Founder Investments are investments and should be treated as such. A Founders should keep founder investments in their own company separate from their founders stock.
When founders put money into their own companies, I believe there are two ways they should do it. First, pay for founders stock with cash. Founders stock is common stock, but with certain characteristics (see related blog post What is Founders Stock, Legally?). This is the founders’ “sweat equity”, so the amount of cash the founders pay for the stock at inception of the business and before there is any value should be quite low. For example, the founders might have the company issue 2,000,000 shares of founders stock at $0.001 per share for $2,000 total. This should be the first money in, and the new company needs a few thousand dollars just to pay incorporation expenses and get going.
Additional Founder Investments as Convertible Notes
Additional funding from the founders is an investment in their own company, and the founders need a different security for that. The equity security for investment is preferred stock—that is what angels and VCs will normally want to purchase. If the founders are the only investors initially, however, they probably don’t want to set a value on the shares of the company by purchasing preferred stock. Instead, it is often times advisable for founders to think about putting the money in as a convertible note. Convertible note transactions do not set a valuation on the company’s stock, and later, when the company raises funds from outside investors, the convertible notes(s) will convert into equity and so the founders will receive additional equity for their investment.
Without a Separate Security For Founder Investments, the Founders Will Not Get Credit for the Investment
When founders do not set up a different security for their investment, the risk is that the additional investment they make will become capital contributions that merely increase the tax basis in their founders stock. It becomes part of the founders’ sweat equity—they don’t get additional shares for their investment. This can happen when the company subsequently brings in money from outside angel or venture capital investors. If the founders haven’t documented their investments, the new investors may consider it “water under the bridge.”
Keep the sweat equity and the money equity separate by issuing different securities.