The vast majority of technology startups are capitalized in the same manner: common stock to the founders, common stock reserved in an option pool for employees and consultants, and preferred stock (Series A, Series B, etc.) sold to investors. However, a small but probably growing percentage of startups consider a more complicated stock structure that includes, in addition to the types of equity above, a special class of common stock reserved for founders. Below is a brief summary of the types of special classes of founders stock and the pros and cons of adopting such a structure for your startup.
There are many names for special classes of founders stock (FF shares, Class F stock, X shares, etc.), but they all refer to basically the same type of equity. For simplicity, we will call these shares Class A Common Stock. The essence of Class A Common Stock centers around two types of stockholder rights that are sometimes combined but more often separate.
The first type of Class A Common Stock is founders shares that have the right to convert into any future round of preferred stock and to be sold by the founders at the same price and on the same conditions as the company’s direct sale to its investors. The corporate charter creating this type of Class A Common Stock will have specific rules allowing the shares to be converted into preferred stock only in connection with a financing initiated by the company where the investors are agreeing to purchase some shares directly from the company (referred to as the “primary” offering) and other shares from the founders (the “secondary” offering). Some companies require additional board approval at the time of the financing to allow conversion and sale of the Class A Common Stock by the founders.
The second type of Class A Common Stock is founders shares with superior voting rights to “ordinary” common stock. For example, the Class A Common Stock could get two (or more) votes for every share or could have one or more seats on the company’s board of directors allocated to the founders holding Class A Common Stock.
There are many variations on the two types of rights described in general terms above, and there are also many other rights that can be attached to the Class A Common Stock (for example, liquidation preferences and redemption rights). But although the advantages to the founders of using Class A Common Stock are obvious—allowing early liquidity, heightened control of the board of directors and/or control with respect to issues requiring stockholder approval—there are disadvantages to consider as well. Investors, both current and prospective, are generally not comfortable allowing founders to get liquidity before investors. Investors also do not like diverting funding from the company to the founders. They also may feel that Class A Common Stock signals that the founders are looking for an early exit, and are not committed for the long haul. Furthermore, control issues are critical to investors, and they are likely to ask for any special voting rights in favor of the founders to be pared back or eliminated as a condition to their investment. If this happens, the time and cost expended to create these rights may have been wasted.
So consider adopting a founders Class A Common Stock carefully before you do so, with input from advisors and prospective investors. Also be sure to consult with an attorney who understands the tax and legal issues associated with adopting a special class of founders stock.
We’re excited to introduce a multipart and ongoing series about the basics of (and some advanced topics related to) equity for startup employees and contractors. The “Human Capital” aspect of any enterprise, especially a technology company, is its most valuable asset, and we hope to highlight the…
Stock options are the most common form of equity incentive for early-stage startups. A stock option grants the option holder the right to purchase a specific number of shares of the company within a fixed period of time at a preset “exercise” price, generally following the satisfaction…
The Human Capitalist Series P.3: How Are Stock Options Taxed, and Which Are Better, Incentive Stock Options or Nonstatutory Stock Options?
The U.S. federal taxation of stock options for U.S. taxpayers depends on whether the options are classified as incentive stock options (ISOs) or nonstatutory stock options (NSOs). Incentive Stock Options (ISOs) ISOs may provide a tax advantage to the holder if (i) the optionee does not sell…