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Tag: 83(b) election

  • What are vesting schedules and how do they work?

    What are vesting schedules and how do they work?

    This is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.

    Understanding the vesting schedule for shares and options is crucial for both founders and key team members. This guide aims to offer a comprehensive overview of what a vesting schedule is and why it matters.

    1. What is a Vesting Schedule?

    A vesting schedule outlines how and when company shares or options are distributed over time to employees or founders. It serves as a commitment mechanism, ensuring that key players are invested in the company’s long-term success.

    2. Types of Vesting Schedules

    • Cliff Vesting: No shares vest until after a specific period, commonly one year.
    • Graded Vesting: Shares vest gradually over time.
    • Accelerated Vesting: Shares vest faster under certain conditions, like an acquisition.
    • Reverse Vesting: Founders or key employees already own their shares but agree to “sell” them back to the company if they leave before a specified period.

    3. Length of Vesting Schedule

    The length of a vesting schedule is the period over which the shares are subject to vesting. A common duration is four years, although this can vary between three to five years. Sophisticated investors often expect a longer vesting period to secure their investment.

    The vesting commencement date marks the start of the vesting schedule. For founders, this can sometimes be backdated to credit time already spent on the startup. For example, if founders began working on the startup on June 1, 2016, but didn’t issue shares until January 1, 2017, the vesting could commence from June 1, 2016. All shares would then be vested by June 1, 2020.

    4. Frequency of Vesting

    Shares can vest either monthly or quarterly after any initial cliff period. For instance, on a four-year schedule with monthly vesting, 1/48 of the shares (around 2.08%) would vest each month. With quarterly vesting, 1/16 (or 6.25%) of the shares would vest every quarter.

    • Cliff: A period (often one year) must pass before any shares vest. Once reached, a significant portion vests at once.
    • Straight Line: Shares vest evenly and immediately from the vesting commencement date until the end of the vesting period.

    5. Upfront Vesting

    While uncommon, some shares can be vested upfront, especially to credit founders for time spent before the company was formally established.

    Example: Assuming 5 million shares granted on January 1, 2018, with a commencement date of July 1, 2017:

    1. Four-year, monthly, one-year cliff: No shares vest until July 1, 2018, when 1.25 million shares vest. The remaining 3.75 million shares vest monthly until July 1, 2021.
    2. Four-year, monthly, straight line: Shares vest in 48 equal monthly installments, ending on July 1, 2021.
    3. Five-year, quarterly, one-year cliff: No shares vest until July 1, 2018, when 1 million shares vest. The remaining 4 million shares vest quarterly until July 1, 2022.
    4. Five-year, quarterly, 20% upfront: 1 million shares vest immediately, and the remaining 4 million shares vest quarterly until July 1, 2022.

    💡When vesting restrictions are agreed to, it’s almost always to the founders’ benefit to file an 83(b) tax election. You can learn more about it here.

    Understanding the intricacies of vesting schedules is essential for both startup founders and investors. It’s not merely a contractual obligation but a strategic tool to align interests and protect the company’s future.

  • What is an 83(b) election, and why does it matter?

    What is an 83(b) election, and why does it matter?

    This is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.

    What is the 83(b) Election?

    • Defining the 83(b) Election: The 83(b) election is a tax provision that allows individuals to elect to be taxed on the fair market value of restricted stock at the time of grant, rather than as it vests. This can result in substantial tax savings if the stock appreciates over time.
    • Who Can Benefit? Founders, early employees, and investors in startup companies are the primary beneficiaries of the 83(b) election. By making the election, they position themselves for potential tax savings down the line.

    Why Make an 83(b) Election?

    • Tax Advantages: Making an 83(b) election allows you to lock in a lower tax rate if you anticipate that the value of the stock will rise significantly. You’ll pay taxes upfront based on the current, lower value rather than the increased value at the time of vesting.
    • Aligning Interests with the Company: The 83(b) election aligns the financial interests of the individual with the long-term success of the company. By paying taxes upfront, the individual is essentially betting on the company’s future growth.

    Risks and Drawbacks

    • No Refunds: The IRS does not offer refunds on taxes paid upfront through an 83(b) election, even if the stock becomes worthless.
    • Complexity and Paperwork: Understanding the nuances of the 83(b) election and ensuring compliance requires meticulous attention to detail. Filing incorrectly or missing the 30-day deadline can result in a lost opportunity for tax savings.

    How to Make an 83(b) Election: The Ultimate Checklist

    1. Consult a Tax Advisor: Given the complexity, it’s advisable to consult a tax advisor familiar with startup equity.
    2. File Within 30 Days: The election must be filed with the IRS within 30 days of the stock grant.
    3. Notify the Company: Provide a copy of the 83(b) election form to the company for its records.
    4. Attach to Tax Return: Include a copy of the 83(b) election with your federal income tax return for the year.

    Example Use Cases: 83(b) in Action

    • Startup Founders: For startup founders who acquire shares at a nominal cost, the 83(b) election is almost a no-brainer. The tax paid upfront is minimal, and the potential upside is significant.
    • Early Employees: For early employees offered stock options, the 83(b) election can be a double-edged sword. It makes sense if the company’s prospects are strong, but it’s risky if the company’s future is uncertain.

    The 83(b) election represents a calculated financial maneuver, and should generally be considered the default choice when founders’ stock is subject to vesting.