Vesting, Tax Elections, and Venture Capital Instruments

This set covers essential venture capital and startup legal concepts including Rule 83(b), Section 1202, vesting mechanics, and the differences between various funding instruments like SAFEs and Preferred Stock.

Rule 83(b) Election

A notification that must be filed with the IRS within $30$ days of being granted restricted stock, allowing the holder to be taxed only on the liquidity event rather than at the time of vesting.

Cliff

A period—typically the first $12$ months of a venture—during which no shares vest; once completed, a portion (usually $25\%$) of the equity vests all at once.

Standard Vesting Schedule

A common equity arrangement where stock vests over a four-year period, with a one-year cliff followed by monthly increments of $1/48$ of the total grant ($1/36$ of the remaining balance).

Section 1202 (QSBS)

The Qualified Small Business Stock exemption that allows founders and early investors in a C-corp to receive the first $10,000,000$ in gains tax-free at the federal level if held for at least $5$ years.

Stacking

A technique used to multiply the Section 1202 tax benefit by gifting shares to family members or multiple irrevocable non-grantor trusts, giving each entity its own tax exemption.

Accredited Investor

An individual with at least $1,000,000$ in investable assets, excluding their primary residence, or who meets specific income requirements.

Special Purpose Vehicle (SPV)

An LLC formed to aggregate multiple smaller investors (such as those from a crowdfunding campaign) into a single line item on a company's cap table.

Beneficial Ownership

Full ownership and control of stock, including the right to sell; restricted stock is not considered full beneficial ownership because it is subject to forfeiture or sale restrictions.

Preferred Stock

A class of stock typically issued to venture capitalists that includes special rights, such as liquidation preferences and protective provisions, over common stock.

Common Stock

The standard form of equity held by founders and employees, which generally possesses no special privileges or preferences.

SAFE

Stands for 'Simple Agreement for Future Equity'; a convertible equity instrument invented by Y Combinator that does not require the company to pay the money back as debt.

KISS

Stands for 'Keep It Simple Security'; an investment vehicle created by 500 Startups that functions as a more investor-friendly alternative to a SAFE.

Liquidation Preference

A right given to preferred shareholders to receive their investment back (often at a multiple like $1\times$, $2\times$, or $3\times$) before common shareholders receive any proceeds from a sale.

Participating Preferred

A type of preferred stock where the investor receives their liquidation preference off the top and then also participates in the remaining common pool based on their conversion ownership.

Non-Participating Preferred

A type of preferred stock where the investor must choose between receiving their liquidation preference or converting their shares into common stock.

Board Observer

An individual who can attend board meetings and receive copies of all board materials but does not have a formal vote on company decisions.

First Right of Refusal (ROFR)

A provision allowing existing preferred shareholders to buy shares that another shareholder is attempting to sell to a third party at the same price and terms.

Preemptive Rights

The right of existing investors to purchase new shares in future funding rounds to maintain their percentage ownership in the company.

Protective Provisions

Veto rights that allow preferred shareholders to block specific corporate actions, such as taking on certain levels of debt or changing officer salaries.

409A Valuation

An independent appraisal required by the IRS to determine the fair market value of a private company's common stock for the purpose of pricing stock options.

Strike Price

The fixed price per share at which an employee has the right to buy their stock options in the future.

Vesting Acceleration

A provision where a portion or all of an employee's unvested stock options become immediately vested upon a specific event, such as an acquisition.

B-Corp

A Benefit Corporation; a legal structure that allows directors to consider altruistic or social goals alongside the financial interests of shareholders without fear of being sued.

Revenue Based Lending (RBL)

A type of loan where repayments are made based on a percentage (often $1.5\%$ to 3.5\%\) of the company's positive cash flow in a given month.

Series A

The first significant round of venture capital funding from institutional investors who are totally motivated by financial returns.