Founder Stock Vesting
Since startups are always cash-strapped, equity is the basic mode of compensation for founders, the people who form the company in the first place.
Founders are the backbone of a startup, so protecting their interests is key to the business’s success. Since startups are always cash-strapped, equity is the basic mode of compensation for founders, the people who form the company in the first place. It is only fair then that founders claim a share in the profits of a business they are working so hard to establish. But these shares are subject to vesting, so they have to wait and adhere to the vesting guidelines to claim full ownership over their equity. But why?
Successful startups seldom operate with a single founder. It is common practice to have multiple founders, with each one contributing their unique skill to the business. And while not all contributions are monetary, it is only fair that a system should be put in place where the entire team of founders should not share the costs of the others. The vesting of founder shares is the baseline of this process.
What is Founder Vesting?
In simple terms, this is the process of applying a ‘vesting’ clause on founder shares. Vesting is a process by which companies offer employees rights over equity that has to be earned gradually during their service in the company. As a concept, founder vesting is done to determine a founder’s total equity ownership in the company at the present moment. However, at this point, the founder is only granted the rights over a certain percentage of company equity, with 100% ownership earned over time. A typical vesting period for founder shares is 3 – 4 years with a 1 year cliff period. If a founder chooses to leave mid-way, they will exit only with the vested shares up til that point.
Founder stock vesting is normally a mandatory requirement by venture capitalists. When dealing with VCs for the first time, it is normal for startup founders to be shocked by a founder vesting clause in the term sheet. A founder can become furious staring at a clause that restricts their ownership over the company they have practically given birth to. Why should a founder agree to restrict ownership over their own company? Is this a valid requirement? The next section precisely deals with this dilemma.
Why is Founder Vesting important?
Well, all know startup life is difficult. It is one thing to get excited by a coffee table discussion around an interesting business idea, but a completely different story to take that idea to market. Startup operations can be unpredictable despite meticulous planning. It takes time to realize project goals and taste tangible profits. This increases the risk of a founder to lose steam and quit midway. The reasons behind premature exits can be unprecedented as well. Hence, founder vesting must be discussed at the initial stages of the startup operations to protect the business, instead of waiting to respond to an investor’s questions.
From the VC point of view, founder vesting is an important component of term sheets, especially for startups with multiple founders. An established founder vesting scheme indicates the overall financial health, professional commitment, and operational stability of the startup. Founders normally do not leave on whims, unless ousted by the board for acts against the company. In rare cases, founders have to leave due to unforeseen circumstances. It is a big blow to the business if a key founder decides to leave. For instance, consider this simple equity structure without founder vesting:
- Co-Founder 1 – 40%
- Co-Founder 2 – 40%
- Investor – 20%
If co-founder 1 decides to leave, he will take 40% of the shares with him. Co-Founder 2 alone can not run the company and there is no equity left to hire new talent. Investor’s 20% is thus worth nothing. But with founder vesting, co-Founder 1 would have left only with his vested shares instead of the whole chunk, thus leaving the rest to be returned to the options pool. Hence it is in the interest of an investor to insist on founder vesting to ensure that their investments are secured in the business.
How does Founder Vesting work?
Let us assume a founder is offered 100 shares in the company with a 4 year vesting period and a one-year cliff. This means that the founder will receive the first 25 shares only at the end of the one year cliff period. Then on, the remaining 75 shares will be vested monthly on an incremental basis for the next 3 years (25 shares per year). If the founder leaves before completing the ‘cliff’, they stand to lose the rights over all the 100 shares. If they leave by the end of the second year, they will exit with 50 shares, and so on.
Here is a representation of this example. As you can see, shares start vesting in equal installments every year after the cliff period. Over a service period of 4 years in the company, a founder will gain complete ownership over 100% shares.
|Date||% Shares||Shares||Total Shares|
Now consider a multi-founder scenario. Imagine Frank, Joe, Nicole, and Anna form a company. Each one holds 25% equity with a vesting schedule of 4 years with a one-year cliff. Within the first year, other founders realize that hiring Frank was the wrong decision. He is not matching up to the company’s expectations. They ask Frank to leave and he will have to forfeit his claim over all shares because he is leaving before completing the cliff period. 25% of the company equity is now free to be used to hire new talent. In the third year of business, Anna announces her exit owing to a medical condition. As per founder vesting rules, Anna will exit the company with 75% of her share (75% of her share of 25% company equity) which has vested over 3 years. The company will purchase all her unvested shares at the fair market value.
In the following table you can see how shares have vested for each of the four founders. Frank does not own any shares. Nicole owns 75% of her shares. Joe and Anna, who have stayed with the company throughout the 4 year vesting period have earned the right to 100% of their shares.
|Date||Year 1||Year 2||Year 3||Year 4||Total Shares|
Sweat Equity also plays an important role in founder vesting decisions. If a particular Founder’s Sweat Equity has a higher valuation, only some of his shares will be vested instead of the whole package. In the case of a company acquisition, founders shares are protected by an ‘acceleration’ scheme and many factors determine eligibility for such schemes. We will discuss ‘acceleration’ in the later sections of this article. At the onset, founders may not be happy to impose ownership restrictions on their own company, but in the long run, founder vesting acts as a prenup protecting all parties against fallouts in the future.
