The Importance of Vesting Shares
When a business is set up, one very important consideration is the allocation of company shares. While this may sound simple, in reality it is anything but.
In terms of the initial founder grant, I have found that many founders dislike the idea of vesting shares – that is, at least when it comes to the founders themselves. Instead, they often prefer to grant these shares outright.
However, in reality it is highly likely that at least one founder will leave the company early on and go their separate way. Splits happen for a number of reasons – and not always because there has been a falling out. Some of the main reasons founders opt to leave a company are changing life circumstances such as sickness, the death of a loved one, childbirth and marriage; these events can leave a founder contemplating the direction of their life, and sometimes this direction is away from the company. Another main reason for leaving is the acquisition of a dream job that has come their way; whether it’s a dream location, the ideal title or a salary that is simply too good to refuse, the perfect job offer can cause a founder to walk away from the company they helped create.
While hostility may not be involved in the initial decision to leave, it often does crop up over the number of company shares the founder gets to retain – this hostility even occurs between family members. In many cases, the departing founder feels they have put in a lot of hard work setting up the company, have done their part and therefore deserve their shares – and perhaps rightly so, depending on the situation. However, the remaining founders often want the shares – or at least a portion of them – returned to the company. Why? Because they will be continuing to put in long hours, working hard to grow the company – they see it as an inequity when a departing founder gets to keep all of their shares.
The issue is foundational
The question everyone needs to ask is “why did the founder receive the shares in the first place?”
Were the shares granted for the founding company? Were they granted for working at the company? Were they granted for an idea or patent assignment to the company? Were they granted for money that was invested during the initial start-up phase?
In many cases, the answer is a mix of the above. Depending on the reason(s), a different number of shares should be allocated to each of the founders upon the company’s formation. These particular shares – i.e. those related to the foundation event – are the ones a founder should keep. The hard part is that these conversations are difficult to have, especially when the company is barely more than a name! For this reason, many companies overlook this important decision-making process at the beginning.
The main point here? When setting up a company, one of the first things that needs to be determined is who has brought what to the table and the corresponding value of each founder’s contribution.
The next step is a vesting schedule…
Once shares have been allocated in accordance with contributions made prior to the formation event, the next step is to decide a vesting schedule. In short, this means deciding how many shares should be earned by founders for future contributions to the company – and on what schedule they should be allocated.
Having shares on a vesting schedule means that when a founder leaves, they receive the portion of shares allocated for initial contributions – and then shares in accordance with the time they’ve spent at the company. Any shares that are for continued involvement in the company should be reclaimed by the company; they haven’t yet been “earned”. In principle, most people can agree this is fair.
For the company, a vesting schedule delivers the following benefits:
- It encourages founders to stay committed to the company to keep the shares vesting (at least for some period of time to be agreed upon).
- It prevents founders from leaving and reaping the rewards of a successful exit event on unearned shares granted outright.
- It allows the company to retain shares that may be granted to individuals replacing the departing founder.
For those outside the founding team, a vesting schedule delivers the following benefits:
- It demonstrates to investors that the founders have a long-term commitment to the company
- It can convince employees that the founders have a long-term commitment to the company
- It can build team attitude among employees and founders.
Most people agree that key members added to the company after the founder should be on a vesting schedule when it comes to shares. When founders are already on a vesting schedule, those new to the company are more likely to be receptive to this idea. It creates a team atmosphere and shows that their future contributions to the company are just as important as the initial founders’.
A small point perhaps, but when it comes to start-ups it’s important that everyone is putting in 100%!
Acceleration on exit – yes or no?
Once shares have been allocated for initial contributions and additional shares have been placed on a vesting schedule, the third point to consider is the acceleration of vesting shares upon a successful exit event.
At present, this is a hot topic; many attorneys are currently moving away from this concept in whole or part. Why? Well, the general consensus I’ve been hearing is the importance of creating an “investor friendly” company in order to receive funding.
Ultimately, an investor will earn a higher payout on a company that does not have acceleration in comparison to one that does – assuming everything else is equal. While this is true, it’s highly unlikely two companies will be alike in every other way – and what investor makes a decision based solely on acceleration?
In fact, just about every investor I know cares very little about acceleration.
Most investors make their decision based on the product, the team and the financial aspects of the company. Investors care about their ownership percentage in regards to the total authorized shares and future dilution risk; if there is an issue with acceleration, they may ask for a percentage or two more.
While acceleration of shares has fallen out of favor with many, I believe that not having acceleration may actually lead to long term harm.
When a company is at the exit stage and a purchase event is on the cards, at least some key employees will be retained by the purchasing company. Generally, the logic is they can provide the purchasing company with important knowledge related to company technology.
So where does acceleration fit in here? No acceleration – when coupled with an upcoming purchasing event prior to the next vesting period – can lead to key employees leaving the company (e.g. they may be offered a dream job by a competitor of the purchasing company). A key employee leaving has the potential to kill the sale deal or reduce the overall value – thereby affecting everyone’s value.
Yes, the risk of an employee leaving in this scenario may be small – but the loss of an exit event could be a disaster!
Conversely, if acceleration is available – making it possible to earn out the remainder of the shares for staying that extra month to complete the hand over – the key employee is more likely to stay. At the end of the day, acceleration may help to ensure that an exit event remains a viable option during an extended negotiation period.
Limiting acceleration – or forgoing it altogether – is an issue that can lead to friction between founders and key employees, and even between founders themselves.
When considering share allocation, vesting schedules and acceleration, it’s important to remember that your company is for you, not the investor. Use acceleration clauses to reward yourself and your key employees – if your company is a good investment proposition, the investors will still come knocking!
Case Study - App Launch
A client of mine – we’ll call him Randy – secured an amazing team of programmers to launch his app. The programmers were on a five year vesting program with 40% acceleration. Randy estimated a one and half year lead time on the app beta version, plus another six months before a public launch.
The estimates were incorrect: the app and the beta test were finished within just one year.
At this point, the programmers had received vested about 20% of their shares – with four more years on the clock before the remaining 80% were vested. Even though they signed the initial deal, the programmers were frustrated; the launch was successful and an exit was expected before the end of the four year period. Consequently, the programmers asked Randy to re-do the stock grants. The problem was the value of the company had increased significantly from day one and therefore re-doing the stock grants was going to be complicated and expensive.
Needless to say, Randy did re-do the documents to reward his team – but he did end up with unexpected legal costs and the tension between himself and the lead programmer continues.