The Importance of Vesting Provisions For Founders’ Equity in Startups
While it might at first seem counter-intuitive, initial ownership in your startup should not be based on entirely on who had the idea or who has contributed the most so for. The nature of startup relationships are unpredictable, and oftentimes founders have different ideas on what is expected of one another. Ownership should, at least in part, be based on future contributions to the Company. The way to accomplish this is to subject at least a portion of the founders’ initial ownership in the startup to vesting requirements. Vesting works to ensure the company can get back some of the equity initially granted to a founder if that founder does not fulfill their expected contributions to the Company.
The Case of the Lost Founder. The worst-case scenario of this is what can be called a “lost founder” – an initial founder who is granted a substantial ownership interest but then disappears because of either disagreement, a change of circumstances, or even a loss of interest. Without vesting provisions, a lost founder will retain their initial ownership, while contributing nothing to the company’s growth. The lost founder can sit and wait for a payday that is unearned, potentially leading to loss of motivation and resentment in the other founders and killing any momentum the startup had. Furthermore, since sophisticated investors will recognize the potential for that loss of motivation, a lost founder often discourages potential investors. A properly structured founders equity arrangement will avoid this outcome.
Why Not Just Grant Equity Later? Founders often suggest that stock just be issued in the future when tasks are completed or after a founder works for the required time. Although perhaps simpler, the problem with this method is that it can have significant tax consequences for the founder since stock granted at a later date is likely to be worth much more at the time of grant than stock granted when the company is formed (let’s hope so). Since they would receive that stock in exchange for working, they’ll have to pay taxes (at ordinary income rates) on the value of it when they receive it; and often neither they nor the company have cash to pay those taxes. To prevent this result, stock (subject to vesting) is issued at the very beginning to the initial founders (and perhaps some of the first employees) and, provided that the correct tax forms are filed (see previous post on 83(b) election), taxes on that stock will be either very small or nothing at all.
Find the Sweet Spot. Since the ultimate goal of vesting arrangement is to properly align the incentives of the founders, great care should be taken to structure these arrangements in a manner that accurately reflects the expectations of the founders. Don’t rely on what your friend says his startup did or what is in some form you found on the internet. The most important question to ask is what is each person supposed to contribute and when is that expected to occur? Is it related to a specific task such as, perhaps, building a particular product? Or is it leadership or expertise provided over time? Has some of it already occurred? You don’t want too much of the equity to vest until the bulk of what is expected of the founder is completed.
To reach that result, founders can specify exactly what portion of the stock is subject to vesting (the more the better) and then specify how and when the vesting will occur, i.e. either time-based vesting, milestone-based vesting or even a combination of both. Time-based vesting means that vesting will occur with the passage of time. Four-year vesting arrangements are common, but time-based arrangements should be based on the structure and plans of the startup, and not just on industry convention. Milestone vesting involves the vesting of ownership shares by articulated events, or milestones. For instance, if one founder will be writing the code for a website, that founder could have 25% of the shares vest upon the launch of the beta version of the site and another 25% upon launch. Milestone vesting works well for founders actively working on particular projects and helps to provide continuous incentive to complete that project.
Put it in Writing. Co-founders armed with a basic understanding of why vesting is important and the various types of vesting arrangements should be able to think through these issues at or near the onset of them working together. Founders shouldn’t attempt to document a vesting arrangement at home as seemingly insignificant drafting variances can have very significant consequences. Having thought through these issues before going to see your lawyer, however, should help keep costs under control.