Close to the Vest: Founders’ Stock and Vesting
December 31, 2013
Your startup was launched only a few months ago and your co-founder has just informed you that he’s leaving. It hits you that your co-founder just walked out the door with 50% of the equity in the company. Oops.
Founder breakups are not uncommon, but what happens to the exiting founder’s stock will depend on whether or not the founders had agreed in advance on a vesting arrangement. Essentially, vesting of stock means that all or a portion of it effectively gets “earned” either over time or upon achieving milestones or a combination of both. The purpose is to align incentives: encourage founders to remain with the company and avoid the unfairness inherent in walking away with unearned equity. The arrangement is typically effectuated with the right of the company to repurchase the individual’s unvested shares, usually at some nominal price.
So if the company could be given the right to repurchase unvested shares for a nominal amount, why not just issue the shares at each vesting interval instead of issuing them all at the outset and then repurchasing shares that haven’t vested? The answer is that issuing shares subject to vesting creates a significant tax planning opportunity for the shareholder. Shareholders are typically better off being taxed when shares are least valuable, i.e., at or within a short period following formation. Although shares issued under a vesting schedule are subject to a substantial risk of forfeiture and would therefore generally be taxed as they vest, shareholders can choose to be taxed at the time of issuance, i.e., when the shares are valued low, by filing a simple Section 83(b) election with the IRS.
Another reason for founders to agree to subject their shares to vesting is that VCs will typically insist on it at the time of their investment in order to incentivize founders to stay, and VCs are more likely to agree to preexisting vesting arrangements if they are reasonable.
Vesting arrangements involve several variables, each of which should be considered based upon the unique facts and circumstances of each case. The three main variables are vesting schedules, repurchase price and acceleration.
Vesting schedules can be either time based, milestone based or a combination of both. Careful consideration should be given to immediate vesting of a portion of the shares allocated to a founder to the extent that founder has made any significant pre-issuance contributions to the startup. Vesting schedules should also be driven by founders’ expectations of their respective efforts going forward. The most common arrangement is four-year vesting with a one-year cliff, meaning that 25% of the individual’s total share allocation vests after one year, with 1/48th of the total shares vesting every month for the next 36 months. Of course any significant pre-issuance contribution by a founder might justify vesting a certain percentage right away. Milestone-based vesting (e.g., some percentage of shares vest upon the development of a prototype) might be appropriate for a founder who is being relied upon to focus on development of the company’s technology.
Under any vesting arrangement, the company has the right to repurchase any shares that have not yet vested at the time of termination of employment. The repurchase price in most vesting arrangements is some nominal amount per share (e.g., $0.0001 per share), which is intended to be the amount paid by the founder, regardless of the nature of departure. Arguably, upon terminations by the company without “cause” or by the founder for “good reason”, the vesting agreement should provide for repurchase at fair market value at the time of repurchase as determined by the board of directors in good faith or as otherwise determined by the parties.
Founders usually negotiate for accelerated vesting upon an acquisition or change of control of the company. Investors resist this on the theory that it would make the company a less attractive acquisition candidate inasmuch as a buyer will want to know that key employees will continue to be incentivized to remain with the company at least through some transition period. A compromise here would be something called double trigger acceleration: unvested shares would vest automatically if the founder is terminated (typically without cause) within some period of time, usually six months to one year, following a change of control. Most acceleration provisions call for vesting of 100% of unvested shares upon the triggering event. A better approach might be to equate the percentage of acceleration with severance. If the individual is entitled to severance of 50% of base salary upon a termination following a change of control, perhaps the vesting of 50% of unvested shares should be accelerated.