Let’s talk about Founder’s Stock: Should founders’ equity be subject to vesting?
Startups often issue Restricted Stock to the founding team (hence, often referred to as “Founder’s Stock). Restricted stocks are basically common stocks subject to a vesting schedule (along with other rights based on the agreement between the founder and the company). Under the vesting schedule, the startup has the Repurchase Right to buy back unvested shares if a founder leaves the company before the shares are fully vested. *
Due to the dynamic nature of startups, it is for the startup’s and founders’ best interest to figure out the adoption of vesting schedule at the very beginning of the startup’s life cycle.
A typical vesting schedule includes a cliff following a vesting period, over which the stock vests in monthly or quarterly increments. For example, a four-year vesting schedule of one-year cliff and three-year vesting generally means: buyback right/vesting for 25% for first 12 months after closing (the founder must be with the startup for a year to vest the first increment); thereafter, right lapses in equal monthly/quarterly increments over following 36 months. Often founders are given some retroactive vesting credit for work done before the vesting schedule adopted.
Why to adopt the vesting schedule?
It prevents the “free rider” from taking advantage of the other hard-working founders. A vesting schedule can help founders to ensure that each of the other founders continues to make contributions to the company (otherwise his/her position could be terminated and unvested shares would be repurchased by the company) and to maintain a stable core team together for a certain period of time;
It is preferred, if not required, by investors. A vesting schedule can help the investors to keep the key founders/employees in the company. When investors investing in a startup, they are investing in the core founding team. Investors, especially sophisticated angels and institutional investors, very often condition their investments on the execution of such restrictions on founders' stocks. If the founders play “wait-and-see” they run the risk that the investors will propose something more burdensome than the founders might have come up with on their own. On the other hand, if the founders adopted a reasonable vesting schedule voluntarily, most investors would leave well enough alone, even if that schedule is not exactly what the investors might have preferred.
*When founders agree to vesting restrictions, it is usually to their benefit to file a Section 83(b) election (for tax purposes).
** This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.