Vesting Agreements – The Startup Prenup

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It is very important for founders and employees to have a basic understanding of vesting agreements. To better explain why vesting agreements are important, let me tell you a little story about two friends of mine, Alice and Jeff.

Standing with a cocktail in hand, chatting with a fellow programmer, it seems like just another night in the valley. Then their eyes meet. The rest of the world falls away, and it is just the two of them. In a trance, they make their way towards each other. “Hi, my name is Alice, and I am a programmer with a passion for developing a web platform that facilitates political engagement.” “You’re kidding! My name is Jeff, and I am a political strategist with a passion for increasing the engagement of candidates and elected officials with the citizenry.”

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It’s fate. They talk and talk, until they are the only ones left in the joint. It doesn’t take long. This is a match made in heaven – there is no room for doubt. “Lets do it! Lets start a company!” Alice grabs the nearest napkin. “We’ll each get fifty percent!” “Yeah!” “Awesome!” Without hesitation they sign the napkin, glowing with an inner radiance that can only come from finding your startup soulmate.”

Now for the second chapter

Alice sits at her keyboard, bleary eyed, while Jeff yammers loudly in the next room. The magic has faded. Jeff has an annoying high pitched voice that she used to think was cute but now finds unbearable. He always complains that she’s too messy, and while she’s working 16 hour days on their company, Jeff always seems to have something better to do. How could she have missed the signs? As if on cue, Jeff storms in. “Alice, I’ve had enough. We’re not working. This company isn’t working. I’m taking a job as Senator Blowhard’s campaign manager. I wish you the best of luck, but it’s time for me to move on.” Alice is hurt, but relieved. Inside, she knows this is better for both of them.

Chapter 3

It’s been a long road, but she finally did it! After 4 years, many sleepless nights, and countless twists and turns, Alice built a successful platform with sizable user engagement, got angel funding, then VC funding, and had a successful exit, selling the company for $100M. She can finally exhale.

Then comes a knock at the door.

Hi Alice! It’s Jeff! Boy it sure does look like you did a great job on our company! Way to go, I’m so proud! Now how do you want to pay me my 50%?”

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THE END

I imagine that this is what Alice was feeling right about then.

VESTING – THE PRENUP FOR STARTUP SOULMATES

Finding a business partner is a lot like falling in love, and starting a company is a lot like getting married. The joy and excitement of finding that special someone and that special idea can overwhelm your sense of judgment. It’s not that you are intentionally ignoring flaws or problems in your mate, it’s that you legitimately can’t see them. It’s psychological. When you’re “in love” you tune out the rest of the world, and you see only blue skies. 

Eventually, however, infatuation will fade, and you then have to maintain a solid business relationship while dealing with the practicalities of real life. Kids, financial needs, work habits, personal habits, risk propensity or aversion – there are countless challenges inherent in building a business while maintaining a business partnership, and the simple fact is that many partnerships, like many marriages in America, don’t last.

The real problem behind co-founder failure is not necessarily that founders fail to recognize one another’s flaws, it’s that they fail to have the honest and frank discussions necessary to ensure that everyone’s interests are truly aligned. The potential reward of a successful co-founder relationship is, like a successful marriage, wonderful and long lasting. However, forming the foundation of a good co-founder relationship requires a mutual understanding of your respective interests, goals, hopes, and expectations. 

The saga of Alice and Jeff is all too common. One or more founders may leave at some point to pursue the security of a conventional salaried position, or to help a sick loved one, or because you no longer work well together. It just happens, even when it’s nobody’s fault. Be prepared. Protect yourself. More importantly, protect your company. The best way way to protect your company from equity controversies is to use the startup prenup, otherwise known as a vesting agreement.

WHAT IS A VESTING AGREEMENT?

A vesting agreement is found within a stock purchase or stock option agreement, and dictates how and when someone’s equity shares in a company “vest” (meaning they get full ownership over their shares). When Alice and Jeff signed that napkin giving each other 50% of the company, their ownership interest in the company vested immediately. Since they didn’t make vesting of their 50% equity contingent on any continuing contributions of any kind, it didn’t matter that Jeff quickly quit. He already owned the shares and was able to come back to claim them, even though Alice had done all the heavy lifting.

This outcome can be avoided by establishing that all grants of equity are subject to vesting restrictions requiring the recipient to satisfy certain conditions – usually staying with the company for a certain period of time – before their interest in the equity vests.

