What should the vesting terms of founder stock be before a venture financing?

July 19, 2007

I think that founders stock before a venture financing should be subject to the same general vesting terms as one would expect after a venture financing. A typical vesting schedule is four year vesting with a one year cliff. This means that 25% of the shares will vest one year from the vesting commencement date, with 1/48 of the total shares vesting every month thereafter, until the shares are completely vested after four years. The vesting commencement date can be the date of issuance of the shares, or an earlier date, in order to give the founder vesting credit for time spent working on the company prior to incorporation and/or issuance of the shares.

Some founders want to accelerate vesting upon a termination without cause or a constructive termination. (I will get around to defining these terms in future posts.) I’m not sure that this is really in the best interest of the founders. It is extremely difficult to terminate someone for cause, so termination of a founder will generally result in his/her shares being vested. For founders that have never worked with each other, I would generally counsel against acceleration of vesting upon a termination without cause or a constructive termination. If personalities clash or things don’t work out and a founder needs to be forced out, the remaining founder(s) will kick themselves for allowing the departing founder to leave with a significant equity stake.

If there is acceleration upon a termination without cause or constructive termination, I think the amount of acceleration should be similar to the amount of severance that a person may receive in the same situation. If six to 12 months of severance might be justified if a person is terminated without cause, then six to 12 months vesting acceleration seems reasonable. Of course, the typical norm in technology companies is that there is no severance in any situation.

In addition, some founders may want to accelerate vesting upon a change of control. Single trigger change of control vesting means that the shares accelerate upon a change of control. This isn’t in the best interest of investors because the fully vested founders have little incentive to continue to work for an acquiror after a change of control. In order to incentivize these people, additional options may need to be granted, which increases the cost of the acquisition to the acquiror, potentially to the detriment of the investors. Double trigger change of control vesting means that the shares accelerate upon a change of control AND the founder is terminated without cause or a constructive termination occurs within 12 months of the change of control.

The amount of shares that accelerates upon these events can be 100%, or written as a certain number of months of vesting, such as twelve. I’ve had one VC express a strong opinion that the amount of vesting upon one of these events should not be 100%, but rather 12 to 24 months of vesting acceleration, due to the fact that it is extremely difficult to terminate someone without cause. I think that double trigger 100% acceleration for founders or certain executives is fairly accepted among investors. However, extending that protection to rank and file employees is not common.

In any event, VCs are likely to impose their own vesting terms and acceleration upon a Series A financing, so it may not matter what terms are implemented when the initial founders shares are issued. However, reasonable vesting and acceleration terms may survive the Series A financing, especially if it would be difficult to renegotiate with a critical founder in a team with multiple founders.

Comments

  • David Thomas

    A key to remember if service-based vesting will be imposed up on the founder stock is that the tax rules provide that it is taxable at vesting on the value of the stock at the time of vesting. These rules will be overridden if the founder elects within 30 days of the issuance of the founder stock to be taxed on the value of the stock at the time of issuance (less anything paid for the stock, which can include the value of IP contributed to the business) [this is an “83(b) election”]. The 30 day limit is extremely strict and the 83(b) election has to be filed with the IRS within that 30 day period, so if service-based vesting will be imposed, it is important to be very careful to consider making an 83(b) election and filing it with the IRS within the deadline.

  • http://www.specialam.com Andrew Carroll

    What kind of stock or equity and at what value should we offer a founder/board member when the stock is of no value in a start up company and no investment is made by the Founder.

  • http://www.startupcompanylawyer.com Yokum

    The founder/board member should be offered common stock. The number of shares should be determined as percentage of fully-diluted shares.

  • lilian

    Yokum,

    If founders are issued restricted common stock instead of options, can I include both employment-based schedule and performance-based schedule into the restricted stock agreement? Let’s say 50% of stock is subject to 4 year release schedule, and remaining stock is released while company reaches certain milestone? For the performance based stock, a term should be specified, right? such as 10 years?

    The reason for me to ask this question is, I see most company grant options for performance based stocks instead of restricted stocks, even for their initial founder.

  • http://www.startupcompanylawyer.com Yokum

    While it is possible to have performance-based vesting with respect to founders’ stock, it’s not common. When a company is initially formed, the founders of the company hold all of the capital stock. Many founders don’t subject their stock to any vesting criteria. These founders often find that when they raise their first round of financing the investors want to impose some vesting with respect to their stock. Investors do this to motivate founders to continue increasing the value of the business and so that the founders will remain focused on the current venture rather than potentially focusing on other interests or ventures. To retain some control over the vesting provisions of their stock, founders will often subject their founders’ stock to vesting prior to the first round of financing so that investors have less incentive to revise or impose their own vesting provisions.

    If founders are going to impose vesting onto their stock, most impose time-based rather than performance-based vesting criteria. It’s often difficult to ascertain appropriate performance-based vesting criteria for a start-up company as the company can grow quite fast and the environment can change quickly often making what was originally thought to be an appropriate goal obsolete or unattainable. Performance criteria related to raising capital might be a viewed as a negative milestone to an outside investor as they may believe the founder’s goal is to raise financing to fund their lifestyle or a way to recoup forgone salary rather than a means of promoting the company and increasing the value of the business. While performance-based vesting can be an appropriate motivator and incentive, performance-based vesting is usually imposed after investors have invested their capital in the company and can help design appropriate and objective performance goals that can best help motivate the founder, as well as promote and increase the value of the business.

