When advising startup clients, I frequently recommend that they subject the shares issued to their founders (as well as those issued to any equity-compensated employees and contractors) to a vesting schedule. This conversation often leads the founders to look at me as if I had just asked them to grow a second head. It’s not hard to see why they would be somewhat confused as to why I recommend this course of action. As a technical matter, usually (but not always) my client is the startup itself and not the founders personally. And while I am always very clear about this with my clients, as I must be as an attorney, my clients’ founders often see me as their adviser, at least on some instinctual level. In addition, at the early stages of a startup, before any significant investors are involved, the founders have complete control over the company. So they often ask why would they do something like subjecting their own shares to a vesting schedule that appears to be contrary to their own interests and why I would recommend that they take such an action. After all, they can only lose by subjecting their shares to a vesting schedule, right?
While this may be true in the context of a startup with only one founder, the calculus completely changes when there is more than one founder. It is absolutely in the best interests of each of the founders to have the founders (or more accurately, the other founders) subject to a vesting schedule. Many founders, when they first hear of the recommendation to subject their shares to a vesting schedule, only think of the unexpected events that could happen to themselves (i.e., they die, become disabled, are fired, etc.) and of the shares they will lose upon forfeiture of their unvested shares.
But these founders often forget to think about what would happen if their co-founder were to die, become disabled, or leave the company. If the founders are not subject to a vesting schedule, and their co-founder were to leave at any point early in the process, their co-founder would be able to keep all of his or her shares, regardless of whether the services that were expected from that co-founder were actually performed. For example, if a co-founder were to leave the startup for whatever reason one year after the formation of the company, and that co-founder owned 3,000,000 shares outright (let’s say 50% of the company’s currently outstanding shares), then the company would be stuck with that co-founder (or his or her heirs) as a large shareholder in the company, even if that co-founder’s actual contribution ended up being very small. In contrast, if the founders had each been subject to a four-year vesting schedule, then the departing co-founder (or his or her heirs) would only be able to keep 750,000 shares (or 12.5% of the company’s then outstanding shares). The other 2,250,000 would be available to be awarded to someone else as compensation to take the place of the departed co-founder.
In addition to mitigating the risks described above, a startup planning to raise funds from venture capital investors should also consider subjecting their founders’ shares to a vesting schedule simply because you can expect the VC investor to demand it, and it will be one less additional step that will be needed to be taken in the venture round (for more about this issue, see this post).
© 2015 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.