Equity Compensation

Do I need to file a Section 83(b) election if vesting is imposed on my stock after it has been issued?

Authors: George Colindres, StartupPercolator

In a prior Founder Tip of the Week we discussed how the Internal Revenue Code (the “Tax Code”) characterizes unvested founder stock as not being purchased until it has vested, and that this characterization can have adverse tax consequences for the founder because the Tax Code treats as taxable income the excess, if any, of the fair market value of stock at the time it vests over the purchase price of the stock (the “spread”). We also discussed how the purchaser can avoid these adverse tax consequences by making a Section 83(b) election.

One reader asked essentially the following question: What if a founder initially purchases fully-vested stock and vesting is imposed on the stock later, for example, in connection with a venture capital (“VC”) financing? That’s a good question. Pursuant to an IRS ruling (Rev. Rul. 2007-49, 2007-2 C.B. 237, Situation 1), when vesting restrictions are imposed on previously purchased fully-vested stock, the imposition of vesting restrictions is disregarded and the stock will be treated as purchased at the time of original purchase, provided the originally issued stock is “old and cold.” Accordingly, in those circumstances, any spread taxable as income will be measured at the time of original purchase of the shares so there would be no reason to file a Section 83(b) election.

Shares generally should be considered “old and cold” if they were purchased well before the first instance where vesting restrictions were contemplated or imposed, for example, the time of first contact with an outside angel or VC firm. Although there are no hard and fast rules, three to six months generally should be a sufficient amount of time to cure the stock. In any event, the founders should be prepared to substantiate that the original purchase and subsequent imposition of vesting restrictions were independent, unrelated transactions.

The situation described above should be distinguished from situations where the imposition of vesting restrictions occurs in connection with a reorganization of the company. This situation most commonly arises in connection with a financing where the VC firm requires the company to reincorporate in another state, usually Delaware, as a condition to the financing and imposes vesting restrictions on the stock received by the founders and other service providers in exchange for previously vested stock. It also may arise in connection with an acquisition of the company by a strategic buyer who imposes vesting restrictions on the founders and other key employees of the company. In these situations, holders of shares generally should file a Section 83(b) election within 30 days after the conversion of the shares in the reorganization to avoid adverse tax consequences when the shares subsequently vest.

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.