Startups 101: What is founder vesting and how does it work?
What is founder vesting?
Vesting of founder shares is one of the most critical and sensitive topics in a startup. If you have a startup that has more than one co-founder, then you must have a vesting agreement in place. When you raise capital from investors, one of the most important things that investors look for is the vesting agreement.
Founder vesting, is a process by which you “earn” your stock over a period of time depending on your performance and commitment to the startup. The company gets the right to buy back the stock if one or more of the co-founders leave.
At the very basic level, founder vesting ensures two principles:
- Incentivize the co-founders to stay; and
- Protect the company in case one of them leaves
Why do co-founders exit a company?
There are four reasons why co-founders leave a company:
- Bad leaver: This happens when you dismiss the co-founder for a “cause”, or a “material breach”, such as gross misconduct, infringement of intellectual property, fraud or embezzlement, or violating critical causes such as a non-compete clause.
- Good leaver: When startups grow and attain a certain level of maturity, the board may feel that the co-founder’s skills are no longer adequate to meet the expected profile.
- Voluntary resignation: Several times we’ve seen that co-founders lose motivation midway, or simply move on because they’ve got a higher-paying job.
- Death or Illness: Things get really complicated when one of the co-founders fall ill for a prolonged period of time, or even die. This falls in the grey area, because this is neither a ‘good leaver’ nor a ‘bad leaver’.
Since things get really complicated in real-life situations, you’ve to classify a co-founder exit into one of the four categories.
So how do you approach this problem?
Approach #1: To keep it simple – If a co-founder departs, he/she loses his/her unvested shares, but the vested ones remain with them. This startup-friendly approach is quite common in the US.
Approach #2: To take a two-fold approach to vesting – if a co-founder is a bad leaver, he/she loses all shares, including the vested ones. If he/she is a good leaver, a voluntary leaver or affected by death or an illness, he/she keeps the vested shares, but loses all the unvested shares. This founder-friendly approach is common in many countries in Europe.
Founder vesting is not just for protecting the co-founders; it is also a mechanism that investors use to ensure permanence of the co-founders, which is essential for company growth.
How does Founder vesting work?
The most commonly used vesting schedule is over a 48-month period, where 1/48th of the shares are vest every month. To ensure that the founders stay in the startup for at least a year, no shares are vested in the first twelve months. Instead, they are accrued and vested at the end of the first year. This initial period of accrual is called a ‘cliff’.
Let’s look at an example.
Startup Inc. issues 4,800 shares of common stock to each co-founder, which vests equally over a four-year period, with a one-year cliff.
So, in this case, the monthly vesting of shares is: 4,800 ¸ 48 = 100 shares per month.
However, since there is a one-year cliff, no stock will vest for the first year. At the beginning of the second year, 1,200 shares will vest, and thereafter 100 shares will vest every month.
As you can see in the chart, during the cliff period, stock will accrue to the co-founder, but he/she does not own them since they’ve not vested. From month 13 onwards, the co-founder will own 100 shares each month beginning with 1,200 shares for the first 12 months, which vest on the first day of the 13th month. As a result, the unvested shares remain 4,800 for the first 12 months and becomes 3,600 on the first day of the 13th month. Thereafter the unvested shares gradually start to fall, as the monthly schedule of vesting begins.
How much should be vested?
Should you vest all the founder stock?
Not always. Quite often we see that founders put in a large amount of money during the early years, before raising capital. Having paid for those shares, it is hard for the founders to let go of their shares before the end of the vesting period, whatever be the reason.
In most deals, we see around 50% to 80% of the promoter stock is subject to vesting. The investors’ perspective on vesting is to take a forward approach to ensure that the team they are betting on is here to stay for the long term. The counter argument from the founders’ side is that they have been slogging for several months (even years), that they have earned the shares anyway.
What happens in an exit?
In the event of a sale, buy-out or another exit event before the vesting period, most agreements have a clause for an immediate vesting of unvested shares. Investors/founders call this ‘accelerated vesting’. There are two ways in which accelerated vesting happens:
- Single vesting: The unvested shares vest immediately prior to the exit date;
- Double vesting: In many cases, the acquirer would wish to retain the core team in order to ensure smooth transition. If you terminate a co-founder (as a good leaver) within a certain period, usually 12-18 months from the date of the transaction, the unvested shares would fully vest to that co-founder.
There is no thumb rule as to which of the Founder vesting options is the best in an exit event. However, many founders agree for a double vesting in return for additional incentives from the buyer, as an extra reward to compensate for this risk.
If your company does not have vested stock, you should address that first. If you are looking to raise capital, you should be having a vesting agreement in place anyway.
Founder vesting is a great tool for protecting permanence of the founders of a company. In fact, vesting motivates and retains the founders in the long term. However, vesting is a complicated problem to address, full of pitfalls and misunderstanding. The key is to strike a balance in your vesting agreement that keeps the co-founders, investors and the company happy in the long term.