Equity Compensation

83(b) Election Basics

Authors: George Colindres, StartupPercolator

We find ourselves explaining 83(b) elections several times a week, so we thought it would be a good blog topic.

In the start-up world, the opportunity to file of an 83(b) election generally arises in the context of a founder purchasing low-priced “founder” common stock of a start-up company that is subject to vesting, or an employee, director or other service provider of such a company “early exercising” an option for stock that is subject to vesting.  Such stock is sometimes also referred to as “unvested” stock or stock subject to “reverse vesting.”  All this means is that the issuing company has the right to repurchase the stock at the original purchase price.  This right of repurchase generally lapses in equal installments on a monthly basis over a period of three to five years, provided that the founder/optionee continues to render services to the company. ((A common vesting scheme for employees is for all of the stock issuable pursuant to an option to vest in equal monthly installments over four years.  Sometimes there is also six- or 12-month cliff, meaning that the company’s right of repurchase with respect to the first six or 12 monthly installments does not lapse until the founder/optionee has provided six or 12 months, respectively, of service.))

This vesting can be complicated enough to grasp for a first-time founder or optionee, but the Internal Revenue Code adds its own twists:  First, stock subject to vesting is not treated as purchased until the vesting restrictions lapse.  Second, if a founder/optionee purchases stock for a price lower than the stock’s fair market value (determined without regard to the vesting restrictions), then the difference between the stock’s fair market value at the time the stock vests and the purchase price (sometime referred to as the “spread”) is income to the founder/optionee.  This can be problematic for founders/optionees of start-up companies, whose stock can increase in value dramatically in a short period of time.  This problem is exacerbated by the fact that start-up company stock generally is not liquid, so the founder/optionee cannot just sell some of such stock to pay taxes on this phantom income.

In order to avoid these potentially adverse tax consequences, a founder/optionee can file an 83(b) election.  The 83(b) election essentially disregards the vesting restrictions on the stock and treats the spread at the time of purchase (which often times is when the stock value is relatively low or equal to the purchase, or exercise, price) as income to the founder/optionee.  However, a founder/optionee generally has just 30 days from the purchase of the stock (including by means of option exercise) to file an 83(b) election, and there are various formalities to be followed in such filing which we will not go into in this blog posting.  Needless to say, a founder/optionee who is purchasing unvested stock, should consult his or her tax advisor to fully understand the pros and cons of purchasing unvested stock and filing (or not filing) an 83(b) election.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.