One of the more sensitive issues that arises over the course of the life of a startup company tends to come several years after the company is founded, and concerns the grant of equity-based compensation to the founders of the company. A startup's standard life trajectory begins with its incorporation. At this stage the founders will both own most, if not all of the company's equity, and lead the company as its executives. As the company progresses and raises investments, the founders’ ownership of the company will become diluted. After an average of about five years, most startups (assuming they survived) will have progressed beyond their series B or C financing round, and, though they will continue to hold key positions, the founders’ ownership will generally be diluted to less than ten percent of the company's capital. At this stage, the founders’ shares will generally no longer be bound by the restrictions imposed upon them through ‘reverse vesting’ mechanism, such that if one of the founders intends to terminate her or his engagement with the company, she or he will not be subject to the forfeiture of shares.
Once the restrictions on founders’ shares are lifted, a company must ask itself whether it should re-incentivize the founders who are still serving as senior executives, by granting them with options or other equity-based compensation, similar to those that are offered to employees and officers of the company. Given that the previous retention mechanism has expired, and assuming that the company is in a stable position and is satisfied with the way in which the founders are carrying out their executive duties, some companies issue the founders with new options that are subject to a vesting mechanism which is conditioned upon the passage of time (usually a 3-4 years) or predetermined milestones. The logic behind this relies on the same considerations underpinning the grant of options to other employees and officers, i.e., retaining and motivating employees, and ensuring that they share common goals with the company and the investors. Increasing the founders’ share of the pie will often have a positive effect on the company, in that the lower the percentage of the company held by the founder, the more she or he will feel like a ‘rank and file employee’ and might consider engaging in other opportunities which may exist outside of the company. This can be highly damaging to a company as we would generally expect a founder, and certainly a senior executive such as CEO or CTO of the company, to successfully navigate the company and maximize its value, rather than preferring her or his personal considerations.
The benefits of providing additional equity awards to founders are even more pronounced when we examine the other side of the coin. In many cases the continued existence of the company is dependent on future capital raising. This becomes much more difficult where there is management-related uncertainty which can arise where there is no future incentive for the founders to remain. Whilst no one is irreplaceable, bringing in a new CEO or CTO comes with a price: the new executive will generally require a substantial salary and a generous options package (generally around 5%, on a fully diluted basis).
Despite all of the above, offering options to founders is actually not the common practice. Generally founders tend not to demand additional equity based compensation, and investors are in no hurry to offer it. In my mind, this approach is a result of psychological considerations that are often not in line with the best interests of the company. As noted above, this is a sensitive issue that, when raised, lead to questions which may raise tensions between investors and founders, and amongst the founders themselves. For example, discussions whether the founders are still essential to the company; are the investors satisfied with the performance of the founders; is someone who lead a young company with a dozen employees and one product fit to lead a grown-up company with two hundred employees and dozens of products; and whether the founders should be treated equally at this later stage of the company.
All of the above raises the question of whether, when, and how this issue should be raised for discussion. It is important to start by noting that there are no established principles as to how to deal with these questions, and each case must be examined on its merits. The condition of the company, its capital structure and free option pool, the contractual obligations of the founders in respect of the company and the investors, founders' participation in previous capital rounds and secondary sales, and even the expected tax rate applicable to the compensation must all be considered when answering these questions. As a general guideline, where the company is not in the best of health, raising the issue may simply accelerate discussion relating to the performance of the founders and the need for change. On the other hand, where the founder already holds over 10% of the company, additional equity compensation may not be deemed appropriate.
The considerations listed above are relevant not only to whether equity compensation should be offered, but also in what measure. Investors generally do not take into account additional allocations to founders, and both investors and employees tend to resist dilution, so they will be prefer to grant only a very small percentage and over long vesting period. This, however, is often quite short sighted. The relatively high salary requirements of a non-founder executive combined with greater overall dilution (given that the leaving founder’s shares are not subject to forfeiture) will often end up costing the company more, both in terms of cash and equity. Ultimately, the best way to approach these issues is to avoid unilateral demands by founders, and to hold an open discussion which concerns the best interests of the company and maximizing shareholder value.
Finally, the parties should attempt to ensure that equity-based compensation provided to founders will be treated for tax purposes as ‘capital gains’ (such that is it taxed at 25% rather than at the more onerous rates of the higher income-tax rates). This is only possible under Israeli law where the founder is not a ‘controlling shareholder’. For these purposes, this means that the founder must hold no more than 10% of the company (including as a proxy of other shareholders), and must not have the right to appoint a director (including along with others or as a party to a voting agreement). It should also be noted that in those instances where the equity-based compensation is made subject to the meeting of certain milestones (rather than vesting over the lapse of time), the targets must be fixed, measurable, and predefined (and it should be also noted that defining an exit event as a qualifying condition to vesting will cause the equity-based compensation to be taxed as income). Nonetheless, the inability to benefit from the capital taxation track should not discourage founders from requesting equity-based compensation, though it should be one of several considerations taken into account by the founder when raising the issue for discussion with investors.
And we cannot fail to mention COVID-19. It is still too early to say how and to what extent this epidemic will affect capital raising for startups, but given that under the present circumstances companies will be able to raise capital on reasonable terms, this may not be the best time for founders to raise demands for equity compensation. On the other hand, where the epidemic lead to a decrease in valuations, so founders will be diluted even more substantially than normal, this can justify the request by founders for equity compensation.
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