Road Less Ventured
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Road Less Ventured

Understanding Why Founder Vesting Better Aligns Incentives

During fundraising, there are multiple terms that are negotiated between founders and investors. In my experience, one of the most emotional topics for first time founders is share vesting. More than any other term in a financing, vesting of a founder’s shares can sometimes be interpreted as the investor taking something away from the entrepreneurs. To understand why vesting can cause friction during the negotiation, we first need to understand the mechanics of vesting.

Vesting is a legal term that means to give or earn a right to a present or future payment, asset or benefit. In the context of startups, it refers to the accrual of shares or options over a period of time. The vesting schedule set up by the company determines when the employee acquires full ownership of all the shares they have been granted as part of their compensation.

For example, an employee might receive 4,800 shares of stock in an early stage startup as part of their compensation. To entice this valued employee to remain with the company for the next four years, the stock “vests” evenly every month. This means the employee earns the right to 1/48th of the share grant (or 100 shares in this example) every month. After 4 years, the employee is “fully vested” and will receive the value of the full number of shares upon a liquidation event.

However, if that employee decides to leave before the 4 years are up, she only receives the number of shares that vested during her service. So if an employee left for another job after 22 months, she would walk away with 2,200 shares rather than the full 4,800 granted when she was hired.

There are a number of other nuances to vesting schedules including cliffs (employee has to stay a minimum amount of time, typically at least 1 year, or receive nothing), back loading the vesting schedule, and tax implications. However, those nuances aren’t the point of this post and if you really want to learn more I suggest consulting an experienced startup lawyer.

So why institute vesting in the first place? Because it incentivizes employees to stay with the company. If the shares that have been granted to an employee have appreciated in value, then employees could be walking away from a lot of money if they decide to leave. Hence, vesting is used as a retention tool.

Viewed from this perspective, instituting a vesting policy seems pretty logical and straightforward. If so, why would this be such a sensitive and potentially volatile topic?

Sometimes we come across companies at the early stages in which all the shares were granted upfront to the founders. In other words, they had no vesting. In some later stage companies, the founders and early key employees might be fully vested already. In these cases, an incoming investor will require that the founders and early employees be put on a vesting schedule.

Most inexperienced founders find this unpalatable. Their first response is typically some version of “This is my company, no way would I ever leave.” Let’s unpack this objection. If you don’t leave, the vesting never becomes an issue and you end up with all the shares you would get regardless of whether the shares vested or not. The vesting only restricts the amount of stock you receive if you do leave prior to the vesting period ending. So, if you believe you will never leave, the vesting schedule is moot.

There is another argument I tend to hear and it goes something like this: “I’ve put in years of work, I deserve credit for that work.” This is a much stronger argument than the previous one and one that I agree with from an entrepreneur’s perspective. While the entrepreneur has built something valuable (otherwise I, as the investor, wouldn’t be funding it), the job is not done. Would you pay someone if they left when a project was only a third or half completed? No chance. Vesting helps strike a balance between rewarding what has been accomplished and aligning incentives for the future. We typically will vest some percent of the founder’s stock upfront with the remaining vesting over some period of time. We might even throw in some additional options on the back end as well, so we are using carrots and not just a stick.

But when talking with founders who do push back, I try to explain that vesting schedules for them and key management personnel are in their own best interest.

Again, if you put in a vesting schedule and everyone stays then everyone gets their full number of shares. Everyone is made whole. But what if you don’t put in a vesting schedule and one of the founders decides to leave? They would take all their shares with them as they walked out the door, meaning they would receive all the economic benefit of everyone else’s hard work when the company exits even though they weren’t contributing during that time.

Furthermore, when they walk away, that’s a key role that needs to be filled. If they walk away with all their shares, that’s less shares available to recruit outside talent with. This could actually lead to further dilution among the founders if the option pool needs to be increased in order to attract a replacement.

This is why I argue that founders should want shares to be vesting (including their own) as it not only aligns incentives among key individuals on the team but also provides the company more flexibility if someone does leave.

If you are an entrepreneur or thinking about starting a company, I would encourage you to institute a vesting schedule right away. If you are raising a new round of financing, expect the investors to want a vesting schedule to be in place so you are not surprised when the topic comes up. Simply understanding the purpose and nuances of such terms can save you a lot of headaches later on.

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Brett Munster

entrepreneur turned fledgling investor. baseball player turned aspiring golfer. wine, food and venture enthusiast.