Basics of Founder Compensation (Part III): Top-Up Grants
Over the course of just a couple of years, a start-up went from napkin sketch to $5M ARR, the team grew from two co-founders to twenty employees, and the company successfully closed a Series A financing. But over this time, the founders' success diluted their ownership to half of what it initially was. A question they now face is whether they should get more equity, and how to structure it intelligently.
Top-up equity grants are an important tool in the founder compensation playbook. When structured correctly, they maintain a founder's economic incentive without creating unnecessary tax burdens. When structured poorly, they can trigger significant tax bills and compliance headaches. This guide breaks down when top-ups make sense, how to minimize tax impact, and what documentation is required to get it right.
What Are Top-Up Grants?
A top-up grant is additional equity granted to founders after the initial stock issuance at formation. Unlike day-one founder shares (issued when the company was worth almost nothing), top-up grants happen after the company has created value, which means they come with different tax and structural considerations.
Founder top-ups are strategic tools to maintain founder-level economic alignment as the company evolves. These grants serve several purposes, including restoring ownership after dilution from financing rounds, rewarding value creation for achieving major milestones, and reflecting expanded roles when responsibilities grow significantly.
Top-up grants almost always dilute all other shareholders proportionally and can eat up a significant portion of the company's equity incentive pool. Therefore, founders seeking top-ups should expect scrutiny from the Board, investors, and potentially other co-founders, and they should prepare for thoughtful discussions with key stakeholders.
When Top-Ups Can Make Strategic Sense
Dilution from Financing Rounds: Early financing rounds typically dilute existing shareholders by 15-25%. If each co-founder started with 40% ownership at formation, and the Series Seed and Series A rounds each sold 20% of the company, then each co-founder's ownership may be as low as 20%, a meaningful reduction in economic stake. Forward-thinking boards often proactively grant top-up equity to founders after significant financing rounds because maintaining founder motivation is critical to investor returns. A founder who feels under-compensated after a dilutive round may be a retention risk. While top-up grants dilute everyone proportionally, from an investor's perspective they're often viewed as a worthwhile investment in keeping founders engaged and incentivized.
Significant Value Creation Milestones: It may be appropriate for founders to earn additional equity when they've fundamentally transformed the business and achieved certain metrics, such as achieving product-market fit, growing revenue, expanding the team, entering new markets, or launching new product lines. If founders have driven this growth while their ownership percentage has remained static or declined, a top-up grant can recognize their contribution and keep them motivated for the next phase.
Role Expansion: Founder roles evolve. A co-founder might have started as a part-time founder while keeping their day job, then transitioned to full-time CEO, or their responsibilities expanded from pure product development to leading a 20-person organization. When a founder's risk, commitment, and scope increase substantially, they may expect their equity to reflect that change. Top-up grants formalize this expanded role and ensure compensation matches contribution.
After Secondaries: While less common, a founder may receive additional equity after selling a portion of their founder shares in a secondary transaction. Post-secondary top-ups may make sense when the company and investors proactively facilitate liquidity, and want to provide the founder with cash while maintaining incentive alignment. These kinds of top-ups are typically part of a negotiated liquidity program and may be built into a financing round as a founder-friendly term.
Structuring Strategies
Unlike a formation grant, which is issued when the stock's fair market value is equal to less than a penny per share, top-up grants happen when the company is worth something, which means there are tax consequences that need to be carefully considered. Here are a few considerations to keep in mind.
Get a valid 409A valuation. A 409A valuation is an independent appraisal of the company's fair market value (FMV), required by the IRS for private companies issuing equity compensation. Companies typically get 409A valuations annually or after financing events. It's helpful to grant shortly after getting a new valuation, since a recent report suggests the valuation is locked in and likely won't increase for several months, and companies should try to avoid approving top-ups right before getting a new valuation that may be higher.
Decide on restricted stock or stock options. For top-up grants to founders, a key question is whether to get shares outright or options to purchase stock, or a combination of both. The answer will depend on a variety of factors, including the then-current FMV and a founder's specific financial position, and requires careful consideration with a founder's tax and financial advisors.
Restricted Stock: If the FMV is low enough and a founder has sufficient cash on hand, restricted stock may be preferable to stock options, assuming an 83(b) election is timely filed. Restricted stock gives the holder immediate ownership, and with a timely 83(b) election, allows the clock to start on the holding period for capital gains treatment. Additionally, the shares may be eligible for "qualified small business stock" (QSBS) treatment, which could have significant tax advantages in a future liquidity event. However, a restricted stock award requires purchasing the shares at the FMV, or paying tax on the value of the shares, which could require a meaningful cash outlay if the FMV is sufficiently high. For example, 100,000 shares at $1.00/share FMV means a $100,000 purchase price, or ordinary income tax on $100,000. Sometimes founders will negotiate loans from the company to cover the purchase price; however, such loans must be at least 50% recourse to the founder personally, and as a result require careful review of various consequences.
Stock Options: If the FMV is high enough that restricted stock would be cost prohibitive, and a company loan is not available or desirable, stock options are the most common alternative to restricted stock. While stock options do not require purchase or trigger tax at grant, they do not offer the same overall tax benefits as restricted stock with respect to capital gains and QSBS. There is the additional question of whether to get "incentive stock options" (ISOs) or "non-qualified stock options" (NSOs).
ISOs: ISOs are available to US employees and are tax advantageous in that there is no tax at exercise on the spread (if any) between the exercise price and the then-current FMV. However, they come with holding period requirements and AMT considerations. Additionally, for founders whose equity holdings represent more than 10% of the company, additional rules apply for ISO grants: ISOs can only be granted with an exercise price equal to at least 110% of FMV and must have a term of only 5 years (instead of the typical 10 years). Additionally, there is a $100,000 limit on the amount of ISOs that can first become exercisable by an individual in any calendar year, measured based on the FMV of the shares on the grant date, and any portion of an option grant that exceeds this limit is treated as NSOs for tax purposes. Depending on the FMV, even a relatively modest number of newly vesting options could potentially push the combined annual exercisable value over the $100,000 limit, causing part of the grant to be taxed as NSOs.
NSOs: A key difference between NSOs and ISOs is that at exercise, the holder of NSOs must pay income tax on the spread (if any) between the exercise price and the then-current FMV. However, a founder who is a +10% stockholder may elect to get NSOs (with a strike price equal to FMV and with a term of 10 years) if they believe that they will remain with the company indefinitely and hold their stock options through a liquidity event. Additionally, if a founder plans to early exercise their options in the near term (and before the FMV increases), NSOs may be preferable to ISOs because of the shorter capital gains holding period.
Implement a vesting schedule. Regardless of whether the top-up is granted as restricted stock or stock options, founders should expect a new 2-4 year vesting schedule on the equity. This addresses investor concerns about a founder's continued commitment. Sometimes top-ups will also include a one-year cliff. Typically vesting schedules are carefully negotiated with the board of directors.
File an 83(b) election. If a top-up grant is restricted stock subject to vesting, an 83(b) election must be filed within 30 days of the grant date. An 83(b) election allows a founder to recognize any taxable income at the time the shares are granted rather than as they vest over time. In practice, this locks in taxation based on the current fair market value at grant, prevents taxation on increases in value during the vesting period, and starts the capital gains holding period immediately. Without an 83(b) election, a founder pays ordinary income tax each time shares vest on the difference between the fair market value of the shares at that vesting date and the amount the founder paid for them. For example, if the shares are worth $1.00 per share when granted and the company’s value increases to $10.00 per share over the four-year vesting period, each vesting tranche would be taxed based on the higher fair market value at the time it vests rather than the lower value at grant.
Proper Documentation and Board Approval
All equity grants require proper board approval and documentation. In certain cases, stockholder approval may be required as well. Cutting corners here can create tax problems and legal disputes down the road. Proper documentation helps support tax positions in the event of an IRS audit, and clear agreements prevent disputes about vesting, repurchase rights, and terms. Additionally, properly documented corporate governance demonstrates proper board oversight and fiduciary duty. Clean documentation is essential for financing rounds, acquisitions, and IPOs. While proper documentation may require a few thousand dollars in legal fees, the cost is trivial compared to the cost of fixing problems later, which could amount to tens or hundreds of thousands in legal fees and potential tax penalties.
Practical Takeaways and Action Items
Top-up grants can be important tools for maintaining founder alignment as a company grows and evolves. The key, however, is strategic timing and intelligent structuring. Before requesting or accepting a top-up grant, founders should be careful to do the following:
✓ Assess 409A timing
✓ Calculate total cash outlay required for restricted stock
✓ Evaluate restricted stock vs. options
✓ Consult tax and financial advisors (including for AMT and capital gains planning)
✓ Update personal financial planning
✓ Engage legal counsel to ensure proper documentation
Top-up grants aren't automatic, but rather require negotiation, board (and potentially stockholder) approval, and careful planning. For founders who have driven real value creation, they are often a worthwhile investment for both the company and the investors. However, it is essential to work with experienced legal and tax advisors to optimize the approach. The cost of professional guidance is minimal compared to the value of getting the equity structure right.
Read the full Basics of Founder Compensation Series: