Series A and later term sheets usually include founder vesting clauses – i.e. where a founder’s shares are issued up front but only unconditionally owned once they are earned over time. In this ‘Tricky Clauses’ guide we look at how vesting works, good leavers and bad leavers, cause, and what you should think about as a founder before you sign.
how does founder vesting work?
Founder vesting comes up in a few scenarios:
- under an ESOP, where an employee receives unvested options over shares in a company
- when co-founders sign vesting agreements before their company has investors (for an example see our founder agreement template).
- in fundraising documents where investors seek new restrictions on founders.
In this guide, we look at the third item above – where investors ask a founder to sign up to new vesting arrangements.
Vesting incentivises founders to stick around for a period, usually 3-4 years. Investors back startups based on the team as much as anything. Your series A term sheet is therefore very likely to have a clause such as this:
“Founders’ shares will be subject to a 4-year vesting period, with a 1-year cliff, with vesting being on a monthly basis thereafter.”
how much should be vested?
Should 100% of a founder’s shares be vested? Not necessarily. If founders have been working in the business for several years they have a good argument that most of their shares should be vested. Sometimes founders may even have put their own cash into the business during its early life. Having paid value for those shares, it is harsh for them to lose them if they leave before the end of an agreed vesting period for whatever reason.
Generally on deals, we see 50% – 75% of a founder’s shares subject to vesting, rather than the full 100%. This varies a lot however. Investors will argue that the purpose of vesting is to look forward rather than back, and that they are simply trying to retain the people who are key to justifying the valuation at which they are investing. The counter argument is that if founders have been slogging away for some time, they have earned most of the shares anyway.
how long should a founder vesting period be?
Vesting periods in Southeast Asia are typically 3 or 4 year periods, with 4 years the most common. Following the lead from the US, we often see a chunk of shares vesting after 12 months (the cliff) with the balance over the next 3 years. So a typical vesting period could be 25% immediately vested, a further 25% vesting after 12 months with the balance over the remaining 3 years. There is plenty of variation on this however.
good leavers and bad leavers
There’s generally a difference between a ‘good leaver’ and a ‘bad leaver’. Typically a founder is a good leaver where his or her employment has been terminated by the company without cause; or where he or she voluntarily terminates employment with approval of the board (including normally the investor director). An example of someone being dismissed without cause might be where he or she is terminated for performance reasons, as opposed to some kind of misconduct.
why does it matter if a founder is a good leaver or a bad leaver?
It matters because the departing founder’s shares are treated very differently. In Southeast Asia, we typically see the following:
- in a good leaver situation, the company can buy-back unvested founder shares at a price based on the greater of the fair market value (FMV) and the subscription price paid for such shares (which is usually nil or a nominal amount). The departing founder typically keeps his or her vested shares.End result: founder walks out, holding on to his/her vested shares, and might get cashed for the unvested portion at FMV – all in all, not a bad result.
- in a bad leaver situation, the departing founder can lose all of his or her shares with the purchase price of the unvested shares set at the lower of FMV and the subscription price paid for the shares; and the vested shares at the greater of FMV and that subscription price.End result: founder walks out holding no shares in the company at all, forfeiting his or her unvested shares for effectively nothing but getting FMV for the vested portion. Harsh on a founder, but bad leaver is meant to be a rare scenario.
In short, there is a material difference in being deemed a good leaver as opposed to a bad leaver.
why it gets contentious
Good leaver and bad leaver discussions get heated because there are many ways a founder can leave the business. Investors often have different views as to how cause should be defined and try to bring in elements of performance. To avoid disputes in the future, our view is that cause should be limited to say misconduct or dishonesty, i.e. behaviour which causes harm to the business.
Sometimes, investors include provisions under which they can take up the shares if the company is unable to do so – for example, the share buy-back is not permitted under law. Our view is that any shares offered should be allocated across all shareholders so investors cannot use a bad leaver scenario to significantly increase their shareholdings at no, or minimal, cost.
the takeaway on founder vesting
Vesting is not meant to penalise founders unfairly. Rather, the idea is to help startups retain key people. And ultimately to rebalance the cap table if a founder does leave so that shares can potentially be re-issued to new hires. The good leaver and bad leaver mechanism should reflect that principle whilst being fair to both company and founders. If founders have been working in the business for a long time, less of their shares should be vested in the first place.
If you are currently discussing a term sheet which might include founder vesting provisions, get in touch with us or book a time to chat with one of our startup lawyers.