Co-Founder Equity Splits and Vesting: Designing Them Together with Buyback Terms on Departure

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When co-founding a company, people naturally wonder what the equity split should be. However, if you decide only the ratio first and complete registration without deciding how the shares will be treated if someone leaves partway through, the means of adjusting things afterwards are limited. The ratio is only the first step. Founders' equity functions as part of the capital policy only when it is designed as a whole, together with the division of roles, the timing of full-time involvement, decision-making rules and the treatment of shares on departure.

I discussed why co-founders should reach agreement while their relationship is still good in A Founders' Agreement Can Only Be Made While You Get Along. At the core of that founders' agreement is the design of the equity split and vesting. You decide roles and the timing of full commitment, and consider who buys back the shares, at what price and through what procedure, depending on the reason for departure. By also checking the tax consequences and the effect on future fundraising, you will be able to give investors a coherent explanation.

Agreement Before Incorporation and Organizing a Role Table

Deciding the equity split is not simply a matter of dividing the capital contribution by the number of founders. Whether the founders' holdings are equal or one person receives more, there needs to be a reasonable basis in light of the amount contributed and expected future contributions. More important than the ratio itself is whether the understanding behind it is shared.

What needs to be organized as a premise is not limited to the amount of money each founder contributes. You need a role table setting out who becomes full-time and from when, who is responsible for each of technology development, sales, hiring and fundraising, and to whom the intellectual property and existing customer relationships each founder brings belong. The timing of the move to full-time work is especially easy to overlook. If a founder who initially works on the side and becomes full-time a few months later is given the same ratio as a founder who is fully committed from day one, it becomes difficult to explain the arrangement convincingly later unless a role table has been prepared in advance.

Whether the CEO should hold a majority is also judged in light of the business and the decision-making structure. If technology is at the heart of the business and the technical lead drives it, the equity design will reflect that. Even an equal split does not immediately lead to dysfunction if the decision-making mechanism and the treatment of shares on departure are set out separately. In practice, what makes the difference is less the size of the ratio itself than the division of roles that supports it, and the prior agreement on how shares will move when roles change.

It is possible to revise the equity split or terms after incorporation, but doing so involves agreement among the parties, Companies Act procedures and tax review, so the burden is heavy. To avoid that burden, the practical starting point is to discuss the following before incorporation and put them in writing:

• Each founder's role, timing of the move to full-time work, and the intellectual property and funds contributed
• The initial equity split and the assumptions on which it is based
• Categories of reasons for departure (loss of position, unavoidable reasons, whether there was a serious breach of trust)
• The proportion of shares to be returned or bought back depending on the reason for departure, and the vesting schedule
• The order of priority of buyers (other founding shareholders, the company, third parties) and the method of calculating the buyback price
• Procedures for confirming corporate approvals and the distributable amount if the company acquires the shares as treasury shares
• The scope of matters requiring prior agreement among founders, and its relationship to corporate approvals under the Companies Act

Upfront Share Grants and Gradual Grants

There are broadly two ways to give shares to co-founders. One is to issue the shares up front at incorporation and, if a founder leaves partway through, have a certain proportion returned or transferred under a contract. The other is to have rights vest gradually according to length of service, as with stock acquisition rights.

A typical example of the former is the mechanism known as reverse vesting, used in places such as Silicon Valley in the United States. Japanese law today no longer has the former par value share system, nor is there a system fully equivalent to US restricted stock. In Japanese co-founder practice, therefore, one possible structure is to issue common shares and then impose, through a founding shareholders' agreement (memorandum), an "obligation to transfer a certain proportion of shares to the other founding shareholders or the company upon departure."

For example, the proportion the departing founder may keep could be set at 0% within 12 months, 25% after more than 12 months and up to 24 months, 50% after more than 24 months and up to 36 months, 75% after more than 36 months and up to 48 months, and 100% after more than 48 months. In this example, the unvested proportion subject to buyback is 100%, 75%, 50%, 25% and 0% respectively. Because the vested proportion and the proportion to be returned are two sides of the same coin, the contract should also set out how the period boundaries and fractions are treated. These figures are neither a statutory standard nor an established practice; they are an illustration to explain the mechanism clearly. A design that vests 25% at the one-year mark, for instance, differs in both timing and proportion, so check the schedule intended in each contract. Even where a clause provides for buyback at the acquisition price, there is room for its reasonableness as a contract term to be questioned, for example in relation to public policy and the prohibition on predetermined damages under the Labor Standards Act.

