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.
LEGAL DISCLAIMER

Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.




Monday, August 5, 2013

Who Prepares a Financing Term Sheet - the Startup or the Investor?

Frequently, a startup that is starting the fundraising process feels that it should prepare a term sheet to take to prospective investors. Whether this is necessary and serves it well depends on two key factors (a) the type of investor that it is targeting, and (b) the stage/type of financing.

Type of Investor: Angels vs. VCs

Generally speaking, if a company is targeting angel investors, and especially if the idea is to get a group of angel investors to participate on substantially the same terms, it is fairly typical to approach these investors with a company-prepared term sheet.

Note, however, that in a bridge (convertible note) financing, and if the amount requested from each angel investor is small, it may be prudent to skip the term sheet step altogether, and to present investors with a draft convertible promissory note instead of a term sheet. This can save time and costs. In an equity financing, the simplest of which are still more complex than an average bridge financing, a term sheet may be unavoidable.

Approaching venture capital firms with a term sheet, unless it's for a follow-on financing on terms from the previous round, is unlikely to be beneficial. In fact, if anything, it might hurt the startup: the venture capital firm that will lead the round will prepare its own term sheet, but if the startups presented its own term sheet with concessions (investor-favorable terms), those investor favorable terms are very likely to be incorporated into the term sheet ultimately presented by the venture capital firm, even though it may not be a standard term for that stage of financing for the fund.

Stage of Financing: First Financing vs. Successive Financing

In the context of a rolling bridge financing, once the first investor has invested, the terms of that investment can be used as a benchmark with other investors that the startup targets. If there is a shift in leverage, making it easier to the startup to raise money (as it gains traction, for instance), the terms might stay substantially, but not exactly the same, with the valuation cap increasing or falling away entirely, as an example.

The first time that a company raises funding through the sale of equity (stock financing), negotiating the right terms is of utmost importance. The bulk of the terms will stay the same, or get worse, through successive rounds. The only term that will, hopefully, improve is valuation. But the control terms will, at best, stay the same, and very commonly will get more complicated and cumbersome as more investors are involved.

When a startup is doing well, and has supportive existing venture capital investors, who are going to invest in the new round, it is quite typical for the startup to mark-up the term sheet from the last round of financing and to use that as the starting point for negotiations with the new investor. The support of the existing investor cannot be understated in this situation. When Accel, Kleiner Perkins, Sequoia or Andreessen Horowitz (it certainly helps to have a first tier VC as an investor) tell the new investor that they like the terms from the prior round and expect them to stay substantially the same in this round, that's what happens.

Where Does a Startup Get a Term Sheet?

Of course, your attorney will be happy to provide you with a term sheet, drafted for your specific needs. No amount of reading insightful blog posts, such as this one, will fully replace consulting with a knowledgeable startup attorney. But if you are not going to be using your attorney for this, or if you would just like to educate yourself about term sheets before talking to an attorney or to investors, here are some resources:

  • The Series Seed term sheet is a good template for a very simple first equity financing. If your investors agree to it, you can save yourself time and money by using the other Series Seed forms as well, which are much simpler than, for instance, the NVCA form documents and better tailored to a financing involving angel investors and a small amount of capital.

  • Wilson Sonsini has done a good deed and created online term sheet generators for convertible note financings and equity financings. In order to generate a term sheet using one of these generators, you have to answer a number of questions, some of which may be difficult if you are not at ease with the vocabulary and the nuances of financings. However, at the very least, it's a good way to see what questions you should be asking yourself and your investors about the terms of your transaction.

  • Not to be outdone by Wilson Sonsini, Orrick also has put out its term sheet creators for convertible note financings and preferred stock financings. If you try both Orrick's and Wilson Sonsini's, let me know in comments which one you like better and why.

    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.
    LEGAL DISCLAIMER

    Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.

    No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).

    Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.

    Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.

    Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.