Founder Vesting: What is an 83(b) Election?
In this article we are going to look at something that a lot of startup founders and business owners fail to understand – the 83(b) election. The 83(b) elections come into play when someone is given stock, a share in an LLC or a type of equity that is vested over time.
What is founder vesting?
Founder vesting is a process by which a founder “earns” the stock over a period of time depending on the performance and commitment to the startup. The company gets the right to buy back the stock if one or more of the co-founders leave.
This means that the founder has all the “rights” on the shares such as voting rights, right to receive dividend, but does not own the shares till they actually vest. This means that the founder cannot walk away with the shares until the vesting happens.
In a typical Silicon Valley style vesting for a venture capital company, the stock vests equally over four years, with a one-year cliff. So, if the founder is given one million shares, he/she doesn’t get anything up until the end of year one.
At the end of year one, at the stroke of midnight, the founder gets to keep 250,000 shares (representing 1/4th of the one million shares). Over the remaining three-year period, the shares will vest equally over 36 months.
Most investors require a vesting agreement to be in place to ensure that the founders stay with the startup, and that the company is protected in case of a founder exit. The investors’ perspective on vesting is to take a forward approach to ensure that the team they are betting on is here to stay for the long term. Vesting is a way to ensure that the founders “earn” their equity, and the entire equity is not given away upfront just because you were there from the first day!
So, if a founder were to leave, it is important to ensure that the equity ownership is left behind, because it has to be given to someone else who is replacing the founder and fulfilling that role.
Tax treatment of vesting
There are two important principles that you need to understand before diving into the 83(b) election:
- Principle #1 – Difference between price and fair market value: When you get something that is more than what you pay for it, the IRS taxes you for the difference. For example, if you acquire an asset whose fair market value is $5,000 by paying cash of $1,000, the IRS taxes the difference of $4,000.
In this case, when a company issues stock to a founder and the founder doesn’t pay for it, then the founder has to pay taxes on its “fair market value” on the date of getting those free shares. This is a taxable event, and the company is likely to issue a Form 1099.
- Principle #2 – Timing difference as a result of vesting: When you receive a stock over a period of time, based on a vesting schedule, the IRS doesn’t consider it as truly receiving the stock until the vesting happens. This is called the substantial risk of forfeiture.
Let’s go back to our earlier example of receiving 1,000,000 shares over a four-year period with a one-year cliff. For tax purposes, the IRS doesn’t consider that the founder has received anything on day one. On day one, according to the IRS, the founder owns no shares, because the vesting hasn’t happened yet.
At the end of the vesting cliff of 12 months, the founder gets to keep 250,000 shares, which triggers a ‘taxable event’. In a typical venture-backed company, you would be raising multiple rounds of capital, and the “value” of the company would be increasing over a period of time.
In our example, on day one when the company was started, the value of the company was almost nothing. Let’s assume that at the end of the 12-month period, the founders made good progress, gained traction and made some revenue. Let’s assume that the company was worth $2 million at the end of the 12-month period.
So, when the first vesting happens at the end of the 12-month period, and when there is a taxable event, the founders would be subject to tax on the 250,000 shares based on a company valuation of $2 million. This could turn out to be disastrous because the founders are paying tax on a taxable event without having any liquidity.
This will also become an ongoing problem for the founders. When vesting happens over the four-year period, and hopefully the value of the company keeps increasing as they generate more revenue, the tax consequences are going to be massive.
What is an 83(b) election?
To avoid these dire consequences of having to pay tax on an asset without liquidity, founders are often advised to do an 83(b) election. In an 83(b) election, you elect to pay the entire tax upfront on the date of the granting of those founder shares, instead of paying them on the date of vesting.
This way the taxable event is not dependent on the vesting schedule, and the entire tax liability is paid on the valuation as of the date of the issue of founder stock (usually day one of the company).
As we saw earlier, the value of founder stock on day one of the company is almost zero. So, you end up paying far less taxes (almost zero, if done correctly) as compared to the default scenario where the taxable event is linked to the vesting schedule.
So, what should you be doing?
It’s simple. You need to fill out a Form 83(b) and send it out to the IRS with an “acknowledge due” self-addressed envelope within 30 days of the restricted stock grant.
Impact of 83(b) election
The good thing with an 83(b) election is that the taxable event is shifted upfront. Let us look at the impact of taxes under both the scenarios. In each of the two scenarios, let us assume you get 1,000,000 shares subject to a vesting agreement valued at $0.01 per share when the grant happens, and $2 per share when the vesting happens at the end of Year 1, and increase in value by 25% at the end of every year. Let us assume a normal income tax rate of 25%. We will ignore employment taxes and state taxes consequences for this example.
- Scenario #1: Without 83(b) election
In this scenario, let’s look at the tax implications with the following assumptions (just to keep things simple). The tax liability would look like this:
- Scenario #2: With 83(b) election
In this scenario, the taxable event is at the beginning. So, the entire 1,000,000 shares are taxed upfront.
The tax liability with the same assumptions would look like this:
As you can see from the tables above, the amount of tax savings (with those assumptions) is significant with an 83(b) election.
So why doesn’t everyone do an 83(b) election?
If you receive stock worth a nominal amount (like in our example), it makes sense to file one. However, if the fair market value of the stock is $1 per share as of the date of the grant instead of $0.01, then you would end up with a tax liability of $250,000. And if the company subsequently fails, especially before the vesting happens, then you would have been better off to not file an 83(b) election.
So, the bottom line is to consult with your tax advisor, but you have to remember that the filing has to be done with 30 days of the stock grant. This is usually when the board approves the grant, and not when you actually receive the paperwork!