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Founder Share Vesting: The elephant in the room that you may not think about, and why you should

Contributed by: Samvad Partners

Whether you call it the innocuous sounding “founder share vesting”, the confusing “good leaver/bad leaver”, or the downright ominous “founder clawback; the effect and the intent (usually) remain the same; critically the way the founders feel also doesn’t change much. In this article we seek to (i) look at the essential elements of these provisions; (ii) provide a simplified understanding of the principles behind them, (iii) attempt to summarise how the parties to such a clause feel about it, and (iv) why it is imperative you set the tone right.

Few topics during an equity investment transaction negotiation get the parties as riveted or as worked up as founder vesting provisions (for ease of reference this type of clause is put under this umbrella for ease in this article). This is because besides being a clause that incorporates elements of corporate, tax and employment laws, it deals with three things that are at the very core of the transaction (i) equity; (ii) the founder’s involvement in the company; and (iii) how the company, founders and investors will deal with a very uncertain future.

Founder vesting provisions seek to protect all the main stakeholders in a company i.e. the company, founders and shareholders (including investors) from a situation where, for whatever reason, one of the founders’ chooses or is forced not to continue with the enterprise. At the core of it, these provisions tackle the following issues: (i) for the company and founders – why should a person who is not engaged with the company in future value creation, benefit as a shareholder from future value augmentation, in which he played no part? (ii) for the investors – how do we ensure that the founders on whose merit and work we are investing, continue to be engaged with the company and incentivized to create future value for the company?

However, founder vesting provisions also strike a deeply personal note with founders as well. After all, they argue, why should they sign up to potentially losing their shares in a company in which they have earned those shares with their sweat and by founding the company and taking the risk of (possibly) avoiding a different high paying vocation. While this is a valid concern, after all founders would have spent months if not years working for little or no pay in the hopes that their company will be able to create bumper value, it does not tell the whole story. Investors, especially venture investors don’t invest only in the company or its assets that exists as on date, they invest in the vision that the founding team holds and where they see the founders taking the company. Conversely even within a group of founders, the founders would be remiss to expect their relationship in the future to be based on the current conditions. Founding and running a company, especially in this age where ideas are the new oil, comes with its own challenges. Challenges which put even the healthiest and strongest of relationships to the test. A visionary founder is the one who does not let their emotions of today, cloud their judgement of tomorrow. In the unfortunate event of a breakdown within the founding team it is imperative to have a blueprint in place to decide how the departing founder and his equity are to be treated.

Another often overlooked aspect is that if a core member of the founding team leaves, he will have to be replaced and any person who steps into a founder’s role is best compensated with equity. However if an exiting founder continues to hold equity in the company then the incoming member cannot be granted shares without diluting all shareholders, which is too much of an allowance to be made for a founder who has left the company journey midway. Founder vesting provisions can step in such a situation to ensure that the equity of the company is allocated in a manner to ensure survival and growth in the company and not on emotional lines whose reality is constantly evolving.

With that understanding in place, the golden rule (as with most clauses of an agreement) is to find a balance. All parties must be clear on what they hope to achieve with the founder vesting provisions and then work to strike a balance in interests’ basis which the elements of the provisions will be decided. Let us now look at the “standard” elements of founder vesting provisions that one can expect to find, with the caveat that including language in clauses simply because they are “standard” or what worked in other agreements is incorrect, each transaction is unique and the mechanism should reflect this.

1. Vesting. Vesting in founder vesting provisions is slightly different from vesting of stock as it is understood in the context of employee stock options or stock incentive plans. After all, how can you expect to take back something (in this case the shares that founders have allotted to themselves while founding the company) which someone already owns? The answer, vesting happens in reverse. Founder vesting provisions don’t dictate how much stock founders will own over a period of time, instead it dictates how much control they will have over their stock over a period of time. In a sense the founders’ shares get encumbered, if the founder leaves or is asked to leave during a specific period then the stock will have to be transferred to another party, whether it be the company, other shareholders or the employee stock pool.

2. Vesting Period. The vesting period speaks to how long it will take for the founders to gain full control of their own stock. This can vary and is subject to negotiations between the parties. Naturally, from a founder’s perspective the hope is to have as short a vesting period as possible and from an investor’s perspective it would be desirable to protract it so that the founders are incentivized to stick around for as long as possible. The standard that you can expect to see being agreed upon it typically between 3-5 years. The vesting period depends on multiple factors inter alia the relative age of the company, the actual involvement of the founders (which would result in common vesting period if they share responsibilities equally, or result in differential periods if responsibilities and time dedicated are disparate), the valuation of the company, the negotiating power of the founders, the past proven track record and market perception of the founders, and riskiness of the business.

