A Startup Lawyer is Not a Founder’s Lawyer

TL;DR Nutshell: It’s extremely important to hire independent counsel who isn’t incentivized to favor, because of existing relationships, the interests of your investors above those of the company.  But it’s also important to understand that company counsel represents the best interests of the company, including all stockholders, and that can often conflict with the personal interests of individual founders.

Background Reading:

A core message that I’ve focused on via SHL can be summarized as follows: many influencers for a startup, particularly investors, will often push founders to use their own preferred lawyers as company counsel, but given the amount of confidential information your lawyers will have access to, and the degree to which you will rely on their counsel for key strategic decisions, ensuring your lawyers’ impartiality is extremely important.  Naval Ravikant put it well in Lawyers or Insurance Salesmen?

Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.” -Naval Ravikant

This post is about a related, but very different point: hiring a law firm that impartially represents the company is not (and cannot be) the same thing as hiring a firm that represents the founders. Company counsel is not founder counsel.  An analogy may be helpful for explaining the difference:

Imagine a family that is going through some tough times – the spouses are in constant disagreement over issues like work-life balance and parenting responsibility, and it’s starting to impact their children. They seek the advice of a family therapist.

The family therapist does not represent one spouse or the other, nor does she represent the children. She represents the family, as an entity/unit that exists apart from the individuals that make it up. Like a family therapist whose priority is the well-being of the family above the individual members, company counsel’s responsibility is the interests of the company as a whole unit, including all of its stockholders, not just the interests of the founders, or the CEO who hired the lawyer.

At Formation

At the very early stages of a startup, this company counsel v. founder counsel distinction is often not terribly relevant, because the founders, as a fact, are the entire company; they make up the entire cap table. Though I have been in situations where disagreement among founders requires me to drive home the fact that, as company counsel, I do not represent one particular founder over another. Company counsel represents the pie as a whole, not any particular slice of it.

In a Financing

In negotiating a financing, the company v. founder counsel distinction is typically far less important than the company v. investor counsel distinction (the first point discussed above). Investors (who should hire their own lawyers) have a desire to maximize their ownership of the company and secure as much potential exit value as they can, at the expense of the ownership stake of the remaining cap table. Company counsel’s primary role in a financing is to advise the existing stockholders of the Company (particularly the common stockholders, making up founders and employees) on balancing their desire for investment with their desire to not give up significant ownership or control to outsiders.

Post-Financing and Exits

It’s after a financing that the company v. founder counsel distinction becomes very important. One of the primary fiduciary duties of a company’s Board of Directors is to maximize aggregate shareholder value (the entire pie), and Company counsel’s role, apart from day-to-day general counsel, is to advise the Board on various matters (like acquisition offers, strategic partnerships, etc.) that influence shareholder value. The reality is that advising the company/board on maximizing total shareholder value is often very much aligned with the interests of the common stockholders (including founders); more so than with investors.

Investors will have a liquidation preference that allows them to be paid something in an exit before any value goes to the common, so there are many scenarios in which they (investors) may favor an exit that the common stockholders do not support. A company counsel that is focused on advising for what maximizes exit value for all is usually indirectly working in the best interests of the common stockholders.

Nevertheless, there can be a number of situations in which company counsel’s focus on the best interests of the company and all stockholders (preferred and common) is not aligned with the personal interests of a particular founder. For example, a founder CEO may want to negotiate for an employment agreement that makes it extremely expensive, almost impossible, to fire her. While providing some protection to a CEO, so that she can focus on value creation and not her personal financial security, can be value maximizing for everyone (that’s why employment agreements are signed), there is definitely a point after which you’re giving too much to the CEO and just unjustifiably entrenching her.

In that kind of scenario, company counsel’s role is to make it clear to the founder that he’s looking out for the company, which certainly includes the founder, but also includes other stockholders. If the founder wants to negotiate heavily for an employment agreement that is biased in her favor, knowing that entrenching herself isn’t the best option for the company, she may want to hire her own lawyer (apart from company counsel). Many times in these scenarios (I’ve experienced) founders are fine not hiring their own personal lawyers, because on some level they too are interested in what’s good for the company as a whole.  There’s a certain dysfunctionality that tends to sink companies when founders have detached their personal motivations from the well-being of the company generally. But it depends heavily on the circumstances, including the composition of the cap table and the Board, the stage of the company, and the personal dynamics between the founder, investors, and even the lawyer(s).

