Founders stock looks deceptively simple at formation. A few hundred dollars, a certificate, and a vesting schedule. But it carries a regulatory overlay that determines whether the issuance is lawful and whether the restrictions comply with federal securities law.
This post focuses on the regulatory framework that governs the issuing of stock to founders after they sign the Founders Stock Purchase Agreement.
What a Founders Stock Agreement Actually Is
The Founders Stock Purchase Agreement, is the operative document by which the corporation issues common stock to a founder in exchange for consideration. It is distinct from but coordinated with several other documents:
- The board consent authorizing the issuance
- The stock certificate, or the uncertificated share notice
- The Proprietary Information and Inventions Agreement (PIIA), which assigns pre-formation IP and ongoing work product
- The founders' agreement or stockholders' agreement, if any, covering inter-founder rights
The Different Jobs the Package Performs
A founders stock package does a. number of different things at once. First, it issues the equity, transferring common stock from the corporation to the founder for valid consideration. Second, it subjects that equity to forfeiture or repurchase through a company repurchase right that lapses over time.
The Core Economic Terms
The share count and purchase price are typically set at par value, often $0.0001 per share, at formation. A standard founder package typically runs $100 to $500 in total. The vesting schedule that is commonly used is four years with a one-year cliff, structured mechanically as a company repurchase right that lapses as the stock vests according to the schedule. Consideration can take the form of cash, intellectual property assignment, or past services.
The vesting schedule is set up to maximize the incentive for a founder to continue working for the startup, but if they decide to leave the company for any reason, the company can repurchase the unvested shares. Mechanically, there are other options for the vested shares to protect the company's interests, such as inserting a Right of First Refusal in the Founders Stock Purchase Agreement. It is important to discuss your exact needs and concerns with a qualified attorney who can address said concerns.
Federal and State Exemptions
SEC Section 4(a)(2) Exemption (the "Private Placement" Exemption)
Any time securities are issued, you must comply with federal and state securities law. The Securities Act of 1933 requires that all offerings be either registered with the Securities Exchange Commission (the "SEC") or be exempt from such registration. The registration of securities is an expensive process, so it is important for founders to understand one of the more common exemptions when issuing securities.
Section 4(a)(2) is the exemption used a majority of the time to issue founder stock. To qualify, the purchaser of the securities must:
- Either have enough knowledge and experience in finance and business matters to be a "sophisticated investor" (with the ability to evaluate the risks and merits of the investment), or be able to bear the investment's economic risk
- Have access to the type of information normally provided in a prospectus for a registered securities offering
- Agree not to resell or distribute the securities to the public
California Blue Sky Law: Cal. Corp. Code §25102(f)
Section 25102(f) is the most commonly used exemption to avoid having to qualify an offering with the Department of Financial Protection and Innovation. This provision of the California Corporations Code exempts transactions from the applicable provisions of Section 25110.
To qualify for the §25102(f) exemption, the following criteria must be met:
- Sales of securities are not made to more than 35 people, including out-of-state residents
- The purchaser could be reasonably assumed to have the capacity to protect their own interests in connection with the transaction
- Each purchaser represents that they are purchasing for their own account and not with a view to, or for sale in connection with, any distribution of the security
- The offer and sale of the security is not accomplished by the publication of any advertisement
To take advantage of this exemption, the issuer must file a Limited Offering Exemption Notice (also called the "Section 25102(f) Notice") within 15 days of conducting the first sale or offer of sale. It must include specific details such as:
- Name of the issuer
- Mailing address
- State of incorporation
- Class or classes of securities sold in the transaction
- Value of securities offered
Failure to file a Section 25102(f) Notice does not impact the availability of the exemption, but the issuer must file the Notice within 15 days of discovery of the failure to file, or after an order from the commissioner to file the Notice, whichever occurs first, and pay a fee equal to the amount that would have been owed if the transaction had been qualified under Section 25110.
The penalty fee for late filing of the Section 25102(f) Notice is capped at $2,500, and is calculated as $200 (the minimum) plus one-fifth of one percent of the aggregate offering value. So it is important for a startup to properly file the Section 25102(f) Notice in a timely manner to avoid the penalty.
Conclusion
Founder stock issuances are routine, but the federal and state exemptions that authorize them are not optional. A short conversation with qualified counsel at formation is the cheapest way to make sure the Section 4(a)(2) prongs are satisfied and the §25102(f) Notice is filed on time.