Starting a company involves plenty of conversations about ownership, funding, and growth. The last thing most co-founders discuss is a breakup. But what happens if your co-founder leaves six months later? Without vesting, that person could keep a large ownership stake while no longer contributing anything to the business.
The short answer is founder vesting: each founder’s shares are issued up front but are subject to a company repurchase right that falls away over time. Vesting creates a tax decision that cannot wait, the founder vesting 83(b) election, which generally must be filed with the IRS within 30 days after the shares are transferred.
What Is Founder Vesting?
Founder vesting is an arrangement where a founder earns the right to keep their shares over an agreed period of service, or upon meeting specific milestones. The shares are usually issued at formation, but they come with conditions. If the founder leaves before meeting those conditions, the company can take back the portion that has not yet vested.
Why Co-Founders Vest Their Own Shares
Vesting protects the founders from each other. If one founder walks away early, the founders who stay should not be left carrying a business in which a departed partner owns a third or half of the equity. Investors often require it, so building it in at formation is simpler than negotiating it later.
The Typical Schedule: Four Years With a One-Year Cliff
Common market practice is a four-year vesting schedule with a one-year cliff. It is not legally required, but investors usually expect it:
- The cliff. No shares vest during the first year. If the founder leaves before the one-year mark, the company can repurchase all of their shares.
- Vesting at the cliff. On the first anniversary, 25% of the shares vest at once.
- Monthly vesting after the cliff. The remaining 75% vests in equal monthly installments (1/48 of the total each month) over the next 36 months, until the shares are fully vested at the end of year four.
The Repurchase Right for Unvested Shares
Because founder shares are typically issued outright, the vesting mechanism is a repurchase right in a restricted stock purchase agreement. If a founder’s service ends, the company has the right to buy back the unvested shares, usually at the lower of the price the founder paid or fair market value, which for early founder stock is often fractions of a cent per share. Vested shares stay with the founder. The agreement should state how long the company has to exercise the right and how notice is given.
Acceleration: Single Trigger and Double Trigger
Acceleration provisions cause some or all unvested shares to vest early when certain events occur.
- Single trigger acceleration vests shares upon one event, usually a sale of the company. Acquirers often resist it because they want founders to stay.
- Double trigger acceleration requires two events, typically a sale of the company followed by the founder’s termination without cause (or resignation for good reason) within a set period after closing. Double trigger is more common in venture-backed companies.
What Happens When a Co-Founder Leaves
If the founder walks before the four years are up, the company can buy back the shares that have not vested, provided the agreement allows it. The departing founder keeps the vested shares, subject to any transfer restrictions, rights of first refusal, and voting agreements in the company’s documents. This prevents someone from keeping equity they did not earn while still rewarding the time they put in. Define “cause” and “good reason” in writing before anyone is thinking about leaving.
Vesting for LLC Profits Interests
Many startups begin as LLCs rather than corporations. In an LLC, founders and key team members are often granted profits interests, which give a share of future growth in value rather than a share of the company’s existing value. Profits interests can vest on the same kind of schedule, with unvested units forfeited on departure, and the operating agreement should address vesting, forfeiture, and buyouts. Their tax treatment rests on IRS guidance specific to partnerships, and many advisors recommend a protective 83(b) election for unvested profits interests, so talk with a tax advisor. See our discussion of choosing between an LLC, S corp, and C corp if your entity type is still undecided.
The 83(b) Election: The Key Tax Step
With founder vesting, there is a tax consequence. Under Section 83 of the Internal Revenue Code, property received in connection with services that is subject to a substantial risk of forfeiture is generally not taxed when it is transferred. Instead, it is taxed when it vests, meaning when the risk of forfeiture lapses (or the shares become transferable, if earlier). The taxable amount is the fair market value of the shares at that time minus what the founder paid for them, and it is taxed as ordinary compensation income (26 U.S.C. § 83(a)).