In the same sense that we, as a firm, have a established a policy of not representing early-stage investment funds who invest in our clients (to preserve trust), we also avoid representing founders as their personal counsel. Apart from the fact that law firms are often overkill for that kind of personal representation (solo lawyers are usually a better fit), we prefer to make it clear to all parties that we are company counsel from Day 1.  When high-stakes situations require us to advise on what’s best for the company, we don’t want any side phone calls (from either side) asking for favors.

Quality founders who build strong companies should want company counsel who will speak with a high level of objectivity on key issues involving corporate governance, even if it’s not exactly what the founders would, personally, prefer to hear. No truly successful family has ever been built by people all fighting for their own interests at the expense of the whole. The same goes for startups and their founders.

Splitting Founder Equity: Avoid “Grunt Funds”

TL;DR Nutshell: If you plan on building a scalable, VC-backed company, you need to learn (early on) to have hard conversations. Fact. Your first hard conversation may involve figuring out the equity split among founders. A few people (who are good at SEO) are pushing a concept called “Grunt Funds” in which founder equity, instead of being negotiated and set from the beginning, continues to change month-by-month according to some overly complex formula.  I’ve never seen it work well in the context of high-growth tech startups. Have the hard conversation. If you can’t figure out how to split founder equity, good luck building a company. 

Negotiating the “equity split” among a pair or group of founders is an extremely important part of a startup’s formation process, and there is a lot of good web content available providing guidance on how to get it done. Below is a list of a few articles worth reading. I don’t necessarily endorse all of what they say, but it’s your job as CEO/Founder to read, make your own judgments, and act on them. Advisor Whiplash is part of the job.

Another piece of relevant reading on how to document founder splits: SHL: How Founders (Should) Break Up

The point of this post is to make one thing clear: if you are building the type of startup that will raise angel and VC money, stay away from “Grunt Funds” or anything that attempts to create a variable, constantly changing founder equity split. 

Figure Out the Numbers. Don’t Hide Behind Formulas. 

I’m not going to link to any articles promoting the “grunt fund” concept to avoid giving it any more air time on Google than it already has. The origin is a book called “Slicing the Pie.” Basically, instead of figuring out founder equity %s like a normal company, “grunt fund” founders set up a formula with half a dozen metrics that are measured on a monthly basis to gauge “performance,” “contribution,” whatever, and founder equity is accumulated over time based on those metrics. It is tedious, ends up costing more in legal fees in the long-run, and in my experience never survives scrutiny from investors. It has, every time I’ve encountered it (thankfully, a significant minority of cases) ended up being a waste of founder time and money.

Good Founder Docs Are Already Flexible

The core driver behind the desire for an always-changing equity split among founders can be boiled down to one question: “what if things change?” What if one person turns out to be a dud, and another unexpectedly a rockstar? What if someone’s personal life causes them to leave? What if the business changes and a particular founder’s skills are no longer valuable?  These are absolutely valid questions, and they require that founder equity have built in mechanisms to allow equity to be readjusted if needed.

Thankfully, there already is such a flexible mechanism in well-known, standard startup formation documents: it’s called a vesting schedule. If one person is no longer valuable to the startup, then they can leave, forfeiting their unvested equity. Or if they refuse to leave, they can be fired, also giving up their unvested equity.  Or if one person knows they’ve turned out to be more valuable than the % they got, they can force a hard discussion, with a credible threat to walk. If they are in fact as valuable as they think they are, the other founder(s) will change their %.

Is this set-up totally flexible? No, it’s not meant to be. Is it as egalitarian as a grunt fund? Maybe not, but nobody said successful startups are democracies. Brilliance is rarely built by committee. See Mark Suster on “The Importance of Benevolent Dictators.” Founder in-fighting probably ruins at least as many companies as flawed business fundamentals.

