Founder Vesting Clauses: What They Mean and How to Negotiate Them
Founder vesting clauses are an essential component of any startup's legal framework. In this blog post, we'll explore what founder vesting clauses are, why they're important, and how to negotiate them effectively in restricted stock purchase agreements (“RSPA”) and stock restriction agreements (“SRA”) for founders. By understanding the intricacies of founder vesting clauses, you can protect your interests and ensure the long-term success of your venture.
What are Founder Vesting Clauses?
A founder vesting clause is a legal provision in a founder’s RSPA or SRA with the company that outlines the terms and conditions under which founders earn (or "vest") their equity in the company. Vesting clauses are designed to incentivize and retain top talent, ensuring that founders are committed to the success of the business.
Vesting schedules typically range from three to five years, with a common structure being a one-year "cliff" followed by monthly vesting over the remaining vesting period. This means that if a founder leaves the company before the one-year mark, they would forfeit all their unvested equity. After the cliff period, the founder's equity would vest incrementally on a monthly basis.
Why are Founder Vesting Clauses Important?
Founder vesting clauses serve several critical purposes:
Aligning interests: Vesting ensures that founders are motivated to stay with the company and contribute to its growth, as they only fully benefit from their equity stake if they remain with the company for the entire vesting period.
Protecting the company: In the event a founder leaves the company early, vesting clauses prevent them from walking away with a significant portion of the company's equity, which could be detrimental to the remaining founders and investors.
Attracting investors: Investors often require vesting clauses as a condition of their investment, to ensure that the founders have a long-term commitment to the company and its success.
Vesting Schedules at Company Formation
At formation, most founders looking for outside funding in the near future would give themselves a standard four-year vesting schedule with a one-year cliff.
If you have co-founders, it is highly recommended to have all co-founders' shares subject to vesting schedules even if the company is not looking to raise capital anytime soon. It motivates all co-founders to work for their equity and can help prevent dead equity on the cap table if someone leaves.
How to Negotiate Founder Vesting Clauses in VC Financings
When it comes to equity financing, investors (typically the lead investor) will always look at each founder's existing vesting schedule. If they see a majority of founder shares have been vested, they may ask for a fresh vesting schedule to be applied to each founder's shares. This means that even if part of your founder shares have vested before meeting your Series A investors, they may want all of your founder shares, including vested and unvested ones, to be subject to a new vesting schedule. The rationale is that the investor wants to make sure the founders are motivated and not going to quit right after the Company raised an equity round.
Negotiating founder vesting clauses can be a delicate process, as it involves balancing the interests of the founders with those of the company and its investors. Here are some key considerations to keep in mind:
1. Determine the Appropriate Vesting Schedule
The length and structure of the vesting schedule should be carefully considered. While a standard four-year vesting schedule with a one-year cliff is common, you may want to explore other options based on your company's unique needs. For example, if your startup is in a highly competitive industry with a high potential for employee turnover, you might consider a shorter vesting schedule to provide a stronger incentive for founders to stay. Conversely, if your startup is in a more stable industry, a longer vesting schedule might be appropriate.
Vesting commencement date is another point of negotiation. Founders may propose a "backdating" of the vesting schedule, which sets the commencement date to an earlier point in time, such as when the founders first started working on the project. This acknowledges the work already put into the company. However, it's important to be transparent about your rationale and be prepared to provide evidence of prior work or milestones achieved before seeking investment. By presenting a strong case and demonstrating your dedication to the company, you may be able to negotiate a more favorable vesting commencement date that reflects your contributions.
2. Accelerated Vesting Provisions
Accelerated vesting provisions allow founders to vest their equity more quickly under certain circumstances, such as the sale of the company or involuntary termination without cause. These provisions can be a valuable bargaining chip in negotiations, as they provide additional security for founders while still maintaining the overall purpose of the vesting clause.
There are two main types of accelerated vesting provisions: double trigger acceleration and single trigger acceleration. Understanding the key differences between these options can help you determine which is best suited for your startup's needs. Here’s a chart summarizing the key features of each acceleration method.
3. Pay Close Attention to the Definitions of “Cause” and “Good Reason”
As mentioned in the chart above that "Involuntary Termination" is typically one of the two conditions for a double trigger to be present; therefore, founders and investors must agree on what constitutes "Involuntary Termination". Here's an example of the definition of "Involuntary Termination" in founder RSA/RSPA:
“Involuntary Termination” means the termination of the Founder’s service by reason of:
(i) The involuntary discharge of the Founder by the Company for reasons other than Cause; or
(ii) The voluntary resignation of the Founder for Good Reason.
As a founder, you want to define “Cause” as narrowly as possible and “Good Reason” as broadly as possible. This makes it easier to accelerate your shares in the company in connection with a termination, by arguing that the double trigger has happened.
Some common definitions for "Cause" are material wrongdoings and misconduct, material breach of agreements with the company, and failure to comply with company policies and government investigations. A good company counsel should push back on anything that's less serious such as mere negligence and should build in language to allow founders to cure the alleged misconduct.
"Good Reason" typically includes a reduction in compensation, material diminution of founder's responsibilities, and relocation of founder's principal workplace by more than certain limit.
4. Be Mindful of the Interplay Between Founder RSPA/SRA and other Financing Documents
It's crucial to review your Founder's Restricted Stock Purchase Agreement/Stock Restriction Agreement in conjunction with other VC financing documents, such as the Right of First Refusal (ROFR) and Co-Sale Agreement, and make sure these documents don't have any conflicting language. In the ROFR and Co-Sale Agreement, the company typically retains a ROFR right, which allows it to purchase shares from founders before they can be sold to third parties. Investors, on the other hand, often secure Co-Sale rights, enabling them to participate in any sale of founder shares to third parties on a pro-rata basis. By understanding how these rights interact with your vesting provisions and other clauses in the Founder RSPA/SRA, you can ensure that all parties' interests are protected and aligned. Furthermore, this comprehensive approach helps mitigate potential conflicts or misunderstandings down the line as your startup grows and seeks additional funding rounds.
Conclusion
Founder vesting clauses are a crucial aspect of any startup's legal foundation and a negotiation point in VC financings. By understanding their purpose and negotiating them effectively, you can ensure that your company's interests are protected, and your team remains committed to the long-term success of your venture.