WHY HAVE A VESTING SCHEDULE?

As the saga of Alice and Jeff demonstrated, if everybody’s equity vests immediately, then your startup could run into a lot of problems. If a founder or an employee leaves after 6 months without doing his or her fair share of work but still gets to walk away with their share, that really doesn’t seem fair to the remaining team, who now have to do twice as much work to earn their shares. Vesting schedules prevent that by requiring founders and employees to “earn” their equity, usually over a specified period of time, similar to salary or wages.

Lets take a simple example, say a startup has 5 founders, each with 20% equity vesting over a period of 4 years. After the first year, each partner owns 5% of the company. After two years, each owns 10%, and so on, until all of their shares are vested.

THE PURPOSE

At it’s core, the true purpose of a vesting agreement should be to align the interests of founders, employees, and investors, with the best interests of the company. Since the needs of each company differ, there is no one size fits all vesting agreement. There are a variety of terms that one can include in a vesting agreement, so when considering how vesting will work for your startup, always ask yourself: “will this term help to align the interests of the equity holder with the interests of the company?”

THE FOUNDER DILEMMA

If you are a founder, you may be thinking to yourself, “this all sounds well and good for employees, but I started this company! Why should my equity in the company be subject to vesting restrictions?” This is a very common thought, but usually a very wrong one. Vesting restrictions, especially for founders, are often very healthy for the company.

If your shares are subject to vesting, it’s true that there is a chance you could lose some of your equity if you are ousted or quit. You may think it would be in your self interest to protect yourself from losing equity in those situations, but it’s not. As a founder, your top priority should always be the best interests of the company. If the company fails, you can own 100% of the equity but you will still end up with nothing of value. You will be much better off if you can make the company a success, even if you have to lose some equity in the process.

Think about the alternative: if you don’t have to earn your equity, then neither do your fellow founders. Vesting agreements protect the company by creating a mechanism for the company to repossess the equity of founders or employees that underperform or walk away early. With vesting agreements in place, each founder can work hard, confident in the knowledge that the company won’t be hamstrung by lazy or ineffective cofounders, and won’t have it’s cap table decimated by a founder walk-away.

WHEN SHOULD YOU PUT IT IN PLACE

At the earliest opportunity. In a perfect world, you would have an attorney to guide you through the process and draft up all the documents for you right at the start, but when all you have is a team and an idea, spending big money on lawyers may not be an option. Try to get some guidance, but at the very least, do your best to write out a basic agreement that sets out the vesting terms right at the beginning. For example:

           “We each get 25%, vested over 4 years, with a 1 year cliff.”
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This text has some jargon that I will explain later in the article, but suffice to say that this simple language is miles better than having nothing at all. The longer you wait to get a basic understanding between the founders sorted out, the more complicated it becomes down the road. Without a doubt, make sure that you put a vesting agreement in place when you incorporate the company. It can be very difficult to “fix” your capitalization after some founders or employees are already vested.

INVESTORS

This is probably the most important reason to implement vesting agreements right from the beginning. Investors will absolutely require that you have them in place before finalizing any Series A funding round (the first major venture capital funding). And guess what? If you don’t already have an agreement in place, they might require you to sign a vesting agreement that starts vesting after the Series A closes. Even if you have been working on the startup for 6 months, a year, or two years, you would have to start vesting all over again. Of course, the terms of the vesting agreement would be subject to negotiation, and if you have sufficient leverage you may be able to negotiate some acceleration, but the point is that if the founders already have a vesting agreement in place, then that improves your odds of keeping some or all of the equity you have already earned.

TERMS

Now that you know why vesting agreements are important, I am going to explain some of the basic terms you will encounter when putting together or negotiating a vesting agreement. Whether you are discussing vesting with your cofounders, or negotiating with a VC, you should have a good understanding of the following:

Vesting Cliffs: A vesting cliff is a specified period of time that an employee must work before they earn any equity. Essentially, the employee gets no equity until the cliff, after which the vesting becomes continuous. A 1 year cliff is typical, meaning that after 1 year the employee is granted all the equity they have earned over that year all at once, but if they leave before the year is finished, they get nothing. This is essentially a “trial period,” allowing companies to test out an employee and really make sure they are a fit before making an equity commitment to them.

