Founder Vesting

Two of the most important questions for companies being launched by more than one founder are: should founder shares be subject to vesting and, if yes, on what vesting schedule? For this post I assume the legal entity being formed is a corporation, which is the standard entity for a startup company.  But, the analysis applies equally to a LLC or other legal entity. I will also use the term “vesting”, which is the term that applies to stock options granted to employees and advisors which become exercisable over time. But, since stock is typically issued to founders at the incorporation of the business, the legal documents will refer to the corporation having a repurchase option on the stock issued to the founder, which lapses over time.

Founders I meet typically are aware of “founder vesting” but often think of it as an unfortunate demand likely to be made by an early stage investor, whether a more sophisticated angel or a seed stage professional investor.  In fact, the key beneficiaries of founder vesting are the remaining founders when one founder departs. The reason founder vesting is important, but often underappreciated by founders, is that founders tend to underestimate the possibilities of both a break in a relationship (like people in personal relationships) and the time involved in building a sustainable organization with enduring value. In SaaS businesses, for example, the founding team may have identified a great market opportunity, worked hard and efficiently, have a strong product, and still be at a $1M annual recurring revenue run rate three or more years after starting work on the business.   

Let’s use an example of a company with three founders, each 1/3rd owners, each playing a critical role (e.g. CEO, CPO and CTO). If one founder leaves after 2 years, the remaining founders, in the middle of the hardest part of the startup journey, will likely deeply regret not having founder vesting. I’ve seen on several occasions regret build into long standing resentment, which creates negative energy and distraction for the business, and may require a complex recapitalization at a later date that usually does not fully address the desires of remaining founders. In addition to the departed founder “free-riding”, the role the departed founder played needs to be filled. Unless the startup is a true rocket ship early on, a quality replacement with market knowledge will expect a decent chunk of equity to join the team, further diluting all shareholders, including the remaining founders.

For founders that need convincing to accept vesting of shares in the company they are starting, reluctant acceptance of vesting is not the end of the conversation for counsel. Almost inevitably founders that initially resist founder vesting, once convinced, push for vesting periods that are too short to accomplish the purpose of vesting. Numerous times I’ve had teams come back to me and say “OK, we get it, we’ll do vesting. We’d like 50% of our shares vested up front, and the rest vested monthly over 24 months”. Like with most things in life, half-measures don’t work. Generally, most people avoid conflict. Even if a founder shows him or herself early to be a poor fit, the odds of the other founders taking action within the first year are low. People rightly put in effort to make difficult interpersonal and job situations work. So, under this example, a founder who has added limited value and either quits or is forced out 12 months after starting the business leaves with ¾ of his or her shares owned free and clear. Problem not solved. 

I recommend a minimum of 4 years of vesting of at least 80% (and ideally 100%) of the shares, and encourage founders to consider 5 or even 6 year vesting schedules, given the time it takes to build a strong business. The average time from venture funding to IPO (and remember most companies are started a year or even two or more before venture funding) is over 6 years. Many great businesses don’t reach a full liquidity event (IPO or sale) until 10 years or more after incorporation.