We don’t want to see another startup go sideways due to bad decisions made by the founders regarding stock vesting.
If you regularly follow our blog, then you know that we emphasize the importance of making sure that all founders of the startup team are subject to stock vesting arrangements for their initial founder shares. (Click here to read one of our most widely-read posts, “Startup Founders Need Stock Vesting”.)
So how does stock vesting work and why does it matter to you and your startup?
How Stock Vesting Works:
In simple terms, the stock issued to a founder at incorporation is subject to a vesting schedule, meaning that incremental portions of the stock will vest over time as the founder’s involvement with the company continues (i.e., the founder continues to provide valuable services to the company).
For example, a vesting schedule may provide that an initial portion of the stock will vest after a specified waiting period has been met (i.e., a “cliff”), and then the stock will continue to vest in equal incremental amounts thereafter for a specified period of time. If at any time the founder leaves the company or stops providing services to the company while the stock is still vesting, then the stock will stop vesting upon his or her termination from the company, and the company then will have the right to repurchase from the founder any stock that has not yet vested.
Let’s do the math using a simple standard cliff vesting schedule and the following assumptions:
- Shares Issued to the Founder: 1,000,000;
- Vesting Schedule: 25% of the shares will vest after an initial 12-month cliff; and thereafter, the remaining 75% of the shares will vest in equal monthly amounts over the following 36-months; and
- No acceleration upon termination without “cause”.
Using the above vesting schedule, if the founder were to leave during the initial 12-month cliff period, then the company would have the right to repurchase all 1,000,000 of the founder’s shares. If the founder were to leave the company during the 25th month of the vesting schedule, then the company would have the right to repurchase 500,000 of the founder’s shares (which had not yet vested), and the founder would get to keep the other 500,000 shares (which had already vested).
Stock vesting is a simple concept. If founders continue to row the startup boat in the same direction, then they get to keep more and more of their shares as they vest. If a founder jumps ship, then the company can pull back some or all of their shares depending on the vesting schedule. The longer the founder stays, the more stock they get to keep.
Why Stock Vesting Matters:
No one likes dead weight, especially in a startup. As the startup team continues to work hard creating value for the company, an absent founder can create morale and motivation issues among the rest of the team.
Why should absent founders get to share in the potential upside of the company when they have stopped doing what they said that they would do to create value for the company? Put simply – they shouldn’t. And that’s why it is critical that each startup establish vesting arrangements among the founders from the start.
How to Navigate Stock Vesting Among Founders – A Cautionary Tale:
Difficulties often arise when co-founders start discussing the actual details of stock vesting. The following is a cautionary (yet true) tale of bad startup decision-making with respect to stock vesting.
The hotshot technical co-founder claimed that he was a startup superstar and he was especially focused on his stock ownership and wanted to cut back the stock vesting on his founder shares.
We deal with a lot of co-founders and we (and you should too) become concerned when a co-founder becomes hyper-focused on the terms of his or her deal and appears to lose sight of the larger startup opportunity. Red-Flag Alert: Dealing with stock ownership, money and officer titles often brings out a person’s true colors and it is extremely important to follow your gut in these situations – more often than not, your gut is right.
So, we raised concerns regarding the difficulties of dealing with this co-founder, but the other co-founders chose to remain optimistic and ignore the situation. They did not want to challenge the technical co-founder in light of his “significant role” in the company and the need to build the company’s technology platform.
Despite our repeated advice to, among other things, include standard cliff vesting on the technical co-founder’s shares (i.e., 25% of his founder shares vesting after 12 months, with the remaining 75% vesting monthly over the next 36 months), the other co-founders eventually acquiesced to the technical co-founder’s demands and allowed a significant portion of his shares to vest immediately at incorporation.
“I don’t see any problems with these vesting terms. John is a good guy and he really is committed to building the company and making the technology work,” they said.
Fast forward to four months after incorporation – the technical co-founder has not provided a single line of software code; he has decided to jump ship to a large public company; he is not returning repeated e-mails or calls from the other co-founders; and he has not signed any of the documents that would formalize his departure from the company, including the company’s repurchase of his stock.
The other co-founders are very upset and frustrated – a key member of the startup team has dropped the ball on a critical piece of the company’s technology development; the company is many months behind schedule in a market where first to market is critical; and they now need to scramble to find a replacement. To make matters worse, the technical co-founder still holds a significant ownership position in the company.
This situation would have been a lot better if the co-founders would have insisted on standard cliff vesting at incorporation, because four months later, they still would be able to buy back all of the technical co-founder’s shares at the low founder stock price. Instead, the company only has the right to buy back the unvested portion of the shares and he will continue to own a significant portion of the company (i.e., his vested shares at incorporation). Ironically, he will continue to hold shares for behavior that actually has harmed the company (and could jeopardize its existence).
Despite the blustering of the other co-founders, they have limited options to correct this situation. They cannot force the technical co-founder to provide something of value. He has moved on to another opportunity and he is not sitting down to write any code for the company. The company is an early-stage startup and it does not have the financial resources to hire litigation counsel to try to resolve this situation (which would be difficult given the stock vesting structure agreed to at incorporation) or to buy out the technical co-founder.
So how do you avoid falling into the stock vesting negotiation trap?
When it comes to navigating stock vesting among founders, you should remember the following tips:
1. Stick to your guns and keep it simple.
It is best to set standard-cliff vesting for the shares of the co-founders, or at least some level of cliff vesting that ensures a required level of commitment from the startup team members. Resist complicated or self-serving arrangements that do not protect the best interests of the company.
2. Make stock vesting the same for all co-founders.
It is easier for the co-founders to reach agreement on stock vesting when all of you can say “don’t worry – I have the same vesting on my stock.” Of course, there are situations when some amount of customization is appropriate, but first try the “all for one, one for all” approach.
3. Long-term commitment is what counts.
A co-founder should not have any issues with stock vesting if he or she really is committed to the startup venture for the long term.
4. Pay attention to co-founder behavior.
Many co-founders start to show their true colors (and ego!) when it comes time to make tough decisions (such as stock vesting). When a co-founder is difficult at incorporation, it often times is a sign of more startup problems in the future.
We applaud the startups that take the steps to put stock vesting arrangements in place for their co-founders. But don’t go half way. No one has a crystal ball to forecast the future and you really don’t know your co-founders until you start negotiating issues that affect them personally or you have to face difficult challenges together.
Be firm on stock vesting and don’t back down when it counts – your startup will be much better off in the future.
Check out our posts below to learn how to choose the right co-founder:
- Co-Founders: How to Choose the Right Wingman to Make Your Startup Soar
- Startups: How to Build Your Dream Team