    [Thanks to one of my employee benefits colleagues for pondering this with me.]

  • LJ

    What are the tax implications of the grant to initial founders of common stock who bring the IP and business plan, and others invest the dollars. There is no vesting schedule.

  • http://www.startupcompanylawyer.com Yokum

    @LJ. Assuming it is structured properly, the contribution of assets for stock and contribution of cash for stock should be a tax-free transaction under Section 351 of the IRS Code.

  • DYstart

    How to structure properly to be tax-free for founder’s stock?

    Thanks!

  • http://www.startupcompanylawyer.com Yokum

    I don’t understand the question. There is no tax on the issuance of the founder’s stock if it is issued at fair market value. There will be tax on the subsequent sale of the stock if there is gain.

  • DYstart

    Thank Yokum! I don’t quite understand this:
    @LJ. Assuming it is structured properly, the contribution of assets for stock and contribution of cash for stock should be a tax-free transaction under Section 351 of the IRS Code.

    What document needs to be filed? Need to file 83b election? or it’s autumatic?
    In short, how to achieve a tax-free transaction?

  • DYstart

    Yokum, I mean even though “There is no tax on the issuance of the founder’s stock if it is issued at fair market value. ” Does it mean all the stocks are vested already also at the same time?

    If not, what if the price is higher when the stocks are vested?

    What if 83b election isn’t filed within 30 days?

  • DYstart

    If I just started a C Corp and authorized 10M common shares. I want to pay $6000 to get 6M shares. What time the transaction shall happen? Do I need to file 83b election to make this tax free?

  • http://www.startupcompanylawyer.com Yokum

    I’m really not following the questions.

    If you contribute assets in return for stock, then you need to comply with the requirements of Section 351 of the IRS code. If the transaction is not structured properly, then it will be taxed as if you sold the assets. You should discuss this with an attorney.

    If you buy the stock for cash, then there is no Section 351 issue and there is generally no tax on the purchase as long as the purchase price is fair market value.

    The 83(b) election has nothing to do with Section 351 and an assets for stock transaction. The 83(b) election is important if the company has the right to repurchase the shares. Please read the 83(b) post for more details.

  • joe

    Are there guidelines on vesting commencement date? In many cases, the startup company is so young when founding members join. The company hasn’t incorporated, or has a formal attorney to get legal advice. However, the founders agree that the vesting commencement date should be based on when they decided to join. When the company finally gets to incorporate the “board” approves the option grants, but is it okay to peg the vesting commencement date to the earlier date? Another option would be to get the board to “grant” the vested stock, but because they are not used to doing that, they insist on the commence date.

  • http://www.startupcompanylawyer.com Yokum

    @joe – as indicated above, the vesting commentment date can be a date prior to the issuance of the stock or option. The vesting commencement date can be the date that work began on the project (even before the date of incorporation).

  • Bill Mc.

    Yokum,

    Per this earlier post and your response:

    Andrew Carroll: What kind of stock or equity and at what value should we offer a founder/board member when the stock is of no value in a start up company and no investment is made by the Founder.

    Yokum: The founder/board member should be offered common stock. The number of shares should be determined as percentage of fully-diluted shares.

    ————

    A few questions below, assuming company is relatively new (2008) and pre-VC backing. Thanks.

    1. Would the “new” founder above typically be granted voting rights for her shares, subject to their vesting arrangement?

    2. Would the “original” founder (about 6 months of work and a six figure investment prior to new founder joining) typically have common shares as well?

    3. An original founder is proposing a liquidity preference to her shares vs. other co-founders. The liquidity preference is based on the value of the company when the new founders join (i.e. new founders only share in upside to this valuation based on their %).

    Have you seen this sort of original founder liquidity preference?

    4. If VC funds are raised, founder shares would likely be subject to vesting. However, if VC funding is not raised, is it customary for both original and new founders to have similar vesting schedules?

    I realize of course that everything is negotiable – just curious your thoughts for a typical agreement. The structure contemplated is an LLC, but it holds a C-corp tech co, which is how I think of the venture.

    Thanks again for any perspective you provide….

  • http://www.startupcompanylawyer.com Yokum

    @Bill,

    The fact that the company is an LLC changes all of the ground rules. VCs can’t invest in LLCs and it is extremely difficult to grant an option-like equity incentive in an LLC. The below assumes that the company is a C corp.

    1. Yes. No reason that any shares would not be voting. Vesting and voting are not linked.

    2. Yes. Occasionally, a founder may be issued a preferred stock with a liquidation preference if that founder has put in a substantial amount of money that should be protected with a liquidation preference.

