Leesah, Brenda, and Dahlia are founders of LBD Inc. They agreed to split their equity into 25, 25, and 50 percent of 2000 shares. Consequently, Leesah will have 500, Brenda 500, and Dahlia 1000 shares. Although the three founders trust each other, they want to ensure that everyone puts in the required commitment and that nobody exits the Company to the detriment of the Company and other cofounders.
Accordingly, they all agreed to subscribe to a process where they earn their shares over time. This is know” as “cofounder vesting.” Not only will this process protect all the founders, but it would also protect investors from investing in a company prone to premature exits.
What is Co-founder Vesting?
Cofounder vesting is a mechanism or process whereby founders earn ownership of a company’s stock over, typically represented by a schedule showing the years or timeline over which the rights of cofounders accrue.
Ordinarily, founders own shares as soon as they invest in the Company, but a vesting schedule can be used to ensure ownership of those shares over a period of time and not at once. Usually, the cofounder vesting schedule is set over 48 months, equivalent to 4 years, where 1/48th of the shares are vested monthly.
The vesting schedule starts operating either upon the Company’s formation or closing of the first round of funding. In a standard schedule, stocks are not vested in the first twelve months to ensure that founders stay in the startup for at least a year. Hence, they are accrued and vested at the end of the first year. This initial period of accrual is know” as a “cliff”.
Why should cofounders consider vesting schedules?
- The vesting schedule encourages cofounders to stay and prevents them from prematurely exiting a startup with a disproportionate amount of equity. Consequently, it ensures that only those cofounders who have invested their time, intellectual property, and effort in a startup will earn the right company stock.
- To some extent, the cofounder vesting schedule protects the investors at the time of fundraising and protects
the Company against the premature exit of a cofounder. Hence, the cofounder vesting schedule is comparable to a prenuptial agreement that protects all parties against negative scenarios that might occur after dissolution. - Illustratively, still using Leesah, Brenda, and Dahlia as founders of LBD Inc. They own 25, 25, and 50 percent
of 2000 shares to be vested using a four-year vesting schedule. Leesah will have 500, Brenda 500, and Dahlia 1000 shares at the end of the four years. cofounder vesting schedule means Leesah will get 25% of 500 shares, which is 125 shares yearly for four years.
If Leesah waited until four years before leaving, 100% is vested on the fourth anniversary. If Leesah leaves on his own accord after a year, the unvested portion of 75% of 500, which is 375, reverts to the Company. The purpose of the shares reverted to the Company would allow the Company to retain and incentivize a replacement without a massive dilution of the other shareholders.
Types and Patterns of Vesting Schedules
There is no one-size-fits-all type of vesting schedule to use. A company may customize its vesting schedule based on its unique circumstances. You may find the variation in the kind of Company, industry, and size of operations. Consequently, vesting schedules may be customized to the taste of the Company.
- Reverse vesting schedule: Here, 100% of the shares are awarded to founders on day one. However, the Company has the right to buy back the shares if a founder exits before the vesting period ends. Hence, founders have 100% of the shares awarded but do not have total control until the end of the vesting period.
For example, Leesah has 500 shares with reverse vesting of 4 years. The reverse vesting schedule gives the Company 100% repurchase rights on the first day. The repurchase right allows the Company to access the unvested shares at a nominal fee. At the end of the first year, the Company will have the right to repurchase 75% of the 500 shares; at the end of the second year, 50% of the shares; and so on. Most of the time, founders and directors qualify for this type of vesting schedule. - Cliff vesting schedule: In a cliff vesting schedule, shares are usually accrued and not awarded until a certain date. The standard vesting schedule is four years, with a 1-year cliff that would not give any founder access to shares until after a year. The purpose of the cliff vesting schedule is to protect the business from claims of undeserving founders.
This is because, irrespective of the number of shares allotted to a founder, such an amount would be forfeited if he exits the Company before the completion of the cliff period. Consequently, the cliff period serves as a testing period for the founders. - Graded vesting schedule: This allows founders to receive incremental ownership of stocks over time till 100% ownership is attained. For example, you might receive 10%, 20%, 30%, and 40% of your shares annually for four years.
Where is the Vesting Schedule Addressed?
A vesting schedule is usually addressed in the Restricted Stock Purchase Agreements (RSPA) or the Cofounder’s greement. The RSPA is a written agreement that stipulates restrictions on the rights of the stockholders concerning the issued shares.