Lets apply our incentive alignment test: how do vesting cliffs align employee interests with those of the startup? First, startups typically want to minimize employee turnover due to the inherent costs of hiring and training, and a vesting cliff incentivizes employees to stay for at least a year, which serves that purpose. A downside is that it can also give an employee that isn’t a good fit for the company incentive to stick around longer than they should, just to hit their vesting cliff milestone. Similarly, by mitigating the penalty for making a bad hire, vesting cliffs could theoretically cause startups to be less careful in their hiring decisions.

Acceleration: Acceleration means that whenever a particular “trigger” event occurs – for example, a funding event, IPO, sale, or termination – equity shares are vested immediately. This makes a lot of sense in some situations, but is a bad idea in others. To determine whether vesting acceleration makes sense, lets apply our little test. For example, does it make sense to grant 100% acceleration to employee equity grants when the trigger even is a merger/acquisition with/by another company? Probably not. Unless the acquirer only cares about the technology and has no interest in retaining employees, acceleration will get in the way of the deal. The acquirer probably wants the employees to have an incentive to stay and continue working hard, and 100% acceleration eliminates that incentive. Alternatively, accelerating vesting of an advisor’s equity upon exit makes a lot of sense. They did their job by advising you well and successfully getting you to an exit. They have earned their shares, and since the company has gotten to an IPO or been sold, the advisor probably doesn’t need to stay on in their old advisory role.

For founders negotiating with VC’s, accelerated vesting is a hot topic. Obviously, a founder friendly term is to fully vest the founder’s shares upon a successful exit event (IPO, acquisition, etc). Typically, accelerated vesting for founders requires a “double” trigger, meaning two things need to happen: 1) an exit, 2) termination. Basically, the startup has an exit event and the founder is let go in the process.

Consider the triggering event, the role of the equity holder (employee/founder/advisor), and evaluate whether acceleration would align their interests with the interests of the company. If it does, then it’s probably a good idea.

Vesting conditions: Vesting typically occurs over a period of time, but that’s not the only way you can do it. Sometimes time-based vesting is sub-optimal because it doesn’t take performance into account, causing disgruntled employees to stick around longer than they should just to grab more equity, dragging down the company in the process. Alternatively, the vesting agreement can make vesting contingent on performance goals, like hitting certain sales revenue targets or launching a product on time. Sometimes this can make sense, but be very careful. Don’t get too fancy with your vesting conditions, because people will find ways to game the system. For example, conditioning vesting on hitting predefined revenue targets could incentivize employees to inflate their numbers or focus on short term goals, rather than to make decisions based on the long term health of the company. Similarly, conditioning vesting on launching a product might give your engineers incentive to launch before it is truly ready. Obviously, consider this aspect of vesting very carefully, but when in doubt, just stick with the tried and true system of time-based vesting.

Continuos vs Discontinuous vesting: If you go with time-based vesting, how does the equity accrue? Does it accrue quarterly? Monthly? Daily? Personally, I think continuous, daily accrual makes the most sense. Monthly or quarterly accrual doesn’t seem to offer much benefit, as it can give dead-weight employees reason to stick around longer than they should.

STANDARD” TERMS

Although there is no one-size-fits all, the most typical terms are:

           Founders/Employees: 4 year vesting, 1 year cliff
           Advisors: 2-4 year vesting, optional cliff, full acceleration on exit
           Investors: no vesting restrictions

Vesting restrictions usually don’t apply to investors, or anyone giving you immediate compensation in exchange for the equity shares. The idea behind vesting is that employees/founders earn their equity shares by working for it. If an investor is paying money for their equity, then they have already earned the equity and it should vest immediately. However, if part of the deal is that the investor will provide some other ongoing value to the company, then some portion of the equity should be subject to vesting based on that component of their contribution.

The same principle applies across the board. If someone has “paid” for the equity with something of present value, as opposed to future value (i.e., the promise to work), then the equity should vest immediately. For example: if you grant equity to an employees as a signing bonus, it makes sense for that equity to vest immediately, because they are “paying” for it by signing the employment contract.

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Vesting is a standard feature of founders agreements, and it’s easy to see why. Vesting restrictions can be a very effective way to align the interests of founders, employees, and investors, with those of the startup. Don’t be like Alice and Jeff. Protect yourself. Protect your startup. Apply vesting restrictions to your equity grants.

Disclaimer: This blog is not legal advice and is only for general, non-specific informational purposes. It is not intended to cover all the issues related to the topic discussed. If you have a legal matter, the specific facts that apply to you may require legal knowledge not addressed by this blog. If you need legal advice, consult an attorney.

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