Smart Founders Figure it Out.

In my experience, successful startups are generally built either by a single founder or by founders who, more or less, know their place in the hierarchy. They have a common vision, often have strong, trusting relationships (friendships), and have a pretty good feel for whose skills really are more valuable to the startup than others. The CEO is the CEO, and the other founders know exactly why he/she is CEO. They have the tough conversations early-on, and if circumstances warrant a change from the original split, they figure it out. Ultimately, a solid founder group cares far more about building a successful company than about burning time in nonsensical formulas every month trying to see whose % went up.

I’ve seen all kinds of equity splits: 50/50 (generally a bad idea, but not always), 60/40, 33/33/33, 51/49, 80/20, all kinds of iterations. The “right” split is highly circumstantial. But in the end, the founders figure out the numbers, paper them with solid docs, and move on.

Does this mean “grunt funds” don’t work for anyone? No, I didn’t say that.  I work with the segment of the startup space that goes after scale and (usually) large amounts of outside investment needed to reach that scale. Founders jumping on that train know from the beginning that they are in for a very bumpy ride, and that anything short of complete trust and unity of vision among the team will result in a train-wreck. I’m sure GFs work in some contexts, just not in high-growth tech startups.

Have the hard conversation, avoid tedious formulas, and then get to work.  

How Startups Burn Money on Lawyers

TL;DR Nutshell: There’s a lot of bad advice floating around startup ecosystems about how lawyers work, and how founders should go about minimizing their legal burn. Much of that advice, which is given without ever actually consulting lawyers, ends up costing founders more in legal fees in the long run.  Below are some thoughts (from someone who actually knows how startup law works) on how to not burn money on legal, while also not blowing up your company.

First off, let’s go ahead and get this out of the way: I am a startup lawyer.  Some would claim that this discredits me in writing about startup legal fees, because clearly I’m just going to write whatever maximizes my compensation. Right? Never mind that I spend 90% of my time on SHL writing about how startups can or should, for example:

If your attitude is that all lawyers are money-grubbers with no ethics beyond maximizing legal bills, then (i) this blog is not for you and please don’t ever e-mail me, (ii) I’m 99.9% confident that you’ve never actually built anything successful in business, and are not likely to, which is why you’ve never known good lawyers, so again please (iii) never contact me.

Now that we have that out of the way, here is a starting fundamental principle: when you put aside the issue of institutional overhead (which is a massive issue), the economics of lawyers closely aligns with the economics of developers: great developers, and great lawyers, expect great pay. If you’ve come to accept the reality that building a company on quality, scalable, durable software code requires paying the money to bring in great developers, it should not stretch your imagination to grasp why building a company on quality, scalable, durable contract drafting (which, when you think about it, is a lot like software code) requires paying the money to bring in great lawyers. And lest you forget, it does not cost $250,000 in education to become a software developer, but sadly (very, very, deeply sadly) that’s the going rate of top-tier law schools. :: deep sigh ::

Software code may determine whether your company ever makes money, but legal code determines whether you ever make money. That’s why founders who actually know what they’re doing hire great developers and great lawyers. 

With all of that in mind, the startups who burn money on lawyers fail to follow these basic rules:

1. Hire an actual Startup Lawyer, early.

Not an M&A lawyer. Not an oil & gas corporate lawyer. Not an IP lawyer. And certainly not the schmuck hanging around your coworking space or incubator who, because he’s friends with someone, decided to re-brand himself as startup lawyer without ever having seen a real VC deal. If you have a heart issue, you call a cardiologist. If you’re building a startup that will raise venture capital, you hire a lawyer who specializes in (guess what?) startups and venture capital.

There is a very simple 2-part test for determining whether the lawyer you’re talking to is actually a startup lawyer, notwithstanding what his LinkedIn profile says:

  • A. Where is your AngelList profile?
  • B. What was the last VC deal (>$2MM) you closed?

If the lawyer doesn’t pass the above test, you will never forgive yourself after going through the world of pain he will bring to your company.

