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Founder Vesting: What is an 83(b) Election?

Founder Vesting: What is an 83(b) Election?

Founder Vesting is a process by which a founder “earns” the stock over a period of time depending on performance and commitment to the startup. In case one or more co-founders leave, the company gets the right to buy back the stock.

That is to say, the founder has all rights on the shares including voting rights and the right to receive dividends, but does not own them until they actually vest. That means the founder cannot walk away with the shares until the vesting happens.

This is typical of Silicon Valley vesting for venture capital companies: it vests equally over four years, with a one-year cliff. If the founder had been given one million shares, he would have gotten nothing until the end of year one.

At the end of year one, at the stroke of midnight, the founder gets to keep 250,000 shares. This is a quarter of the one million shares.

Over the three-year period, the remaining shares vest equally over 36 months.

Most investors need this agreement for protection. Founders must stay with the startup. The company is protected against founder flounder.

Investors see vesting as a forward approach. It ensures that the team remains involved for the long haul.

It’s a way to ensure founders “earn” their equity. All equity need not be given away up front just because you were there since day one!

If the founder leaves, the equity ownership should be left behind. The equity must go to someone else who replaces the founder and takes that role

Principle #1 – Difference Between Price and Fair Market Value

When you receive something more valuable than what you pay for, the IRS taxes you on the difference. For example, if you acquire an asset with a fair market value of $5,000 by paying $1,000, the IRS taxes you on the $4,000 difference.

Case in Point: When a company issues stock to a founder without payment, the founder must pay taxes based on the “fair market value” of the shares. This value is assessed on the date the founder receives the shares. There is tax liability here, and the company will likely issue a Form 1099.

Principle #2 – Timing Difference Resulting from Vesting

When you receive stock over time according to a vesting schedule, the IRS doesn’t consider it truly received until the vesting occurs. This is referred to as the substantial risk of forfeiture.

Example: If you receive 1,000,000 shares over four years with a one-year cliff, the IRS considers you have zero shares on day one because vesting hasn’t occurred yet.

Taxable Event at Vesting

At the end of the 12-month vesting cliff, the founder receives 250,000 shares, triggering a ‘taxable event.’ In venture-backed companies, you would typically raise multiple rounds of capital, increasing the company’s value over time.

In Our Example: On day one, the company’s value was almost nil. By the end of the 12-month period, assuming the company has made progress and is worth $2 million, the first vesting occurs.

Tax Consequences: Founders now have to pay tax on the 250,000 shares based on the company’s valuation of $2 million. This situation can be problematic as founders face taxation on a taxable event without liquidity.

Ongoing Tax Issues

As vesting continues over the four-year period and the company’s value hopefully increases while generating more revenue, significant tax consequences may arise for the founders.

To avoid the dreadful consequences of an asset that may create tax liability without liquidity, founders should file an 83(b) election. By making the 83(b) election, you choose to pay the entire tax upfront on the date you receive the founder shares instead of at the vesting dates.

This approach disconnects the vesting schedule from a taxable event. You pay the entire tax liability based on the valuation as of the date you receive the founder stock—usually day one of the company.

As we saw, founder stock is worth essentially nothing on day one of the company. Therefore, you owe almost no taxes—let’s say none, if done properly—compared with the default situation where the taxable event ties to the vesting schedule.

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What should you be doing?

It’s simple. You need to fill out a Form 83(b) and send it out to the IRS with an “acknowledge due” self-addressed envelope within 30 days of the restricted stock grant.

The good thing with an 83(b) election is that the taxable event is shifted upfront. Let us look at the impact of taxes under both the scenarios. Assume that in each of the two cases, you get 1,000,000 shares subject to a vesting agreement, and the share price at grant is $0.01 per share, $2 per share when vesting occurs at the end of Year 1, and appreciated in value by 25% at the end of every year. Assume further that the normal income tax rate is 25%. We will ignore employment taxes and state taxes consequences for this example.

Scenario #1: Without 83(b) election

In this scenario, let’s consider tax implications with these assumptions (just to keep things simple). The tax liability would look like this:

Scenario #2: With 83(b) election

Here the taxable event is at the very beginning. So, here the whole 1,000,000 shares are taxed up front.

The tax liability with the same assumptions would be as follows:

As you can tell from the tables above, the amount of tax savings, with those assumptions, is meaningful with an 83(b) election.

If you receive stock worth a nominal amount, as in our example, it makes sense to file one. However, if the fair market value of the stock were $1 per share at grant date rather than $0.01, you would be looking at a tax liability of $250,000. And if subsequently the company fails, especially before the vesting takes place, then not filing an 83(b) election is better. So, as painful as it may seem, you should seek out your tax advisor, but remember that the filing has to be done within 30 days of the stock grant. This is generally when the board has approved the grant—not when you actually get the paperwork!

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