For a growing startup, that default rule can be painful. Each monthly installment becomes a taxable event at the then-current value, even though the founder has received no cash. An 83(b) election changes the timing. It allows the founder to include in income, in the year of transfer, the fair market value of the shares at transfer minus the amount paid (26 U.S.C. § 83(b)(1)). If the election is made, later appreciation is not taxed as compensation when the shares vest, and the founder’s basis is the amount paid plus any amount included in income (Treas. Reg. § 1.83-2(a)). For what the election contains and how to prepare it, see IRS Form 83(b) elections explained.
A Simple Example
Suppose a founder buys 4,000,000 shares at formation for $0.00001 per share, paying $40 in total, and the fair market value of the shares at that time is also $0.00001 per share, or $40. If the founder files an 83(b) election, they report $40 of value minus $40 paid, which is $0 of income. Without the election, the founder would recognize income as each tranche vests. If the company has grown and the shares are worth $1.00 each when the first 1,000,000 shares vest at the cliff, that could mean roughly $1,000,000 of ordinary income in that year alone, with more to come every month after.
The 30-Day Deadline
The election must be made no later than 30 days after the date the shares are transferred, and it cannot be revoked without IRS consent (26 U.S.C. § 83(b)(2)). There is no extension. It is filed with the IRS office where the founder files, with a copy to the company (Treas. Reg. § 1.83-2(c), (d)). Since 2024, the IRS has offered Form 15620 as an optional, standardized way to make the election; a properly drafted written statement remains acceptable. For property transferred on or after January 1, 2016, a copy of the election no longer needs to be attached to the founder’s income tax return (Treas. Reg. § 1.83-2(c), (g)). Many founders send it by certified mail to prove timely filing. Miss the deadline and the default vesting rule applies.
The Downside: Forfeiture After an Election
There is a downside too. If a founder makes the election, includes an amount in income, and later forfeits the unvested shares, no deduction is allowed for that forfeiture (26 U.S.C. § 83(b)(1)). Under the regulations, the founder’s loss on forfeiture is generally limited to what they actually paid for the shares, less anything received when the shares are taken back (Treas. Reg. § 1.83-2(a)). When the shares are worth only what was paid, as in the example above, little is at stake. When an election would require reporting meaningful income, weigh your finances and the risk of forfeiture first.
What the Election Does Not Cover
An 83(b) election applies to restricted property that has actually been transferred, not to every form of equity compensation. Stock options, for instance, usually require separate analysis, because Section 83 does not apply to the grant of an option without a readily ascertainable fair market value (26 U.S.C. § 83(e)(3)).
Vesting Covers Shares, Not the Work Itself
Vesting addresses ownership of company shares, not ownership of the work founders create. Every founder should sign an intellectual property assignment agreement that transfers relevant inventions, software, designs, and other business assets to the company. See our post on IP assignment mistakes that come up in startup acquisition due diligence. Vesting, the 83(b) election, and IP assignments are usually handled together as part of corporate formation.
Frequently Asked Questions
Is a four-year vesting schedule with a one-year cliff required?
No. It is common market practice, not a legal requirement. Founders can agree to other schedules or milestone vesting.
When does the 30-day 83(b) deadline start?
The 30 days run from the date the shares are transferred to the founder. The election must be filed with the IRS within that window, and there is no extension.
Do I have to attach my 83(b) election to my tax return?
Not for property transferred on or after January 1, 2016. You file it with the IRS within 30 days and give the company a copy, but no copy needs to be attached to your return.
What happens if I file an 83(b) election and later forfeit my shares?
No deduction is allowed for the amount you included in income. Your loss is generally limited to what you paid for the shares, less any amount you received when they were repurchased.
We Are Here to Help
For assistance with founder vesting, restricted stock agreements, 83(b) elections, and IP assignments, the experienced business lawyers at Revision Legal can help. Contact us or call (855) 473-8474.
This post is general information and is not legal advice.
