Founders’ Stock – The Importance of Vesting

For most startup companies, vesting of founders’ equity – whether over time, based on achievement of defined business milestones, or some time/milestone combination – is a necessary means to properly align the interests among the founders and between the founders and the company’s future investors.

Simply put, “vesting” means that the founders must continue to earn their founders’ equity after the startup company is formed and the slices of equity pie are initially divided up among the founders.  Typically, this is accomplished by the company retaining a right to repurchase the founders’ equity at a nominal price (presumably, the same nominal price paid by the founders for their equity) with such repurchase right lapsing in portions over a period of 2-4 years and/or, in somewhat less common cases, upon achievement of certain business milestones (e.g., launch of beta version of website; development of initial product prototype; etc.).    Why is this important?   Let’s take two simple examples:

Example 1:    Four founders start a company and split the equity in equal portions – 25% each.  All four founders contributed a fair amount to the development of the business plan and the company’s technology platform prior to formation, but as is always the case there is an enormous amount of work still to be done before the company can hope to be funded.   Six months after formation, one of the founders leaves for a different opportunity (or any variety of other reasons).   Should that founder retain the same 25% ownership as the other founders who, presumably, will continue to work long hours in an effort to add value and build the startup?  Obviously, not.    The departing founder, as with the other founders, should be subject to vesting and a portion of the departing founder’s equity should be repurchased by the company, effectively reallocating the equity among the founders to achieve a different ownership allocation that reflects the continuing investment of time and effort by the founders who remain with the startup.

Example 2:   Same four founders as above, with the same initial ownership allocation but nobody has left.   An angel investor is considering providing a few hundred thousand dollars of seed financing to the startup company 9 months after formation.      Should the angel investor make this investment if the founders are not subject to vesting and, in a highly unlikely but still possible scenario,  one or all of the founders can depart with their initial equity stake intact leaving the angel investor with holes in the business team he invested in?  Obviously, not.   The angel investor has similar interests to the founders when it comes to vesting of founders stock.   At this early stage of development, the angel investor is investing much more in the founding team and their future efforts to effect a business plan and much less in what has been developed so far.  The angel investor will want, and will often demand, that the founders’ equity vest over some extended period of time to help ensure that the founders remain committed to the startup for years to come.

I kept the two examples above fairly simple to make the point, but even when the facts are fairly nuanced the point remains true – in most cases when there is more than one founder and/or when a startup will seek investment capital, vesting of founders stock is an important tool to properly align the incentives and interests  of the key players in a startup company.

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