Founder vesting is a term used to describe an arrangement among startup founders that limits their control over company shares as time progresses. Under this arrangement, founders get their stock assigned upfront but are entitled to these shares incrementally, over a span of typically 2 to 4 years.
The primary purpose of founder vesting is to align incentives and encourage long-term commitment to the company. Without vesting, founders could leave with their full equity stake even if they depart early on. Vesting incentivizes founders to stay for the long haul and earn their full allocation of shares.
Here's how founder vesting typically works:
By gradually earning their equity stake over time, a founder's stock vesting powerfully aligns incentives. Founders are motivated to add long-term value, not just short-term gains. This retention mechanism boosts the resilience and success of startups.
Founder vesting is a crucial component in building a successful startup for several reasons:
Retaining Talent
Vesting ensures that founders earn their equity stake over time through continued contributions. This incentivizes founders to keep working hard to build the company rather than resting on their laurels. Without vesting, founders could leave soon after getting their full equity, depriving the company of their skills and know-how. Vesting aligns incentives by tying the founders shares' rewards to their ongoing participation.
Avoiding Free Riders
Vesting protects against "free riders" - founders who leave early with substantial equity despite minimal contributions. For instance, a founder may put in 6 months of initial work and then depart with their full 10% stake. With the new vesting schedule in place, they would only get a portion of shares tied to their time served. Vesting ensures equity splits reflect actual contributions over the long-term.
Protecting the Company
Vesting gives companies leverage if a founder becomes uncooperative or negligent. Rather than being stuck with a disengaged founder with substantial equity, unvested shares can be repurchased. This minimizes potential damage from founders who lose motivation or no longer add value. Proper vesting terms prevent companies and other shareholders from being held hostage by errant founders.
When starting a company with multiple founders, one of the most important early decisions is determining how to split equity ownership among the founding team. This split lays the foundation for the company's ownership structure and cap table. While there's no one-size-fits-all formula, there are some best practices founders should consider.
The most common factors to weigh when dividing founder equity include:
There's no perfect formula, but being thoughtful about equity splits and vesting early on prevents issues down the road. Founders must balance rewarding contributions fairly while retaining talent for the long run.
Founders should establish a standard vesting schedule for their equity at the business plan outset. This defines the timeframe over which founders will earn full rights to their shares. Typical vesting schedules last 4 years with a 1-year cliff.
This means founders do not earn any vested shares during the 1 year cliff period. After the first year, they begin vesting their shares on a monthly or quarterly basis over the remaining 3-year period.
The cliff period is important because it incentivizes founders to commit for the long-term. If a founder leaves before the 1-year cliff, they walk away with no vested equity.
Vesting schedules may also include acceleration clauses. These allow founders to add vesting of shares faster upon certain events like an acquisition, being terminated without cause, or hitting growth milestones.
Overall, standard vesting ensures founders earn their equity over time while protecting the company from early departures. The typical reasonable vesting schedule aligns incentives and sets clear expectations.
A vesting cliff period refers to the initial timeframe in a founder's vesting schedule during which none of their shares vest. Often set at 1 year, the cliff period is an important provision that aligns incentives and deters founders from leaving too quickly.
The rationale behind cliff periods is to ensure founders have "skin in the game" for an initial substantial period as the company gets off the ground. If founders were allowed to take vesting restrictions out right away, they could leave after a short enough time period and still walk away with significant equity.
Cliff periods incentivize founders to stick around for at least the initial critical phase of the startup journey. Knowing their shares won't begin vesting until after 1 year motivates founders to fully dedicate themselves to the venture.
The implications of a founder leaving before the cliff period are drastic - they forfeit all of their unvested shares. While this may seem harsh, it prevents a lack of commitment. Founders who make it through the demanding first year demonstrate their dedication to the startup.
Overall, cliff periods are an important alignment tool. They give comfort to co-founders and investors that the team is committed to the long haul. Founders should understand cliff implications to avoid painful surprises if departing too soon.
Founder vesting offers an advantage in dealing with shares in specific situations such as an acquisition or the termination of a founder.
If a startup gets bought out before the founder's shares are completely vested, there are a couple of outcomes for those unvested shares:
The specific treatment is usually outlined in the acquisition agreements and heavily negotiated.
If a founder leaves or is let go before they fully own their shares, the company can choose to buy or cancel their shares depending on the reasons for their departure.
