Founder Vesting: Everything You Need To Know
As a founder, there are a lot of things that need to be understood in the world of startups. One such important concept that you should know is founder vesting. In this article, we will discuss everything you need to know about founder vesting.
What is Founder Vesting?
Founder vesting is a procedure, where you will “earn your equity or stock over time”. This is based on your competence and dedication to the firm. If one or more of the co-founders leaves, the company gains the right to buy back the equity.
This mechanism is one of the most important and delicate issues of a firm. If you have more than one co-founder in your startup, you must have founder agreements in place. The vesting agreement is one of the most significant things that investors look for when raising funds from them.
At its most basic, founder vesting maintains two values. First, encouraging co-founders to stay with the startup in the long-term. Second, protecting the company if one of them leaves.
Why Do You Need a Vesting Schedule?
The vesting schedule might well be determined upon when the founder’s shares are first issued, or it may be enforced afterwards as a condition of outside investors’ investment. There are two major reasons why you need a vesting schedule.
First, this might be part of a deal struck by numerous founders. If a founder decides or is asked to leave the company early on, the vesting limitation protects the other founders from the “free rider” problem that would otherwise arise.
While some founding teams remain together from start to finish, it is normal for a founder or more to depart from the company during its early years. In the absence of a vesting limitation, the startups founder benefits from the contributions of those who remain to develop the company.
Second, the limitation may be imposed in expectation of future investment. The issue might be addressed at the time of investing. If the founders play “wait and see,” they risk the investors proposing something else more costly than the founders could have come up with by themselves.
In contrast, if the founders implement a decent vesting mechanism, most investors will be content, despite the fact that it isn’t exactly what the shareholders would have desired.
How Does Founder Vesting Work?
The most usual vesting schedule is a 48-month period in which 1/48th of the shares vest each month. Neither any shares vest during the first 12 months to ensure that the founders remain in the company for at least a year.
They are instead accumulated and vested at the conclusion of the first year. This first period of accretion (i.e. 12 months) is referred to as a vesting cliff.
For example, if a company grants each co-founder 4,800 shares of common stock, which vests evenly over a four-year span with a one-year cliff.
In this situation, the monthly share vesting will be 4,800 : 48 = 100 shares/month.
Nevertheless, due to the one-year cliff, no shares will vest during the first year. The first 1,200 shares will fully vest at the start of the second year, followed by 100 shares every month.
During the cliff phase of founder vesting, shares will flow to the co-founder, but they will not possess it because it has not vested. Starting with 1,200 shares for the initial 12 months, which vest on the initial day of the 13th month, the co-founder will hold 100 shares every month starting in month 13.
As a result, unvested shares remained at 4,800 for the first 12 months before decreasing to 3,600 at the beginning of the 13th month. Following that, once the monthly vesting schedule begins, unvested shares continue to fall steadily. In order to simply things, some startups may also have a year vesting schedule (instead of monthly).
What are the Reasons for Co-Founders to Leave the Company?
Founder vs Co-founder issues are quite common in many startups, Co-founders leave the company in different situations, which may be related to their personal or professional issues. Here, we summarize four major reasons why the co-founders leave the company.
This occurs when you fire a co-founder for a serious reason, such as gross misconduct, intellectual property infringement, fraud or embezzlement, or breaking essential factors such as a non-compete provision.
As a firm grows and matures, the board may believe that the co-founders are no longer sufficient to meet the required profile.
There are some co-founders who lose motivation or simply resign because they have a better-paying job.
Death or Illness
When one of the co-founders becomes unwell for an extended length of time, or even dies, things get extremely complicated.
Because things can get difficult in real-life scenarios, you must categorize the departed founder into one of those four categories above.
But the next question will be, how do you tackle this issue? You can try several ways below.
1. Keep Things Simple
To keep it simple, if a co-founder leaves, they will lose their unvested part but keep vested shares. This startup-friendly approach is extremely widespread in the United States.
2. Take a Two-Pronged Approach to Vesting
If a co-founder is a bad leaver, they will lose all shares, including vested ones. If they are categorized in other categories, they can keep the vested part but lose all unvested shares. This founder-friendly strategy is widespread in many European countries.
Founder vesting is a strategy used by investors to maintain the permanence of co-founders, which is critical for company growth.
What Happens When You Exit?
Most agreements provide for accelerated vesting of unvested stock in the case of liquidity event before the vesting period. This is referred to as ‘accelerated vesting’ by investors/founders. Accelerated vesting clauses can function in two ways:
- Single Vesting: Unvested shares vest in a single transaction just before the exit date.
- Double Vesting: In many circumstances, the acquirer will want to keep the core personnel in place to guarantee a smooth flow. If you fire a co-founder, who is a good leaver within a particular time frame, usually 12-18 months after the deal, the unvested shares will automatically vest to that co-founder.
There is no hard and fast rule for determining which of the founder vesting alternatives is best in an exit event. Many founders, though, agree to a double vesting in exchange for special benefits from the buyer as an additional benefit to compensate for the risk.
Why Does It Important If You are Good Leaver or Bad Leaver?
It is crucial to know which category the departed founder is. It is because the shares of the departing founder are regarded quite differently. We commonly encounter the following in Southeast Asia companies:
In a good leaver scenario, the firm can purchase back unvested founder shares at the greater of the fair market value (FMV) and the subscription payment made for these kinds of shares.
Typically, the departed founder retains their vested shares. This way, the founder walks away with their vested shares and may be paid for the unvested shares at FMV, which is not a bad outcome.
In the case of a bad leaver, the founder who is leaving may lose all of their shares. The price of the unvested shares will be adjusted based on the lower of FMV and the subscription price. The price of the vested shares will be adjusted based on the higher of FMV and the subscription price.
As a result, the founder walks away with no shares in the company, having forfeited their unvested shares for essentially nothing other than FMV for the vested half. It is indeed thought of a founder, yet a bad leaver is supposed to be an unusual occurrence.
In summary, there is a significant difference between being a good leaver and a bad leaver.
How Much Should You Vest?
Founders frequently put in a significant amount of cash during the initial periods before raising finance. After paying for those shares, it is difficult for the founders to sell them before the vesting period ends.
In typical transactions, 50% to 80% of the promoter shares is subject to vesting. The investors’ approach on vesting is to look ahead to guarantee that the team on whom they are betting is here to remain for the long haul. The founders’ counter-argument is that they have been working for months or years and have acquired the shares regardless.
How Long is the Founder Vesting Period?
In Southeast Asia, founder vesting typically lasts for three or four years, with four years being the most prevalent. Following the lead of the United States, we frequently see a portion of shares vesting after 12 months or the cliff, with the remainder vesting over the next three years.
A common vesting term could be 25% instantly vested, 25% vesting after 12 months, and the balance vesting over the next three years. Nonetheless, there are numerous variations on this thing.
Founder vesting is not intended to unfairly punish founders. Rather, the goal is to assist startups in retaining important personnel. Finally, if a founder leaves, the company should be rebalanced such that shares can possibly be reissued to new hires.
If your company hasn’t started this mechanism, you should address this first. A founder vesting agreement should be in place anyway if you are intending to raise funds.
Founder vesting is an excellent strategy for ensuring the long-term viability of a company’s founders. In fact, vesting drives and retains entrepreneurs over time.