Startups rarely (if ever) go perfectly to plan; things often go wrong and life throws up all sorts of scenarios that can have an impact. Sometimes things get so bad that founding teams split up.
The chances of this are often increased where you have large founding teams formed in a short period of time (ie. when the team haven’t really worked together before). Regardless of the size of your team and the likelihood of a founder fallout, how big an impact such a split has on your startup can make or break it. This is where vesting comes in.
One of the primary drivers behind the idea of vesting is to help reduce the impact of a co-founder leaving by ensuring they don’t leave with a disproportionate amount of equity. How this often works is that founder shares vest over time. So, as a founder you are 100% vested when you ‘own’ 100% of the shares that have been allocated to you.
For example (very simplified), if you have a straight-line (meaning you vest daily a proportion of shares) vesting schedule in place over four years and you started vesting two years ago you will have vested 50% of the shares allocated to you.
Vesting is important to ensure that, should a co-founder leave during the vesting period, there is enough equity left in the company to adequately incentivise the remaining founders and team. This is even more important when you think that the company will likely have to hire someone to replace the departing co-founder and they will likely want a chunk of equity.
Often vesting is thought of as solely an investor protection provision requested at the time of a fundraising round. I always advise founders not to think of it purely this way because, as described above, it helps protect against a potentially catastrophic impact of a founder fallout situation for all stakeholders (founders and investors).
Personally, I’m always impressed with founders who think about vesting early on and appreciate the theory behind it. It’s not necessary to worry about the detailed mechanics, your lawyer will incorporate this into the long-form legals when it is required (usually at a fundraising round).
Often vesting schedules are set over three to four years with some form of a cliff after one year. This means that an amount (often 25%) is deemed to be vested only after one year of continued work (the ‘cliff’), with the remainder vesting incrementally on a straight line basis over the following two to three years. For example (assuming a four-year vesting period):
- 0–12 months = 0% vested
- 12 months = 25% vested
- 12–48 months = straight line vesting (ie. you vest a small amount each day)
- 48 months = 100% vested
All sophisticated investors will request some form of vesting schedule should you raise a round of financing from them, so it’s worth giving some thought to this when you are starting out.
Vesting schedules aren’t only relevant for founders, they are also important to consider when granting share options to employees or advisers. Most high-growth companies will incorporate some form of equity consideration as part of a package to incentivise high impact employees or advisors. For many of the same reasons highlighted above, it’s advisable for founders to make any share option grant also subject to a vesting schedule. The type of vesting schedule may differ for founders, employees or advisors with the later sometimes set subject to certain milestones being hit.
The actual implementation of a founder vesting schedule is usually dealt with in a company’s articles of association. The articles will contain the specific drafting about how the vesting schedule shall apply to each founder’s shares. A company’s articles are typically amended to incorporate these provisions around the time of a funding round at the request of the investor leading the round. This ensures that the vesting schedule is legally enforceable and the process by which a founder’s equity shareholding is dealt with in the event they leave the company during the investment period is clear.
Should options granted to early employees be subject to a vesting schedule then the mechanics of this will generally be dealt with in the company option scheme and the terms of each employee’s respective employment contract.
There’s additional complexities to be considered and that haven’t been touched upon here - in particular circumstances around founders leaving ie. good leaver, bad leaver, acceleration on exit etc. It goes without saying how important it is to fully understand any legal documents and the implication of the terms contained therein.