4 Reasons Why Startup Founders Should Have a Vesting Interest in Their Companies
“It’s our company, shouldn’t we already own our shares?” This question is one of the most common that I hear during my initial discussions with entrepreneurs organizing a company. For entrepreneurs who have often already invested significant sweat, tears and personal resources to launch a company, structuring their ownership is a very important and personal decision. So it’s an understandable reaction when I suggest that they leave a significant portion of their ownership subject to vesting. However, taking this seemingly unfair risk is actually an important step in mitigating future risk for the company and protecting the entrepreneurs’ long-term interest. Of course, this is most crucial in companies with multiple founders.
First, a little bit about what “vesting” means. Founders’ stock with vesting is called “restricted stock.” With restricted stock, the founder owns all of his shares, but the company holds a right of repurchase which lapses with respect to portions of the shares over time according to a specified “vesting schedule.” In the event that the founder leaves the company prior to the end of the vesting schedule, the company has the option to repurchase any shares for which the right of repurchase has not lapsed – the “unvested” shares – typically at the same price the founder initially paid.
For example, let’s say that a founder was issued 1,000,000 shares at a purchase price of $0.001 per share ($1,000 total) with a four-year vesting schedule. If the founder leaves the company after two years, the company would have the right to repurchase 500,000 of the founder’s shares for $500. So, why would founders want to take the risk of losing their shares?
- Need to Replace the Departed Founder: At the outset of a company’s life, founders are excited and totally committed to the new venture. In some cases, founders have close personal relationships, so it seems unthinkable that they would not all see the venture through to the end. However, growing a company can be difficult, and the founders' lives outside of the company can cause an unforeseen departure. Presumably, the departed founder brought unique talents to the company that will need to be replaced. If the founder’s shares were subject to vesting, the company could use the repurchased shares to offer an equity incentive to a good replacement. Otherwise, the remaining founders will be subject to additional dilution of their ownership interests and the company may also need to incur costs to amend its charter and/or option plan to accommodate the additional required equity.
- Avoiding an Unjust Allocation upon Exit. Take the example above where a founder leaves the company after two years. Say that the company then has a successful exit at the end of four years. If the departed founder had no vesting, then (assuming equal initial ownership) the founder will receive the same portion of the proceeds for the founder's two years of work as the founders who worked twice as long and saw the venture through to the exit. Vesting protects the founders who stick with the company and produces a more just allocation upon exit.
- Avoiding a Costly Repurchase Negotiation. If the founders’ shares do not have vesting and a founder leaves unexpectedly, the remaining founders face the reality of the two previous points. They may then decide to negotiate a repurchase of the departing founder’s equity. This negotiation can be time-consuming and costly to the company, and it usually results in the company paying far more than the original purchase price to repurchase the shares. With vesting, this situation is avoided, because the terms of a repurchase have been agreed to upfront.
- Investors Will Often Require Vesting Anyway. If the company takes on significant financing from sophisticated investors, they will typically require the founders’ shares to be subject to vesting. If the company does not have vesting in place, the investors will get the first opportunity to dictate the terms of the vesting, which may start from the time of the financing. However, if the company already has vesting in place on its terms, the company may be able to get the investors to accept the existing terms, or agree to a reasonable compromise, which means the founders are more likely to get favorable terms, including credit for the time they have served from formation to the financing.
As four-time Indianapolis 500 winner Rick Mears says, “In order to finish first, you must first finish.” If the founders are willing to take this step at the outset, it can pay significant dividends for them individually and for their company in the long run.
Author: D. Adam Wanee
The blog content should not be construed as legal advice.