As the credit crunch drags on, startups are relying on investors more than ever. And one result, especially for first-time entrepreneurs, is often a struggle over founder stock.
In simple terms, founder stock is issued early in the life of a startup to the founder and co-founders. It determines how the ownership is divided up and it is typically based on each founder's contribution to the key assets of the company. Unlike stock that is acquired as the business grows, founder stock is primarily granted for sweat equity--so it's difficult to distribute fairly if there are multiple founders with different roles and levels of commitment. Lawyers who specialize in business startups can help you allocate founder stock, and the list of resources with this column includes blogs and advisors that specialize in the subject.
But once the allocations are settled, many first-time entrepreneurial teams don't take the next step and create a vesting schedule, which requires founders to earn their stock in monthly installments, usually over a three- to four-year period. Since business partners often don't maintain the same level of commitment or contributions to the company over the years, vesting prevents founders from diluting the company (or their co-founders) by earning stock when they are not contributing.
Some sources to consult on founder shares and vesting:
This blog by Basil Peters is among the most comprehensive on the mechanics of angel investing, written from the perspective of an investor. Check out the detailed entry on share and option vesting.
Naval Ravikant and Babak Nivi blog from an entrepreneurs' perspective. Read the excellent article on how to pick a co-founder. The archives are a treasure trove of advice, among the best of the web on this topic.
The law firm Morse, Barnes-Brown & Pendleton, PC specializes in helping entrepreneurs and is among the best (and most cost-effective)at structuring vesting terms during the startup stage.
If you don't create a vesting schedule, your first round of institutional investors will usually demand it. Typically, they will let you keep 25 percent to 50 percent of your stock, with the remainder vesting monthly over three to four years. If your company is mature and profitable, they may let you keep as much as 75 percent to 100 percent.
Entrepreneurs often chafe over imposed vesting: They earned their stock before the investors came along, so why re-earn it now? The answer is, investors are looking for a way to keep you at the company--and rather than issuing additional stock with a vesting schedule, they prefer to tie up your existing stock.
But this is a negotiable point when you are raising money. For example, investors can adjust the price of the deal if they add more stock to the company. Or, they might consider "cliff vesting," which essentially creates a large payout of stock or stock options at one time. A cliff-vesting arrangement might provide a founder with 50 percent of his stock vesting on the four-year anniversary of the grant, with 50 percent of his vesting in advance. That's a strong incentive for a founder to stay for four years.
However they're arranged, vesting schedules are an important way of aligning incentives for founders and investors.