And separately, cleaning up the mess of a bad lawyer ALWAYS costs 10x what it would’ve cost to have it done correctly on Day 1. You are not being capital efficient by letting your “lawyer friend” handle your formation, with plans to get a real lawyer when you’ve raised a little seed funding. You’re just accepting a smaller legal bill early on for a much much larger one a bit later.

2. Hire a law firm (not a solo lawyer), but not one too big.

Now I’m ruffling some feathers, but SHL is not about making friends. Background reading:

Hire a solo lawyer, and you will (i) end up paying for a massive amount of inefficiency that an intelligently structured law firm would’ve avoided by adopting the appropriate technology, processes, and staffing, and (ii) max them out quickly. A $200/hr rate is not efficient if it’s multiplied by 3x the number of hours. If you are building a small company for which maybe a 6 or 7-figure exit is the end-game, a solo lawyer can be a great, even optimal fit. But companies going after big exits outgrow solo lawyers very quickly, and switching lawyers is very expensive.

Hire a very large firm, however, and you will pay for an enormous amount of bureaucracy and overhead that will not add a single bit of value to your company.  You’ll pay $600/hr, and $150 will make it to the lawyer, if she’s lucky. The fundamental principle requires paying for lawyers, not a bunch of unnecessary fluff. Modern software/SaaS has rendered the institutional structure of large firms completely unnecessary.

And be careful with referrals w/o your own verification. Out of hundreds of people I interact with, there are only a handful whose opinions on referrals for various services I actually trust as objective and based on merit. There are so many side-deals, “I scratch your back, you scratch mine” arrangements, and general cronyism in startup ecosystems that should lead you to be skeptical of any particular person’s lawyer recommendations. See also: Why Founders Don’t Trust Startup Lawyers. 

3. Use Specialists.

Background reading:  Startups Need Specialist Lawyers, But Not “Big Firm” Lock In

If a single lawyer says he can form your startup, close your seed financing, draft your real estate lease, draft your provisional patent, and apply for your trademark, run like the wind. This should be self-explanatory.

4. Do your homework, but don’t pretend that you can DIY.

If your startup law firm offers some work on a fixed fee (and they should), they are not doing it out of the kindness of their charitable heart. They are doing it because it (hopefully) makes economic sense for both sides. If you expect your lawyers to spend hours explaining to you the ins-and-outs of vesting schedules, IP, how convertible notes work, etc. etc., and yet somehow magically fit it all into an affordable fixed fee, you’re only going to select for crappy lawyers who have no choice but to accept such an unprofitable arrangement. Remember the fundamental principle.

The best founders I work with do their homework, and when they come to me with a request, they have already developed a working grasp of 75% of the concepts. Reading startup/vc law blogs, books, articles, etc. is to building a startup what reading WebMD is to being a medical patient. You will save money, make fewer mistakes, and get an overall much better end-result.

But the flip side of this is – accept that, no matter how much startup law might seem totally simple, even easily automatable, this is some complicated sh**. Very very smart people hire smart lawyers because they are smart enough to know what they don’t know.

You may think “I just want to issue some stock. That’s simple, right?” without having any clue as to all the steps that need to be taken, questions that need to be answered, and processes that need to be followed to actually accomplish that goal in a way that doesn’t create huge regulatory or contractual problems.  If you’ve hired the right lawyer(s), trust them to do their job. You will mess it up. 

5. Be Organized, and Make Clear Requests.

Related to “do your homework,” go to your lawyer(s) w/ clear action items or, at a minimum, clear questions that will help you arrive at clear action items.  You will burn a lot of legal funds asking your lawyer for one thing on Monday, changing the request on Wednesday, and then asking for tweaks on Thursday, than if you’d just waited until you knew exactly what needed to get done before making the request.

6. Be Realistic.

Good developers try everything they possibly can to avoid clients/CEOs whose views on how much time it actually takes to accomplish a task are totally detached from reality.  Good lawyers do the exact same thing with clients.  If (i) you have vetted your lawyer(s) and determined that they are trustworthy, efficient, and highly knowledgeable, then (ii) you should not be badgering them every month about why the bill is higher than you wanted it to be. It could backfire.  It would be ridiculous for me to walk into a company and tell the CEO how to run it, with zero domain expertise. Don’t be just as ridiculous with your lawyers and their practice.

