How to Rebalance Ownership Between Founders

How to Rebalance Ownership Between Founders

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First of all, why do this? Well, oftentimes like a company gets going maybe it's a solo founder, maybe there's two founders and the company's going for a little bit and then Miss Amazing or Mr. Amazing walks into the picture with a key skillset or connections or whatever that would make the company so much better and so you're tempted or you want to add someone to your founding team even though the company kind of got going already and so you need to kind of balance out the founder stock, right? Another situation could be their is two founders and they split it evenly at first but one is kind of over the course of time everyone kind of realizes that one is significantly stronger than the other or has more valuable expertise and so you kind of re-cut the pie, so to speak.

So that's why you would rebalance the ownership positions of founders. Now there's a couple different mechanisms you can try. I'll go over those and then I'm also going to give you a couple points to just be careful of. So the first and probably the easiest mechanism is to issue stock options to the new founder. This is easiest and best if the company's been kind of operating for a while and the beauty of stock options is there's a strike price established by the 409A Valuation.

In the early days is still pretty low and because that valuation is low it's still very appetizing for the founder. Of course, it's going to be a higher valuation than what the original founders or the original cut was because at that point, when the company was started there was like nothing there and so when the company is founded and the founders do their 83(b) and buy the stock, the founder stock, they usually we're talking like tens of pennies or one hundreds of pennies per share of stock.

But as soon as the company starts making progress or is about to raise money or does raise money you need to do a 409A Valuation to establish the fair market price of the stock and so the options are based on that but the nice thing about the options is that if they're issued at fair market value then there's nothing taxable at that moment. It's not a taxable transaction for whoever is getting that stock and so there's no like cash out of pocket in that transaction, which for these super early stage companies you just never know. A lot of people don't want to write like a 50 or $100,000 check super early, if they can kind of wait the other options.

Now, if they chose to exercise those options and start the long term capital gains process, yes, there would be cash out of the pocket. They'd actually have to write the company a check to cover that option exercise. So, and we'll come back to that for a second on how to write that check and how to fund it but so that's options. Easy, very quick, non-taxable and the other option is to just issue more restricted stock or founder shares to this person that you want to beef up their ownership and that can work really well except restrictive stock often has like a vesting clock and you're actually getting the shares or not exercising to get the shares and so that restrictive stock is actually oftentimes taxable.

So the founder who's getting the extra shares and rebalancing upward is going to have a tax bill in that year for all the stuff that's vested. So that's kind of the negative to restricted stock and again, if you're doing this like two weeks after the founding of the company the restricted stock is going to be, you'll probably just use the par value, but two months, six months, a year after the company and there's significant progress made. That restricted stock's going to be pretty valuable and it's going to be a pretty big tax bill. So those are the two main mechanisms. Now, in terms of funding that option exercise. Sometimes we see companies grant a loan to the founder and the founder takes that money and then actually buys shares, exercise the options. And that can work except you just got to be wary of if the company goes down and that loan is forgiven. The forgiven piece of that loan becomes taxable income for the person who had the loan forgiven.

So like anytime a loan is forgiven in the real world that's taxable income. That's how the IRS sees it. So the person could end up paying taxes on a loan that was for stock that went to zero, right? So you got to be really, really careful with any kind of loan at the startup level. You would only really want to do that at a later stage moment when you're very, very sure the company's not going to go down. The other kind of mechanism or approach we see people do, which I want to highlight, which can be potentially dangerous. Is the company buys some shares back from one of the founders and then reissues those shares to another one of the founders.