This introduces the concepts of "good leaver" vs "bad leaver":
Proper founder vesting provisions protect the company from an adversarial founder departure, while still providing fair treatment for cooperative founders who move on amicably. Defining good and bad leavers is key.
Founders have several options to protect control of their company even as their shares vest over time. Three common mechanisms are leveraging supervoting shares, implementing transfer restrictions, and rights of first refusal when allocating stock.
Supervoting Shares
Instead of assigning all the founder's shares to the same common stock class, founders have the option to create a distinct category of supervoting shares with increased voting rights per share. This allows the founders to hold onto the supervoting shares that grant them voting authority and influence. As regular common shares subject to vesting move over the vesting schedule, the founders maintain their heightened voting rights through their supervoting shares. This prevents dilution of control.
Transfer Restrictions
Transfer restrictions limit founders' ability to sell or purchase shares or transfer unvested shares. Often founders cannot sell or transfer any shares, vested or unvested stock, without approval from the board of directors or a shareholder vote. Transfer restrictions ensure founders don't offload large numbers of shares before vesting terms are satisfied.
Rights of First Refusal
Rights of first refusal give common shareholders of the company the option to purchase any shares a founder wants to sell, usually at fair market value. This prevents founders from selling a certain percentage of their equity to outside parties and maintains existing ownership and control dynamics. Rights of first refusal help curb potential issues with founders transferring shares before vesting is completed.
Vesting protects startups, but mechanisms like supervoting shares, transfer restrictions, and rights of first refusal help protect founders' control as well. Founders should consider these options when negotiating vesting terms.
Investors in startups, including venture capitalists, typically look for founders to have a vesting plan before they decide to invest. The idea behind this is to make sure that the founders are dedicated to the company for the haul and motivated to drive its growth.
Here are some tips when negotiating vesting with investors:
With thoughtful negotiation and compromise, founders and potential investors can agree upon fair vesting terms that work for all parties involved. Being flexible while also clearly communicating your interests is key.
Founder vesting has important tax and legal implications that must be considered.
The tax treatment of founder stock and equity is complex. When stock vests and founders receive shares, it is generally considered taxable income. The value of the shares at the time of vesting determines the amount of income recognized. Founders are then responsible for paying taxes on this income.
There are strategies to reduce the tax load, like opting for 83(b) elections or delaying tax payments. It's essential to seek advice from a tax consultant to enhance tax planning and submissions related to founder vesting.
Founder vesting arrangements must comply with federal and state securities laws. The offer and sale of stock to founders is considered a securities transaction. Care must be taken to either qualify for an exemption or register the securities appropriately.
Legal counsel that specializes in securities regulations should review any founder vesting terms before they are finalized and executed. This helps avoid noncompliance issues down the road.
Proper documentation is critical when implementing founder vesting. This includes stock purchase agreements, restricted stock agreements, bylaws, shareholder agreements, and 83(b) elections.
Ensuring that the necessary legal documents are in place is crucial to defining founder vesting for both the company and its founders. By planning and documenting everything from the beginning, potential uncertainties and disputes can be avoided.
Founder Vesting Case Studies
When founder vesting is implemented carefully it can align incentives, and keep individuals engaged in a startup. Yet, if not structured correctly it may result in disagreements. Examining real-world examples provides valuable lessons for founders.
Good Founder Vesting Example
Social media startup Snapchat implemented founder vesting successfully. The three co-founders Evan Spiegel, Bobby Murphy, and Reggie Brown agreed to a vesting schedule where their shares vested over 3 years with a 1-year cliff.
When Brown left the company early on, Snapchat exercised its right to repurchase Brown's unvested shares. This protected the interests of the remaining founders Spiegel and Murphy and aligned incentives going forward. Snapchat's thoughtful founder vesting enabled the startup to move forward smoothly after a founder's departure.
Problematic Founder Vesting Scenario
In contrast, communications company Ooma structured founder vesting in a way that later caused disputes. Ooma had two co-founders, Andrew Frame and Peter Prasad. Prasad left Ooma after 2 years, before fully vesting.
Frame argued that Prasad's unvested shares should be voided. However, Ooma's agreements had no provisions for what happens when a founder departs pre-vesting. The lack of clarity led to a lengthy legal battle between the founders.
Key Lessons
These examples highlight the importance of carefully constructing founder vesting terms upfront. Vesting should clearly outline the equity split, vesting schedule, treatment of unvested founder shares thereafter, and contingency plans. Vague founder agreements can lead to conflict later. Proper founder vesting alignment enables smooth sailing even when founders depart.
