Getting Founder Equity Right: Key Issues Every UK Startup Should Consider Early
Congratulations! You have started, or are about to start, your company.
As you embark on your startup journey, you are likely focused on the high-octane business of commerce: building a product, finding customers, hiring talent and raising money.
Before going too far, however, take a moment to consider something slightly less glamorous: founder equity. Most founders think about equity as a question of ownership. Who gets what? How should the pie be divided? What percentage should be set aside for future hires?
These are all important questions, but they are also only part of the picture. The reality is that founder equity is simultaneously a question of ownership, incentivization and tax, and decisions that seem straightforward when a company is worth next to nothing can become surprisingly significant once the business begins to gain traction. The broader lesson is that tax considerations should form part of the founder equity conversation from the outset. The decisions founders make when the business has no value are often the same decisions that resurface years later when it does.
The most successful startups we see tend to recognize this early. The ones that do not often find historic equity decisions reappearing during fundraising, diligence exercises or HMRC enquiries at precisely the moment they would rather be focusing on growth.
Founder Vesting and the Risk of a Dry Tax Charge
Venture-backed companies will almost always adopt founder vesting arrangements, with these arrangements incorporated in the UK Private Capital (BVCA) model document suite. Vesting protects the business against the problem of an exiting founder benefiting from the future work of others. After all, if a founder leaves after six months, most investors (and co-founders, for that matter) would consider it unfair for that individual to retain the same economic interest as those who remain and continue building the company. Venture capital investors therefore routinely expect founder shares to be subject to vesting, leaver provisions and transfer restrictions. Not least as it allows the employment of another individual without dilution.
Commercially, the rationale is straightforward, but tax-wise, things become more complicated. Where founders who are (or will become) employees and/or directors of the company acquire shares that are subject to restrictions (e.g., vesting), the UK’s employment-related securities regime needs to be considered, particularly in regard to section 431 election. This election is a short document, typically signed by the company and founder when the shares are issued, under which the founder elects to be taxed on the shares as if certain restrictions did not apply, helping to prevent potentially much larger tax charges arising later as vesting and other restrictions fall away. It is relevant here because if no election is entered into and the share restrictions subsequently fall away as the company grows in value, some of that growth can potentially be taxed as employment income rather than capital gain and as such be subject to a much greater tax rate.
This is where the concept of a “dry tax charge” comes from. Imagine a founder receives shares when the company is worth very little. Four years later, the startup has raised several rounds of investment and the founder’s shares are worth millions on paper. As vesting restrictions fall away, a tax charge may arise despite the founder not having sold a single share or received a penny of cash.
The founder may be asset-rich and cash-poor simultaneously, which is not an ideal position to find oneself in when the taxman comes calling. Fortunately, where appropriate, this issue can often be addressed at the outset through a section 431 election. Of critical importance, the election generally needs to be made within 14 days of acquiring the shares; miss the deadline and the opportunity is gone. It should be noted that no filing is needed, but the Company and the shareholders should retain a copy.
Equity Gets Harder Once Value Starts to Emerge
We sometimes see founders treating the cap table as something that can be sorted out iteratively rather than on day one. Sometimes that works, but more often it creates avoidable complexity.
At incorporation, issuing founder equity is usually relatively straightforward. There may be little more than an idea, an ambitious founding team and a prototype. At that point, the company will often have little or no material value.
Fast forward six or 12 months, and the picture may look very different. The company may have developed valuable intellectual property, secured pilot customers, generated revenue or attracted investor interest. The business may still be at an early stage, but value has begun to emerge.
This matters because founders do not receive a free pass to acquire valuable shares at nominal value simply because the company remains private. Where a founder who is also a director or employee acquires shares for less than their market value, the difference between the amount paid and the market value of those shares may be taxable as employment income. Depending on the circumstances, this can give rise to income tax and potentially National Insurance contributions at the point the shares are acquired.
In practical terms, this means that the later founder equity is allocated, the greater the risk that someone is receiving valuable shares at a discount, which in turn creates a greater risk of an upfront tax charge.
The issue frequently arises when a new co-founder joins after the business is already up and running. A solo founder may have spent months developing the product before finding the technical or commercial counterpart they have been searching for. The instinctive response is often simple: “I’ll just give them 20% of the company.”
Commercially, that may be entirely sensible. Tax-wise, however, there is an important difference between giving someone 20% of a company worth £100 and giving them 20% of a company worth £2 million. This distinction can be overlooked because founders naturally think in percentages; HMRC, on the other hand, tends to focus on value.
Where meaningful value already exists, founders should therefore think carefully about how new team members are incentivized. In some cases, a direct share issuance may remain the right answer. In others, structures such as Enterprise Management Incentive (EMI) options or growth shares may offer a more tax-efficient route to rewarding and retaining key individuals whilst avoiding an immediate acquisition of valuable shares.
That’s not to say founders should avoid using equity to attract key people. Quite the opposite. Equity remains one of the most powerful tools available to startups. The point is simply that founder equity is usually easiest to structure before value accrues rather than afterwards, which is all the more reason to check with your friendly lawyer or tax adviser before you issue shares to an incoming employee to ensure that you don’t trigger a tax charge.
Looking Ahead
Founders understandably spend most of their time thinking about customers, products and fundraising. Those things matter; they are the reason the company exists in the first place.
Nonetheless, some of the most expensive mistakes we see are made long before a term sheet arrives. They are made when the company is first incorporated, the founders are deciding how to split ownership and everybody assumes there will be plenty of time to tidy things up later. Often, there is not.
