According to a popular meme no one enjoys the snug fit of a good vest more than a finance bro. This is almost certainly a petty slight and shallow wisdom. But it’s a fine conduit to a discussion of another kind of vesting that is ubiquitous: founder vesting.
“Vest” (or, for that matter, “invest”) wasn’t used in English outside the context of clothing or garment related conversations (“Nice vest, Cromwell”) until around the sixteenth century when it developed an association with papal power (“vestments”) and then property rights. Its usage in connection with equity compensation solidified in mid-20th century and became prevalent as a standard component of employee stock options (whereby service providers gradually acquire ownership in stock options over time) in 1980s Silicon Valley. Presently, the conventional practice is to attach a four-year vesting schedule to employee equity, including (less intuitively) founder stock.
“Founder stock” itself is a colloquial not legal term, referring to the common stock granted to persons self-identifying as “founders” immediately after the company is formed and before it has meaningful operations or revenue. Founder stock is typically priced at par value or other nominal value and purchased by the founder using cash and/or intellectual property assignment. The purchase is documented through a purchase agreement that (if drafted by an attorney familiar with US tech startups or provided by Clerky or Stripe Atlas (or equivalent)) contains restrictions limiting the founder’s right to sell or transfer the stock and giving the corporation a right of first refusal to purchase any shares in the limited circumstances where the founder has a right to a sale.
In addition, at least as a default, these purchase agreements subject founder stock to time-based vesting that enables the company to repurchase any shares that remain unvested at the time a founder ceases to be a service provider. The typical vesting arrangement tracks the conventional employee vesting schedule: four years with a one-year "cliff” (i.e., 25% of the shares becomes available at year 1 and the remainder vests monthly over the subsequent 36 months).
There are variations to the above as founders within the same company may have varying vesting schedules based on their roles and initial contributions. For example, a founder contributing significant assets or IP developed before formation (like a patent) may have a different vesting arrangement (depending on his/her share allocation) than a founder whose principal contributions will occur post formation in the form of, say, sales or promotional activities.
The main premise behind founder vesting (and why it counterintuitively serves founder interests) is that future investors (e.g., sleeveless finance bros) will invest in the founding team as much as the business idea and will want some assurance that founders stay motivated. If this is true, of course, one might argue that since investors may seek to adjust or extend vesting schedules in future funding rounds as a condition of investment ANYWAY wouldn’t founders be better positioned to negotiate that vesting at that future event within the context of those circumstances?
In practice, in most cases it’s in the founders’ best interests to implement standard vesting schedules from the outset for two key reasons. First, future investors tend to respect preexisting schedules. Their absence encourages a fresh analysis which given investor motivations will invite more onerous vesting terms. Second, founder vesting helps manage the free rider problem inherent in the joint nature of the enterprise. Investors or no investors, building and scaling a company involves intense work often at minimal pay over a prolonged period of time and there will be incentives for a fully vested founder to bail if the others will continue to work for the company’s long-term success. The occurrence of this is legion and, while some founders left holding the bag in such cases find solace by realizing on reflection that all they’ve really lost, in the end, is money and power, there’s a greater tendency to judge it as a negative outcome.
A useful heuristic in establishing a fair and balanced vesting schedule is to model out what ownership share a founder should have when exiting the company at given points in time. Naturally, this is the very fact pattern that vesting schedules are fundamentally intended to address.
A second layer to vesting is acceleration. Acceleration provisions provide a countermeasure to the risk that a third party will benefit from a founder’s unvested sweat equity. The two most common types of acceleration provisions are “single trigger” and “double trigger” acceleration.
Single-trigger provisions accelerate vesting upon a single event, typically a change in control of the company or, less commonly, upon termination of employment without cause. By comparison, double-trigger provisions require two events for acceleration: first, a change in control of the company and second, termination without cause or departure for good reason within a specified period after the change in control transaction. A common split is 25% of unvested shares accelerate on change of control and 100% accelerate if there is a termination event related to the change of control.
Single-trigger acceleration provisions are generally more favorable to founders but are often not favored by outside investors and arguably can discourage acquisition opportunities.
At present, four-year vesting with double-trigger acceleration is the centrist and preferred formulation for initial grants of founder stock, balancing founder and company interests with those of prospective investors.
This alert was prepared by Jake Molland, a Principal at Bound Legal Strategy P.C. The content of this alert is informational only and does not constitute legal or professional advice. Please note that the law changes frequently and further that the generalized information reflected in this alert may not address the specifics of a given factual situation. Please contact Jake at jake.molland@boundlegal.com if you have specific questions or concerns relating to any of the topics covered in here.
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