Founder preferred stock is a pretty new thing in the startup game. Historically, founders would always getcommon stock, usually in the form of founder shares that they received early on. By getting their common stock so early, founders could lock in capital gains and all of the increases in value. However, a new phenomenon has developed in the form of founder preferred stock.
Some founders are now getting roughly 10%, 15%, or 20% of their normal common allocation in founder preferred stock. This is a special class of stock that converts topreferred stock when the founders sell it to investors during a future round of financing. Founder preferred stock must be fully vested when granted, and it’s not subject to repurchase or forfeiture if the founder leaves the company.
Lowering a Founder’s Tax Bill
Founder preferred stock can also provide a lower tax bill in some instances. When a founder sells common stock for a price that’s higher than its fair market value, the difference between the two could be deemed compensation to the founder (who was granted the shares by the company), and therefore be taxed at ordinary income rates. Founder preferred stock automatically converts into shares of preferred stock when it’s sold to an investor in connection with a new financing round without involving the company at all. In theory,* this avoids the “compensation” argument, and may allow any profits the founder makes on the sale to be considered capital gains, which are taxed at lower rates than income.
Founder preferred stock was developed by the law firms who structure this kind of thing. The idea is, if you give founders, say, 20% preferred stock, when they sell some of those shares to venture capitalists down the line, both the founders and the venture capitalists are happy because the founders can sell those preferred shares at the higher preferred price, and the VCs can acquire preferred stock rather than common.
*NOTE: We would like to make clear that this is by no means official tax advice! We are only discussing a current trend in the startup world. You need to work with your legal counsel regarding founder preferred stock.
Preferred Stock Is More Valuable
Preferred stock is always more valuable than common stock. For example, common stock might be 30 cents a share and preferred stock would be $1. This is because preferred stock includes liquidation preferences and other rights. Therefore, founders are able to sell their portion of preferred stock in a secondary sale at a higher price.
It’s consistent with the rest of the preferred share class, meaning there’s less risk. As always, there’s still some risk, but there’s less of a risk that ordinary income tax rates would be applied. It’s more likely thatcapital gains tax rates will be applied instead.
The Downsides of Founder Preferred Stock
There are a couple of downsides to founder preferred stock:
- Unbalances liquidation preferences. Founder preferred stock can affect theliquidation preferences for the company. Liquidation preferences are supposed to mirror however much the investors put in. If they put in five or ten million dollars, they get the first five or ten million dollars out. When founders are gifted or receive preferred shares, they are not really putting money in there, so it throws the liquidation preferences off balance.
- Affects board voting. Founder preferred stock could also potentially change a vote on the basis of a share class or something like that. Investors often negotiate certain voting rights or protective provisions for specific company actions or transactions. For example, there are some governance situations where VCs will say, “Hey, you can’t sell the company unless all of theseries A or all of the series B approve it. We as a share class want to be able to vote on this.” Founder preferred stock can affect these voting rights.
So there’s a lot of mechanisms at work here, but the basic logic is that preferred stock is there to protect the founder from paying ordinary income tax rates. Instead, they pay capital gains tax rates and it’s a benefit for them. Naturally, the VCs get preferred stock.
Talk To Your Law Firm About Founder Preferred Stock
If you want to know more abouts the ins and outs of founder preferred stock, you should talk to your law firm. Your law firm will need to structure founder preferred shares, and you need to do it early when you form a company.
You also have to remember that founder preferred stock is not a guarantee. TheIRS is very much capable of looking at this kind of stuff, seeing what’s happening, and potentially questioning it when you have most of your shares in common stock. They are within their bounds to say it is “against the spirit of the deal” or the spirit of founder stock. If they do, they could make you pay ordinary income taxes.
We’d like to reiterate Kruze is not making any recommendations or vouching for founder preferred stock. If you’re interested in this mechanism, you need research it thoroughly and talk to your legal counsel.
If you have any other questions on other startup related trends, valuations, startup investing, startup accounting, or taxes, please contact us.
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