“Ask the Attorney” – Founder Vesting

by Scott Edward Walker on January 6th, 2010

Introduction

This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

The goal here is two-fold: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain english (as opposed to legalese).

Question

My two friends and I are launching a new venture, and we have agreed to split the stock ownership equally.  The problem is that I’m not sure how committed they both are.  What happens if one of them leaves in a few months?  Does he still get to keep all of his stock?

Answer 

This is a common issue among founders.  I strongly suggest that you create what is called a “vesting schedule” upon the company’s incorporation, which would require stock ownership to vest over time.  Indeed, it is customary to impose reasonable vesting restrictions on founders’ stock because the stock has generally been issued not only for the founders’ services and/or property (e.g., software) relating to the conception of the venture, but also for their continuing commitment and efforts.  As your question implies, it would be inherently unfair for one of the founders to quit the venture after a few months (or weeks), but still be permitted to keep all of his stock.

The most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis.  Sometimes, however, it may be appropriate to impose a one-year “cliff” (i.e., the founders would not get their first 25% unless they have remained with the company for 12 months) – particularly where the founders don’t know each other or don’t have a history of working together.  Another possibility is to vest a portion of the stock “up front” (i.e., one or more founders would receive a certain percentage immediately) – usually as a result of their contributions to the venture prior to the issuance of the stock or date of incorporation.  Vesting restrictions are addressed in a restricted stock purchase agreement, which each founder would be required to sign and which would grant the company the right to repurchase any unvested shares (at the initial purchase price) at the time of the founder’s departure.

In addition, a vesting schedule will usually be required by the investors in connection with the first professional (“Series A”) round of financing.  Accordingly, it would be prudent for the founders to impose a reasonable vesting schedule upon incorporation for a second reason: if a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place.

If the founders have not established a vesting schedule or a large percentage of the founders’ stock has already vested (due to either the lapse of time or the unreasonableness of the schedule), the investors will impose their own vesting schedule, which means that vesting will, in effect, force the founders to “earn” stock they think they already own.  This may be a difficult pill for the founders to swallow; however, from the investors’ perspective, this is a significant issue — i.e., they believe they are paying for the founders’ long-term commitment and “sweat” — and thus one that they will rarely give-up.

Finally, there are often issues relating to the acceleration of vesting that need to be addressed among the founders, including (i) what happens if the company is sold and (ii) what happens if a founder is terminated “without cause.”

Conclusion

If you would like to learn more about founder vesting, you can check out my post Founder Vesting: Five Tips for Entrepreneurs; and if you have any questions that you would like answered with respect to any legal issues, please send them to me through the comments section of this post.

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