The Case of the Late Co-Founder - 26 Apr 2009

This situation comes up for me all the time and it is really hard to manage in a way that makes everyone happy.

The scenario is that founders A and B start a company and split the
initial shares. Time passes, business happens. The company may or may
not take on investors or issue equity to employees, but the business
grows one way or another to the point that even by the most
conservative valuation methodology - free cash on the balance sheet -
the company can no longer justify the super-duper-low stock price the
founders paid.

Person C them comes into the picture. C is an extremely high-powered
executive who can bring tremendous value. A and B want to treat C as
effectively a co-founder and give her a share of equity equal to
theirs. The challenge is that since the company now has real value, C’s
share of it can be expensive.

A, B and C come to me and say “please do your legal magic and make
this all work out right.” Sadly, there is no magic here, just a bunch
of unhappy compromises. There are three main intertwined issues: how
much the stock costs, when to pay for it, and what the tax consequences
will be. Here’s my shot at acknowledging them and pointing out the
options in 500 words or less.

What the Stock Costs

This is simple on its face. Per share value = company valuation /
number of shares. The valuation number is the toughest variable to work
out, and the methodology we use depends in part on IRS rules.

When to Pay For the Stock

Wherever possible, we want to buy the stock early. Owning stock
outright starts the capital gains clock ticking and that can make a big
difference when the company is sold (the SEC’s Rule 144 holding period
starts at the same time). Owning a stock option does not count toward
the capital gains period until the option is exercised.

What are the Tax Issues to Dodge?

The two big ones are capital gains rules, which require the stock to be
held for one year before it is sold, and Section 409A, which imposes a
penalty on stock or options issued as “deferred compensation” (i.e.
basically any equity issued now and paid for later) if the stock or
options are issued at a price deemed below fair market value (more on
409A here).

And here are the preferred ways to handle this situation, with their attendant drawbacks.

Buy the Stock

This is the cleanest option. Buying the stock outright avoids
409A issues completely and starts the capital gains clock. In my
experience, though, most people do the math and decide that a year or
two of sweat equity is one level of risk, but cash is something else
entirely. Most people opt not to take this option, especially when the
price is in the 5, 6 or 7 figure range.

Stock Options

This used to be everyone’s favorite way to handle this situation, and
it may still be the best. If the company has real value, co-founder C
could have a huge bill to get her stock. Options let her defer payment
of the price until she knows the company is going to be worth something
(esp. the night before the company is sold).

409A throws up one roadblock here. To avoid the 20% penalties, the
company will need a valuation of its stock. This is often manageable,
though no one likes paying ~$10,000 for the valuation.

The bigger drawback is that she will probably lose her shot at
capital gains treatment. She would need to exercise a year before the
company is sold to get into capital gains land, and if the exercise
price is high that may not be feasible.

Historically, more of my clients have elected this option than any
other. No one likes paying taxes, but at least this option limits the
risks (assuming the 409A issue is handled well).

For more information on Equity and Late Co-Founder's.

Posted by Dan Walter

Performensation: Equity Compensation for High Performance Companies.