Startup Act 101 Series: What Are Restricted Stocks and How Are They Used In My Startup Business?
What is restricted stock?
Restricted shares are the primary mechanism by which a founding team will ensure that its members earn their capitalization. Being fundamental for startups, it is worth understanding. Let’s see what it is.
Restricted shares are shares that are owned but can be lost if a founder leaves a company before it has been acquired.
The startup will generally award such shares to a founder and retain the right to buy them back at cost if the service relationship between the company and the founder ends. This arrangement can be used if the founder is an employee or a contractor in connection with the services provided.
With a typical restricted stock grant, if a founder pays $ .001 per share for restricted shares, the company can buy them back at $ .001 per share.
But not forever.
The repurchase right expires progressively over time.
For example, Founder A is awarded 1 million shares restricted to $ .001 per share, or $ 1,000 total, and the startup retains a repurchase right at $ .001 per share that expires on 1/48 of the shares . for each month of permanence in the service of Founder A. The repurchase right applies initially to 100% of the shares awarded in the grant. If Founder A stopped working for the startup the day after receiving the grant, the startup could buy back all of the shares at $ 0.001 per share, or a total of $ 1,000. After one month of service by Founder A, the repurchase right would expire up to 1/48 of the shares (ie 20,833 shares). If Founder A left at that time, the company could buy back all but the 20,833 shares it acquired. And so on with each month of service until the million shares are fully consolidated at the end of the 48 months of service.
In technical legal terms, this is not strictly the same as “adjudication.” Technically, the shares are owned but can be confiscated by what is called a “buyback option” held by the company.
The buyback option can be activated by any event that causes the termination of the service relationship between the founder and the company. The founder could be fired. Or resign. Or be forced to resign. Or die. Whatever the cause (depending, of course, on the wording of the share purchase agreement), the startup can normally exercise its option to buy back the shares that have not been invested on the termination date.
When shares tied to a continuing service relationship can potentially be lost in this way, an 83 (b) election should normally be filed to avoid future adverse tax consequences for the founder.
How are restricted shares used in a startup?
We have been using the term “founder” to refer to the recipient of restricted shares. These stock grants can be awarded to anyone, founder or not. Typically, startups reserve these grants for founders and very key people. Why? Because anyone who obtains restricted shares (as opposed to a stock option grant) immediately becomes a shareholder and has all the rights of a shareholder. Startups shouldn’t be too lax in giving people this status.
Restricted stocks generally don’t make sense to a solo founder, unless a team joins shortly.
However, for a team of founders, the rule is that there are only occasional exceptions.
Even if the founders do not use restricted stocks, the venture capitalists will force the concession on them on the first funding, perhaps not on all of their stocks, but on the majority. Investors cannot legally force this on founders, but will insist on it as a condition of funding. If the founders overlook VCs, this is of course not a problem.
Restricted shares can be used for some founders and not others. There is no legal rule that says that each founder must have the same acquisition of rights requirements. One can be granted shares without restrictions of any kind (100% acquired), another can be granted shares, that is, 20% immediately granted with the remaining 80% subject to consolidation, and so on. All of this is negotiable between founders.
The acquisition of rights does not necessarily have to be over a period of 4 years. It can be 2, 3, 5, or any other number that makes sense to the founders.
The rate of acquisition of rights can also vary. It can be monthly, quarterly, yearly or any other increment. Annual award for founders is comparatively rare, as most founders will not want a one-year delay between award points as they build value in the company. In this sense, restricted stock grants differ significantly from stock option grants, which often have longer award gaps or initial “cliffs.” But again, this is all negotiable and arrangements will vary.
Founders may also attempt to negotiate acceleration provisions if the termination of their service relationship is without cause or if they resign for good reason. If they include such clauses in their documentation, “cause” should normally be defined to apply to reasonable cases where a founder is not performing the proper duties. If not, it becomes nearly impossible to get rid of a non-compliant founder without risking a lawsuit.
All service relationships in a start-up context should normally be terminated at will, whether or not a termination without cause triggers a stock acceleration.
VCs will normally resist throttle arrangements. If they agree with them in any way, it is likely to be in a more limited way than the founders would prefer, such as saying that a founder will get an expedited award only if a founder is fired within a set period. after a control change (“double trigger” acceleration).
Restricted stocks are normally used by startups organized as corporations. It can be done through “restricted units” in an LLC membership context, but this is more unusual. The LLC is an excellent vehicle for many small business purposes, as well as startups in the right cases, but it tends to be a clumsy vehicle for managing the rights of a founding team that wants to put caps on equity grants. It can be done in an LLC, but only by injecting them with the same complexity that most people flocking to an LLC seek to avoid. If it is going to be complex anyway, it is usually better to use the corporate format.
conclusion
All in all, restricted stock is a valuable tool for startups to use in creating significant incentives for founders. Founders should use this tool wisely under the guidance of a good business attorney.