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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice. |
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Restricted Stock in Startups
"Restricted stock" is generally common stock that is subject to standard transfer restrictions for private company stock and repurchase or forfeiture based on a vesting schedule. Vesting is usually over a four year period (with an optional one-year cliff, meaning the first vesting event happens at 12 months) and conditioned upon the stockholder maintaining their relationship with the company as an employee or officer.
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's stock is split between five founders. Six months into the bootstrapped venture, one of the founders decides he's tired of living on a Top Ramen budget. 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 rounds of VC financing 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 unvested shares 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). Haha :-|
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 implementing a vesting schedule in their stock. 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 that resets some or all of the vesting, 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 VCs) 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 commenced. 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.