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83(b) Elections and Founder Equity Vesting Demystified | A Startup Lawyer Explains - YouTube
Channel: Brett Cenkus
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Hi, I'm Brett Cenkus, the right-brained
business lawyer and a business
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consultant. Today we are talking about
something that a lot of startup founders,
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business owners struggle to understand.
There are 83(b) elections so 83 and then
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b in parentheses, which is a reference
to the IRS code 83(b). Let's talk generally
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about where 83(b) elections come into
play. They come into play when someone is
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given stock or LLC interests--a type of
equity that is vested over time. So,
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vesting means you're getting something
today but it's really not yours, you
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can't walk away with it. So, in the case
of stock or LLC interest or some other
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type of equity usually, not always, but
usually you can vote those shares and
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you get dividends from them, but if you
were to leave before the vesting kicks
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in then you don't get to walk away with
the shares. So typical Silicon Valley
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style vesting for founders, in a venture
capital backed company, is going to be
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four-years with a one-year cliff. What
that means is if our founder is given a
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million shares, the one year cliff means
she/he will not get anything for a year
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and the 365th day they receive or
finally get to get to keep 250,000
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shares and then over the course of the
next three years, the remainder of the
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four year period, they will vest equal
traunches or slugs of stock. So, the other
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750,000 shares will vest over the course
of thirty six months, something like
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20,000 shares a month. So again, up front
our founder would have a million shares,
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be able to vote them and cash the
dividend checks but if she were to walk
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away before the end of the first year,
she walks with no shares and after that
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you know pro rata. So, the reason vesting
is used--venture capitalists almost
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universally require it--I mean, you really need
to earn your equity.
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You're not given a whole bunch equity,
usually, just because you have a good
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idea or you showed up on the first day.
You've got to be there for a while and if
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you leave early, somebody doesn't work
out on the team, it's important that they
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leave most of that equity behind, depending on
when they leave because you've got other
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people who have to come in and be in
that role-take over for them. So again,
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you kind of earn your equity over time, very common. There's two concepts you
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need to understand, to really understand
the 83(b) election, just two. Now, the first
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is that when you receive something as
compensation and it's worth more than
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what you pay for it they IRS taxes you on
the difference, right. So, if I come and I
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give you a bunch of shares of stock at
my company and you don't pay anything for it
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you have a taxable event. I need to send
you a 1099, you need to pay for that
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That's concept number one. The difference
between what you pay and what you get in the
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compensation realm, you pay tax on that.
The second thing you need to understand
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is when you have vesting on that stock
or equity, the IRS doesn't treat you as
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truly receiving it until the vesting
falls off. Until it's no longer subject
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to what they call substantial risk of
forfeiture. So, in the example earlier of
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the four year, one year cliff, on day one
our founder hasn't, for tax purposes,
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received anything.
Remember again, you know she would
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have shares, she can vote them, she
could cash dividend checks, can't walk
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away with them. The IRS would not treat
her as owning those. On day 365, when
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250,000 of them vest, the IRS would say aw taxable event, you receive shares on
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this day. So, the reason this can become a
problem is in the typical venture-backed
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company, the idea is you're gonna do
multiple rounds, in every round,
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hopefully, the company's increasing in
value. So, on day one when our founders
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get together and issue themselves
founder shares, those shares aren't worth
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anything. I mean they're worth hardly
anything, maybe a couple thousand bucks
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that the founders put in. So, they're really
worth hardly anything. So, the million
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shares our founder would have
received on day one, arguably, defensively
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aren't really worth anything,
there's no taxable event. But if they
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don't invest, remember the IRS doesn't
treat founders receiving those but in a
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365 maybe they're worth something, maybe
the company has done a value-had a
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valuation event, done a round, grown. In the
second year, the third year, the fourth
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year hopefully the value of the
company's going up and up and up.
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So, what that means
is the shares the founder's receiving
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right, when the vesting falls off, are
worth more and more and more, but the founder
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is not paying anything, not usually
founders paying something negligible,
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something called par value. So that means
they're constantly getting these
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valuation events. They're getting tax
bills and they have a illiquid, they
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have an illiquid stock they can't sell.
So, the 83(b) election takes care of that
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problem. Never say you, never say there's
no free lunch, I mean this is as close as it
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comes to it, because if our founder files
in 83(b) election upon receiving that
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that million shares on day one, even
though they're subject to vesting okay
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the IRS says okay we'll accelerate the
taxable event and we'll tax you entirely on
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day one and remember the shares are
arguably worth nothing. When I say
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arguably, what I mean is that that would
be what you would say to the IRS and
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they, in most every instance would
agree with you.
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And our founder paid almost nothing so
there's no taxable event and then as the
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vesting falls off, hopefully the stocks
growing in value, but our founders not
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having to pay tax on it. Ultimately, when
the founder sells those shares they
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would pay tax on the difference between
you know zero or whatever they paid at
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the beginning and the sale price so the
IRS, no surprise, will ultimately get
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their money, but it avoids a couple
issues. Number one, it defers the taxable,
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the tax, plus you overcome the issue of
having to pay tax on illiquid shares,
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because if you pay tax on private stock
and never sell the stock then all you
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had is a tax bill and you never get
liquid. So, that's the one thing to watch
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out for, by the way, sometimes later on as
companies grow, they'll still get
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restricted stock and things like that
and I saw back in the .com days, a lot of
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people paying the-accelerating the
vesting, filing an 83(b) election, paying
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tax today, because they assumed during
1998, 99 and 2000 the stocks gonna go up
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forever. Well then when it drop
precipitously and couldn't be sold it
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wasn't worth anything, the employees
were still stuck with these tax bills. So,
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that's 83(b) elections, it's as close
to a free lunch as it comes. Decisions if
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the companies, you know those shares are
worth something, it becomes harder, but
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at the time when you're founding
a company, if you're gonna vest the
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shares, you almost always want to file an 83(b)
election. You have 30 days to do it from
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the date you are granted the shares. So,
you send in your 83(b) election to the
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IRS, you send it with a self-addressed
stamped envelope, you send it certified
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return receipt requested, and you've got
30 days and that's it. Do it or lose it.
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So, I'm Brett's Cenkus. If there's still
something confusing or you have a
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question or I didn't cover something, leave
me a comment if you want to hear
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something in particular shoot me an
email [email protected]. Appreciate
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you stopping by. I will see you in the
next video.
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