What is Founders Stock?
Founders stock refers to the equity that is given to the early founders of an organization. The stocks differ in a few ways from common stocks in a secondary market. The key differences are that founders stock can only be issued at face value, and it comes with a vesting schedule.
Founders stock is not a legal term per se. It’s simply used to describe the shares issued to the early participants of a firm. It could be investors and any other individual who helped transform the idea of a company into reality. Consequently, a firm’s bylaws may not even include the term.
Why Consider a Vesting Schedule for Founders Stock
As already mentioned, one unique characteristic of founders stock is that it comes with a vesting schedule. The schedule determines the exact time that shareholders are allowed to exercise their stock options. For instance, if an individual owns shares vested over a five-year period, it means that they become exercisable after five years. As such, the shareholder would need to work for the firm for that period before is allowed to exercise his stock options.
But why would an individual consider a vesting schedule for their founder’s stock? Two reasons: one, if one of the early founders chooses to leave or is asked to leave when the company is still young, a vesting schedule helps to protect the other founders from the “free rider” problem. Although most founding teams remain united from the start to the end, it is not unusual for one or more of the founders to part ways. When such an event happens, a vesting restriction ensures that the departed founder does not get any more benefits resulting from the efforts of those who remain to build the firm.
Secondly, a vesting schedule is prepared if the company is expecting a future investment such as venture capital or angel investors who usually ask for these kinds of vesting restrictions. An individual may decide to wait up to the time of investment to address the issue. The drawback for the founders playing the “wait and see” game is that it puts them at risk of getting fair allocations of company equity. The investors who put their money into the firm later may come up with a more onerous proposal of how to divide equity compared to the one that the founders would’ve created if they were on their own.
How to Allocate Founders Stock
The guiding principle when dividing equity among the stakeholders is fairness. In fact, the practice is more important than getting the largest stake in the firm. So, how should founders stock be shared out?
First, an individual should keep in mind that just as his firm expands, so does the number of employees and participants involved. It can be described as adding people in “layers.”
- The uppermost layer will consist of the early founders of the firm. They may be one, two, or more individuals, but the idea is that they all started to work at the same time. This means that they all incurred the same risks of leaving their jobs to venture into the unknown.
- The second layer is comprised of the first real employees. They can be an accountant, a recruiter, IT specialist, among others. By the time the founder is bringing in these professionals, he already sees a small amount of money flowing in and out, be it from investors or regular clients. The employees don’t risk as much as the founders did, as they’re guaranteed of salaries right off the bat.
- The third layer consists of employees who are recruited much later. By this time, the firm is doing pretty well and probably making profits.
For a majority of organizations, each layer takes about one year. So by the time the firm expands to the point of going public, it has five or more layers of employees.
Now, when dividing equity, the very first founders should get at least 50% of the company. Each of the subsequent layers should receive 10% of the company, which is then divided equally among all the employees in that layer.
Practical Example of Founders Stock
- Assume that a firm has two early founders, each of whom takes 2,500 shares. Since the company has 5,000 outstanding shares, each founder receives half.
- If the firm hires four employees in the first year, then each one of them would receive about 250 shares. This brings the sum of the outstanding shares to 6,000.
- Suppose the company hires 20 more workers in the second year. Each of them is issued 50 shares. The reason why they get fewer shares is that they are not incurring much risk in working for the company. They each get 50 shares since every layer is receiving 1,000 shares to split up.
- Once the firm reaches its sixth layer, it would’ve issued 10,000 shares with each of the early founders owning 25% and the remaining shares allocated equally among the layers.
Company owners don’t always need to adhere to the above formula when allocating founders stock. However, the main idea is that stripes of seniority or hierarchy be set up first so that those who risked the most receive the greatest share.
Founders stock refers to the shares issued to the originators of a company. Often, the stock does not receive any returns up to the point that a dividend is payable to the common stockholders. Founders stock comes with a vesting schedule, which determines when the shares are exercisable. A vesting schedule is vital because it helps protect founders from the free rider problem if one of them decides to leave. It also protects the founders’ equity when other investors come into the equation.
Thank you for reading CFI’s explanation of Founders Stock. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: