83(b) Election: The Multi-Million-Dollar Ticking Time Bomb

March 06, 2024

Lawyers can be such a buzz-kill.

(I can say this because I’m a lawyer myself).

$20,000,000 term sheet in hand, you pick up the phone to call your lawyer.

Your top-pick VC fund wants to invest in your business.

You couldn’t be any more thrilled.

The years of hard work, the missed family events, and the sleepless nights are finally leading to some semblance of success.

“Hey, Michael, guess who just gave us a term sheet?”

“Really? That’s great!”

“Yes! $20,000,000 post-money valuation,” you shout into the phone.

“Remind me once again – you filed your 83(b) election, right?”

“What are you talking about? What election?”

“83(b) election,” Michael repeats with hesitation in his voice.

“First time I’m hearing of it. What’s that?”

“Are you free this afternoon? Let’s meet, we should chat.”

Your heart sinks like a cold stone as you tap on the red circle on your phone’s screen.

This has got to be bad news.

What is the 83(b) election?

The 83(b) election is a tax document filed with the IRS within 30 days of getting equity subject to vesting. By filing this document, a stockholder chooses to pay any income tax due on the day they got their equity grant instead of paying the tax due as the stock vests.

By definition, this document is relevant in instances where the equity grant is subject to vesting – or, in official parlance, the stock is subject to a “substantial risk of forfeiture”, meaning, it can be taken back by the company that issued it.

Vesting? What’s vesting?

When something (such as a right or stock) vests, it means that the person who holds that right or stock gets to take full advantage of it. The term I like to use in relation to vesting is “inalienable” – when stock vests, it becomes the owner’s inalienable property.

The most common vesting in a high-growth startup setting is time-based vesting. In other words, as time passes, portions of the granted stock vest – that is, they become the full, inalienable property of the stockholder and cannot be repurchased by or forfeited back to the company that issued it (except under rare circumstances).

Does that remind you of the four-year vesting schedule with a one-year cliff? That’s because this is exactly a type of time-based vesting that is very common among high-growth startups. To recap, under this vesting schedule, 1/4th of the stockholder’s stock grant vests upon the one-year anniversary of the “vesting commencement date” (normally, the day they joined the company), and the remaining stock vests over the next three years (36 months) monthly, in 1/36th increments.

If the stockholder leaves the company’s employ or service before they have fully vested, the unvested portion of the equity grant can be repurchased by or will be forfeited back to the company, hence the “substantial risk of forfeiture.”

Somewhere up there you said “income tax”. I’m listening.

When you get equity, you’ll likely owe tax on that grant. The amount of tax owed is based on the spread between the fair market value of the equity and the amount you paid for it.

This begs a natural question: the fair market value… as of when?

That’s where the 83(b) election is relevant.

When you file the 83(b) election, you’re telling the IRS that you’d like to pay your income tax dueas of the day you get your equity. Arguably, in the case of an early-stage startup, that equity is pretty much worthless when it’s granted. Very often, founders get their equity issued at par value, with the total equity grant having a price tag of, say, $40.00 for 40% of the company.

If the founder pays $40 (preferably in cash) for the equity grant, their spread is $0 and so they won’t owe tax. If the founder doesn’t contribute any consideration for the equity grant (i.e., gets it for free), the spread will be $40 and so the tax will be due on that income of $40.

When you don’t file the 83(b) election, you’re essentially agreeing to be taxed under default rules, which provide that you’ll be taxed as of the day your stock vests, to the portion it vests. In this case, we’re going to look at the fair market value as of the relevant stock as of the day it vests. Using that fair market value, we would calculate the spread between that value and the amount paid for it and the tax will be paid on that income.

Now, in a high-growth startup setting, your stock is likely appreciating over time (or at least it should).

But it really skyrockets the moment you get a term sheet.

What happens when I get a term sheet?

The moment you get a term sheet, even if it hasn’t been signed yet, something magical happens: your company instantly receives a venture valuation. An independent third party has just expressed, in writing, their position that your company is worth however much the term sheet says it's worth – a textbook example of determining a “fair market value”.

