What happens when a VC requires a vesting reset of Founder Stock?
When raising a priced round, venture capitalists (“VCs”) often require founders to reset the vesting of their Founder Stock to incentivize founders to continue building the company.
For most high-growth companies, the founders receive their shares at or shortly after the time of incorporation at a low price (e.g., $0.00001 per share) and, typically, subject to a 4-year vesting schedule with a 1-year cliff.
Because founders receive their shares at such a low price, they are often encouraged to file an 83(b) election with the IRS, electing to be taxed on the value of their Founder Stock at the time of grant.
Conversely, if an 83(b) is not filed, then the founders will be taxed on the value of the Founder Stock as it vests—which could be substantially more valuable and, thus, more costly to the founders for income tax purposes.
We’ve covered Founder Stock, vesting, and the importance of 83(b) elections extensively here.
However, what happens if a founder (a) never received Founder Stock subject to vesting or (b) the Founder Stock is fully vested at the time of the priced round, and then the VC requires a vesting reset?
Should the founders file an 83(b) based on the value of the Founder Stock at the time of the vesting reset even though the value of the stock is substantially higher?
For instance, at the time of grant, a founder received 1,000,000 shares of unrestricted (i.e., not subject to vesting) Founder Stock for $0.00001 per share and timely filed an 83(b) election.
In this example, the Founder would have been taxed on the full value of the stock (i.e., $10, being $0.00001 (the price per share) multiplied by 1,000,000 (the number of shares)).
However, at the time of the price round, three years after the initial grant of Founder Stock, the latest 409A valuation has priced the company’s common stock at $5.00/share.
If the VC requires the Founder to reset the vesting of 75% of her shares (750,000) over the next 3 years, should the Founder file an 83(b) election?
That hardly seems fair, given that filing an 83(b) would seemingly result in the Founder receiving phantom income of $3,750,000.
This is a hefty tax consequence for a startup founder if the revesting of her stock requires an 83(b) election to avoid being taxed as the stock vests over time (which could be even higher).
Thankfully, the IRS threw founders a life vest.
The IRS has stated that there is no “transfer” under Section 83 for the Founder in our example, who held her stock for at least three (3) years.
Therefore, the Founder does not recognize compensation under Section 83(a), and there is no need to file a new 83(b) election.
Effectively, the new restrictions (e.g., a new vesting schedule) are ignored for stock held for at least three (3) years.
Because the Founder’s stock is substantially vested, the IRS has concluded that the Founder already owns these shares for purposes of Section 83.
Adding new restrictions has no effect for Section 83’s purposes.
In summary, a period of at least three (3) years between issuance of Founder Stock (either vested initially or subject to vesting) and imposition of new restrictions on that stock (e.g., a vesting reset) has been blessed by the IRS to avoid the receipt of phantom income under Section 83(a) when such previously vested stock becomes unvested.
Therefore, in our example above, when the stock owned by our Founder becomes subject to new vesting restrictions imposed by a VC as a part of a priced round, the Founder does not recognize compensation under Section 83(a).
As a result, the Founder’s basis (i.e., the original value or purchase price of an asset for tax purposes) in the stock remains at $10.00, and no new 83(b) election is necessary.
However, we note that the IRS has yet to provide definitive guidance relating to Section 83 for situations where the original grant of Founder Stock occurred less than three (3) years before a reset or new imposition of vesting.
While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your individual facts or circumstances without speaking to an attorney.