CORE CONCEPT: VESTING AND 83(b)

Vesting and 83(b) are important concepts so I'm bringing it up here in this section of this site.

Summary of Vesting and 83(b)

1. Texas startups and vesting

As I've discussed elsewhere, Texas has many energy/oil & gas, health/life sciences and other tech startups. Founders of these companies will need to "vest" their shares. Investors often demand to see this. Vesting is a legal/tax concept that entrepreneurs need to understand. As a startup lawyer in Houston, Texas and Dallas, Texas I get asked about it frequently. This article will explain what these concepts are.

2. Vesting meaning

Stock or stock options can be either vested or unvested. Vested means that the stock or stock options are yours. Unvested means that they are yours or they have been allocated to you, but they can be taken away if you leave the company before a certain time (i.e. it's subject to a vesting schedule.)

3. Purpose of vesting

Vesting and a vesting schedule is used to give incentive to company personnel to stick around with the company. If you leave before your stock has vested, then you will give up your unvested stock.

4. Importance of vesting

Stock issued to founders at the start of the company needs to be subject to a vesting schedule. This will ensure that if one of the co-founders decides to leave the company after day 1, they don't take half of the company with them. The unvested stock will go back to the company.

5. Vesting schedule

A typical vesting schedule will be 4 years (it takes 4 years for all of the stock to vest.) Vesting can be accelerated if certain things happen regarding the company and personnel.

6. 83(b) Filing

It's important to make an 83(b) filing with the IRS regarding vesting. There are strict requirements as to the timing of this.

Explanation of Vesting and 83(b)

Table of Contents

I. What is vesting
II. Vesting schedule

A. Typical schedule
B. Acceleration

III. Where you will see vesting

A. Common stock vesting
B. Employee stock option vesting

IV. 83(b) Election

A. What is an 83(b) election?
B. Step by step explanation of an 83(b) election

V. Practical tips

I. WHAT IS VESTING?

Vesting is a system used by a startup to incentivize founders, employees, etc. to stay with the company.

Vesting is a concept that you'll see come up again and again in a few contexts.

I use vesting provisions all of the time in various types of deal documents.

In other words, unvested vs vested is the difference between what is yours and what is REALLY yours.

Stock will go from unvested to vested as time passes.

For example, a startup can give you 10,000 shares when you join the startup, but if these shares are unvested, they aren't really yours outright. Yes, they have been allocated to you and you have them, but because they are unvested, they can be repurchased by the company if you decide to leave within a certain amount of time.

On the other hand, if the shares are vested, then the company cannot simply repurchase the shares if you decide to leave. The shares are yours.

II. VESTING SCHEDULE

When stock or stock options go from unvested to vested depends on the vesting schedule.

A vesting schedule is a time table that dictates when stock or stock options vest. The stock starts out as unvested. As time passes, more and more shares vest. By utilizing a vesting schedule, a startup can give you benefits spread out over time instead of all up front at once. This system is used to incentivize you to stick around. Because, after all, if you leave, you give up the benefit of having that stock or stock options.

A. What does a Typical Vesting Schedule Look Like?

I typically see a vesting schedule of 4 years with a 1 year cliff. That means that no shares will vest until the cliff has been reached. At that point, 1/4 of the shares will vest. The rest of the shares will vest slowly on a monthly basis for a total of four years.

I want to make clear that it's not set in stone that it needs to be 4 years. There are other ways to do this, but 4 is pretty typical.

B. Vesting Acceleration

The vesting schedule can be accelerated on the happening of certain events. You can imagine a situation where you work your butt off for a few years and the company is sold but you don't get rewarded for it because your shares didn't vest by that point. To prevent such a situation, acceleration clauses can often be triggered that will speed up the vesting schedule. There are two types of acceleration:

Single Trigger Acceleration: shares automatically vest in the event of a merger or change of control.

Double Trigger Acceleration: shares automatically vest in the event of two events (e.g. merger + termination of employment.)

