I’ve always thought FF stock was pretty creative. And with the secondary purchase plus “magical” exchange structure losing favor, perhaps it’s time to give FF stock another look.
What is FF stock?
Founders start a company. They grow it successfully for several years but get tired of living in their parent’s garage and want to take a little money off the table by selling shares at the company’s next round of financing.
The founder’s problem? The founders don’t want to sell shares at the 409A price. Everyone knows that 409A valuations produce an intentionally deflated value. Rather, the founders want to receive the same price for their shares as the shares being sold in the current preferred round.
The investor’s problem? Investors don’t want to pay the preferred price for common shares. And if the company redeems common shares at the preferred price the spread between the amount paid and the 409A value of the common is most likely taxed as compensation.
So, years ago Sean Parker and Founder’s Fund (yes, that’s what the FF stands for) had an idea. Why not grant a special class of stock to founders that converts into preferred stock at a future financing round. Then you can sell it to investors at the preferred price, the investors receive the preferred stock they want, and the founder’s gain is entirely capital gain or possibly even QSBS gain.
Creative, right? So if FF stock is so wonderful…
Why doesn’t everybody use it?
Perhaps one reason FF stock hasn’t caught on universally is that many investors (and therefore, founders) don’t like the signal it sends: setting up for a partial liquidity event well before the company is at growth stage; or, “I think I’m Sean Parker”.
Also, some practitioners worry it doesn’t actually solve the withholding risk, i.e., when it converts into preferred and the founders receive the preferred price for it, some nervous nellies think there is still potential withholding required on the delta between the fair market value of the common and the preferred price. Personally, I don’t share that concern, I think it should allow the full payment for the stock to be purchase price and not compensation.
I have seen a couple of people try to put it in place shortly before a financing. I think that is not helpful, because the value of FF stock at that point should essentially be the preferred value and thus the compensation hit on grant of the FF stock would be all ordinary income anyway. But if put in place at formation when both the common and the preferred are worth a nominal amount, I think it’s helpful. I do think it’s good practice to have the founders pay a little more for the FF stock at formation than they do for the common.
Mike Baker frequently advises with respect to corporate tax matters. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.