire from the risk taking and efforts of the other four founders he bailed on. Rather than allowing this result, founders will restrict each others' stock and subject themselves to a vesting schedule, so that a departing founder's stock can be repurchased by the company.

Investors also demand restricted stock to ensure that the founders don’t walk away from the company.  One of the primary components that the investors are putting their funds into are the founders.  If the investor wants the founder to continue to make contributions to the company, they will demand a vesting schedule that gives the founder their portion of the company over time.  It’s a common joke in the Valley that founders enter into an investment with 100% of their company, leave with 0% (with their share to vest over time), and are happy about it (because they received their investment funds).  I didn’t say it was a funny joke.

What do you have to do to prepare for the investors?

Many entrepreneurs are under the impression that they will make their startup more appealing to investors by giving themselves a vesting stock schedule.  This is unlikely, because investment transactions with institutional investors and sophisticated angels will be subject to the investors' approval of a satisfactory stock restriction agreement. If one is in place, investors may approve or propose a new one, and if one is not in place, investors may condition the deal upon the execution of such an agreement. Having a standard four year vesting schedule with one year cliff in place (or restricted stock agreement with terms agreeable to VC's) prior to the deal may be beneficial for founders if the investors do not require a new one upon the transaction, because the vesting period will have already begun. Otherwise, they may attempt to negotiate the equivalent of a few months of vesting. However, the existence, or lack thereof, of a stock restriction agreement will not likely impact the company's appeal to investors, unless there is reason to believe that co-founders will not enter into agreements to close the deal.

Whenever using restricted stock in equity structuring or employee compensation, familiarize yourself with IRC Section 83.

Related Articles:
Founder Considerations for Vesting Stock
Negotiating Stock Restriction Agreements
Paying Employees with Options or Restricted Stock
Section 83(b) election letter generator
Section 83(a)

Representation: 
Angel and Venture Capital Representation for Founders
Angel and Venture Capital Representation for Investors