Vesting of founder shares is often one of the most sensitive topics in a financing round. Founders understandably wonder why they should agree to potentially losing shares in their own company, no matter how unlikely (at Point Nine, in well over 100 investments we at best had a handful of founder departures with vesting implications so far). After all, they have founded and built the business and therefore “earned” their holdings! Christoph told me that when he heard about vesting for the first time, when he raised a seed round at his first Internet startup back in 1998, and the VC put a vesting provision into the term sheet, he was shocked.
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Why founder share vesting?
There is truth behind this thinking, but as often in life, there is another perspective. Yes, the founders have already created something, often over many months or even years and at little or no salary. But especially at the early stages, the existing assets of a business are not the key motivation for a VC to invest. What drives the investor is the potential of the business, and in order to achieve that the founding team is all-important. Investors therefore seek to set up a mechanism that minimizes the risk of a founder leaving and that, if it happens, will lessen the impact.
Founder share vesting in principle achieves these objectives: A departure by a founder will be more “painful” and therefore increase commitment (this should not be overemphasized though: a founder will hardly ever leave light-hearted due to his/her intrinsic motivation and the likely negative impact on the company and his/her shares, but if he or she is in a tough position for whatever reason, then the vesting might be a factor). More importantly: the shares returned will allow the company to retain and incentivize a replacement without massive dilution of the other shareholders. If there are two or more founders, the founding team often recognizes that there should be no “free lunch” for a founder who changes his/her mind later on, and sets up a vesting schedule even before any investors comes on board.
While these principles are largely uncontroversial, the devil is in the detail: The vesting structure needs to find a balance between the objectives of the investor and the legitimate interest of the founders to protect their ideas and achievements. The first thing to avoid is equating the terms of founder share vesting with those of an employee incentive program (“ESOP”). An ESOP, whether done with “real” shares, options or virtual shares, will generally have stricter terms than founder vesting as the shares or options granted to employees in almost all cases are exclusively in return for future work rather than having been, to a certain extent, earned already. At Point Nine we think this difference should primarily be reflected by excluding a portion of the founder shares from the vesting. Depending on how long the founders have been working on the business already, we are happy to exempt up to 25% of founder shares from vesting in a Seed round and potentially more in a Series A financing (plus there is an argument for more lenient vesting terms, see below).
Beyond this, “philosophies” on founder vesting get more complicated. Depending on the country/jurisdiction, legal customs and market dynamics, a variety of vesting models have evolved with intricate structures and legal prose. Technicalities aside, the terms of a vesting scheme can be separated into three areas: (1) Vesting period and frequency, (2) departure consequences and (3) treatment of unvested shares in case of an exit event.
Vesting period and frequency
Based on our experience, most vesting schemes foresee a vesting period of 36–48 months starting at or just before the investment. The shares subject to vesting (let’s call them “Vesting Shares”) gradually become vested during this period, i.e. fully owned by the founder without risk of losing them in case of a departure (some exceptions may apply, see below). The vesting generally occurs monthly (quarterly or even annual vesting is increasingly considered too imprecise), at times with a “cliff”, which means that the initial vesting interval is longer, say one year, and the regular vesting only starts thereafter (this concept is more common in employee incentive programs though). Over time the vesting could therefore look as follows:
Founders must keep in mind though that vested shares may not stay vested forever. If there is a large new financing round the new investor(s) may demand a “reset” with the same argument that the initial vesting was agreed on. However, later stage investors tend to accept the argument that the business is more mature and the (vested) founder shares have been through a vesting cycle already, during which the (active) founders have shown that they are fully committed. “Reset” vesting schemes therefore tend to have a smaller portion of shares subject to vesting and/or a shorter vesting period (plus potentially more lenient vesting terms, in particular in case of a “voluntary resignation” — see below).
Departure of a founder
If there is disagreement over founder share vesting it often centers around the events that trigger a transfer obligation and the terms of a transfer. The buzzwords here are “good leaver” and “bad leaver” — which sound fine from a high level but offer plenty of discussion potential when it comes to agreeing the details.
The clear cases first: A founder is always a bad leaver if he or she is dismissed for “cause”, which covers in particular cases of gross misconduct (e.g. a felony against the company such as fraud or embezzlement of funds) or the breach of a material obligation (e.g. a non-compete). The typical case of a good leaver is the founder who is dismissed without cause, i.e. without having breached a material obligation. A good leaver event may occur when the business has reached a certain level of maturity and the (majority of) shareholders or the board feels that the founder in question no longer meets the profile needed for this phase of development. Because a termination does not have to take the form of a legal termination, but can also come as an unreasonable change of employment terms (“we have a new assignment for you in Siberia”), a resignation by the founder in response to such a measure is generally also considered a good leaver (“involuntary resignation”). :-)
Things get more complicated if a founder resigns of his/her own free will (“voluntary resignation”), which investors tend to see as a bad leaver. Founders argue that life is unpredictable, and a voluntary departure is not comparable with a dismissal for cause. There also is an argument that it would not be in the interest of the company if a founder “does his/her time” simply because the downside of leaving is too big. The gray zone becomes even “grayer” if the resignation is forced by severe illness or even death.
