In our earlier blogs, we discussed the nuances of the various nomenclatures, i.e. promoter / founder / co-founder, and the perils of handing out the co-founder tag to a CXO. In this blog, we discuss whether one should grant ESOPs (or stock options) or shares to their co-founder.
The foremost consideration is the stage at which the co-founder is joining the startup. If the co-founder has been part of the startup from Day 1, and forms part of the founding team, then the co-founder would be one of the subscribers to the Memorandum and Articles of Association of the startup, and hence, would ideally have been granted shares in the startup from Day 1. However, if the co-founder joins the startup at a later stage, when the question of structuring the stock incentives arises, one faces the classic dilemma of whether the co-founder be granted shares or ESOPs. Further, if one decides to grant shares upfront, then the question is what percentage stake in the startup should the co-founder be granted?
As one would guess, there is no right or wrong answer to this. The structure adopted depends on a variety of factors and answers to questions such as “Whether the co-founder (let’s refer to him/her as the “joining co-founder” henceforward) will be investing in the startup as well, thus buying his/her stake?”, “How well do you know the joining co-founder?”, “Have you worked with him/her before?”, and “How vested is the joining co-founder in your startup?”.
If the joining co-founder is investing in the startup and buying his/her stake, then the answer to the titular question is a no-brainer; the joining co-founder will be given equity shares in the startup. If this is not the case, then one needs to decide between ESOPs and shares!
Listed below is a set of pros and cons of the two, devised from our experience of having assisted over hundreds of startup founders through this journey:
Argument for granting shares upfront from the startup’s perspective
During the early stages of a startup, granting shares is a fairly simple process and involves less complexity and almost no structuring!
Argument against granting shares upfront from the startup’s perspective
Once shares are allotted to the joining co-founder, he/ she is vested with control over these shares. If at a later stage, the joining co-founder leaves, the existing co-founder / company will not just have to pay to buy back these shares, but will also incur tax liabilities in the process (depending of course on the price paid for these shares)!
Simply put, the existing co-founder / company will end up paying the price for the joining co-founder reneging on his/her promise to be part of the startup’s journey. Also, we have witnessed several disputes arising in such scenarios, especially if the startup has fund-raised or added substantial value through traction. Then, the joining co-founder could push for a premium on his/her shares, in spite of abandoning the ship midway.
Argument for seeking shares upfront from the joining co-founder’s perspective
Well, there can only be one use case here, i.e. why should the joining co-founder seek his/her shares upfront?
The joining co-founder would not incur tax liabilities at a later stage.
During the early stages, value of the startup is presumably low and the startup can issue shares to the joining co-founder at face value, without any income tax liabilities accruing to the joining co-founder.
However, if this process were to be delayed and the joining co-founder were to buy shares of the startup at a later stage, once the startup has raised funds or the value of the startup has surged because of increase in revenues, then the joining co-founder might incur tax liabilities on the notional income i.e. difference between fair market value of the shares and their face value (or whatever consideration is being paid by the joining co-founder).
What if the existing co-founder / company renege on their promise to grant shares?
Confused? Like we mentioned earlier, there is no right or wrong answer, so one needs to evaluate the pros and cons and then decide. If, as the company, you do decide to grant shares upfront, consider incorporating a vesting schedule.
What is a vesting schedule? In our next blog in the “co-founders’ agreements” series, we discuss the nuances of a vesting schedule and how to structure one.
To further your understanding on granting ESOPs to co-founders, you can peruse our previous blog on the issue here:
Missed out on the previous blogs in the “co-founders’ agreements series”?
In the first blog titled “The Basics of a Co-founders’ Agreement”, we discuss what a co-founders’ agreement is, focusing on the distinction between the various terms employed in that regard. [https://www.lexstart.com/post/the-basics-of-a-co-founders-agreement]
In the second blog titled “Is it okay if I grant my CTO the coveted co-founder tag?”, as is evident from the title, we discuss the pros and cons of granting your CTO the co-founder tag. [https://www.lexstart.com/post/is-it-okay-if-i-grant-my-cto-the-coveted-co-founder-tag]