III. WHERE YOU WILL SEE VESTING

You will see vesting in two scenarios: A. common stock vesting and B. employee stock option vesting

A. Common Stock Vesting

This scenario comes up when the company is being founded.

When the startup is incorporated, the founders get shares. The shares need to be subject to a vesting schedule. The founders receive all of their shares upfront but the company has the right to repurchase these shares back from a founder if a founder leaves the company within a certain amount of time. The shares that the founders received initially are considered unvested. As time passes, and the shares vest to the founder, and the company is not able to repurchase these shares if the founder decides to leave.

This is sometimes referred to as "reverse vesting."

For example:

Two founders of a company. Each gets 1,000,000 shares.

Without vesting:

After day 2, one founder says, "screw this," leaves, and takes half of the company with him.

With vesting:

After year 1, one founder decides to leave. Out of the million shares the founder has, only 250,000 shares have vested. The founder owns 250,000 of the shares. The other 750,000 are forfeited back to the company.

B. Employee Stock Option Vesting

When a potential employee gets a job offer for a startup, they may be given a stock option to purchase a certain amount of shares. A stock option is not stock. A stock option is the right to buy those shares of stock at some set price in the future.

Stock options are used to give incentive to the employee to stick around at the company.

For example, an employee is granted a stock option to purchase 4,000 shares.

Without vesting:

The employee can exercise their whole option and purchase all 4,000 shares of stock in the stock option and then leave the company immediately.

With vesting:

The option vests over a certain number of years. So after one year, the employee is able to purchase 1,000 shares. After another year, the employee is able to purchase another 1,000 (and so on until the entire option has vested.)

With vesting, the company is able to incentivize the employee to stick around and also to reward them with stock ownership.

IV. 83(b) ELECTION

A. What is an 83(b) election?

83(b) is a filing made to the IRS telling them "tax me on all of this stock now regardless of if they are vested or not because the value of the tax is low. I want to do this now instead of taxing me later when the stock vests because the value of the stock in the future will be higher."

It is important to make this election and there are strict requirements as to the timing of the election.

B. Step by step explanation of an 83(b) election

Only move on to the next numbered section if you understand the point before it.

Why would you make an 83(b) election? From the beginning:

1. You have to pay income tax on property you receive in return for your services

You know this. You have to pay income tax when you get cash for doing a job. Same thing with when you receive property (e.g. stock) in connection for performing some services. The tax will be based on the fair market value of the stock.

2. However, you don't have to pay that tax until at the time it becomes certain that you get to keep that property or it becomes transferable.

3. When you receive stock that is subject to a vesting schedule, you're not sure if you can keep that stock.

There's a substantial risk that you lose the stock back to the company. Until that risk is gone (i.e. until you're certain you get to keep the property) you DON'T get taxed on it.

Therefore, you won't be taxed on the receipt of that stock just now. You'll be taxed on it when it vests (i.e. when the substantial risk of the stock being taken away is gone.)

4. But here's the deal: it would be better if you were taxed on it now (when the value is low) compared to later when the stock has vested and when the value of the property is high.

Look at it this way. If you have some property that you will be taxed on, would you rather be taxed on it now (when the value is almost nothing) or in the future (when the value has increased considerably)? Of course you would rather be taxed on it now. The amount of tax should be negligible.

So even though there's no taxable event now because of the uncertainty that you will keep the stock, it is a major advantage to do so now.

5. Therefore tell the IRS to go ahead and tax you now.

You do this by filing an 83(b) election with the IRS. This election needs to be filed within 30 days of receiving the stock. This is an important deadline and must not be missed.

V. PRACTICAL TIPS WHEN IT COMES TO VESTING

- Stock for investment (e.g. investor buying shares of the company) do not need to vest

- Don't file an 83(b) election for stock that is vested

- Don't file an 83(b) election for a stock option. A stock option is not equity.

- The language of 83(b) is helpful to read. You can read it here: https://www.law.cornell.edu/uscode/text/26/83