Before we get into the how, let’s start with why you may want to rebalance ownership between founders. Most companies start with one or two founders, but as they get going (and growing), someone new arrives and they have a key skillset or connection that will help make the company even better. In that case, you may want to add them to the founding team, in which case you will need to balance out the founder stock.
Another scenario that might lead to this situation is if a company has two founders who split the founder stock evenly between the two of them. But, then over time, everyone realizes that one of those two founders is significantly stronger than the other, or has more valuable expertise. In that case, you want to re-allocate the stock in a more equitable way. In both of those cases, there’s a good reason to rebalance the ownership positions of founders.
The different ways to rebalance ownership between founders
Distributing equity to stakeholders helps to align them with the success of the company. In addition, venture capitalists often look at founder equity splits as an indication of the team’s value to the startup. An equal equity split suggests that all the founders have the same value, and, as noted above, that may no longer be true. If that’s the case, it may be time to rebalance the ownership. There are some different mechanisms you can use to rebalance the ownership positions of founders.
Issue stock options
The first and probably the easiest way to rebalance ownership is to issue stock options to the new founder. This is the easiest and best way to do it if the company has been operating for a while. And, the nice thing about this method is that there is already a strike price established by the 409A Valuation. In the early days, the strike price is still pretty low and because that valuation is low it’s still very appetizing for the founder.
Of course, it will be a higher valuation than the price at which the original founders purchased their stock. Typically, founder stock is one-hundredth of a cent per share of stock. But once the company starts making progress or is about to raise money, you will need to do a 409A Valuation to establish the fair market price of the stock.
The nice thing is that if the options are issued at fair market value then it is not a taxable transaction. Of course, if they choose to exercise those options and start the long-term capital gains process, then there will be cash out of the pocket. They will need to write a check to cover that option exercise.
Issue more restricted stock
The other option for rebalancing ownership between founders is to issue more restricted stock or founder shares to the person. However, the restricted stock often has a vesting clock, and is oftentimes taxable.
So the founder who receives the extra shares and is rebalancing upward is going to have a tax bill that year for all of the stock that has vested. That is the downside to restricted stock.
And keep in mind if you’re issuing the restricted stock well into a year or two after the company launched, it’s likely the restricted stock is going to be valuable. So that means it’s going to be a pretty big tax bill.
How to fund the option exercise
Sometimes companies will grant a loan to the founder who takes that money and actually buys shares and then exercises the options. This often works well, but you also have to keep in mind what could happen if the company goes down and that loan is forgiven. The piece of the loan that is forgiven then becomes taxable income for that person.
Anytime a loan is forgiven, the IRS sees it as taxable income. That means that person could end up paying taxes on a loan that was for stock that went to zero.
It’s a good reminder to really careful with any kind of loan at the startup level. The smartest thing to do is only do a loan at a later stage when you’re very sure the company isn’t going down.
Don’t do this when rebalancing ownership
In some cases, in order to rebalance ownership, the company will buy some shares back from one of the founders and then reissue those shares to another founder. While some companies do use this approach, it is a potentially dangerous way to rebalance ownership. The appeal is that it keeps the company’s share count the same.
The downside to this approach is that it can be considered a redemption and qualified small business stock treatment (QSBS), which is a capital gains shield for a lot of early-stage companies. That redemption is against the rules for QSBS. So you have to be really careful not to sacrifice the QSBS for all the shareholders by doing this one buyback and issue.
So beware of redemptions, which can mean your QSBS tax benefit is forfeited, which will create a lot of tax implications down the road.
The safest thing to do is to consult a CPA and your startup lawyer on the best course of action for your company. They should be knowledgeable about QSBS. The best option is to issue restricted stock or more stock options, with an eye toward what the taxable amount is for restricted stock. It’s a complicated topic, and one your CPA should be able to help you with.
If you have any other questions on startup taxes, please contact us.