Vesting of Founders’ Shares – Basic Concepts

© Juli jk5854 / flickr, CC BY-NC-ND 2.0

© Juli jk5854 / flickr, CC BY-NC-ND 2.0

In my last blog post, I presented some ideas for determining the split of a startup’s shares among the founders. Another question that should be addressed in this context is the vesting scheme for founders’ equity: basically, what happens when a founder leaves the company earlier than expected?

Why Implement Vesting?

Implementing a vesting scheme for founders’ equity is generally recommended for startups to address the following scenario: several people start a company together and agree on an equity split based on the value of everyone’s expected contribution. They work together for a while, they incorporate, work some more – and then, something unexpected happens and one of the founders reduces his / her contribution or leaves the company altogether.

In this case, is it fair that this founder gets to keep his / her full stake in the company? Probably not, at least not if the founder leaves very soon, and his or her contribution is much smaller than originally anticipated. However, if the founder already has made some important contributions over a significant amount of time, say for two years, he or she should get a lot of the allocated shares.

Vesting Schedules and Cliffs

A common solution for solving this problem is through a vesting schedule: basically, founders agree that they need to earn their shares through their contributions over time.

The team will have to define the period after which a founder’s shares are fully vested, i.e. the founder has earned the full amount of shares that was agreed initially. This period is often 3 to 4 years.  In addition, teams can define a minimum time period that’s required for a founder to earn any shares at all, for example 12 months. This minimum time period is called a cliff. A founder who leaves before the cliff date will retain no shares in the company at all.

Between the cliff date and the full vesting date, a vesting schedule needs to be defined: At which points in time do founders earn their next portion of shares? This can be done on a monthly basis, or quarterly, or even on a yearly basis. Shares are typically allocated on a pro-rated basis.

Let’s look at a scenario with

  • a cliff of 12 months
  • full vesting after 4 years (48 months)
  • and annual vesting on a simple, pro-rated basis

In this scenario,

  • if a founder leaves before contributing fully over 12 months, he or she gets no shares at all
  • at reaching the 12-month date, each remaining founder will earn 25% of the total amount of shares allocated to him or her – and they will stay at this level until the next milestone on the vesting schedule
  • at the 24-month juncture, another 25% are earned, same after 36 months, and finally, after 48 months, the founders who are still with the company will have earned the full amount of “their” shares

Both Founders and Investors Benefit

The whole vesting concept is relevant for two types of stakeholders in a startup:

  • for the founders themselves – it’s just a fairness thing: founders who leave at some point in time still get a fair reward for their contributions so far, but they do not get a free ride on the hard work of the co-founders who stay with the company
  • for future external investors – it makes the startup more investable: a vesting scheme creates an incentive for founders to stay on board. And since founders are usually key to generating a return on the investor’s money, incentivizing founders to stay on board makes it more palatable for investors to put their money into the startup.

Acceleration Protects Founders in Special Situations

However, what happens when the company gets acquired before the founders’ shares are fully vested and some founders get fired as a result of that? Without special protection, the fired founders would lose the unvested shares – since they are leaving the company (even though it is unvoluntary).

Founders usually get protected in that scenario through a clause that accelerates vesting of some or all of the outstanding shares in case of certain events, such as change of control of the company (“single-trigger acceleration”) or change of control plus getting fired as a result of that (“double-trigger acceleration”).

Summary

Implementing vesting for founders’ shares  is absolutely standard once a VC comes in, and it is recommended (and only fair for everyone involved) to already put it into the incorporation contract of the startup.

For a little more background on the basic concepts and on the situation in the US, I found the following articles helpful

The next question then is: does this apply to Germany at all?
And if yes, how would this typically be implemented in a German GmbH?
That’s what I’ll address this in my next blog post.

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