Saturday, August 24, 2013

Should Founders’ Shares be Subject to Vesting

In the startup world, contributors are frequently incentivized with shares of stock in the venture to align their interests with those of the startup. These shares sometimes represent a significant percent of the company’s total capitalization, especially in the early days, when there are few contributors and the contribution of each contributor is therefore that much more significant.

Who Should Have Vesting. Every contributor’s shares in a venture should be subject to vesting. I use the term “contributor” here because these concepts apply not just to the founders, or the early employees, or the consultants, but to anyone in a startup who is incentivized by a grant of shares, or the right to purchase shares (known as a stock option).

Vesting Definition. Vesting is the process, whereby shares or stock options granted to a contributor are, in effect, earned over a period of time, such that they may be repurchased or cancelled, as applicable, in whole or in part, from the contributor if his involvement with the venture does not continue for the entirety of the vesting term.

Vesting Term. Vesting should be imposed over a term, typically calculated in months, that is the shorter of (a) the period over which the contributor is expected to meaningfully contribute to the venture, or (b) 48 months.

No Cliff on Founder Shares. There is usually no cliff on founders’ shares—their shares vest monthly from the beginning and frequently they get “credited” in their vesting for the number of months that they worked on the project prior to getting their shares. For example, if a founder worked on his startup for a year before he was issued shares, it is not uncommon for his shares to be 1/4th vested up front, and the remaining shares to vest monthly over 36 months.

Cliff on Shares by Other Contributors. By contrast, non-founder contributors typically have what is known as a “cliff” on their vesting—a block of time up-front, during which they are tested to make sure they are a good fit. At the end of the cliff, which is usually a year for full-time hires and may be shorter for other contributors, a portion of the contributor’s total share grant, usually proportionate to the ratio of the cliff period to the entire vesting period, vests at once. However, if the contributor’s services to the company are terminated before the cliff runs out, none of the shares vest.

Vesting Acceleration. Sometimes the vesting of founders’ shares or the shares of other top contributors, accelerates in full or in part upon the happening of certain events. Most typically, vesting accelerates, if at all, either on a single trigger (which can be termination of the contributor or acquisition of the company), or on a double-trigger (termination of the contributor in connection with an acquisition of the company). Vesting acceleration is a heavily negotiated term whether with investors, new hires, or an acquirer of the company.

Why Do We Need Vesting. There are several good reasons why it is a very good idea to impose vesting on the founders’ shares.

First of all, investors insist that the founders’ and other contributors’ shares be subject to vesting. So if the founders do not subject their own shares to vesting in the beginning, when they engage with investors, imposing vesting on founder shares will almost invariably be one of the conditions to the investment. Founders who impose vesting on their own shares may get better terms than those that investors will require of them. But as long as those terms are reasonable, investors will typically not require founders to amend their vesting terms.

But even if investors are not in the picture, as long as there is more than one founder, imposing vesting on all founders protects the company and its viability. Let’s consider an example to see why vesting can make or break a company. All names, characters and specifics are completely made up, but situations like this in an assortment of variations come up all the time.

    GameFriends is a startup developing a new social gaming application. Jim does the coding and Rhonda does the graphics. Jim and Rhonda have known one another since college and came up with the idea over coffee one day. They started working on GameFriends a few months ago and agreed that everything would be split fifty-fifty between them. They have not incorporated the business yet, waiting to complete a game first.

    At a gaming conference, Jim and Rhonda meet Pete. Pete has an MBA from Stanford and did a summer internship at a venture fund. Pete is a gamer and after spending several long weekends talking to Pete about their vision, they decide that they would benefit from Pete’s business expertise in getting GameFriends off the ground. Pete agrees to join the company for a 20% stake, but insists that they need to incorporate the venture and formally issue shares. Everyone agrees. The founders incorporate the venture with 10,000,000 authorized shares of Common Stock, of which Jim and Rhonda hold 4,000,000 each and Pete holds another 2,000,000.

    Jim and Rhonda trust each other, so they decide they don’t need vesting on their own shares. Since Pete is new, they decide to have his shares vest monthly over one year.

    In the meantime, Rhonda’s sister, who is working on a children’s book, asks Rhonda to help with illustrations. Rhonda can’t say ‘no’ to her sister, she’s always really liked doing children’s books illustrations, and her sister promised to pay her! She decides she can help her sister, while continuing her role with GameFriends.

    Unfortunately, she isn’t able to do both well. She takes longer to respond to Jim’s emails and lets his calls go to voicemail because she feels bad about not having her deliverables ready when she promised.

    After a couple of months, Jim and Rhonda have a heated discussion, where Jim accuses Rhonda of not being dedicated to the project and Rhonda defends herself and finds fault with Jim’s own coding efficiency, which she thinks is to blame for their first game not being ready yet. Rhonda is upset and decides to leave the project. She has 40% of the company at this time. In order to finish the project, Jim needs to bring on another graphical artist. At a high school reunion, Jim runs into a good friend of his, Kevin, who would be perfect to replace Rhonda. Jim wants to bring him on and offers him 4,000,000 shares in the company, the same number of shares that Rhonda received. Kevin is interested, until he realizes that a large percent of the company belongs to a former co-founder, who is no longer involved.

    Here is what the capitalization looks like: Jim and Rhonda each have 4,000,000 shares, Pete has 2,000,000 shares and Jim would like to offer Kevin 4,000,000. If Kevin accepts, he will have approximately 28.5% of the company, but so will Rhonda, who invested only a few months of her life into the project.

    Kevin turns down the offer. When Pete realizes that there is not anyone to replace Rhonda, he leaves as well. At this point, 6 months have passed since he joined the company. Because his shares are subject to vesting over 12 months, half of his shares have vested. The company repurchases the remaining shares.

    Jim is now the only one left, trying to salvage the business. Rhonda and Pete together hold 5,000,000 shares and Jim holds the remaining 4,000,000, or roughly 44.5%. It is very difficult for Jim to bring on either a new graphic artist or a new business person because such a large percent of the company is owned by people, who are not contributing to the business. Jim closes the company and accepts a job at Zynga.

GameFriends could have avoided this untimely demise, if Jim and Rhonda had not made critical mistakes at the formation stage. Had Jim and Rhonda’s shares had vesting on them, then, when Rhonda left, GameFriends could have repurchased most of her shares, which could have gone to Kevin instead. Pete’s shares were subject to vesting, but the vesting period was too short, which is why he ended up with over 10% of the company when he left 6 months later.

When shares are granted to contributors, the expectation is that they will continue to contribute for some significant period of time. If they don’t, their shares have to be made available to other contributors, who will be brought in to take their place. Otherwise, those who stay with the company suffer dilution, when additional shares have to be issued to attract replacement contributors, and the recruiting process itself becomes very difficult.

For this reason, to improve a venture’s chances for success, it is the industry practice for the founders’ shares to be subject to vesting.

Happy company making!

Inna


White Summers  Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.
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