October 25, 2021

Volume XI, Number 298

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October 25, 2021

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Startup University: Founder vesting, a must in most situations

Founder vesting. It’s a subject that causes heartburn with all first-time entrepreneurs.

“What do you mean I can lose my equity?”

“Hey, this is my idea, so I’ve already earned my share of the company.”

“I trust my co-founders – they are diving into the deep end of entrepreneurship.”

I can spend this entire blog post on the reasons I’m given as to why first-time co-founders should not be subject to vesting. Guess what? Those reasons fall on deaf ears, with two notable exceptions, which I’ll detail later in this post. Equity is something that is either purchased or earned over time. Not something that that a co-founder is entitled to just because he or she is part of the initial team.

Time and time again, a group of founders who form a company without vesting attached call me a few weeks or months later with one of a handful of situations that any experienced advisor could see coming a mile away.

A member of the team doesn’t have the stomach for the risks and Raman noodles associated with starting a new venture. They can’t tolerate the time without a paycheck or health benefits. It’s a fair concern. Entrepreneurship isn’t for everyone. So they quit or drop to a nights-and-weekends schedule while returning to the comforting world of gainful employment.

A member of the team may be all-in from a commitment standpoint, but maybe he or she isn’t contributing like anticipated, whether as the chief technology officer, chief executive officer, or whatever. The other co-founders are starting to wonder why that person has such a large equity stake. Maybe a reduced role is appropriate. Maybe a separation is appropriate. Something has to change.

The co-founders have a falling out over strategy or execution. Entrepreneurs are often very strong-minded and strong-willed. They are passionate about what they believe in, so compromise is sometimes difficult.

In each of the three aforementioned scenarios, one of two things has to happen. The team either needs to separate from one or more co-founders or the respective roles and responsibilities need to be adjusted. Both of those actions also require a reallocation of equity. And that, my friend, is next to impossible without the benefits of vesting.

Granted, someone who is really completely committed to the cause may volunteer to give back equity. But if you believe that to be the norm, drop me an email so I can sell you that infamous bridge in Brooklyn.

Vesting is not the enemy. Maybe it is from an individual’s standpoint, since it holds that co-founder’s feet to the fire in terms of pulling his or her weight. But the issue of founder vesting should not be decided based on what is best for an individual. It needs to be decided based on what is best for the founding team, which means what is best for the company as a whole.

Absent the Good Samaritan, a departing or role-adjusted founder without vesting means that individual will own an unfair proportion of the equity. And that isn't good for anyone.

Generally speaking, the only time co-founders should not be subject to some sort of vesting is when they each contribute significant and proportionate upfront value for the equity received. The contribution can be in the form of seed cash. Not a few grand; I’m talking enough cash to carry the company for six months to a year.

The contribution can transferring an individual’s existing intellectual property rights to an invention that predates either the formation of the company or the issuance of equity. The IP shouldn’t just be an idea or a business plan. It needs to be developed intellectual property – a prototype, an alpha product, a developed method for doing something – that truly forms the foundation of the company and gives instant value in the eyes of angel investors.

The last, and probably the most common, type of contribution is prior services rendered to the company. Some co-founders put off dealing with the issue of entity formation and formal equity splits months, if not years, after starting their venture. They want to see if the business idea has any legs before papering their relationship. I’m not a big fan of that approach because of the inherent risks – which is another post for another day – but it happens more often than I would like to see.

Each of those three scenarios justifies some form of upfront, fully vested equity for the contributing co-founder. I’m less sympathetic to an argument based on the fact that someone is quitting a job to join the team. Very few jobs are guaranteed, and those that are guaranteed are typically held by people who are imminently employable at all times. Taking risks is what entrepreneurship is all about. I still firmly believe that person should earn his or her equity with future contributions to the company, absent bringing cash or IP to the table.

What is the appropriate vesting? That is decided on a case-by-case basis. Monthly over four years it the most common type of vesting. A one-year cliff is much more common, particularly in Silicon Valley, than no cliff. A cliff just means the period of time before the individual earns any equity. Thus a four-year monthly vesting schedule with a one-year cliff means the individual vests no equity during the first year, earns 25% of the total equity grant at the one-year anniversary and then earns 1/48th of the overall equity grant each month thereafter.

Since founder equity is almost always granted in the form of issued and outstanding equity, rather than options, due to the extremely low value at the time of grant, vesting is enforced through a repurchase right. I would be remiss if I didn’t mention that the repurchase right should ALWAYS be for the original issue price, not the fair market value at the time of repurchase.

In other words, if a co-founder pays $100 for 25% of a company and leaves two years later, that founder should walk away with 12.5% of the company and a check for $50 to repurchase the rest of his or her equity (assuming no dilutive issuances in the interim, which will almost always happen). Time and time again, I see operating agreements or founder stock purchase agreements where a departing founder is entitled to be paid the then fair market value for unvested equity. That is nuts. It rewards the person for leaving by triggering an actual cash gain for equity that wasn’t earned -- illiquid equity at that.

That is another full-length post for another day. I’ve hit the 1,000-word limit. I’m sure your eyes are bleeding by now, so I’ll wrap this up by repeating something that serial entrepreneurs know all too well.

Founder vesting is your friend. Embrace it early, and it will save you a lot of pain later. Trust me on that one.

© 2021 Dinsmore & Shohl LLP. All rights reserved.National Law Review, Volume II, Number 57
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