Term sheet provides a $20,000,000 post-money valuation with $4,000,000 new money being invested? Subtract the latter from the former, and the difference of $16,000,000 is how much your company is worth today, before raising the round.

Own 40% of that company? Your stake is worth $6,400,000.

See where I’m going with this?

If you get this term sheet before you have fully vested and you haven’t filed an 83(b) election, that means that:

potentially, a quarter of your stockholding is going to vest that year,
its fair market value is going to be based on the venture valuation, and
you’re going to owe income tax on the spread of that venture valuation and what you paid for the stock in the first place.

Chances are, you paid peanuts when you got the stock (if anything), so that purchase price is going to be negligible.

To add numbers to it: roughly $1,600,000 worth of stock will be vesting in that year, and applying an approximate tax rate of 40%, you’re looking at a tax bill of $640,000.

Ouch.

So, wait, what happened to the founder in the story?

At this point, there’s not much that Michael (the attorney in our story above) can do to help the founder. With the term sheet officially out, even if unsigned, the venture valuation of the company is already set, and any “maneuvering” after this point will likely cause more problems than solve them.

The absence of a properly filed 83(b) election will necessarily come up during due diligence, which sends a message to the investors: their investment is probably going to be used to bankroll the founders’ personal income tax… or, alternatively, the founder is going to be under significant financial stress to service that tax bill, detracting from his focus on the company.

Under this light, it’s probably not surprising to hear that venture deals have blown up because the 83(b) election wasn’t filed back in the day.

With so much at stake, why would anyone not file their 83(b) election?

It seems like a no-brainer that this document should be filed… but, hey, it’s easy to judge. At least three reasons come to mind on why this document is very often fumbled.

Founders don’t know about.

Despite all the content out there on 83(b) elections, a lot of founders still don’t know about it. It may be brushed aside as “just a tax document with a weird name” – and with founders strapped for resources, including time and mental capacity, when starting a company, it’s easy to see how this document can just miss their radar.

Only 30 days to file.

Even if founders have heard of this document, the window to file it is so narrow that it’s very easy to miss it. To emphasize, you have only 30 days from the day you get your stock to file the 83(b) election (what’s relevant here is the postmark date). Everything moves at such a fast pace in a startup 30 days is just a blink of an eye.

The filing procedure is tedious.

There are so many hoops to jump through to properly file the 83(b) election that it’s easy to get it wrong if you haven’t done it before. You print it in a set number of copies, add a cover letter, sign the documents… and that’s the easy part. Then you have to physically mail it via certified mail, get a stamped postmark, request a return receipt, and include an extra copy of your filing along with a self-addressed, stamped envelope so that the IRS sends you back an acknowledged, date-stamped copy. If you lose your breath just reading all that, imagine how you would feel in real life.

Conclusion: Look into the 83(b) election ASAP.

Here’s a formula to keep in mind: if anybody is getting stock that is subject to vesting, think “83(b) election” and look into it ASAP. There may be instances where you decide not to file it, and you should always talk with your tax professional about it as a tax matter. In any case, don’t sleep on it as you have only 30 days from the day you get the stock to file it in case you so decide.

If you’ve missed filing it, your options will vary depending on your situation. Make sure you speak with a competent lawyer ASAP. Feel free to reach out to me if you’d like to be introduced to one.

Finally, to make your life easier, we’ve built a tool that helps you file your 83(b) election entirely online, from anywhere in the world, without visiting a post office or touching a piece of paper. Check it out at file83b.com.

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Stepan Khzrtian is a former corporate lawyer with 10+ years of experience helping 100s of founders navigate the legal journey across all stages of the startup lifecycle, from incorporation to exit. He quit his private practice to start Corpora and help founders raise money faster by automating the legal backend. Connect with him on LinkedIn.

By Stepan Khzrtian
Co-founder and CEO

Corpora