Newsflash: you will ALWAYS pay more for lawyers than you want to pay. Remember the fundamental principle.

Hire an actual startup lawyer, at a firm that isn’t too big. Use specialists. Do your research, but trust your lawyers. Stay organized, and stay realistic.  Follow these principles and you will not get that Series A financing for $5,000 like you always wanted, but you will easily save 6-7 figures in legal fees over the life of your startup, and have a much healthier relationship with some of your closest advisors.

Friends and Family Rounds

Nutshell: A friends and family round should look, contractually, much like an angel round, and it will be subject to all the same rules/laws. However, there are a few crucial differences that will ensure (i) a smooth transition from F&F to angel money, and (ii) that your friends and family were given fair economics for all the risk they took on.

Before anything else, let’s get the definition of “friends and family round” out of the way: a financing round… involving only friends and family.

Notice how that definition doesn’t sound very “legal” or “official?” That’s because it isn’t. There is no legal definition of “friends and family round” because the term is meaningless with respect to all the regulatory restrictions/requirements that go into raising money as a startup.  Everything still applies. Most importantly, if you want to eventually raise VC money and aren’t totally desperate, those friends and family still need to be accredited investors, just like angels and VCs do.

Good Background Reading:

It’s well known and documented that the average cost of “starting” a startup and getting to a professional funding round is, today, a fraction of what it was 10 years ago.  And while that’s very true, a lot of founders have taken this fact to a conclusion that doesn’t quite fit with reality: that you can start a tech company with very little money, and bootstrap your product until angel investors find it attractive enough to close a seed round. This works for a limited number of businesses and groups of founders (with strong technical skills), but the truth is that for a whole lot (most) of tech companies it still takes at least $75-$200K of capital to get to a point where even angels will find it attractive.

Reality Check: Before Angels, You Still Need Money

Angel investors, especially angel investors in Texas, very very rarely fund ideas or even MVPs.  They fund companies who can show credible traction with paying, or at least strongly interested, customers. All the cloud products and X-as-a-Service economics don’t change the fact that getting there usually takes some real money. The result is that, in the vast majority of instances I’ve observed, founders who close on seed money were supported first either by a decent amount of their own funds, or by affluent (accredited) friends and family.

Truth: many, if not most, founders who start successful startups are not coming from working class, or even middle class backgrounds.  They’re able and willing to take risks many others won’t because they have a personal support network to (i) fund them before professional angels are interested, and (ii) keep them from hitting rock bottom if everything blows up. That or they’ve already earned some money and have built their own bootstrap fund. They’re still ballsy risk-takers, no doubt, but they usually have parachutes unavailable to a good portion of the population. In any event, they are not attending pitch competitions or angel meet-ups before they even have a functional product, credible traction, and a rational business model. They use F&F money first to get there, and then go after angels.

As a side note: I’m not writing the above to discourage anyone without affluent friends and family or a decent savings account from pursuing their dreams.  I’ve of course also seen successful founders who risked actual homelessness to build their companies, but those are few and far between.  If you’re going to do it, at least know what you’re getting into, and what resources others had available to them before they themselves took the plunge.

The Structure of a Friends and Family Round

So friends and family rounds are important. Very important. A few key principles for structuring one:

  • Everyone should still be an accredited investor.
  • To keep legal costs down, it should look (on paper) exactly like a small seed round with angels (convertible note or SAFE with discount to future Series A price), save for a few crucial differences (described below).
  • Unless someone in your F&F group is a professional angel investor who is comfortable setting a valuation on your company, it should under no circumstances have a valuation cap.
  • It should contain what’s often referred to as an “MFN” (most favored nation) provision allowing the terms to be amended and restated to be on par with the next financing round (when angels get involved). This ensures that the lack of a valuation cap does not result in your later investors (who usually insist on a cap) getting a better deal than your biggest risk-takers (your friends and family).

