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The founders of startups and high growth companies face unique challenges balancing control of their business, the introduction of new shareholders and their personal interests.
What are they?
Founder shares are a separate class of share issued to the founder(s) of a company, usually upon incorporation – in the United States Founder shares are sometimes known as Class F stock.
Founder shares carry unique rights regarding voting, control and distribution of profits which are not available to other shareholders. The rights attaching to Founder shares are not pre–defined, so can vary widely.
Some of the more common Founder share provisions are discussed below.
A common problem for startups is that the founders risk losing control of their company as a result of ongoing equity capital raising ie as more funding is raised through share issues, the founders % ownership successively decreases – at some point the founders will no longer be able to control the business through the votes attaching to Ordinary shares.
To counter this problem, Founder shares with special voting rights are used – examples include voting multipliers, where the Founder shares carry say a 10 for 1 voting entitlement (or more), or protective provisions where certain actions (eg a sale of the business) require a majority % of votes attaching to Founder shares. There are also examples where the Founders stock allows founders to appoint Directors who have more than one Directors vote.
“Dual class” share structures are used by a variety of companies to allow founders to retain effective control despite not holding a majority of shares – high profile examples include Atlassian, Facebook and News Corp.
Another common problem for startups can occur when for example a co-founder leaves the company early (whether voluntarily or terminated). If that co-founder held a significant unrestricted shareholding, this leads to a situation where a person who is no longer associated with the business still has significant control or influence – the so-called “free rider” problem.
To address this, Founder shares with a vesting schedule are often used.
When shares “vest”, they become the unconditional legal property of the holder – to vote, receive dividends etc as they see fit.
A typical Founder vesting schedule is for their shares to vest in equal monthly instalments over say four years, with a 12 month “cliff”.
A cliff refers to the period before vesting takes place – so a 12–month cliff means no shares are vested in the first 12 months.
For example, if a Founder were to receive 100,000 shares which vest monthly over 4 years, with a 12–month cliff, they would receive;
Months 0 -12NIL shares
End month 1225,000 shares
Months 13 – 482,083 at the end of each month
until 100,00 shares have been vested.
In the case of a Co-founder who leaves early, a vesting schedule helps to ensure they receive only the number of shares which reflect their contribution.
Other features of Founder shares
There are several further common features of Founder shares;
- They may not receive a dividend until Ordinary shareholders have been paid their dividend
- Accelerated vesting upon termination / sale of the business etc
- Right of first refusal in the event of Co-founder share sales
Implications of Founder shares
Founder shares can be an effective mechanism to address issues which often arise with startups. However, Founder shares should be considered with caution;
- Many investors, particularly Venture Capital firms, won’t agree to unbalanced control provisions or dual class share structures where their voting power does not correspond to their shareholding
- Overly onerous vesting arrangements can act as a disincentive to founders
- Complex Founder share structures can give rise to unintended legal or taxation consequences
It should also be noted that many of the issues raised above can be addressed in other ways – for example by having all shareholders enter into a binding Shareholders Agreement or a Founders Agreement.
We recommend that when setting up a startup share structure you follow the principle of Occam’s Razor – that the simplest solution is most likely to be the best.
If your business’ finances require more expertise at the helm, reach out to the seasoned team at Fullstack who can help with outsourced CFO services at email@example.com