The company has the Right to Purchase a Percentage of the Founder’s Equity in case the Founder Walks Away
You have an awesome idea and a great co-founder with whom you want to work. Both of you work hard for the first couple of months until your partner decides to walk away for any reason. You really believe in this idea and keep working hard for more time until things start to work out and you sell your company for a whopping 200 million dollars.
Next morning your phone rings. It’s your old partner asking for his $100 million because of the 50% you had agreed when both of you founded the company.
An exit does not only mean to sell your company, it is also the sign hanging on top of the door through which your partners can walk away with your equity. If things like this happen, they can really jeopardize the possibilities of success of the company. This is why vesting is so important.
Invest in Vesting:
Vesting means that at the very beginning each founder gets his or her full package of stocks at once to avoid getting taxed for capital gains; but, the company has the right to purchase a percentage of the founder’s equity in case he or she walks away. This means that if your partner walks away after a couple of months, he or she will not be able to claim those 100 million dollars because the company purchased his or her equity when he or she left the company. In essence, vesting protects founders from each other and aligns incentives so everybody focuses towards a common goal: building a successful company.
Standard vesting clauses typically last four years and have a one year ‘cliff’. This means that if you had 50% equity and leave after two years you will only retain 25%. The longer you stay, the larger percentage of your equity will be vested until you become fully vested in the 48th month (four years). Each month that you actively work full time in your company, a 1/48th of your total equity package will vest. However, because you have a one year cliff, if one of the founders leaves the company before the 12th month, then he or she walks away with nothing ; whereas staying until day 366 means you get one fourth of your stocks vested instantly.
Let’s take the example of a company that has already gained some traction and raised a seed round from angels during its 24th month. Imagine the equity was divided 35% for yourself, 35% for your partner and 30% for the angel investors. Given the case that your partner walks away he will hold 17.5%.
What happens with the other 17.5%? Nothing. It virtually disappears after the company has repurchased it from your partner. When the company was registered, a fixed number of shares- usually 2,000,000- were issued to cover 100% of equity. If the previously mentioned example occurs, 350,000 shares vanish representing that 17.5%, bringing down the total to 1,650,000 shares. All the other shareholders benefit because now they have a larger percentage of the company.
Single Trigger and Double Trigger Accelerations:
If We take an optimistic example, there is a chance that your company gets acquired before the founders are fully vested. In this case, your vesting literally accelerates until all – or at least most- of your shares get vested. There are two types of accelerations: single trigger and double trigger.
Single trigger accelerates between 25% to 100% of your unvested shares in case your company gets acquired. In case less than 100% of your unvested shares become vested, your vesting period will remain unchanged. Double trigger acceleration occurs whenever your company gets acquired and at the same time your employment at the company gets terminated.
Now that we’ve seen how important vesting is for yourself and the well being of your company, the question is, when is the right moment to implement it. Usually entrepreneurs include vesting clauses when incorporating the company or raising a financing round. Nonetheless, I recommend doing it whenever you and your partners feel you have all officially begun working on the company.
Sometimes there’s a delay between working (coding, planning, etc) and incorporating the company. I personally recommend doing the not-so-official napkin vesting document so you are all on the same page from the very beginning.
The legal aspect of vesting varies significantly from country to country. So, contacting a lawyer to make a consultation is generally a good idea.
Image Credit: IT-Lagune Vorpommern