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Rationale for Founder Vesting

Ashish Fafadia
posted on 11th September 2014
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Context

Starting a business is a risk that founders take and in turn investors finance it conscious of the risks underlying.  There are some risks for founders and few others for investors.  One of the common risks faced is that of – a co-founder leaving mid-course.  This not only hurts investors but even the other founder who is keen to continue the biz.  Commonly accepted measure to mitigate this risk is – Founder’s Vesting.

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What is the need for Founder's Vesting (FV)?

If an investor has invested half a million dollars (US$ 500k) in a business for 20 % and ESOPs are allocated at 10%, Founders (say 2 of them) hold 35% each in the Company.  While the Founders are entitled to believe that they are likewise entitled for the rest of the stake, investors would like to at least ensure that part of the risks that emerge from one of the Founders losing interest in the biz is protected by trying to ensure a mechanism to deal with such a situation and avoid disputes later.

We have seen at least 4-5 dispute situations between founders already. Although FV clauses in SHAs can help you tide over the situation to a small extent – and ensure a solution with pre-decided terms rather than a dispute over it at the time when one of the Founders choses to pull the plug – the rest of the agony of having to deal with a key member of the team gone and find a suitable replacement remains.

How is FV implemented?

In the above case, when a founder has 35% stake in the company, contractually, parties may agree that the stake will accrue to the founders upon passage  of time (lets say – 3 years); at times certain business milestones.  In such as case, Founder gets to keep a small part of this stake (technically it is called Vested shares).   Rest of it is to be vested over the next 3 years (called ‘unvested shares’).  Unvested portion could vest monthly, quarterly or such other frequency that may be agreed between Founders and Investors.

Once all shares are vested, Founders are legally entitled to keep those shares.  Until founders are entitled to hold the shares, they are transferred to an escrow account and shares are periodically released  as and when they get vested.

What are the negotiating factors between founders and investors regarding FV?

Founder Vesting is an area where there is a significant and needless time spent.  I say significant time, because founders find it of utmost importance to protect and pre-vest as much as stake as possible and investors would find it in their interest to ensure a level playing field rewarding the Founders for their stay in the Company, over a period of time, most commonly over 3 to 5 years.

Please note that it is quite common for seed investors and angels to postpone solving this problem till such time that the company manages to raise the next 'big' round, by whatever name called.

What happens to the UNVESTED Shares?

Unvested Shares would go into the Company pool and be available to be used as follows in combination or otherwise:

  1. Try and identify a suitable senior person to be a Co-founder / Top management key person equivalent.
  2. Add part of the stake or stake that remains for employees ESOP
  3. Remaining Founder(s) and other shareholders assume the shares depending on circumstances and upon finding other suitable top manager, dilute in his favour

Are there tax implications when shares are vested?

No.  Just because shares become vested, these don’t become subject to tax.  However, when a founder quits and if he holds the shares that are not yet vested, then there are some tax implications that could arise on a case to case basis but not each time.

Does Founder vesting solve the problems that arise?

As mentioned earlier, FV clauses in SHAs can help you tide over the situation to a small extent – and ensure a solution with pre-decided terms rather than a dispute over it at the time when one of the Founders choses to pull the plug – the rest of the agony of having to deal with a key member of the team gone and find a suitable replacement remains.

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