Because a clear-cut bad leaver in real life hardly ever happens (to give you an idea: most likely not even the departure of the founder of the world’s most valuable mobility venture fell in this category), one line of thinking takes a simple approach: no differentiation between good and bad leaver. If a founder departs, for whatever reason, he or she loses his/her unvested shares, but keeps the vested ones. This is how it is generally done in the United States.
A second line of thinking, mostly in Continental Europe, is unhappy with this “one size fits all” approach. It seeks to differentiate between good and bad leaver, and may even introduce additional categories for certain “gray leavers”. For instance a vesting scheme in Germany may look as follows: A clear-cut bad leaver loses all Vesting Shares, even the vested ones. A clear-cut good leaver keeps all vested shares and loses only a portion of the unvested shares or gets compensated for the unvested shares to be transferred. A “voluntary leaver” may lose his/her unvested shares, but keep all or at least a portion of the vested shares, and a founder resigning due to severe illness may be able to keep all vested shares.
Vesting in an exit
While for founder departures the US approach generally can do without the good/bad leaver concept, there is one area where this concept may well play a role in any vesting scheme: If there is a sale or other exit event (“change of control”) before the end of the vesting period most vesting schemes foresee that the so far unvested shares either vest immediately (“single trigger”) or they vest if the relevant founder is terminated without cause, i.e. departs as a good leaver, within a certain period (generally 12 months) after the exit (“double trigger”).
At first sight, the single trigger rule appears more favourable for the founders, but upon closer inspection the double trigger approach has its merits: It helps tremendously with the sale of the company. Most buyers, even if strategic, will want to ensure a smooth transition and keep existing management on board at least for a while. In some cases founders are even willing to forgo an agreed single trigger for some of their unvested shares to make the transaction happen. In return they may even be able to negotiate some additional incentives with the buyer as an extra reward. Investors will generally accept this if the reward is within reasonable bounds and not a (hidden) incentive for the founders to push this deal over another one.
Point Nine’s approach
As you can see, especially for founder departures things can get complicated and the discussion potential is immense (to be clear: this refers to the contract stage; luckily vesting clauses rarely become relevant in practice). At Point Nine we tend to favor the US approach (no differentiation between good and bad leaver) for early stage (seed) financings. It is simple, straightforward, much less open to interpretation and on balance probably also more founder-friendly than the European concept. Against this, the fairness argument may be overrated at least in early-stage funding rounds:
- In real life only two “cases” make up the overwhelming majority of departures: regular dismissal (i.e. without cause) and voluntary resignation. These cases are closer to each other than one may think: If a founder wants to leave, his/her decision will often be driven by a feeling that his/her skills are no longer optimally employed as the business enters a more advanced stage — essentially the same motivation that may drive the decision of shareholders to replace a senior manager. This is also reflected in the day-to-day handling of departures which are generally implemented by a dissolution agreement rather than by formal notice.
- Dismissing a founder without cause generally requires at least some of the (other) founders to agree, even more so given that the affected founder has a vote in the decision (if the competence for management dismissals lies with a board it is, of course, conceivable that the founders don’t control the board, but at least after a seed round this would be unusual). The lesson from this? Never think about vesting without looking at governance!
- The requirement of the US approach to return all unvested shares also in case of a good leaver not only protects investors, but also the company and the remaining founders. Based on our experience it is often the other founders who feel the need for a change even more than investors. This happens in particular when one or two “main” founders who had the business idea and initiated the venture took on co-founders at an early stage because of their special skills, but with a (much) lower shareholding. These “junior” founders may have been considered employees if hired a bit later and may even be employees from a labor law perspective. For employees somewhat stricter vesting terms are generally accepted for reasons of practicality and their less prominent role in the initial formation of the venture (see above).
On exit vesting we tend to favour the double trigger approach: An exit is still far away at the time of a seed financing. If a sale happens quickly (and therefore there are unvested shares to think about) the reason will rarely be an irresistible offer (which could make the double trigger seem unfair). Also, the founders will likely have a say on the “if” and “how” of the sale anyway (even if they no longer hold the majority of shares, the purchaser will hardly want to pursue a “hostile” takeover). Requiring the founders to stay on a bit longer to maximise value therefore makes sense — even for many founders. This does not mean that particular circumstances, e.g. the realistic possibility of a quick and high-value exit, should be ignored. For instance, a shorter handover period (e.g. 6 instead of 12 months) or an immediate vesting of a portion of the unvested shares may do the trick.
In summary: Vesting is complicated, full of pitfalls and prone to misunderstanding. And unfortunately founder vesting schemes are no exception to the rule that greater balance and fairness comes with greater complexity and impracticality. We hope that the above perspectives will help to clear some of the fog around this unloved topic and help you to cut it down to size quickly and with minimum friction.
Please do not hesitate to contact us with any comments or questions!