    3. No. I supposed you could create something like this in an LLC, but it would be difficult to draft.

    4. Yes. If there are multiple founders, everyone should be subject to vesting to prevent slackers.

  • Glauco

    Should I get a lawyer to prepare the vesting term for my newly formed company? Could I prepare it myself?
    Thank you

  • http://www.startupcompanylawyer.com Yokum

    @Glauco. You need a lawyer to draft the repurchase option. It is not a DIY project.

  • Bill Mc.

    Yokum, thanks much for your earlier post.

    Couple of follow-ups:

    Your assertion that VCs avoid investments in LLCs corresponds with what I have heard elsewhere.

    1. That being said, have you seen VCs invest for a stake in a c-corp when the remaining equity in the c-corp is then held by an LLC?

    2. If so, did any factor drive the VCs comfort with the structure?

    3. Just to drill down further, how often roughly is the “occassionally” you wrote that you have seen a founder “liquidation preference” vs. her co-founders? What might constitute the “substantial” amount of money you cite?

  • http://www.startupcompanylawyer.com Yokum

    @Bill,

    1. To repeat, venture funds cannot/will not invest in LLCs. Because an LLC is a flow through entity, operating income will pass through the LLC to the fund and create unrelated business taxable income. In addition, mimicking the rights preferred stock and creating the equivalent of an option plan in an LLC is too difficult.

    3. If a founder puts in enough money to buy a new luxury car (i.e. an arguably painful amount of money), then I think that issuing a junior preferred stock with a simple liquidation preference to a founder might be appropriate.

  • newfounder

    Hi Yokum
    We have been working for 2 years and have just received a series A term sheet. We had all agreed that our founder’s shares vested over 4 years from the start of the company. However, if an original founder recently left the company voluntarily after 2 years of work, but prior to the series A financing, what legal recourse does the original founder have if the series A investors impose 25% vesting at closing for all founder’s? I am certain that this founder still expects full 50% of vested founder’s shares. Do all founder share rignts go out the door when a term sheet is accepted by current managing founder’s?

    thanks

  • newfounder

    one more follow up question:
    what about another term sheet that has better financial terms for company but requires founder’s shares to be 0% vested at close? What happens to previously vested, non-active founder’s shares? Is this simply to be negotiated with VC or does the original founder have legal rights to previously vested shares?

    thanks

  • http://www.startupcompanylawyer.com Yokum

    @Newfounder – when a founder leaves, his unvested shares are repurchased by the company. Typically if the shares are not repurchased, they are released from the repurchase option (i.e. are fully vested). Vesting depends on continued services. There is no “handcuff” for someone that is no longer a service provider. Thus, I don’t understand the question. With respect to currently employed founders, if one of them doesn’t agree to the revised vesting terms from the VC, the VC may not invest.

    Also, if you have received a Series A term sheet, congratulations.

  • tia

    Hi Yokum,

    In a situation where founders own common stock shares not subject to vesting and there is a contemplated subsequent Series A round, how will the Series A investors impose vesting? I assume they would have to provide the founders options to purchase additional shares that are subject to a vesting schedule?

  • http://www.startupcompanylawyer.com Yokum

    @tia – The founders would enter into a stock restriction agreement that subjects the already issued shares to a repurchase right in favor of the company that lapses over time as the stock vests. Founders would NOT be granted additional shares subject to vesting.

  • newtonprep

    What are strengthens and pitfalls of this example: The Jewel Company is a C status corporation; incorporated in the State of Florida on June 1, 2009. Initially, it authorized 20,000,000 shares of common stock as indicated in its Articles of Incorporation. On November 9th, 2009, its Board of Directors approved the issuance of 4,000,000 shares [representing 20%of its class “A” (one vote per share) stocks]. In addition, the Board of Directors approved the issuance of 2,650,000 shares of its class “A” stock and 800,000 of its Class “B” stock (carrying voting privileges of 20 votes per share) to its Founder. 40% of the Founder’s Class A shares is vested at the end of the first year following such issuance, with the remaining 60% to vest monthly over the next three years. The unvested shares are fully vested in the event of a merger or acquisition if the Founder is terminated without “cause” by the acquiring entity within one year.

  • http://www.startupcompanylawyer.com Yokum

    @newtonprep – don't understand exactly what you question is.

  • http://www.startupcompanylawyer.com Yokum

    @newtonprep – don't understand exactly what you question is.

  • Ryan S.

    Yokum,

    Can founders shares be subject to a vesting schedule if they are purchasing them for fair market value, rather than contributing service?

    In other words, if a founder purchases common stock at $0.001 per share for 5m shares, would that investment into the company ($5,000 seed money capital contribution) entitle the founder to all 5m shares upon investment, or can those 5m shares be subject to a vesting schedule over a few years despite the fact that they have already been paid for them through capital into the company?

  • http://www.startupcompanylawyer.com Yokum

    @Ryan – stock purchased at FMV can subject to vesting. However, if the transaction is for capital raising purposes, it would be odd to have them subject to repurchase if the founder quits.

  • Jheur03

    Yokum
    I have question. I had company common share 10% and I was work for contractor, company was set up S-Corp.
    Company loss since when start up, i had used loss for my incometax, during the this day I left company.
    What is benefit of 10% share to me? and what responsbility I have? can I sell this share?