Founder Vesting: Five Tips For Entrepreneursby Scott Edward Walker on September 10th, 2009
There have been several relatively recent blog posts with respect to the issue of founder vesting, including (i) two posts by Chris Dixon, a smart angel investor and co-founder of Hunch, here and here; and (ii) a post by Mark Suster, a successful entrepreneur turned VC (and another smart guy), here. There are also a number of solid older posts addressing this issue, including (i) Venture Hack’s post here and (ii) Brad Feld’s post here. The purpose of this post is three-fold: (i) to weigh-in from the legal side; (ii) to try to pull the foregoing posts together in an organized manner; and (iii) thereby to provide five practical tips to entrepreneurs in connection with founder vesting.
1. Impose Reasonable Vesting Restrictions Upon Incorporation to Address Issues between or among the Founders. If there are two or more founders, they should impose reasonable vesting restrictions on the stock issued to them at the time of incorporation because, in most cases, the stock has been issued not only for their services or property (e.g., technology) relating to the conception of the venture, but also for their continuing commitment and efforts. Indeed, it would be inherently unfair for one of the founders to quit the venture after a few weeks or months, 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; however, it may be appropriate (depending upon the founders’ respective contributions and relationship) (i) to impose a one-year “cliff” and/or (ii) to vest a portion of the stock “up front.” Vesting restrictions are addressed in a restricted stock purchase agreement, which each founder would be required to execute 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.
2. Impose Reasonable Vesting Restrictions Upon Incorporation to Address Issues with the Series A Investors. A vesting schedule will usually be required by the investors in connection with a Series A 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. If a founder has strong leverage, the best deal he can likely negotiate with respect to a vesting schedule is the following: approximately 25% of his stock deemed vested at the closing of the Series A financing and the balance of the stock vesting on a monthly basis over the next three years.
3. Make an “83(b) Election”. Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock (i.e., stock subject to forfeiture) to the grant date, rather than the vesting date. As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale. Absent an 83(b) election, any subsequent appreciation of the stock would be subject to ordinary income tax rates at the time of the vesting — which could create a situation where the founder has significant tax liability, but no cash to pay it. It is therefore advisable (subject to consultation with tax counsel) for any founders receiving restricted stock to make an 83(b) election with the Internal Revenue Service (the “IRS”). Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable).
4. Push for Acceleration Upon a Change of Control. As Brad Feld aptly points out: “Acceleration on change of control is often a contentious point of negotiation between founders and VCs, as the founders will want to ‘get all their stock in a transaction – hey, we earned it!’ and VCs will want to minimize the impact of the outstanding equity on their share of the purchase price.” From the potential acquiror’s perspective, full acceleration is generally not a good thing because the founders have no incentive (i.e., “skin in the game”) going forward, and the acquiror will thus have to come out-of-pocket to re-incentive them. Accordingly, a common solution is for the founders to push for either (i) partial acceleration upon a change of control (i.e., some percentage of vesting is accelerated, with the balance continuing to vest perhaps at an accelerated rate provided the founder remains employed by the acquiror); or (ii) as Chris Dixon suggests, full vesting upon a change of control after a transition period (e.g., after the founder remains employed by the acquiror for one year). The investors will likely push back and will generally only agree to a partial acceleration in the event of a “double trigger” (e.g., a change of control and a termination without cause within one year). Founders should push back on this and require full acceleration in the event of a double-trigger. Bottom line: this issue must be resolved in the context of the negotiation of all of the significant issues and will obviously depend upon the parties’ respective bargaining power.
5. Discuss Partial Acceleration Upon a Termination Without Cause. Another potential hot button is what happens if a founder is terminated without “cause” or he quits for “good reason” (e.g., his job responsibilities have been substantially diminished). This is a tricky issue. Obviously, from an individual founder’s perspective, there should be full acceleration of all of his unvested shares if he is terminated without cause or he quits for good reason because he has, in effect, been denied the opportunity to “earn” his stock. From the investors’ and the other founders’ perspective, full acceleration is a problem for two significant reasons: (i) startups need the flexibility to make personnel changes if things aren’t working out, and it is difficult to establish “cause” or negate “good reason” from a legal perspective (and startups certainly do not want to expend time and money litigating this issue); and (ii) a replacement will likely need to be hired and additional stock/options will thus need to be issued. A compromise position, which may be amenable to all of the parties, is a partial acceleration akin to the amount of severance (e.g., six-months’ acceleration).