What is vesting? Companies can either issue stock outright or subject to vesting. Recipients of shares issued outright own these shares on the date of grant, with no risk of losing the shares in the future. By contrast, recipients of shares issued subject to vesting own some or all of the shares subject to forfeiture or repurchase if certain conditions are not met.
Founder shares: When starting a new company, founders must consider whether the shares they receive should be subject to vesting. Founders commonly expect to receive shares subject to no vesting because they own the company, came up with the idea and are often the only ones working on the company, often without pay. Even founders who expect their shares will be subject to vesting often prefer to delay implementation until a venture capitalist requires vesting in connection with a financing.
Best practice: In most situations, applying vesting on founder shares at the time of issuance is in the best interest of both the founders and the company for the following reasons.
Sometimes founders develop conflicts and wish to part ways. In addition, if a company struggles to get funded, sometimes a founder simply cannot afford the economic risks involved with a startup, and needs to pursue other employment.
- Avoids inequity. No matter what the cause, if there is no vesting in place and a founder leaves the company early on, that founder will still own all of the shares he or she was issued. Consequently, the share allocations that initially reflected the founders’ roles at inception no longer accurately reflect the work being put in.
- Avoids dilution. If the company needs to replace the work the departing founder was providing, the company will likely need to issue additional shares (or an option) to that founder’s replacement, resulting in dilution to the other stockholders.
- Protects against windfalls. If a founder leaves before his or her shares have vested, the unvested shares are either forfeited or repurchased by the company (usually at the de minimis price the founder paid). As a result, there is no “windfall” for a departing founder, and the shares returned to the company are retired.
Almost all venture capitalists or other institutional investors want to invest in a company where the founders have “skin in the game.” In many venture capital investments, VCs are investing in the founders just as much as the company idea. Investors want founders motivated to work for the company’s success, and therefore they typically will not allow a scenario in which a founder can simply resign at any time and still retain all of their equity.
Vesting terms. Founders should establish vesting terms before the company seeks outside investment. Having vesting in place not only shows investors that the founders have long-term vision, but often allows for more favorable vesting terms for the founders. If the founders wait to add vesting to their stock until they are in discussions with investors, the investors are more likely to dictate the vesting terms (e.g. longer vesting, fewer acceleration triggers). However, if the investors see that vesting provisions are already in place, the investors are less likely to demand changes to these terms as long as a meaningful amount of shares are still subject to vesting and the other vesting terms are at market.
As more fully discussed in 5 Important Considerations for Founder Vesting Schedules, there are different types of vesting provisions that a company can implement. Founders are well-served to consider these terms and implement mutually agreeable vesting provisions likely to withstand later scrutiny from potential investors.