The RSPA is executed when the stocks are issued to cofounders and gives the Company the right to repurchase any unvested shares at a nominal value in the case of the exit of any founder. On the other hand, the Cofounders’ agreement is a contractual agreement between a company’s cofounders, which stipulates the rights, responsibilities, and liabilities of the cofounders.
You may include a vesting scheduleluded in any of these documents to detail the shares vesting to the cofounders.
What happens when a Cofounder exits the Company before all his shares are vested?
The consequence of exiting the Company depends on the vesting agreement and the reason for the exit of the cofounder. If a founder leaves or stops rendering services to the Company on his own accord, the unearned portion reverts to the Company depending on the vesting agreement.
Where the vesting agreement allows the Company to take back the shares, the Company would be said to have “a “R” purchase Ri” ht”.” Under the repurchase right, the Company may repurchase unvested shares at the same price they were issued to the founder. It is noteworthy that the longer the founder stays with the Company, the fewer shares it may take back if the founder exits.
In a situation where a founder is asked to exit the Company, it is usual for him to get some additional vesting on his stocks. However, it is essential to note that whether or not a founder would get another stock depends on the separation agreement.
What happens to the shares if the Company is acquired before the stocks are vested?
When the Company is sold before the stocks are vested, the founders would have accelerated the vesting of the cofounder’s shares. Again, this depends on the provision of whatever agreement the cofounder has executed, i.e., an RSPA or Cofounder Agreement.
The clause that provides for accelerated vesting lays down transparent expectations regarding the unvested shares in the event of the sale of the Company, and the terms of the agreement bind the parties.
Even though a cofounder vesting schedule is not compulsory to run a company, it is expedient for founders to include it in the agreements being executed between themselves.
It serves as a sufficient incentive to attract investors to a company, as investors have been found to request that the provisions be placed on the cofounder’s stock before investing in a company where no cofounder vesting is in place.
The cofounder vesting schedule prevents founders from exiting the Company, especially in its formative years.
It would be helpful to learn more about how this is executed exactly. For instance, if there are 2 founders with 50:50, vesting over 48m with 12m cliff – are all shares of the company unallocated as it is incorprated? Is that even possible to not have any shareholders? Or does one share go to each co-founder and the rest gets vested? Or how exactly does it work upon incorporation.
Then, when are shares finally allocated – only in certain events such as when a co-foudner drops or everything is vested?
May 22, 2023 at 6:44 amThanks!
Hi matt, thank you for your comment.
A co-founder vesting schedule is a common mechanism used to incentivize co-founders of a startup to stay committed to the company for a certain period of time. It’s essentially a time-based schedule that outlines when and how co-founders’ ownership in the company becomes fully vested. Let’s break down your questions step by step:
Initial Allocation at Incorporation:
When a company is incorporated, it typically starts with a certain number of authorized shares. These authorized shares can be allocated in various ways, but it’s common for founders to allocate some shares to themselves right away.
In your scenario with two co-founders, they may choose to allocate some percentage of the authorized shares to each of them when the company is incorporated. For instance, they might allocate 1 million shares each out of 2 million authorized shares, resulting in a 50:50 ownership split initially.
The remaining shares (in this case, 1 million) may be designated for the vesting schedule. These unallocated shares will vest over time as part of the vesting agreement.
Vesting Schedule:
In your example, the co-founders have a 48-month vesting schedule with a 12-month cliff. This means that for the first 12 months, neither co-founder has any ownership rights to the unallocated shares.
After the cliff period (12 months), co-founders start vesting their shares on a monthly basis. So, at the end of month 13, they each own 1/48th of the unallocated shares. The ownership percentage increases gradually each month until they are fully vested at the end of 48 months.
Allocation Events:
Shares are typically allocated to co-founders as they vest. This means that as each month passes, the co-founders’ ownership in the unallocated shares increases.
Shares can also be allocated in certain events or triggers, such as:
Co-founder Departure: If one co-founder leaves the company before their shares are fully vested, the vesting schedule usually dictates what happens to their unvested shares. For example, these shares might be subject to a buyback option by the company at the original purchase price.
Exit Events: When the company experiences an exit event, such as an acquisition or an IPO, any remaining unvested shares might accelerate and become fully vested for the co-founders. This can be subject to negotiation and the terms of the vesting agreement.
Shareholder Ownership:
From the moment of incorporation, both co-founders are shareholders of the company, and they each hold their allocated shares (1 million each in the example). The unallocated shares are subject to the vesting schedule and will gradually be allocated as the vesting milestones are met.
September 5, 2023 at 10:19 am