In establishing our new company, one of the first decisions we have to make is our founder equity structure. It is up to us to decide the allocation of equity among us founders and our vesting schedule. While this topic has little bearing on the actual business of a startup, its implications are far-reaching, so we wanted to give it sufficient thought before locking it down. We want to be sure that all of our incentives are perfectly aligned with future employees, investors, and customers.
The first and most obvious question with founder equity is how should it be split among the founders. We decided to do a 50–50 split for the simple reason that we see each other as equal partners. Allison and I are both incurring substantial opportunity cost to start this venture. We’ve also known each other and worked together for several years, so we have a great sense of what skills we each bring to the table. We did consider slight modifications, such as me taking one extra share as a tiebreaker, but ultimately we felt that the fairness and optics of a perfectly equal split were more important than addressing the narrow scenario of a deadlocked dispute between the two of us prior to us bringing on additional shareholders (in which case we probably have bigger fish to fry).
Equity vs. options vs. RSUs
The next question was in what form should our equity be issued, although fortunately this was an easy one. The optimal mechanism for issuing equity to employees — for example, stock, options, or restricted stock units — typically comes down to capital outlay requirements and future tax implications.
When you first start a company, it has basically no intrinsic value, so founders can purchase equity from the company outright for next to nothing. The main benefit to this approach is the founder owns the stock and if he or she sells it at a later date, any gains will be taxed at the capital gains rate, which is generally much lower than income tax. If this purchase is subject to vesting (i.e. restricted stock), which it generally would be (see below), the founder must make sure to file a Form 83(b) election with the IRS to declare that the taxes have been paid in full upfront, so that each vesting period does not trigger a separate taxable event.
Once a company has amassed value, however, asking future employees to purchase their equity grants in this fashion would force them to front a lot of cash and stomach substantial downside risk; it just wouldn’t be practical. For that reason, post-funding companies typically issue equity as compensation in the form of options or RSUs. These instruments allow employees to gain substantial upside in the case that the company’s equity accrues value without requiring a capital outlay or creating downside risk. More information on these various instruments can be found here.
Standard vesting schedule and acceleration triggers
The standard practice for equity vesting seems to be a linear 4-year vest, with a 1-year cliff, and a double-trigger acceleration clause. This means that while the founders technically purchase their stock outright on day one, the company has the right to claw back some or all of the equity if a founder leaves or is fired before 4 years have passed. Equity grants to employees are generally subject to a similar vesting schedule.
Acceleration triggers address what happens in the scenario that the company is acquired (single trigger) or if the employee is fired without cause (single trigger) or both (double trigger). The idea is that if any of these situations occur, the new reality is likely not what the founder/employee signed up for, and acceleration removes their handcuffs by fully or partially accelerating the vesting schedule. While including an acceleration clause in the case of an acquisition may seem reasonable, it can backfire by creating a red flag for a potential suitor (although an acquirer that’s not thrilled about the existing equity structure would probably just mandate revising the schedule as part of the terms of the deal). Regardless, it does seem standard practice to have full acceleration upon a double trigger (i.e. the company is acquired and you get fired without cause by the new management within 12 months).
Why we don’t like the standard schedule for Proof
While conventional wisdom tells us not to get too creative when it comes to vesting, we felt for a financial services company, four years simply isn’t long enough to establish a real presence. Take our former employer IEX, for example — I was there for 7 years, and while they’ve had an unprecedented impact on the industry already, it still feels like they are only in the early innings, and it would have been a disaster if the founding team all up and left when that 4 year mark arrived. A startup can re-up founders with an additional grant as they approach their vesting end date, but this just dilutes everybody else, and the additional grant is usually much smaller amount than the original one. We don’t want to set ourselves up to be in that position so soon if things go well.
A 10-year vest for founders
That line of thinking brought us to this idea: what if the founders vested over ten years instead of the usual four? This might be a hefty commitment for us to make to each other and to the company, but we’re not looking at this venture as a stop along our career journeys; we see it as the destination. Ten years isn’t forever, but it’s a whole lot longer than the standard schedule, and as soon as we thought of it, we were very intrigued. We would still want to stick with a standard schedule for future employees, but we felt this would send a strong signal that we founders are in it for the long haul.
It did however open a new can of worms. What would happen if the board fired one of us without cause after 5 years, or if the company got acquired after 3? In these cases, would we really want to put ourselves in such an inferior position relative to the norm?
Then we thought maybe we could address these cases with additional acceleration triggers. But a simple full acceleration upon a single trigger wouldn’t be quite fair either.
As we thought through the various cases, we moved around the levers to try to maintain the right incentives while still being fair. The best combination of terms we could think of was as follows:
- 10-year vest for founders
- 1-year cliff
- In the case of an acquisition or a termination without cause, all shares that have vested are multiplied by 1.5, up to the full original amount. In other words, we retroactively convert from a 10 year vest to a 6.67-year vest.
- In the case of a double trigger within 12-months of acquisition, full acceleration, just like in the standard schedule.
- In the case of a termination without cause more than 12-months after acquisition, the multiple is 2.5 instead of 1.5 (i.e. retroactively convert to a 4-year vest).
This seems like a robust solution, but it is pretty unwieldy, and we didn’t want every prospective investor down the road to have to spend hours wrapping their heads around our special snowflake of an approach.
Where we landed
Ultimately, we decided we didn’t want the headache of deviating too far from the standard approach. While choosing a 10-year vest created the long term alignment we were hoping for, it also created a lot of sub-optimal edge cases for which we couldn’t find a simple elegant solution. As such, we’ve chosen to do a 6-year founder vest with otherwise standard terms (1-year cliff, double trigger acceleration, etc.). We felt this struck a good balance of sending a positive signal to future employees and investors, while also keeping things simple.
Future topics: other issues with equity and compensation
Founder equity vesting is the only question on this subject we’ve had to tackle so far, but several other related areas interest us too and may warrant follow up posts:
- Transparency and fairness in pay practices, particularly for marginalized groups
- Creating consistent liquidity for employees
- Avoiding golden handcuffs