What are restricted shares?

Restricted shares are the primary mechanism by which a founding team will ensure that its members earn their endeavor capital. Being critical to startups, it’s worth understanding. Let’s see what it is.

Restricted shares are shares that are owned but may be lost if a founder leaves a company before it has vested.

The startup will typically grant such shares to a founder and retain the right to buy them back at cost if the service relationship between the company and the founder ends. This arrangement can be used whether the founder is an employee or a contractor in connection with the services provided.

With a typical restricted stock grant, if a founder pays $0.001 per restricted share, the company can buy them back at $0.001 per share.

But not forever.

The repurchase right expires gradually over time.

For example, Founder A is granted 1 million restricted shares at $0.001 per share, or $1,000 in total, and the startup retains a right to repurchase at $0.001 per share that expires on 1/48 of the shares for each month of the permanence in the service of the Founder A. The repurchase right is initially applied to 100% of the shares carried out in the concession. If Founder A stopped working for the startup the day after receiving the grant, the startup could buy back all the shares at $0.001 per share, or $1,000 in total. After one month of Founder A’s service, the repurchase right will be extinguished on 1/48 of the shares (ie 20,833 shares). If Founder A left at that time, the company could buy back all but the 20,833 granted shares. And so on with each month of service until the million shares are fully vested at the end of 48 months of service.

In technical legal terms, this is not strictly the same thing as “grant.” Technically, the shares are owned, but they can be lost through what is called a “buy-back option” held by the company.

The buyback option can be triggered by any event that causes the end of the service relationship between the founder and the company. The founder could be fired. Or quit. Or be forced to resign. Or die. Whatever the cause (depending, of course, on the wording of the share purchase agreement), the startup can typically exercise its option to repurchase any shares that have not been vested as of the termination date.

When shares tied to a continuing service relationship can potentially be lost in this way, an 83(b) election should normally be filed to avoid adverse tax consequences for the founder in the future.

How is restricted stock used in a startup?

We have been using the term “founder” to refer to the recipient of restricted shares. Said grants of shares can be made to any person, whether or not he is a founder. Normally, startups reserve these types of grants for founders and very key people. Why? Because anyone who gets restricted shares (as opposed to a grant of stock options) immediately becomes a shareholder and has all the rights of a shareholder. Startups shouldn’t be too lax in giving people this status.

Restricted shares generally don’t make sense for a solo founder unless a team is coming on board shortly.

However, for a founding team, it’s the rule that there are only occasional exceptions.

Even if founders don’t use restricted shares, VCs will vest them in the first funding, maybe not all of their shares, but most of them. Investors cannot legally force this on founders, but they will insist on it as a condition of funding. If the founders bypass the venture capitalists, this, of course, is not a problem.

Restricted shares can be used for some founders and not for others. There is no legal rule that says that every founder must have the same acquisition requirements. One may be granted shares without restrictions of any kind (100% vested), another may be granted shares, ie 20% immediately vested with the remaining 80% subject to vesting, and so on. All this is negotiable between founders.

The acquisition of rights does not necessarily have to be for a period of 4 years. It can be 2, 3, 5, or any other number that makes sense to the founders.

The award rate can also vary. It can be monthly, quarterly, yearly or any other increment. The annual vesting for founders is comparatively rare, as most founders will not want a one-year lag between vesting points as they build value into the company. In this regard, restricted stock grants differ significantly from stock option grants, which often have longer vesting gaps or initial “cliffs.” But again, this is all negotiable and arrangements will vary.

Founders may also attempt to negotiate acceleration provisions if their service relationship is terminated without cause or if they resign for good reason. If they include such clauses in their documentation, “cause” should normally be defined to apply to reasonable cases where a founder is not performing appropriate functions. Otherwise, it becomes almost impossible to get rid of a non-compliant founder without risking a lawsuit.

All service relationships in a start-up context should normally be able to be terminated at will, whether or not a termination without cause triggers a stock rush.

Venture capitalists will typically balk at acceleration provisions. If they do agree with them in any way, it will probably be in a more restricted way than the founders would prefer, such as by saying that a founder will get an accelerated grant only if a founder is fired within a set period after a change. control (“double trigger” acceleration).

Restricted shares are typically used by new businesses organized as corporations. It can be done through “restricted units” in an LLC membership context, but this is more unusual. The LLC is an excellent vehicle for many small business purposes, and for startups in the right cases, too, but it tends to be a clumsy vehicle for handling the rights of a founding team that wants to put conditions on capital grants. It can be done in an LLC, but only by injecting them with the same complexity that most people who go to LLCs seek to avoid. If it’s going to be complex anyway, it’s usually best to use the corporate format.

conclusion

In general, restricted shares are a valuable tool for startups to use to establish significant incentives for founders. Founders should use this tool wisely under the guidance of a good business lawyer.