Why Startup Co-Founders May Voluntarily Impose Vesting on Their Equity
Vesting of founder shares – typically acquired by restricted stock purchase agreement, refers to a contractual provision whereby the company retains a right to repurchase some or most of those shares upon the occurrence of certain events. Those events typically include a founder’s premature departure from the company, death, or disability.
Upon a “triggering” event, the Company has the option to repurchase a co-founder’s unvested shares at the low price – often par value (perhaps $0.001 per share), which the co-founder initially paid for his or her shares. Under founder vesting, the company’s repurchase right typically lapses incrementally at regular intervals with the passage of time, or in whole or in part upon a defined event such as a change of control.
I believe there are at least five primary reasons why startup co-founders may want to self-impose vesting on their shares – even in the absence of a venture capital investor making it a condition to an equity financing. They are:
- alignment of long-term interests
- mitigation of risk
- attraction and retention of talent
- establishment of investor confidence
- framing future vesting negotiation with investors
Note, that the “vesting” at issue here, is a lapsing repurchase right. This means that unless and to the extent a repurchase right is triggered, the founder retains ownership of 100% of his or her founder’s shares and enjoys all rights and benefits therefrom, including voting rights.
Aligning Long-Term Interests:
Vesting creates an incentive for co-founders to stay put, literally, and remain aligned and committed to the company over a significant period. It can prevent co-founders from departing prematurely and retaining a large equity stake, which could very likely be disproportionate to his or her actual contribution. Aligning co-founder interests for a long term commitment is key considering startup success generally depends heavily on the cofounders’ sustained efforts over many years.
Beyond trying to align tenure with reward, vesting can also motivate one to perform at a high standard. Most co-founders provide service under at-will employment, meaning a company’s Board of Directors can terminate one’s service provider status (employee or independent contractor) at any time without having to prove cause for termination. And while it is not generally in the economic interest of a Company to terminate a service provider who is otherwise making a material contribution, it happens. Given this, cofounders may seek a middle ground which preserves the Board’s power to terminate employment at-will but permits the co-founder to retain his or her sizable equity stake (in whole or in large part) by causing the Company’s repurchase option to lapse with respect to the unvested shares of a co-founder terminated without cause.
An example of a definition of “cause” for this purpose which co-founders might adopt under their stock purchase agreements at the time of the startup’s formation might read as follows:
“Cause” for the Company (or a successor, if appropriate) to terminate Purchaser’s [read “Founder’s”] employment shall exist under the following conditions (I) Purchaser’s willful and continued failure to substantially perform Purchaser’s duties to the Company after there has been delivered to Purchaser by the Company’s Board of Directors a written demand for substantial performance and opportunity to cure which sets forth in detail the specific respects in which the Company’s Board of Directors believes that Purchaser has not substantially performed Purchaser’s duties; (II) Purchaser having committed willful fraud, willful misconduct, dishonesty or other intentionally wrongful action in any such case which is materially injurious to the Company; (III) Purchaser’s having been convicted of, or having plead guilty or nolo contendere to, any crime that results in, or is reasonably expected to result in, material harm to the business or reputation of the Company; or (IV) Purchaser’s material breach of any material written agreement between Purchaser and the Company (including without limitation Purchaser’s Proprietary Rights Invention Assignment Agreement with the Company) and, where such breach is capable of cure, Purchaser’s failure to cure such breach within 30 days after receiving written notice thereof.”
Item “(i)” above in particular sets a fairly high, but not unreasonable, bar for the Board of Directors to clear if it wants to terminate a co-founder involuntarily and retain the Company’s option to repurchase his or her otherwise unvested shares.
Risk Mitigation
We addressed above how vesting can mitigate the risk of early co-founder departures. Co-founder vesting can also help prevent disputes among founders regarding equity distribution. This is true at the Company’s start when the core co-founder team is assembled, and when no one can really be assured that any among them will in fact stick around and be capable of making the long contribution required of him or her. Vesting hedges bets when awarding sizable, possibly substantially equal, equity stakes among cofounders. And, if someone decides to leave prematurely, everyone already knows what equity he or she leaves on the table; it was negotiated up front and is reflected by a vesting schedule.
Attracting and Retaining Talent
By reclaiming equity from departing co-founders, startups can offer it to new and existing employees as part of their compensation package, helping to attract and retain top talent beyond the founder core. To the extent co-founder vesting schedules result in equity being distributed more fairly based on contribution and tenure, it should make the startup a more attractive place for employees who want to see their efforts recognized and rewarded.
Investor Confidence
Investors are more likely to fund startups whose founding core holds its equity subject vesting. Among other things it provides some assurance that the founders are committed for the long haul. And, to the extent this mitigates certain risks to the Company, the mitigation is favorable to all equity holders –investors as well as founders.
Framing the Vesting Negotiation with Investors
Venture capital and corporates investing in Seed or early lettered rounds will very likely require that the core founders, if they haven’t already, impose vesting on a sizeable chunk of their equity as a condition to the equity financing. There is a possible benefit for founders to get ahead of and “frame” this discussion by showing they share the objectives of vesting and already have it place as “an item resolved” before seeking institutional investors. So, rather than a four year vest with a one-year cliff, the founders may present as a fait accompli vesting schedule which vests ratably monthly from day one without a cliff and provide for accelerated vesting should they be terminated without cause – and not limited to where this occurs after a change of control.
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