Performance-Based Equity or Founders’ Stock: Which Should You Use and When?
Founding a startup isn’t just about raising money, delivering product, marketing, sales and more–as if those aren’t enough! It’s also about leadership and building a team. One of the first team issues you’re going to have to confront is how to divide equity up fairly and in a way that incentivizes everyone.
This is true whether you’re the only founder or one of many. Basically, you’ve got two choices:
- Give the founding team stock right away. There are clear tax benefits (as we’ll see later), but the only real incentive is sticking around until that equity vests.
- Use Performance-Based Equity (PBE). Everyone, you included, earns equity for completing tasks or achieving milestones. The incentives are directly aligned with meaningful accomplishments.
So which is right for you–or is it some combination of both? That’s what we posed to Casey Fenton, our very own co-founder and a veteran of startups, including Couchsurfing. In that previous life, Casey already figured out how to solve the tough problem of how to get strangers to trust others enough to let them sleep in their own homes, kind of the informal version of–and non-profit precursor to–AirBnB. But he also learned about a problem, the solution to which led to the creation of Upstock: how do you motivate people at your own startup?
That’s what this Q&A is all about, set up as a dialogue between Casey and various members of the Upstock Team (MT).
MT: Hey Casey. First of all, we love the work that you did on Couchsurfing.
CF: Yeah, it has been an epic journey for all involved. I’m honored to have lent a hand in creating what I feel is something special in this world, built entirely on the engine of personal trust. It’s been a lot of truly rewarding blood, sweat and tears. But I only wish I had a system like Upstock back then. My life would have been so much easier.
MT: Let’s delve into that. To start, can you explain the difference between Performance-Based Equity and Founders’ Stock?
CF: That’s a great question, and let’s start with some basic definitions.
When we say “Founder’s Stock,” we mean real shares of a company owned by the founding team (or options that can be exercised in exchange for these shares). Now, these shares may vest over time, but they are what lawyers and CPAs call “Restricted Stock,” and they confer not just ownership but also voting rights. Because Founders’ Stock is issued when the company is first founded, you can use an IRS provision called an “83(b) Election.” This means that all future gains–and remember, the stock’s worth nothing to start–get preferable capital gains treatment, instead of being treated as regular or “ordinary” income, like a wage. Capital gains tax rates can be half or even less (taking into account Social Security and Medicare contributions) of ordinary income tax rates. You pay them when you’re ready to cash in your stock due to a sale, an IPO or another what we call “landmark event.” Now if you want to do this right, you’re going to need lawyers and accountants to do a good amount of work right from the get-go. And there are also downside risks, ones we’ll talk about later.
Performance-Based Equity is completely different. PBE is a flexible and modern approach to equity sharing. In fact, it’s favored (in the form of Restricted Stock Units or RSUs) by Fortune 1000 companies, including Google, Facebook, Amazon, Uber and other technology giants. At Upstock, we see it as a much fairer system for distributing equity because you earn equity (actually, the right to a gain you would realize if you had equity) based on time worked, tasks completed, milestones achieved. There’s another big advantage, too: you can easily award it to anyone: contractors, developers, agencies, to a building owner in exchange for a better deal on your building lease, etc. You can even provide some equity to the friend whose couch you slept on for months while you were setting your company up. The developer who built your MVP (Minimum Viable Product) can get a lot more than one who built a far-less-viable product. What’s really great about PBE is that it changes over time: the more time, money, connections and other resources an individual adds to your business, the more PBE that person earns.
While it can still make sense for the true co-founders to have Founders’ Stock, it makes a lot more sense and can be far more rewarding to use PBE for all other internal and external team members.
MT: That’s pretty awesome. But isn’t PBE difficult to track?
CF: It used to be unless you were a Fortune 1000 firm that could afford all the accountants’ and other fees. But with Upstock it’s automatic. We’re democratizing PBE for startups and small businesses by eliminating almost all of those costs. With Upstock, founders can assign values to tasks and time, but never have to manually calculate changes as new contributions are made. Upstock does all that work for them. And we support combinations of equity, such as tracking both Founders’ Stock and PBE.
MT: When is Founders’ Stock right? How about PBE?
CF: Founders should seriously consider using Founders’ Stock for two reasons. First, restricted stock comes with voting rights, while PBE does not. Second, with an 83(b) election, founders qualify for capital gains tax rates which are generally much lower than those for ordinary income.
But you don’t want to give out control of the company to anyone or to allow contractors, outside developers, building owners or even friends to have that. In addition, you want the best way to incentivize them not just when you first hire them, but for the entire time they are part of your team. PBE does precisely that. And as I mentioned before, that’s not just my personal forecast: that’s what the biggest technology companies on the planet are already doing today.
