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Vesting: A Founder's Need to Earn Equity

January 27, 2014
URL: http://www.entrepreneur.com/article/231044

Vesting is absolutely standard in venture deals. It is predicated on the notion that the founding and management teams must earn their equity ownership by contributing to value creation through so-called "sweat equity," or hard work. Vesting requirements address free-riding issues by mandating a commitment to the enterprise -- a requirement around which both investor and founder interests are aligned.

When vesting is imposed on a founder's stock, the unvested shares held by the founder become subject to a contractual right of repurchase, often at a nominal value, if the founder is no longer providing services to the company. The founder's stock vests once the right of repurchase terminates, usually upon the occurrence of a specific event or simply with the passage of time.

Standard vesting provisions typically entail a one-year cliff with monthly vesting over the ensuing three years. That means that one quarter of the equity is deemed to be vested only after a full year of continued contribution, with the remainder vesting monthly over the following three years. If you, the founder, leave or are terminated before your shares are fully vested, then you only get to keep the portion of your equity. While this four-year vesting structure is the norm, there is some variance on vesting when it comes to the founder's equity.

Upfront vesting and shorter horizon
It is not unusual for a founder to get some credit upfront for the sweat equity that has been put into an idea or business prior to funding. The idea here is pretty simple. The founder has "earned" some portion of his or her equity for work already done and shouldn't be subject to a complete reset on ownership.

The range of credit that venture investors are willing to give a founder tends to fall somewhere between 10 to 25 percent, depending on the amount of sweat equity that a founder has already invested, the progress made in the business and the founder's leverage in term sheet negotiations. It is also not unusual to see a shorter, three-year vesting horizon, particularly with companies that are likely to hit high-value milestones within a short time.

Related: Everything You Wanted to Know About VC Liquidation Preference But Were Afraid to Ask

Acceleration upon a change of control
So what happens if three years into your four-year vesting schedule, you sell the company? Is it fair that you should forgo a quarter of your equity? The fair answer is: Of course not. But in order to have an informed conversation with your venture investors, you need to appreciate the fact that "single-trigger" acceleration, which fully accelerates all of a founder's unvested shares upon a change of control, is not the norm in venture deals. The most common compromise is "double-trigger" acceleration, which means that in addition to the first trigger -- the change of control -- you would have to be fired by the acquiring company within some time frame, typically 12 months after the acquisition, in order to fully vest in your equity.

That doesn't mean you can't have a reasonable conversation with your investor around single-trigger, or better yet, partial acceleration on a single-trigger and full acceleration on a double-trigger, but you should engage in the conversation knowing that you are asking for something that is the exception and not the norm, given that "double-trigger" acceleration is commonly viewed as the most equitable form of founder acceleration upon a change of control in venture deals.

Acceleration in the event of termination
Another common conversation during term sheet discussions centers on whether or not it is appropriate to have some amount of acceleration if a founder is terminated. Obviously, if a founder is terminated for cause, then he or she can't rightfully expect to walk away with any additional equity that he or she would have had to earn through future contributions. But if a founder is terminated without cause, should he or she get fully accelerated? While there may be some equitable arguments for full acceleration, the consensus is that termination without cause should entail some amount of acceleration, typically 12 months' worth.

This is largely due to the fact that replacing a founder will in all likelihood require significant equity grants for a new hire that will be very dilutive to everyone else, and the opinion that a founder shouldn't get a windfall if he or she hasn't earned the equity through contribution to the enterprise. Moreover, given the inherently fact-based nature of any inquiry around whether or not a termination was predicated on cause, there is typically little appetite by venture investors for the possibility of litigation around full acceleration in the event of a founder termination.

Related: Why You Need to Take a Close Look at Dividend Provisions