3. Cliff, vesting amount and intervals. An important element is the arithmetic calculation of vesting of shares and this is where this legalese comes to the fore. It is a fallacy to think that 100% of founders shares have to be subject to vesting, it is a very real scenario and most investors are open to it if founders are able to establish grounds to say only a set percentage such as 50-75% each founder’s shares would be subject to vesting this would again depend on the age and maturity of the company and also on how much (if any) amount has been invested by the founders in establishing the company. So then, what is a cliff? A cliff quite simply put is a bullet vesting at the start of the vesting cycle to ensure that founders aren’t working for crumbs from the get-go. It is common to see (in the case of 100% founders’ shares vesting) a 25% cliff vesting after 1 year of the clause coming into effect. The vesting intervals for the balance shares would be subject to discussion but typically you would see them vesting either at monthly or annual intervals, annual intervals provide ease of calculation whereas monthly intervals afford founders more control over their own shares. Whatever the vesting period, cliff or intervals may be, we highly suggest incorporating a schedule for vesting specifying the dates on which shares will vest, the number of shares that will vest and the number of shares that will remain subject to vesting, this leads to clarity for all parties concerned and eliminates any disagreements in the future based on different interpretations of the vesting formula.

4. Good Leavers and Bad Leavers. The treatment of a founder’s shares should the founder choose to leave during vesting period forms the most contentious and negotiated core of founder vesting provisions. There are three questions that this provision would have to address (i) should the founder continue to hold any of his shares i.e. the vested portion? (ii) what are the scenarios in which a founder may leave and how will he be treated for each scenario? (iii) at what price will the founder’s shares be transferred?

A good leaver situation is usually a situation in which there is no malfeasance attributable to the founder such as the founder has been rendered redundant due to a shift in business or business priorities of the company, or the board requires him to leave due to breakdown in relations although the founder is willing to continue to work with the company, or there has been a shift in the priorities of the founder and he is unable to continue with the company and has discussed and had his resignation from the company approved by the board or investors. Typically in a good leaver scenario a founder is: (i) allowed to continue to hold his vested shares and must transfer the unvested shares to a designated party (could be the investors, other founders, company itself, or an employee welfare trust) at par value; or (ii) required to transfer his vested shares to a designated party at fair market value, and the unvested shares at par value. Whether you choose to allow the founder to continue to hold shares as in scenario (i) or remove his shareholding altogether as in scenario (ii) would have to be negotiated. There is a push to include unforeseen situations like, death, disability or rendered incapacity as good leaver scenarios to benefit the successors of such founders and allow them to receive their shares vested and/or unvested. These unforeseen circumstances should be extricated from good leaver scenarios and form a separate category of events in which, we suggest, the successors receive an option to either receive the said shares or receive value for these shares. This is with a view that the company may not benefit from a person unrelated to the company getting a founder’s shareholding (which is typically sizeable) and in the future consciously or unconsciously affecting the functioning of the company. However, the reason for the successors to opt for shares vis-à-vis the current value of the shares, is to receive the optimal value of such shares at the appropriate time.

A bad leaver situation is where things get more complex. This is because in a bad leaver scenario the departing founder is to be penalized, typically by receiving the lowest value for his shares, mostly around the par value irrespective of whether the shares have vested or not. Naturally this is the worst of the worst scenarios and therefore, it is upto the founders to ensure that the matters that give rise to “cause” or a bad leaver scenario are very limited. Usually these matters are fraud, embezzlement, gross negligence, offences or moral turpitude or the founder flaking on the company and leaving unceremoniously without consent of the board. Some investors may seek to include non-performance or under performance in the list of causes giving rise to a bad leaver scenario; in the first instance founders should argue for this not to be included since it has far reaching interpretational issues, if a founder should find himself in a position where investors insist on this, then it should be ensured that non-performance and/or under performance are not left as nebulous terms and the parameters are explicitly listed out.

5. Assignment. Not often thought about but, for the founder vesting provisions to be of full effect they have to be linked to the transfer rights of the founder as well. Even if the founders have rights to assign or transfer shares to permitted transferees for whatever reason, they should only be permitted to transfer the vested portion and never the unvested portion for the simple reason that the assignee owes no obligation to the company and such a transfer would frustrate the purpose of the founder vesting provisions altogether.

6. The nuts and bolts. There are several issues with the practical enforcement of these provisions, the devil after all lies in the details. For instance, who pulls the trigger? Who says when a founder is a good leaver or bad leaver? In a venture capital transaction, there is an inherent issue, the investors (typically) do not hold majority on the board, the founders themselves do! Therefore, investors are reliant on persuading the other founders to vote in a certain manner. Careful and diligent drafting can mitigate these issues however, and the drafting counsel needs to be cognizant of this. On to another issue, a leaving founder may not play ball with the transfer process, more so in a bad leaver scenario, such as by refusing to sign the transfer forms or dragging his feet in the transfer process. To mitigate this one could contemplate a power of attorney scenario which could be baked into the investment documentation, appointing an authority to complete transfer formalities on behalf of a departing founder. Due to these and several other issues of semantics, getting appropriate advice when negotiating and drafting founder vesting provisions becomes imperative.

In conclusion, prudent founders would see the value in founder vesting provisions even before an institutional investor suggests it. It is imperative that founders be upfront about all of these and work to get clarity on these items for themselves, because armed with this knowledge it is far easier to negotiate favourable positions. Investors on the other hand need to be able to balance their investment priorities with the priorities of the founders; an unduly onerous provision benefits no one and would only serve to distance to the investor from the company’s management creating a wall of uncertainty.

Contributed by Samvad Partners

The above article has been authored by Ms. Nisha Mallik(Partner) and Mr. Ayush Mohan(Senior Associate)

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