MT: Could you elaborate on the different tax treatments for Founders’ Stock vs. PBE?
CF: Happy to, but do keep in mind that I’m a co-founder of Upstock, not an accountant or tax attorney. So always check with your personal tax advisers first before making a decision that’s going to be right for your situation. That’s true for all the advice in here. But here’s my personal perspective, from my own experience.
Founders’ Stock is pretty complex. It can be issued as restricted stock. Or it can be structured by granting Incentive Stock Options (ISOs) or Nonqualified (or Non-Statutory) Options (often called NQOs). To get that all right, you’re going to need help from a licensed CPA and/or attorney, and they’re not cheap. As I mentioned before, an 83(b) Election, which refers to a section of the IRS code, allows you to pay ordinary income tax on a gain that is either zero or very small, so that the rest of any gains you may realize become taxed at the favorable capital gains tax rate (of course, Congress could pass a bill to change this at any time, if signed by the President).
But there’s still a downside and it could be a big one. This can happen if you have options on stock. During the 2001 dot-com crash, many people exercised their options, expecting to make a killing on the appreciation in the stock. But the stock crashed, leaving their options “underwater,” meaning that the company’s stock price was below the strike price of the options. Unfortunately, exercising certain options creates a “taxable event.” This is how some people made absolutely no money on their stock; in fact, they lost money because they had to pay real money to exercise their options; but these people ended up owing the IRS millions of dollars in taxes on the “gain”! Sounds crazy, but it’s true.
PBE is taxed at ordinary income rates, but Upstock times the vesting so that you’re never taxed unless you have cash available to pay the taxes. This cash can come from selling some of your shares or all of them. And as I noted before, Upstock is incredibly flexible and simple. Should you check with your advisors first? Of course. But what’s key is that if you go ahead with PBE, you probably won’t need to hire expensive professionals to make sense of your tax situation. What happens instead? If your company gets sold or has an IPO, then the team member either gets actual stock at that time, or just a cash payout. In either case, they only owe tax and have to pay it once they’ve actually made the money and have cash in hand, directly or by selling the stock. This really takes away the downside that Founders’ Stock has.
MT: Suppose I want to do PBE but my co-founder doesn’t?
CF: It’s really the same as any disagreement you have with your co-founder. Which product should we launch first? Which features should it have or not have? Can we agree on the pre-money valuation? Etc. Absolutely you may not see eye-to-eye on equity distribution or even on the philosophy of equity distribution. Maybe your co-founder fears being replaced in rank and function by another team member who excels at their position. Like any other disagreement, you’ve got to sit down and work it out. First figure out your shared vision for your company and its future. Then ask each other which type of equity framework best supports that vision. There’s no magic bullet. Founding a company is hard work and disagreements–and their resolutions–are part of your journey. In most cases, you can figure it out. If you can’t, maybe this isn’t the partnership you’d hoped it would be.
MT: What do you personally think is the biggest problem or challenge with Founders’ Stock?
CF: At both Couchsurfing and Upstock, I have realized that company culture is one of the greatest assets we have, if not the greatest. Company culture can make or break your organization. Rigid equity splitting that isn’t based on performance can really harm that culture. For one, it can break down the co-founder relationship, and that’s definitely one of the fastest ways to handicap or completely end a really great idea. Two, equity structures that aren’t perceived as fair can cause you to lose seriously great employees or just as bad, to lower the contribution and engagement from your team. Smart people like to be compensated for their work and they want to know that you’re recognizing their value.
MT: Can you start with Founders’ Stock and move to PBE?
CF: Definitely. It happens all the time. We can help companies make the transition, even if they already have a more traditional equity plan in place.
MT: What about investors? What’s their view on PBE vs. Founders’ Stock or other kinds of equity?
CF: Sophisticated investors never invest in a company if they don’t believe in the team and the decisions that leadership has made. So probably no one understands the importance of motivation and staff retention better than investors. More and more, investors are actually gravitating toward businesses with modern approaches to splitting equity–like PBE.
MT: Is there still a place in the startup world for Founders’ Stock?
CF: Will it continue to exist? Yes. But is it going to continue to be the best option to offer team members? No, we don’t think so. Or course, there will always be exceptions, but that’s not the trend. The reality is that most companies can use PBE for almost everyone, with the Founders’ Stock owned just by founders and investors.
MT: Any final tidbits, words of advice?
CF: Performance-Based Equity has helped me as a founder to motivate my team and to offer them real value based on their performance. I use it myself at Upstock and have been really pleased with the results. Any founder who has any questions and is looking to learn more about PBE, I’d love for you to reach out. I am always available to chat and lend you my perspective as an entrepreneur, startup founder, and Upstock inventor.