This article is written by Shreya Kalyani, pursuing a Diploma in Business Laws for In House Counsels from lawsikho.com.

Introduction

Vesting is a scheme, through which founders or any other members of a start-up venture accrue rights over their stock ownership, not forfeited by the company and which helps in deciding how the shares will get distributed after any founder leaves the venture. It is included as a clause in the co-founders’ agreement that enables the company to buy back a percentage of equity from co-founders share if they leave the company within a shorter period from the incorporation of the venture. It is done through a vesting schedule which determines when the founders would have full ownership over their equity and how much of it will be retained by the company once they leave. Without vesting, a departing co-founder may walk away with all his shares and stock, and leave the responsibility of all the work and risks of venture with the rest of the founders. 

Need for founders vesting

It becomes important for start-ups having multiple founders, critically as a protection against all the negative scenarios that may arise in the future, for all the other founders who are working for the entity to make it successful. If one co-founder leaves the company in early years and keeps the same amount of equity without actually putting any effort into the working of business, that will be unfair to the shares of existing founders. For example, consider a business getting started without a vesting scheme in place, and there are two founders. Founder A and founder B both have equally 50% of share in the business and both put in all their effort and hard work for the growth of business, but one day if Founder B decides to leave he may leave with that 50% of ownership in the venture while leaving the complete burden of running the company with Founder A. If business succeeds in the future, the benefits of such fruits of success will be enjoyed by Founder B also, without having to actually work for it. Therefore, the vesting clause becomes important for the protection against such scenarios for the existing founders. More often than not, the founder’s departure is a voluntary phenomenon and may be based on unplanned circumstances which completely makes such events uncertain. It can also arise, in cases where there are multiple founders and due to certain issues they split up, which can impact the company profoundly. So also in such scenarios vesting is what is preferred as a protection. 

What is a cliff period

A cliff period means a founder would not get anything other than the capital contributed by him in the venture, until they have worked at the business for a certain amount of time. For example, if co-founders have agreed for a 5 year vesting period with a cliff of 1 year, that means that the co-founder will receive his share of equity over a 4 year period and must work for the company for one year to start receiving 25% of their equity. And if the founder leaves the company even before the expiry of 1 year, then he will not get anything out of his share of equity.

How does vesting work

Usually start-ups have 4-5 years of vesting period for the founder’s shares with a cliff period of one year. Since companies these days might even take longer to reach the growth pace, so the vesting period is kept longer to maintain the long term incentive of the vesting mechanism. The founders agree to a vesting period and a vesting schedule. For example: If there are two founders both having 45% of share each in the company. Now assuming 5 years as the vesting period and following as the vesting schedule:

Here the 1st year is the cliff period within which if any of the founders leaves, he will not get anything out of his share of equity. From the second year onwards 25% of his holding would start vesting in him, which means that if he leaves the company in 2nd year, he will only be entitled to 25% of his share i.e. 25% of 45 which will be 11.25% share in profits of the company. Founder A can walk away with that share and the rest of the shares will be retained by the company. So, the vesting starts from 2nd year by 25% each year. If he leaves in 3rd year he would be entitled to 50% of his ownership share. Similarly, if he leaves the company in 4th year, he will get three quarters of his share. But if the founder leaves after 5 years of vesting period then they can retain the full 100% of ownership (i.e. 45%) in the company while leaving, earned on a month by month basis after 1 year cliff. Thus, this is how the vesting schedule helps in determining when the founder will be entitled to full ownership of their part of share and how much of the ownership the company can acquire back in case the founder leaves.

How to draft a vesting clause

Before stating the vesting clause, ownership in the business with percentage and number of shares should be mentioned clearly in the Agreement. For starting a business, roles and responsibilities should also be well defined to build a strong foundation. The related clauses may be drafted as follows:

• Upon formation of the company, entire share ownership of the company shall reflect as follows:

Founder A. name                                                                    Founder B. name

Shares amount                                                                        Shares amount

Shares percentage                                                                   Shares percentage

In case founders wish to reserve any portion of the shares for future employees, such portion of shares reserved shall dilute all founders equally. 

• The shares issued to each founder shall vest accordingly:

Founder A and B’s interest in the Company shall vest pursuant to a 5 years vesting schedule beginning (date), which shall vest 30th per month in exchange for consecutive service to the Business of company. The interest shall vest by 25% with each year. Additionally, both founder’s vesting schedules shall be subject to a 1 year cliff. Founders shall all reasonably agree to the consecutive service commitment for the purpose of this vesting schedule.

Vesting will occur on the basis of following schedule:

Until and through (first vesting date) neither founder’s shares will vest

On and not before (first vesting date) 25% of each founder’s shares will vest

On and not before the (second vesting date) 50% of each founder’s shares will vest

On and not before the (third vesting date) 75% of each founder’s shares will vest

On and after the (fourth vesting date) i.e. on end date each founder will be 100% vested.

The vesting schedule can alternatively also be written as:

The option shall not be exercisable with respect to any of the shares for the first year i.e. till (date). If the founder has provided services towards the business, the option shall become exercisable in 2nd year as to 1/4th i.e. 25% of the shares. In the 3rd year option would be vested as to ½ i.e. 50% of the shares. In the 4th year the vesting shall accrue as to 3/4th i.e. 75% of the shares. From 5th year onwards, the rights over the whole of the ownership share shall be vested on the founders.  

If a founder who is subject to vesting schedule, departs the company prior to full vesting of his/her share, the remaining portion of any unvested shares shall be returned to the company in accordance with the vesting schedule. 

Why do VCs insist on founder vesting

Many times when founders get into financing with any sophisticated angel investor or venture capitalist firm, they are required to fix vesting on their share as a part of the investment deal. At early stages, the existing assets of a business are not the key motivation for the VCs to make investment. Therefore, investors under the term sheet insist on a vesting clause for the founders to set up a mechanism that minimizes the risk of a founder leaving and even if that happens, the impact will be lesser than if there was no such vesting clause. Moreover, if a founder holding a responsible position leaves, there is a requirement to hire somebody at his place to contribute to the business. Thus, the shares returned will allow the company to retain and incentivize a replacement without massive dilution of rest of the founders. It should also be noted that vested shares may not stay vested forever, and if there are new financing rounds taking place in the company, new investors may demand a reset by offering them a handsome sum of money in return.

Conclusion

Including the clause of vesting in Co-Founders agreement is aimed majorly at reducing the impact of a co-founder who leaves, by ensuring that they don’t walk away with a disproportionate amount of equity. Also, a vesting scheme gives the founders of the business a right to benefit from the success of the company who made effort to get the company started and get into a well working position but left after some years because of any reason be it owing to dispute with other founders or voluntarily because of personal choice. Vesting schedules may be modified as per the needs of the company. When the value of the company grows because of the amount of work done by them or risk taken by them, the value of the shares constantly keeps increasing and that benefit will be equally provided to both kinds of founders, the ones existing and those who left early but after completing their vesting period.

References

1. https://linkilaw.com/startup-advice-tips/what-is-share-vesting/
2. https://constitutioncenter.org/interactive-constitution/interpretation/article-ii/clauses/347
3. https://www.morse.law/news/winning-term-sheet-part-2#:~:text=Investors%20will%20argue%20that%20the,until%20this%20period%20has%20elapsed
4. https://avc.com/2018/03/founder-vesting/

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