When founders launch their new startup, optimism is typically running rampant. However, it is not uncommon for one or more founders to leave the very startups they launch within the first few years. There are various reasons why founders leave – new job opportunities, personal relationships, changes in family situations, general cooling off on the idea, and team dynamics are chief among them. If a founder does leave, the remaining founders are usually very happy if they had the foresight to subject their shares to vesting.
Mechanics of Vesting
As a general concept, “vesting” means that shares aren’t “earned” or “fully owned” until they have “vested.” In the startup context, this concept comes up most frequently in the context of stock option grants and issuances of common stock to founders. With respect to stock options, “vesting” means that stock options cannot be exercised until they have “vested.” This is usually straight forward – if 1,000 shares of a 5,000 share stock option grant have vested, then the optionee may exercise its option to purchase the 1,000 vested shares (but not the 4,000 unvested shares), at which point the optionee will own those 1,000 shares outright.
Vesting in the context of shares issued to founders can be counterintuitive. Founders who receive shares of common stock subject to vesting (often referred to as “restricted stock” that is subject to “reverse vesting”) actually own all of their shares on day one (i.e., they can vote all of those shares, and if the company was in a position to pay dividends, they would receive a dividend with respect to all of those shares). Rather than the shares being subject to the typical vesting mechanism where an increasing number of shares vest, a “reverse vesting” mechanism is actually a repurchase option in favor of the company.
For example, in the case of a typical four-year vesting period, if the founder leaves the company after two years, the company will have the right (but not the obligation) to repurchase the unvested portion (or one-half) of the shares. The repurchase price is typically the nominal price at which the founder originally purchased the shares from the company. Thus, if the founder purchased the shares of restricted stock at incorporation for a price of $0.0001 per share, then upon the founder’s departure, the company could purchase back the unvested portion at the price of $0.0001 per share.
When is Vesting Appropriate?
Vesting, or “reverse vesting,” should be considered when a startup has more than one founder. It is also recommended in the typical situation where the founders are contributing intellectual property and a nominal amount of cash for their shares. The common wisdom is that the founders haven’t really “earned” their shares until they have performed some number of years of service on behalf of the company (typically four years, although this can vary).
However, there may be instances where founders are contributing property with real value (e.g., patents, real property, depreciable assets) or a substantial amount of cash to the company. In those cases, a strong argument can be made that the shares have been fully paid for with these valuable contributions, and therefore should not be subject to vesting. But keep in mind that every situation is different, and consulting with experienced corporate counsel can help determine the path that is best for your startup.
Benefits of Vesting
There are several benefits to a startup if it uses vesting for founders and early employees. Below are a few of the common ones:
Incentivizing Founders. One of the key benefits is incentivizing founders to stay with the startup. If a founder’s stock is fully vested from the date of issuance, there is less of an incentive for the founder to continue to actively participate in the company. With no risk of losing ownership of the shares, a founder may choose to take a great paying job at an established company and leave his or her co-founders to toil away building the startup – with the hope of cashing out years later thanks to the efforts of others. With vesting in place, leaving early is much more difficult, because the founder could be walking away from a big payday if the startup’s great idea turns into a valuable company.
No “Stray” Shareholders. Vesting allows the company to keep all (or most) of the initial shares with people involved in the company on a day-to-day basis. A typical vesting provision has a one-year “cliff,” which means that none of the shares are vested until the founder’s one-year anniversary with the company. This is helpful in heading off departures in the company’s earliest and most vulnerable days. Vesting of founder shares also helps prevent situations where a large shareholder has no active interest in the company, and therefore, no incentive to vote on stockholder issues or otherwise cooperate when stockholder action is needed. Even worse, a founder who left the startup on unfavorable terms could use his or her ownership of shares to prevent certain actions or otherwise disrupt the company. Finally, the idea that a departed founder has a significant ownership percentage of the company can have a negative impact on key non-founder employees who, by virtue of joining the company a bit later in its life cycle, may have a much smaller ownership percentage.
Treatment in Future Financings. If a founder obtained his or her shares for nominal consideration upon incorporation, and didn’t subject their shares to vesting, then there is a high likelihood that a sophisticated investor will require the founder to subject its shares to vesting on a going-forward basis. On the other hand, if the founder had subjected his or her shares to a rational vesting schedule at the outset, there is a good chance that the investor will honor the original vesting schedule. This is, of course, a case-by-case determination that is dependent on a number of factors. Investors like to impose vesting on founders because it gives some assurance that the management team who successfully built the startup to a company worthy of investment will to continue to run it and continue to increase the company’s value. By subjecting shares to vesting from day one, founders can potentially avoid being forced to subject their shares to a new or extended vesting period.
When discussing the concept of vesting with startup founders, they initially view it as a negative thing. However, there can be many benefits to vesting, especially in the startup with multiple founders. When it comes to determining whether or not to adopt vesting schedules, my motto is usually “do it once, do it right, and (hopefully) never do it again.”