An example of the latter, gradual-grant approach is to use stock acquisition rights, with the number exercisable increasing according to length of service. With stock acquisition rights as well, departure does not automatically extinguish the rights. The terms of issue need to set out the conditions for exercise, call provisions, and the procedures for lapse and cancellation. In addition, tax considerations that differ from a direct share issuance, such as the requirements for tax-qualified status and the tax treatment at exercise, are indispensable.

Reasons for Departure and Buyback Terms

When setting out the treatment of shares on departure, merely using abstract English labels such as "good leaver" and "bad leaver" can lead to disputes when a departure actually occurs. Leaving room for interpretation as to who qualifies as a good leaver can itself become a cause of dispute.

As another design example with stricter terms, there is an approach that classifies reasons for departure based on objective facts. The basic structure defines departure as losing all positions as representative director, director and employee, and in principle makes most of the shares held (90%, excluding 10% of the number of shares held immediately beforehand) subject to return or transfer. Where the board of directors recognizes that there was an "unavoidable reason" for the departure, one possible design calculates the number of shares that may be kept using a formula based on length of service (number of shares held x number of days of service x 5% / 365 days, provided that the number kept is at least 10% and at most 20% of the number of shares held), and buys back the remainder after deducting that number from the shares held. On the other hand, if the departing founder establishes or joins a competitor, is dismissed for "justifiable grounds" under Article 339, paragraph 2 of the Companies Act, or commits a serious breach of contract, all (100%) of the shares held become subject to transfer. In this design, even after four years of service the founder can keep at most 20% of the shares originally held, and the example provides that all shares vest if the founder remains until an IPO or buyout. The parties also agree on the definition of an IPO and similar events, and on the treatment of partial sales along the way.

Whether this example clause can actually be adopted requires an examination of the reasonableness and enforceability of the terms. The key point in the design is to break down reasons for departure into objective elements such as "the fact of loss of position," "whether there were unavoidable circumstances" and "whether there was a serious breach of trust," and to design the buyback proportion and price for each. If a distinction between good leavers and bad leavers is drawn, the contract should settle who determines whether there were unavoidable circumstances and by what standard.

Choosing the Buyer and Companies Act Procedures

The options for who takes over a departing founder's shares are the other co-founders, the company itself and third parties.

If the other co-founders buy the shares personally, funding is the first hurdle. If the company's value has risen, individuals cannot necessarily raise the cash to buy the shares out of their own pockets. In addition, since these are non-public shares with transfer restrictions, even where other founding shareholders buy them, check whether the articles of incorporation require approval for transfers between shareholders and follow the procedure.

If the company buys the shares as treasury shares, it must comply with the financing restrictions and procedures under the Companies Act. Under Article 461 of the Companies Act, the total amount of money and other assets delivered to shareholders must not exceed the distributable amount as of the effective date. In early-stage startups without accumulated retained earnings, situations arise where, even with cash on hand, the distributable amount is insufficient and the company cannot acquire treasury shares for consideration. A distributable amount of zero does not immediately prohibit every acquisition; there are exceptions such as acquisition without consideration, and methods of creating a distributable amount through procedures to reduce stated capital or reserves, but these involve other prescribed procedures such as creditor protection procedures. Procedurally, the rule is that a shareholders' meeting resolution sets the acquisition framework (number of shares, consideration, acquisition period of up to one year, and so on) (Article 156, paragraph 1 of the Companies Act). When acquiring from a specific shareholder, a shareholders' meeting resolution designating that specific shareholder (Article 160, paragraph 1 of the same Act) is required, and it must be a special resolution (Article 309, paragraph 2, item 2 of the Companies Act: in principle, attendance by shareholders holding a majority of the voting rights of shareholders entitled to vote, and approval by at least two-thirds of the voting rights of the shareholders present; the articles of incorporation may lower the quorum to one-third or raise the approval threshold). Other shareholders are in principle entitled to request to be added as sellers (Article 160, paragraphs 2 and 3 of the Companies Act), but there are exceptions, such as where the articles of incorporation provide otherwise (Article 164, paragraph 1 of the same Act) or where shares with a market price are acquired at or below a price calculated by the statutory method (Article 161 of the same Act). The specific shareholder who is the seller in principle cannot exercise voting rights (Article 160, paragraph 4 of the same Act, except where none of the other shareholders can exercise voting rights, and similar cases).

