When starting a company, early decisions about equity structure can dramatically impact your future. Beyond the business model and product, how you allocate and handle your company’s stock is crucial to long-term success.
This guide explains the basics of founder's stock (also known as restricted stock) and the employee equity pool. It also covers the key tax decision every founder should understand,the 83(b) election.
Note: This content is educational and not financial or legal advice. Consult with qualified tax and legal professionals to ensure compliance.
What is a Founder's Stock (Restricted Stock)?
Often misunderstood, a founder's stock is not simply free equity granted at incorporation. Instead, your company authorizes a specific number of common shares,typically millions and these shares are classified as restricted stock.
As a founder or early employee, you get the right to purchase these shares at their Fair Market Value (FMV) at grant time.
How Founder’s Stock Works?
- Purchase: At incorporation, the FMV is usually extremely low (e.g., $0.0001 per share). Founders purchase their shares immediately at this price, usually for a nominal amount.
- Vesting: Shares vest over a period (often four years). If you leave before full vesting, unvested shares can be repurchased by the company, typically at your original price.
- Ownership: From day one, you hold ownership and voting rights for both vested and unvested shares.
How to Allocate Equity Between Founders and the Employee Pool?
When dividing initial shares, founders face choices about reserving equity for future hires.
1.The "Employee Pool" Model
A common approach is to set aside a portion of the equity for future hires.
- Founder 1: 30%
- Founder 2: 30%
- Founder 3: 30%
- Employee Pool: 10%
This 10% employee pool is reserved for granting stock to the key employees you'll need to hire later. This is often a smart move, as it earmarks equity to incentivize new talent without the founders being diluted immediately.
2.The "All-In" Model
Alternatively, founders can split all the equity among themselves.
- Founder 1: 50%
- Founder 2: 50%
This is simpler upfront, but there's a tradeoff. When you need to hire your first key employee, you will have to create new shares for them, which will dilute your and your co-founder's ownership.
Both approaches are reasonable, but planning for future team members is a standard practice.
What is 83(b) Election?
The 83(b) election is a special provision under the United States Internal Revenue Code that allows founders and early employees who receive restricted stock to pay income tax on the full fair market value of their shares at the time of grant, rather than paying taxes gradually as the stock vests over time.
Filing this election within 30 days of receiving the restricted stock means you pay taxes upfront based on the stock's current, often minimal, value. This can result in substantial tax savings because any increase in the stock’s value after the grant is taxed later as capital gains, which generally have lower tax rates compared to ordinary income tax.
You can also explore how NRIs can lower their US tax load using QBI deduction and SALT cap planning: QBI and SALT benefits for NRIs
The 83(b) Election: Key Tax Benefits Every Founder Should Know
- The 83(b) election is an IRS provision allowing startup founders and early employees to pay income tax upfront on the fair market value of restricted stock at the time of grant, rather than paying taxes later as shares vest.
- Filing must be completed within 30 days of the stock grant to be valid, making this a very time-sensitive decision.
- By paying taxes early, when the stock value is typically very low, founders can minimize their immediate tax liability.
- Any increase in stock value after filing is taxed later as capital gains upon the sale of stock, which generally has lower tax rates than ordinary income.
- Without filing the 83(b) election, founders face paying taxes on the value of shares as they vest, potentially resulting in large tax bills on “phantom income”, income they haven’t realized as cash.
- This election is particularly important for US-based NRIs and startup founders who expect significant stock appreciation.
- Failing to file timely can lead to unexpected tax burdens and cash flow challenges, making the 83(b) election an essential part of tax planning and equity management.
Learn how NRIs can use cash balance retirement plans to boost savings and lower taxes: NRI tax savings
Conclusion
For US-based NRIs and founders, understanding how to structure founder’s stock, equity pools, and strategically utilize the 83(b) election is fundamental to protecting ownership and minimizing tax burdens. Navigating these complex topics carefully ensures strong foundations for future growth.
Using platforms like iNRI can help streamline compliance and simplify your investment and equity management process. Always engage experienced legal and tax advisors to align your equity plans with evolving regulations and your long-term business goals.
Frequently Asked Questions (FAQs)
1. What is the difference between a founder's stock and stock options?
Founder’s stock is purchased outright at grant with immediate ownership and voting rights, giving founders equity from the start. Stock options are rights to purchase shares in the future at a set price and are commonly granted to employees during company growth phases.
2. What happens if I leave before my founder’s stock fully vests?
Unvested shares are generally subject to repurchase by the company at your original purchase price, protecting the company’s control. Vested shares belong to you and are retained.
3. Why is the founder's stock so inexpensive initially?
At founding, the company’s value is minimal since it primarily represents ideas and legal structure. This low valuation lets founders buy shares cheaply before value appreciates.
4. What is an 83(b) election and why file it?
An 83(b) election is a formal IRS filing notifying intent to be taxed on stock value at grant rather than as shares vest. Filing within 30 days locks in low upfront tax, avoiding large taxes later if stock value rises.
5. Is the 83(b) election mandatory?
No, it is optional but highly recommended because failing to file can lead to large unexpected tax bills. Most founders file it to optimize tax outcomes.
