Founder Considerations for Time Vesting Stock
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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice. |
Vesting stock is stock which is granted to a holder that has contractual restrictions placed upon it until certain conditions are met. The “vesting” occurs when the conditions are met and the stock becomes free from the contractual restrictions. This mechanism allows for vesting upon the occurrence of certain performance metrics by the founder, or passage of time, and is used as incentive for the continued contribution of founders.
The convention in Silicon Valley is for founders, upon the formation of their corporation or upon Series-A financing, to enter into a four year vesting stock arrangement with a one year cliff. This means that one year from the vesting commencement date, 25% of the founder’s stock grant becomes vested and free from the corporation’s contractual right to repurchase the stock. Each month thereafter, an additional 1/48th of the grant vests, leaving the founder with a greater proportion of their stock the longer they stay with the company.
The four year vesting period with one year cliff is designed to prevent founders from bailing on a struggling startup and taking a huge equity chunk with them. For instance, if a founder left in the early months of the corporation, taking their equity share, and the remaining cofounders subsequently built a successful company which is acquired for several million dollars, the departing founder could become a millionaire despite abandoning the company. Additionally, if a co-founder cannot work well with the CEO and/or other co-founders, and is forced out, their vested equity will be based upon the amount of time they spent with the company.
This arrangement is popular, because investors and founders agree that the first year of a tech startup is formative and unprofitable, and that if any founder leaves during that time, they should not be entitled to any equity in the company which is made valuable by the execution of the business plan after their departure. Thereafter, the value of the company comes incrementally from the efforts of the founders, making the monthly vesting appropriate.
Popularity and convention should not justify the use of this arrangement without question, especially on the part of the individual founders. Founders would be prudent to question whether the right balance between their personal interests and the company's interests has been struck.
The four year vesting period with one year cliff comes with conflicting interests. This is a pro-company tool, because it requires founders to dedicate four years of time to receive their full equity stake. It also gives significant leverage to the CEO, who can fire a founder, terminating the vesting of their stock and allowing the company to repurchase the unvested stock. If the founder’s contribution to the company was cash and intellectual property, however, with minimal value added afterward, the four year vesting period might not be appropriate and can be dangerous for the founder. If the CEO decides to terminate the founder as an employee, and employment was the only way they satisfied their vesting conditions, the company can repurchase the unvested stock, leaving the founder with a fraction of their equity – 0% if terminated before the one year cliff. There are disincentives for doing this: threat of litigation, company morale, not being an asshole. However, certain incentives will outweigh those disincentives.
First, financial incentive is created when the value of the company grows at a pace faster than the acceleration provisions. If the company becomes profitable before the one year cliff, or grows quickly in the first four years, there may be financial incentive to terminate a founder and repurchase their unvested shares. Second, personal incentive is created when the founders’ relationships become strained. Third, business incentive is created when a founder stops contributing or becomes difficult to work with. The business incentives may be a “fair” reason to terminate a founder and repurchase their shares, but the personal incentive, and especially the financial incentive, may be less “fair”.
The best way individual founders can protect themselves is to stay vital to the company's success. Other ways are through terms of employment, accelerated vesting provisions, or setting the repurchase price at something higher than nominal. Any of these provisions should be drafted to appease future investors if they are intended to stay in place after financing. They should also take into account what leverage (i.e., irreplaceable IP) the individual founder brings to the table.