The reason for not having a valuation cap is simple: if you don’t know what you’re doing, you’ll either (i) make it too high and signal to future investors that you’re a bit clueless, and it will look bad if your next money gets a lower cap than your earlier (highest risk) money, or (ii) you’ll set it too low, and future investors will use it as a starting point for arguing why their valuation cap should be low as well.

A convertible note with a discount on the Series A/AA price, no valuation cap, and an MFN provision is the most common structure for a F&F round. However, it often makes sense to provide one extra provision that, while totally logical, isn’t quite convention: the MFN should ensure that your F&F get a discount on the valuation cap that angel investors get.  

The classic MFN in a F&F note ensures that, at best, your F&F will get the same terms as your first angel investors.  But obviously your friends and family took on way more risk than even your earliest angels will. Though it means a bit more dilution, if you want to be as fair as possible you’ll ensure your F&F MFN includes language amending the F&F notes to include a valuation cap that’s, say, 20% lower than your first angel notes. Most friends and family won’t ask for something like this, because maximum return is not their primary motivation in writing you a check: but many founders would agree it’s the right thing to do for the people without whom you could never have built the company.

Finally, the above principle can logically be applied to Founder Convertible Notes as well. If you’re papering investment in your own startup well before angels will even talk to you, you shouldn’t be setting a valuation, but there’s a good argument for why it should still receive terms that are at least slightly better than what your first angels receive.

Early Hires: Options or Stock?

Nutshell:  While the conventional equity path of a startup is to issue (i) common stock to founders and (ii) options to employees, early hires concerned about taxes will often insist on receiving stock as well. Voting power, along with other political factors, present a few tradeoffs for founders to consider in that scenario.

Vocabulary:

  • Option Pool” – a portion of the company’s capitalization set aside (after founder stock is issued) for equity issuances to employees, consultants, advisors, etc., and subject to a special “plan” designed to comply with complex tax rules.  Even though it’s referred to as an “option” pool, properly designed equity plans will allow for direct stock issuances under the pool as well; not just options.
  • ISO – Incentive Stock Option – a tax-favored type of option issuable only to employees, if certain requirements are met. The main benefit is that upon exercise, the difference between the exercise price and the fair market value on the stock at the time of exercise is not taxed as ordinary income. However, it is subject to the Alternative Minimum Tax (AMT), which can hit certain people depending on their tax situation.
  • Restricted Stock” – For purposes of a private startup, just another way of saying Common Stock. The same security that founders get, except for non-founder employees it’s usually issued from the “pool” (under the Plan) using different form documents.
  • Early Exercise Options” – Conventional options issued to employees are not exercisable until they vest; meaning until the recipient has worked long enough to “earn” the right to exercise them.  Early exercise options have modified vesting/exercise provisions so that they can be exercised from Day 1 – with the underlying shares becoming subject to the vesting schedule.  From the Company’s perspective, early exercise options are very similar to restricted stock issuances. The only real difference is that the recipient has the option to exercise and receive the Stock on Day 1, or sit on it and exercise later.

Convention.

The conventional path of a Company’s equity issuances goes something like this:

  • Founders receive direct issuances of Common Stock (not options)
  • Non-Founder employees receive ISOs (options)
  • Consultants, advisors, etc. receive NSOs (options)
  • Investors receive Preferred Stock, or SAFEs/Convertible Notes that convert into Preferred Stock

Backround:  

  •  The value of restricted stock is taxable as ordinary income on the date of issuance, unless its fair market value (FMV) is paid in cash.
  • Options, both ISOs and NSOs, however, are generally not taxable on the date of grant, as long as their exercise price is equal to the FMV.
  • So, you would normally expect employees to prefer receiving options over stock. No tax > Tax. And this is the case when the stock’s FMV is relatively high. That’s why later hires (usually after a Series A) almost always receive options, without question.
  • Stock gets to vote on stockholder approvals. Options do not (until they’re exercised for stock).

The Issues: Early employees want to minimize tax. Companies want to avoid giving away voting rights/complicating stockholder votes too early.