If the shares are to be transferred to a third party, the company's approval procedure for transfer-restricted shares is likewise required. In addition, if investors have already come in, check consistency with the rights of first refusal and prior consent clauses in the investment agreement and shareholders' agreement.

In practice, one option is to keep the contractual transferee flexible, such as "the other founding shareholders or a third party designated by the board of directors," so that the decision can be made after the fact according to the circumstances of the departure, the share price and the cash position.

Tax and Price on Transfer

When a departing founder is made to transfer shares at a low price such as the original acquisition price, the tax treatment changes greatly depending on who the parties to the transaction are.

In a sale between individuals, the transferring individual may be taxed on capital gains from shares based on the actual consideration and the acquisition cost. In addition, an individual who acquires shares at a price significantly lower than market value may be subject to gift tax on the difference from market value. Whether a price is significantly low is not judged by the uniform "half of market value" standard used for low-price transfers to corporations, but on the basis of the individual circumstances (National Tax Agency No. 4423 (Japanese)). If the company's market value has jumped significantly, there is a risk of a heavy gift tax burden for the acquiring individual.

If an individual transfers shares to a corporation (including the issuing company itself) at a low price below half of market value, the transferring individual is deemed to have transferred them at market value, and capital gains and the like are taxed with market value as the total revenue, after deducting the acquisition cost and other amounts (Article 59, paragraph 1, item 2 of the Income Tax Act; Article 169 of the Order for Enforcement of the same Act). Setting the consideration at half of market value or more formally avoids deemed transfer taxation, but because of issues such as the denial of acts and calculations of family companies (Article 157 of the same Act), it cannot be said to be automatically safe. Furthermore, the tax framework differs depending on whether the acquiring corporation is the issuing company itself (acquisition of treasury shares) or another corporation. Where the company buys the shares as an acquisition of treasury shares, in principle the portion of the money and other assets delivered that exceeds the amount of stated capital and the like corresponding to the shares acquired is treated as a deemed dividend, and capital gains and the like are calculated based on the remaining consideration (Article 25, paragraph 1, item 5 of the Income Tax Act). Confirm the specific tax amount, including exclusions depending on the acquisition method and the relationship with the low-price transfer rules. On the other hand, where the shares are transferred at a low price to a corporation other than the issuing company, taxation of the gain from the gift on that corporation's side becomes an issue.

For example, if shares with a market value of JPY 100 million are transferred to a corporation for JPY 100,000, tax may be imposed based on an amount far exceeding the money actually received. The specific tax amount is estimated by setting assumptions such as the acquisition cost. These tax conclusions depend on the premise of how the market value of the shares is calculated. Even if preferred shares have been issued, common shares and preferred shares carry different rights, so the unit price of the preferred shares cannot be mechanically applied to the common shares. There is also an argument that the very existence of a low-price buyback clause in the founding shareholders' agreement affects the valuation for tax purposes, but whether the tax authorities will accept this requires careful assessment case by case. To prevent trouble at the time of departure, consulting a tax accountant in advance when the formula is written into the contract helps reduce risk. We handle the preparation of founding shareholders' agreements and the design of buyback clauses in Startup Legal and Fundraising Support.

Frequently asked questions

Is a 50/50 equity split between co-founders a problem?

The split itself is not always wrong. What matters is whether the division of roles and the timing of full commitment that support the split are shared, and whether the treatment of shares on departure and vesting are designed separately. Even with an equal split, if these are in place, the split alone will not necessarily lead immediately to dysfunction.

Can we translate a U.S. reverse vesting clause into Japanese and use it as-is in our agreement?

Using it as-is is not contemplated. U.S. reverse vesting is a mechanism premised on the framework of U.S. corporate and securities law, such as a Restricted Stock Purchase Agreement. In Japan, it needs to be redesigned as a structure in which common shares are issued and a founding shareholders' agreement imposes an obligation to transfer the shares on departure.

Can we buy back a departed co-founder's shares at par value or at the acquisition price?

It is possible to agree on this contractually, but the buyback will not always proceed without problems. If the company's value has risen since acquisition, different tax consequences, such as gift tax or deemed transfer taxation, may arise depending on whether the parties to the transfer are individuals or corporations and on how the price compares with market value. Consultation with a tax accountant should be anticipated from the stage of designing the agreement.