Startup Founders Need Stock Vesting

Stock Vesting Can Ensure Co-Founders Stick Around

Choosing a co-founder is sometimes analogized to choosing a spouse to emphasize the importance of good founder relationships to a startup’s success. Also, like marriage, founder love can sour over time, and breakups can be ugly.

But don’t worry, we’re not trying to get personal here (we’re not that kind of law firm). We’re talking about stock vesting – a tool that entrepreneurs should put in place when starting a company in order to make sure that your co-founders stick around for better, for worse, with financing or without. Fortunately for entrepreneurs, the perils of founder fallout can be avoided without the stigma of a prenuptial agreement.

Stock vesting is a huge point of emphasis whenever we counsel a group of entrepreneurs who are launching a company together. (Read our similar post: 5 Key Ways to Not Stink Up Your Startup).

Yet, we continue to come across too many entrepreneurs who take early shortcuts and from companies without proper legal foundations. Often, they choose a DIY or similar online incorporation service like LegalZoom to save money. Or they misapply the principles of “lean startup” and believe that they can fix the legal stuff later. Whatever the reason, treating co-founder relationships as matters of the heart and hoping everyone gets along in perpetuity is a recipe for trouble down the road.

As startup attorneys, we’ve seen things fall apart among founders with and without vesting arrangements in place. Take a few pointers from the founder’s stock vesting stories below, so that you can embrace founder love without throwing caution to the wind as you start and grow your business.

Stock Vesting Stories:

The Good: The Iron-clad Prenup

The first company started last year with five founders who agreed to put stock vesting arrangements in place for all of the founders. These founders realized from the start that, while they believed that they were in it for the long run, you never know how things are going to play out in the future.

During the first year, all but one of the founders worked tirelessly to grow the Company while the non-contributing founder completely checked out. The contributing founders recognized this lack of involvement and contacted us to navigate and remedy the situation.

Because the team put proper stock restriction agreements in place from the beginning, we were able to help the team avoid a potentially devastating situation. In less than 24 hours, we worked with the company to determine applicable stock vesting and ownership calculations, secure approval from the Board of Directors to repurchase the non-contributing founder’s unvested shares and complete the stock repurchase. By repurchasing the stock, the other founders increased their respective ownership positions in the company and quickly resolved a founder situation that was a drain on the company.

(Click here if you want to know the secret to starting your startup right.)

The Bad: The Seven Month Itch

Another company was formed by four founders in early 2013 using the LegalZoom service. The founders apparently wanted to save money by doing the initial legal work on their own, which has since cost them a lot of money in the long run.

After the company was formed, it was time for the founders to get to work. Three of the founders dedicated themselves to the company by working 60-80+ hour weeks for modest pay. The other founder, by contrast, participated in some early business meetings but quickly lost interest and did not focus his time and energy on the company. The other three founders felt confident that they could continue to build the company, although the company’s capitalization was plagued by the fact that the non-contributing founder had the same 25% equity interest as each of the other founders, and he wasn’t willing to give up any equity.

Not surprisingly, this unequal situation resulted in significant resentment towards the inactive founder and decreased morale. The three working founders also have spent significant time and energy processing the negative aspects of this toxic founder situation, which have diverted their attention from the other positive and lucrative activities of the business.

The initial corporate documents were never signed, initially because the founders did not prioritize the company’s legal foundation, and then because the toxic founder became uncooperative. A new set of cleanup corporate documents were prepared; however, as time went on and trust among the initial founders faded, almost three years later, it still is unclear when the corporate structure will be finalized properly. This situation also has affected critical company issues, such as the contribution and ownership of intellectual property and an increasing interest from outside investors to put significant capital into the company.

You can probably see where this is going – the three contributing founders are working to keep the company afloat, while the non-contributing founder will benefit greatly from their efforts if they are successful (hello, founder alimony).

The Bottom Line (so that you and your co-founders can live happily ever after):

1. Put stock vesting arrangements in place from the start to keep everyone motivated;
2. If someone is not carrying their weight, then take action and enforce the agreements that you’ve put in place, and
3. Get the right legal help to make sure you create iron-clad vesting arrangements.

Your Turn:

How have stock vesting arrangements helped save your startup? Did you have to pull the trigger and repurchase unvested shares?

Thanks in advance for your input, as it reinforces the importance of these issues to new entrepreneurs who are starting companies for the first time.