  • However, in the very early days of a startup’s life, avoiding tax on restricted stock is easy because of how low the FMV of the stock is (fractions of a penny): write a check for a few dollars (the full FMV), or just pay the tax on the few dollars of ordinary income.  You therefore get the “no tax on grant” benefit of options, without worrying about paying tax later on an exercise date.  Receiving stock also gets the clock running on long-term capital gains treatment.
  • Therefore, very early hires, when they do their homework, tend to insist on receiving restricted stock (or early exercise options) over conventional options. Better to deal with tax when the stock is worth (at least to the IRS) virtually nothing, instead of years later upon exercising the option when the tax bill could be much greater (ordinary income for NSOs, or AMT (for some people) for ISOs).
    • Sidenote: Conventional equity plans also have a 90-day post-termination exercise period, meaning, when an employees leaves a company (voluntarily or involuntarily) they have to exercise their options within 90 days, or they then get terminated – even if vested. Paying the exercise price isn’t an issue for an early hire in that scenario, because it’s very low (the fractions of a penny FMV), but if the AMT comes into play it can hit them with a tax bill.  This doesn’t come up in a Restricted Stock scenario.
  • The tradeoff from the Company’s perspective is that, just like founders, those hires that receive restricted stock will have full voting rights (including seeing whatever is submitted for stockholder votes) for all of their stock on Day 1, before they’ve vested in anything.  When only one or two people are in question, this may not be a big deal. It can be a way of making early employees feel like a part of the core team, because their equity is being treated just like founders.  When there are more than a handful of hires, however, it can get unwieldy fast. The number of people to consult for stockholder votes can go from 2-3 to 10, 15, 20. If there are consultants and advisors in the picture, they may start to ask why they aren’t getting the same tax benefits as early hires. And then at some point you have to draw a line and start granting options. Is the first optionee not as special as the restricted stock people? Politics. 

Generally speaking, the decision to give restricted stock v. options to very early hires is a practical/political one.  While the tax-favored nature of ISOs means that most early employees won’t see much of a tax difference between receiving ISOs v. restricted stock, the prospect of an AMT hit in the ISO scenario does make restricted stock, on net, better for recipients.  That needs to be balanced, on the company’s side, against the early voting power/information rights given away when an employee receives stock instead of options, and how it will play out with all of the company’s other hires.  

My general advice to founders is to be aware of the tradeoffs, and to consciously treat the early voting power and tax benefits associated with restricted stock as currency not to be wasted.  If there’s a very early superstar that you deliberately want to single out as a key player, use the currency.  If not, then make the decision based on all the other factors. Company culture will likely factor greatly into the calculus.  Many, many founders prefer to avoid the politics/complications and simply draw a line at the founder (stock)/non-founder (option) division.  Others are more selective. There’s no magic formula.

A few separate issues worth addressing:

  • The 90-day post-termination exercise period (after which unexercised options, vested or not, are terminated) often gets criticized as being unfair to employees, and there’s some justification for that criticism. The view is that the employee shouldn’t be forced to “use it or lose it” if they did their time (their option vested) and are now moving on to a new company.
    • The actual 90-day number comes from tax rules requiring that ISOs be exercisable only within 90 days of termination.  If an option is exercisable after that, it automatically becomes an NSO for tax purposes. But there’s nothing in the tax rules requiring that the option be terminated at 90 days. That’s largely meant (i) as a deterrent (frankly) to people quitting, and (ii) a way to clean up the cap table for people who didn’t want to pay their exercise price, allowing that portion of the pool to then be re-used for new hires.
    • While the 90-day period is still convention, key executives/hires will often either negotiate for an extended exercise period for their own grants, or the Company will as a gesture of good will, decide on its own to selectively extend the period when someone leaves on good terms.

Obligatory Disclaimer: This post contains a lot of fundamentals and generalizations on tax rules, but it’s obviously not intended to be an exhaustive statement of those rules. Circumstances vary, and you should absolutely not rely on this post without consulting your own attorney and/or tax advisors.  If you do, don’t blame me when it blows up in your face.  You’ve been warned.