Posted by Early Growth
January 4, 2017 | 4-minute read (778 words)
Per recent surveys, over 80% of startups have two or more founders at the helm. Of those with one co-founder or more, only 40% define their relationship as collegial. That same survey reveals that 5% find their relationship strained and an additional 5% have fired a co-founder.
With multiple leaders in play, taking time to think about how equity is divided - as well as what expectations are between co-founders down the road - becomes crucial. Usually this can get overlooked until venture financing is being considered and pursued, but there a few reasons why doing it at the start is highly advisable.
A major initiative that helps is initiating vesting schedules , and setting up founder’s agreements which we strongly recommend getting in place from day one. Think of it as the prenup for the marriage of possibilities you’re growing.
A vesting schedule ties the awarding of founder’s stock to a timetable, delaying receipt of the full value and rights over a window of time, typically 4 years. In addition to the window of time to accrue the full amount there is often a one year “cliff” period where none has been awarded yet. After this cliff period, vesting may occur quarterly or monthly, in rare cases even daily.
In addition to how a vesting schedule staggers the stock ownership it also allows the company the ability to buy back any unvested portions at either cost or fair market value, whichever is lower at the time. This helps keep ownership of equity closely tied to the company’s best interests at this early stage.
Why is vesting important?
Two reasons vesting is important, and why cofounders agree to it are:
- Vesting provides incentive, as well as addresses if one or more founders should decide to part or is asked to leave. Rather than assign all shares at the get-go, vesting ensures that a founder who parts at an earlier stage does not retain the full benefits of the continued growth of the company without providing their participation. It helps keep skin in the game for the big win.
Vesting eliminates the risk of a “free ride”: a founder involved in the initial stages of creation or growth of the company who benefits from the continued work of others if they part ways early on. Vesting keeps cofounders on an established footing in terms of active commitment, something that can come into doubt during the lean initial phase.
The "One Year Cliff”
Due to the high-risk nature of startups, founders would do well to consider including a "one year cliff" in their agreed upon vesting schedule. While vesting in established companies generally begins right away for employees, a one year cliff is a well-known additional safety net. It helps to protect everyone involved in the startup from the “free-rides” mentioned above. Additionally, it protects by allowing growth (and potentially profit) to occur before equity is given out.
By implementing a one year cliff, founders’ shares will not begin to vest until one year has passed. After one year 25% will vest, then the typical 4-year vesting period can begin.
Vesting can be sped up in part or full by certain events. Some founders will want to negotiate on behalf of their best interests that full vesting occurs if they are involuntarily let go. Another possible “trigger” event is if the company is sold off.
In the case of the latter other concerns come into play. Naturally outside investors would think twice about an investment if a founder of value has such a single trigger incentive to leave. To handle this “single trigger” event a “double trigger” may be implemented instead, such as that the company must be bought AND the founder let go to undergo accelerated vesting. Usually this double trigger must occur within a determined window of anywhere from 9-18 months after the closing period.
With careful planning, these recommendations can create a winning structure that incentivizes all and keeps your team strong and well rewarded. Keep in mind that everyone's situation can be a little different; set up a consultation with your legal and financial teams to determine the structure that best fits you and your company.
- For companies anticipating and/or planning for fundraising: implementing a reasonably well-outlined vesting agreement beforehand demonstrates to venture capitalists and other institutional investors that continued and committed involvement from the founders has already been discussed and implemented.
Generally, investors will use this initial agreement as a basis for any new agreements drawn up, rather than reorganize it. This gives founders more of a foothold in creating the continued vision of their own company.