Getting founder equity right at the outset may not guarantee success, but getting it wrong? That has a habit of resurfacing at exactly the wrong moment.
As you embark on your startup journey, you are likely focused on the high-octane business of commerce: building a product, finding customers, hiring talent and raising money.
Before going too far, however, take a moment to consider something slightly less glamorous: founder equity. Most founders think about equity as a question of ownership. Who gets what? How should the pie be divided? What percentage should be set aside for future hires?
These are all important questions, but they are also only part of the picture. The reality is that founder equity is simultaneously a question of ownership, incentivization and tax, and decisions that seem straightforward when a company is worth next to nothing can become surprisingly significant once the business begins to gain traction. The broader lesson is that tax considerations should form part of the founder equity conversation from the outset. The decisions founders make when the business has no value are often the same decisions that resurface years later when it does.
The most successful startups we see tend to recognize this early. The ones that do not often find historic equity decisions reappearing during fundraising, diligence exercises or HMRC enquiries at precisely the moment they would rather be focusing on growth.
Founder Vesting and the Risk of a Dry Tax Charge
Venture-backed companies will almost always adopt founder vesting arrangements, with these arrangements incorporated in the UK Private Capital (BVCA) model document suite. Vesting protects the business against the problem of an exiting founder benefiting from the future work of others. After all, if a founder leaves after six months, most investors (and co-founders, for that matter) would consider it unfair for that individual to retain the same economic interest as those who remain and continue building the company. Venture capital investors therefore routinely expect founder shares to be subject to vesting, leaver provisions and transfer restrictions. Not least as it allows the employment of another individual without dilution.
Commercially, the rationale is straightforward, but tax-wise, things become more complicated. Where founders who are (or will become) employees and/or directors of the company acquire shares that are subject to restrictions (e.g., vesting), the UK’s employment-related securities regime needs to be considered, particularly in regard to section 431 election. This election is a short document, typically signed by the company and founder when the shares are issued, under which the founder elects to be taxed on the shares as if certain restrictions did not apply, helping to prevent potentially much larger tax charges arising later as vesting and other restrictions fall away. It is relevant here because if no election is entered into and the share restrictions subsequently fall away as the company grows in value, some of that growth can potentially be taxed as employment income rather than capital gain and as such be subject to a much greater tax rate.
This is where the concept of a “dry tax charge” comes from. Imagine a founder receives shares when the company is worth very little. Four years later, the startup has raised several rounds of investment and the founder’s shares are worth millions on paper. As vesting restrictions fall away, a tax charge may arise despite the founder not having sold a single share or received a penny of cash.
The founder may be asset-rich and cash-poor simultaneously, which is not an ideal position to find oneself in when the taxman comes calling. Fortunately, where appropriate, this issue can often be addressed at the outset through a section 431 election. Of critical importance, the election generally needs to be made within 14 days of acquiring the shares; miss the deadline and the opportunity is gone. It should be noted that no filing is needed, but the Company and the shareholders should retain a copy.
Equity Gets Harder Once Value Starts to Emerge
We sometimes see founders treating the cap table as something that can be sorted out iteratively rather than on day one. Sometimes that works, but more often it creates avoidable complexity.
At incorporation, issuing founder equity is usually relatively straightforward. There may be little more than an idea, an ambitious founding team and a prototype. At that point, the company will often have little or no material value.
Fast forward six or 12 months, and the picture may look very different. The company may have developed valuable intellectual property, secured pilot customers, generated revenue or attracted investor interest. The business may still be at an early stage, but value has begun to emerge.
This matters because founders do not receive a free pass to acquire valuable shares at nominal value simply because the company remains private. Where a founder who is also a director or employee acquires shares for less than their market value, the difference between the amount paid and the market value of those shares may be taxable as employment income. Depending on the circumstances, this can give rise to income tax and potentially National Insurance contributions at the point the shares are acquired.
In practical terms, this means that the later founder equity is allocated, the greater the risk that someone is receiving valuable shares at a discount, which in turn creates a greater risk of an upfront tax charge.
The issue frequently arises when a new co-founder joins after the business is already up and running. A solo founder may have spent months developing the product before finding the technical or commercial counterpart they have been searching for. The instinctive response is often simple: “I’ll just give them 20% of the company.”
Commercially, that may be entirely sensible. Tax-wise, however, there is an important difference between giving someone 20% of a company worth £100 and giving them 20% of a company worth £2 million. This distinction can be overlooked because founders naturally think in percentages; HMRC, on the other hand, tends to focus on value.
Where meaningful value already exists, founders should therefore think carefully about how new team members are incentivized. In some cases, a direct share issuance may remain the right answer. In others, structures such as Enterprise Management Incentive (EMI) options or growth shares may offer a more tax-efficient route to rewarding and retaining key individuals whilst avoiding an immediate acquisition of valuable shares.
That’s not to say founders should avoid using equity to attract key people. Quite the opposite. Equity remains one of the most powerful tools available to startups. The point is simply that founder equity is usually easiest to structure before value accrues rather than afterwards, which is all the more reason to check with your friendly lawyer or tax adviser before you issue shares to an incoming employee to ensure that you don’t trigger a tax charge.
Looking Ahead
Founders understandably spend most of their time thinking about customers, products and fundraising. Those things matter; they are the reason the company exists in the first place.
Nonetheless, some of the most expensive mistakes we see are made long before a term sheet arrives. They are made when the company is first incorporated, the founders are deciding how to split ownership and everybody assumes there will be plenty of time to tidy things up later. Often, there is not.
Getting founder equity right at the outset may not guarantee success, but getting it wrong? That has a habit of resurfacing at exactly the wrong moment.