Top up grants may be a costly gift for founders

You're raising a round and your investors want to give you and your cofounder some top up grants to offset dilution and keep you incentivized. There may be some milestones you need to hit, but it seems like a good deal.

It's probably not such a good deal. And you likely won't be able to negotiate it, but it's good to understand it.

Why your initial founder stock is so valuable

Hopefully, you got some decent advice when you formed your C-corp and got your chunk of founder's stock, so you filed an 83b with the IRS. This allowed you to pay the income tax on your stock when it was issued, rather than when it vests. Since most startup stock is worth next to nothing at the very beginning, the tax due probably wasn't enough to buy lunch with.

And, since your initial grant was likely restricted stock, not stock options, there's no exercise price - when you sell it, it's yours (less capital gains tax).

Both of these points are important.

The mechanics of a top-up grant

Here are the mechanics of a top-up grant:

• The equity pool is enlarged to accommodate your top-up grant, diluting your initial ownership.
• You are given a grant, usually incentive stock options (ISOs), usually vesting the same way your original grant vested, perhaps a one year cliff then monthly for 36 months.
• You may be promised another grant if you hit certain business milestones.

The paperwork should all look familiar - it's generally the same as if you are issuing ISOs to non founder employees, with two exceptions. First, if you own more than 10% of the company, your strike price has to be at least 110% of fair market value (which is the 409A value per share). Second, if the total fair market value of your ISOs vesting for the first time in a calendar year is over $100K, the overage is treated as non qualified stock options (NSOs). You'll generally pay more tax on these, so it's not ideal.

The math: why top-up grants aren't a great deal

Here's an oversimplified example with easy numbers (and assuming you live in the US):

Scenario 1:

• You and your cofounder currently own 30% each of your startup
• You are raising a round that will dilute you 20% without any top-up grants involved (so dilution comes from new money in as well as an increase in the equity pool, which is totally standard).

You'll each own 24% after the round closes.

Scenario 2:

• You and your cofounder currently own 30% each of your startup
• You are raising a round that will dilute you 20% before considering top-up grants (so dilution comes from new money in as well as an increase in the equity pool, which is totally standard).
• Your investors want you each to get a 5% top-up grant
• An additional 10% is added to the equity pool to create enough shares in the pool to give you the grant. You're now diluted by that as well.

You'll each own 21% after the round closes, and have a 5% grant that vests over time. So you traded off 3% original ownership for 5%, maybe, if it all vests, if you meet any relevant milestones.

But wait, there's more (and caveat that I am not a tax professional, and you should talk to yours).

That original 3% ownership, you probably paid something like $20 tax on it when you filed your 83b. No tax was due at vesting. And if you sell, you'll just owe capital gains tax on the difference between the value at vesting and what you sell it for.

On the 5% ISO grant, you'll still only owe capital gains tax when you sell (assuming all holding periods, etc. have been met). However, since you make the difference between the sale price and the strike price when you sell, the strike price takes a bite out of your value. How much depends entirely on how much the fair market value increases between the date you options are issued and when you sell them.

So, your 5% top up is really, at best, a slightly less than 2% gain if you have a cofounder.

More than two is too many cofounders

This is another example of when more than two cofounders will really hurt. Imagine adding 15% dilution to get 5% back with three cofounders. What are the investor's incentives regarding any cofounder they view as weak in this situation, especially if they invested in earlier rounds and are also getting their previous investment diluted.

Beware VCs bearing gifts.

I'm not your lawyer, your therapist, your advisor, or your accountant. We're just internet friends, and these are just my experiences and personal opinions. Consult professionals for advice before you make any sudden moves in your startup.

You will see the occasional affiliate link. I do earn a commission if you buy the products I recommend. I appreciate you buying through the links if you're going to buy. This is a labor of love for my fellow cofounders, and I do love receiving a few coins to pay hosting costs if you like my work.