A few days ago we came across this post from Rebekah Campbell, Founder of Posse.com. In a nutshell, Campbell explained the only mistake she really regrets is giving away too much equity to people who were there at the start, but didn’t end up pulling their weight.

Her proposed solution is to have the business lend each founder the agreed value of their equity, in order to purchase their shares. Then if something goes wrong or a founder doesn’t pull their weight (in line with the shareholders agreement), the company rescinds the loan, and takes back the equity. There are some potential issues with this approach, which we’ll outline below.

Founders leaving early or not pulling their weight is an issue faced by plenty of startups, says Niki Scevak, co-founder of Startmate and the recently launched Blackbird Ventures. He suggests the best thing to do is to establish a vesting schedule, which sets a timeframe and criteria for shares to be handed to the recipient, although this will have some tax implications, which we’ll explain.

“It really is the most important thing,” says Scevak. “Basically it’s this concept of relationships being able to fail gracefully. People leave for all sorts of reasons, so you need to get to have all this agreed upfront.”

Establishing a vesting schedule: what does it mean?

An “unvested” share is a share that is yours, but which you can’t act on until some future date, set out in a “vesting schedule”. A “vested share” is a share you can act on (e.g. sell). There can be some personal tax liabilities for the people granted shares under a vesting schedule, depending on the type of shares, and the way the vesting schedule is structured.

Scevak says it’s important founders buy the shares, even for a nominal amount, rather than being ‘given’ them in exchange for their labour. This way you won’t have to pay the tax upfront. You may, however, have to pay tax each time new shares vest.

Startmate offer templates for financing documents including a Term Sheet and a Shareholders’ Agreement. The Startmate Term Sheet includes a clause which spells out a suggested vesting schedule.

The vesting cliff

One important principle in the Startmate documents is the “cliff” in the vesting schedule — a one-year cliff would mean that if you, as a founder, left before the first year was up, you wouldn’t be entitled to any of your shares.

If we were talking about a four-year vesting schedule with a one-year cliff, then it wouldn’t be until after year one that you’d be entitled to any of your shares. Following that, you’d receive 25% of your equity each year after that. Often, people will choose to vest monthly — your shares are allocated pro-rata, based on the time that’s passed.

There is a potential tax liability for founders when shares are vested, because of the increase in value, seen as a financial gain once the shares are realised. This happens when shares are vested at a discount to the market rate (as the value of the company increases).

One of the ways around this issue is to have all the shares allocated up front for a nominal sum, say $100 for 100 shares, but include the option for the company to buy back a proportion of the shares, if the founder is not meeting their vesting criteria.  If the company opts not to purchase the shares, they are divided amongst the remaining shareholders. The proportion of shares subject to the option reduce over a period, in line with what would be a vesting schedule.

A third option, favoured by other Australian startups, is to establish a unit trust to hold the shares. The company can lend money to the trust to buy the shares. Founders are then given units in the trust. The units in the trust equate to shares in the company, and the liability is only realised when the shares are sold. This avoids some issues around taxation, and if established correctly can remove some personal liability, however you will incur some additional legal and accounting expenses in setting up the trust.

Loan to purchase shares

Campbell’s loan suggestion is another way to go, though again, there are tax and legal implications in choosing this approach. Michael Reid and William Chau, co-founders of the Majoran Distillery incubator in Adelaide, have outlined a few of them on their blog. It seems like a good solution, although the devil is in the detail. Below are a few of the potential headaches which may arise if this approach is adopted.

Company goes into administration

As Reid and Chau explain, if you adopt this approach, and something goes wrong, you could be personally liable. Let’s assume your company is worth $100,000 (the loan to shareholders was also $100,000 to buy initial shares). Now, what happens if you get into serious trouble? This could be because an employee files a claim with Fair Work Australia, or you overcommit on a lease. If the trouble is insurmountable and you call in an administrator, the first thing they’ll do is attempt to recover any assets on the books… that means the loan. The founders could now be in the red for $100,000, plus any other money the business has spent.

Am I breaking the law?

The Corporations Act has a clause, which in simple terms, is designed to prevent a company from providing assistance to a person to acquire shares in the same business. The clause exists to prevent people starting companies that are worthless. Although there are a few exceptions to this rule, the legal and accounting costs to navigate them may amount to tens of thousands of dollars.

Reid and Chau also suggest a large loan on the books could raise some concerns with any future investors. In order to clear the loan, the founders would have to put additional money into the company, or have the business declare a dividend (which doesn’t get paid) but would offset the balance. Because the dividend would appear in the founder’s tax return, they would pay tax on cash they never receive.

Capital Gains Tax

If a founder leaves before fully realising their shares, they can also be hit with capital gains tax. If the value of the company has increased, the shares will also be worth more. Say that after two years, things aren’t going well between the founders; you’re having disagreements with your other two founders, and decide to move on.

What happens to the third of the 30% interest in the company that the shareholders’ agreement allows to be cancelled? Those 30,000 shares were initially valued at $30,000. If over time, the business has increased profits and grown in value this $30,000 may now be worth $60,000. If you leave, you’ll be entitled to two-thirds of that value, or $40,000. Hopefully, the other founders, or the company, will buy them from you.

The tricky part comes as the remaining third needs to be cancelled. These 10,000 shares are now valued at $20,000. You also owe the initial loan value of $30,000. While you can repay the loan by exchanging your 10,000 shares, there will be a $10,000 gain which has been realised. Even though you won’t receive any actual money, you’ll be up for a few thousand dollars in tax.

The other option is the company forgives the debt, in exchange for the shares. With this approach, there will still be an increase in the value of your shares, and there could also be tax concessions which the company could lose as a result of the exchange.

So what should I do?

This is something that really needs to be considered depending on the circumstances. There are some helpful discussions on Silicon Beach, good templates on the Startmate website, and some answers on Quora (you just need to dig).

Ultimately, you need to make a call based on your own advice. Scevak suggests having a look through the information out there, have a go at drawing up your own agreements, based on the available templates, and then seek the advice of an accountant or lawyer to finalise the details. Doing some of the work upfront yourself will save you money, and you’ll develop a better understanding of the issues. There’s no doubt though: it’s important to get these things right or they can cause serious headaches later.