Founder Vesting basics
Investors normally insist on founder vesting and is one of the most sensitive topics during the finance rounds. It is of utmost priority for investors to ensure that the founding team is stable and efficient because they are driven by the future potential of the company. No investor is betting on the present. Hence as a startup, understanding the basics of founder vesting is key to the business winning lucrative investors.
Should 100% of a Founder’s shares be vested?
Not at all. As it is, it can be argued that it is unfair to vest any part of founder shares because they have formed the company and have complete ownership over it. Many a time, founders invest money and assets from their own pockets to start the business. Even if they have to leave midway, as painful as it is already, how is it fair for them to let go of their shares? Founder vesting may seem like a curse.
But in the long run, it is only fair play. If one of the founders has to leave, they should take only a share of the profit based on their inputs till that time. Plus, as mentioned earlier, sweat equity is also a qualifier. Combining all these factors, in practice it is seen that 50 – 75% of founder shares are vested instead of the entire 100%. Besides, some founders may receive a share package as a sign-up bonus. These shares vest immediately. Thus, founder vesting ensures that in case of an unpopular scenario, other founders do not pay for the actions of one.
How long should a Founder Vesting period be?
Typically these vesting periods span over three to four years with a one-year cliff. 25% of founder shares are vested immediately on joining, and the next 25% is vested after the cliff period. The remaining shares are vested monthly in equal installments over the next three years. However, different variations are available for founder vesting schemes. These are based on factors like geography, industry, company size, founder’s work experience, and so on.
Many a time large investors enter startups at a later stage and request a ‘reset’. This means re-setting vesting schedules with revised equity allocations as per a new funding structure. Based on the founder’s period of service in the company and their commitment to the business, founder vesting can be exempted from strict ‘resets’ and only a small percentage of their share will be vested anew, with shorter vesting periods.
The departure of a Founder – Good Leaver or Bad Leaver?
Founder vesting is affected by founders departing for various reasons. But how to decide if their exit was fair to the company? This judgment of fairness determines whether a founder is a ‘good leaver’ or a ‘bad leaver’. Before judging the ‘goodness’ or ‘badness’ of a leaver, we must understand the ‘cause’. In simple terms, a ‘cause’ happens when an employee commits a felony against the company (fraud, money embezzlement or breach of material obligations).
A founder is termed a ‘good leaver’ if their employment is terminated by the company without ‘cause’. Alternatively, if the board of directors approves a voluntary termination of the founder, this is also considered without ‘cause’. In such cases, the founder keeps all his vested shares earned until that date. All unvested shares are repurchased by the company from the founder at fair market value. Founder vesting thus protects the founder’s interests.
A founder is termed a ‘bad leaver’ if their employment is terminated by the company with ‘cause’. Situations could be of misconduct, bad performance, or any other act that directly affects the health of the business. In such cases, the founder loses all their shares. The company purchases back all vested shares at fair market value and the founder forfeits all unvested shares. Founder vesting thus protects the Company’s interests.
What happens for an unvested stock if the Founder leaves?
Though founder vesting is essentially an investor driven requirement, vesting structures must strike a balance between the investor’s need and the founder’s hard work and achievement in the business. Startup founders must be careful not to undersell themselves in a race to secure competitive investments, and the interest of founders must be protected at all times. Over time, various founder vesting models have evolved based on the country, jurisdiction, and market dynamics. It is finally up to the company to choose a structure that suits their operations.
As discussed in the previous section, a founder’s decision to exit has to be judged before crediting the rewards vested in their name. However, there is a grey area between a good and bad leaver. To avoid contentions, the US has a standard practice in case of founder vesting, where the departing founder keeps all vested shares and forfeits all unvested shares. This may vary for other regions as well.
In the case of a company acquisition, the vesting shields the founder’s interests. When the company’s management faces a change of control, founder shares are ‘accelerated’. By single-trigger acceleration, all unvested founder shares are vested immediately and the founder is free to leave the company. While by double-trigger acceleration, all unvested founder shares are vested after 12 months from the time of the acquisition, and the founder graduates as an important resource into the new management. This ensures a smooth transition of the business and protects the founder’s investment in the company so far.
Set up Founder vesting on Eqvista
Founder vesting is done to essentially protect the interests of the founders. Understanding the philosophy behind this scheme in the early stages of a startup operation will help minimize risks of unprecedented fall-outs among the founders. These schemes ensure that key people are retained in the business for as long as possible and only the deserving ones reap the rewards.
As discussed throughout this article, the founder vesting process is nuanced. It is also a sensitive issue and has to be handled with utmost precision and subtlety.
Eqvista’s state-of-the-art automated software provides just the user-interface you need. We ease the burden for busy founders to efficiently handle their cap table and allow an efficient and cost-effective way to issue and manage company shares. Here is an opportunity to Create a vesting plan with Eqvista software. To know more or understand any other process, check out these support articles or contact us today!