Vesting Agreements: How They Work & Why You Need One

6 min read
Vesting Agreements: How They Work & Why You Need One

Founders are naturally entitled to shares of stock in return for the hard work they put into their startups. However, it’s common practice for founding teams to create vesting agreements that dictate how much time and effort a founder must devote to the company before they fully earn their shares. 

Vested stock is unequivocally owned by a founder and may not be repurchased by the company if that founder exits. Unvested stock may be repurchased by the company from the founder if the founder leaves. A founder stock vesting agreement sets the conditions that must be met in order for unvested stock to become vested stock — in other words, for the company to forfeit the right to repurchase the shares in the event the company and the founder part ways.

How do vesting agreements work?

A founder vesting agreement sets a schedule over which a founder will gradually earn the right to indefinitely keep their shares of stock in the company. The standard vesting period is typically 48 months. Each month, the founder earns 1/48th of their unvested shares, which then convert to vested shares. After the founder has put in four years of service, they may keep all their shares even if they depart from the company.

It’s also standard for founder vesting agreements to include a twelve month period at the beginning of the vesting schedule, called a “cliff,” during which shares are not vested but rather accrued. At the end of the 12th month of the vesting period, 12/48ths (or 25%) of the founder’s shares are immediately vested. Adding a cliff to the vesting schedule incentivizes founders to stick with the startup for at least one year if they want to keep any stock at all.

Vesting agreements don’t have to abide by a 48-month schedule — they may be shorter or longer or treat the cliff differently — but a vesting period shorter than 48 months may come across as a red flag to some investors.

Let’s look at a few example scenarios. Imagine one founder in a group of co-founders receives 1,000 shares of stock in their new startup and agrees to a standard 48-month vesting agreement with a 12-month cliff.

Why do startups create founder vesting agreements?

First and foremost, vesting agreements are designed to prevent founders from jumping ship early in the life of the startup and taking a large slice of the company’s stock with them. It’s sort of like a prenuptial agreement for founding teams; it protects the remaining founders from owing an exiting founder more than they’ve earned according to the amount work they’ve put in so far. 

Vesting a substantial percentage of a founder’s stock up front with no cliff can lead to disaster if that founder quickly loses interest and moves onto something else. For a young startup, an integral co-founder going AWOL with a significant amount of vested stock could be an insurmountable obstacle. However, with a vesting agreement in place, the startup can simply buy back the exiting founder’s remaining unvested stock.

Investors also usually want the startups in which they invest to have founder vesting agreements before they’ll commit their money. Whether a founding team wants to create a vesting agreement for their own sakes or not, they may have to create one to satisfy the requirements of venture capitalists or angel investors.

Sometimes, vesting agreements stipulate that certain founders are entitled to a portion of vested stock up front to compensate them for the effort they’ve already put forth to establish the startup. This can be a risky decision for the other co-founders involved, and it will probably be met with some pushback from investors. However, if there’s ample evidence that a founder has already contributed significantly at the time the vesting agreement is created, that founder may be able to negotiate a small amount of unvested stock up front (likely no more than 10% - 20%). 

What if the startup is sold before the end of the founder vesting period?

A scenario that sometimes worries founders is the startup changing ownership (in the event of a buyout, for instance) before the vesting period is complete. Most vesting agreements include an accelerated vesting clause that protects founders’ unvested shares if the company changes hands. These clauses typically take one of two forms:

Single trigger vesting stipulates that all the founders’ unvested shares be immediately vested at the time the change in ownership occurs.

Double trigger vesting stipulates that the founders’ unvested shares be vested only if the company changes ownership and the new owner terminates them. The new owner may feel that retaining the core leadership team is necessary to achieve an efficient transition — double vesting encourages the founding team to remain involved after the ownership change because they still have unvested shares to earn. 

What if a founder is terminated without cause?

Another understandable concern from founders’ perspectives is the vesting protocol when a founder is terminated without cause (and there’s been no change in ownership). Just as no founding team wants to find themselves in a position where they’re forced to relinquish shares to an uncommitted founder, no individual founder wants to be required to give up their unvested shares because they were forced off the team for no good reason.

In many cases, allowing accelerated vesting in the event of termination without cause seems perfectly fair. Nevertheless, startup teams should be careful when adding this kind of exception to their vesting agreement. The problem is that the legal definition of “cause” in the context of termination is very vague. While criminal behavior and other gross misconduct is fairly easy to define, there are many subjective reasons for firing a founder that are not so easy to judge. 

For example, if a startup team realizes one founder has an inadequate soft skill set for their position, that’s a perfectly valid reason for termination from a business strategy standpoint — but it may not be protected under the legal definition of “cause.” Clearly, this is a messy issue, so it’s vital for a founding team to agree on clear definitions up front before they pen an allowance for accelerated vesting based on cause of termination.

Does your startup need a vesting agreement? 

A founder vesting agreement is almost always a good idea. Even if you feel certain that everyone on your founding team is fully committed for the long-haul, it’s wise to plan for the worst case scenario. Founder disagreement is a common cause of startup failure, and without a vesting agreement, a bad founder exit will only get uglier. 

If you’re still not sure whether your startup needs a vesting agreement, or if you want to create one but aren’t sure where to begin, a mentor can set you on the right track. An experienced startup founder, investor, or other seasoned professional in the startup space can give you tailored advice and provide a knowledgeable perspective.

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