Founder vesting

The topic of founder vesting came up recently in working through a term sheet with the founding CEO of a business we offered to fund. In this situation, the founding team had been working together for nearly four years with a standard four year vesting plan in place. They would have been fully vested within six months of us making our investment. The company raised $500,000 previously on a note structure and were able to turn that investment into $1 million in annual recurring revenue before we offered to invest. In our term sheet, we asked them to reset their vesting schedule with the closing of our investment to align our interests. In other words, they would need to earn back a large portion of their equity as they spent the money we were investing in their business. We offered them 1/4 acceleration for time served - vesting to "the cliff" - but asked that the founders' remaining equity vest monthly over four years. This, justifiably, created some stress and agita amongst the founders, who felt they already earned their stock. Their perspective was reasonable and, as a longtime entrepreneur, I was sympathetic. From our perspective, as new investors, the investment was largely about partnering with a team that we think has the potential to build something special. If they weren’t properly motivated to stick around and work constructively together to build the business, it would have been a difficult investment for us to make. Fundamentally, this came down to alignment of interests.

Plenty has been written already about founder vesting by the venture blogging forefathers so there’s no need to rehash it all here. My favorite post on the topic is by Brad Feld who does a great job discussing alignment of interests and incentives, which is at the core of the issue in a partnership between VCs and entrepreneurs. Fred and Chris also have thoughtful discussions - the comments in Fred’s post are particularly worthwhile. The average gestation period for venture investments is long - five to seven years - so when we commit to invest in a team, it’s important that the timing of our investment lines up reasonably well with the timing of the team's commitment to build the business. The best way to do this is with vesting schedules. Vesting schedules should apply to, not just founders, but all employees. It’s fair and balanced, and keeps everyone on the same page earning their equity compensation over time. This is most important at the Seed/Series A stage since that’s traditionally when a company makes the decision to take outside funding partners for the first time in building their business. Later stage investments involve different considerations, and are theoretically larger businesses with larger teams, but it’s not uncommon for growth investors to want to re-align the interests of key employees via new stock grants or other similar measures.

In my discussions with the CEO of this company, I tried to present the case why resetting vesting schedules do more than protect the interests of the VCs. They also protect management from two very real possibilities that are common in early stage businesses - (i) bad hires and (ii) estranged founders.

Bad Hires: Hiring is hard and bad hiring decisions are inevitable in the course of building most businesses. No company hires perfectly. With a typical one year cliff, employees don’t vest any stock until the one year anniversary of their start date. This makes it much easier to part ways with someone who is a bad cultural fit or underperforming member of the team after 4-6 months (usually long enough to know) without complicating matters by them walking away with meaningful stock in the business for a minimal amount of time with the company. It makes intuitive sense for one year to be a threshold of time served before being able to own a piece of a business, and makes for a cleaner break if employees don’t reach that milestone.

Estranged Founders: Founders typically own the largest chunks of equity among the employees and when a founder leaves the business in the early days, they should only leave with the equity that has vested to that point in time. If no vesting schedule has been setup, there’s a chance that an early founder could leave with a sizable chunk of the company in exchange for a minimal amount of time served. Those of us who have been in the startup business a while have seen this play out and, needless to say, it adds complexity for management that’s less than ideal as the business evolves and grows.

In the situation above, after the initial resistance to resetting 3/4 of their vesting, the company agreed to our proposal. We are happy they did because we love the team and feel this aligns all of our interests in a way that gives us - as a team - the best chances for building a big business together. The CEO of this particular company eventually saw the value in resetting the vesting schedule and commented to me:

"For us, what it really came down to was that we have no intention of leaving. We all want to stay at the company and work together for as long as we can. Once we had comfort in the intention of the vesting schedule, we got back to thinking about building a big company."

Part and parcel with discussion of vesting schedules is what happens in the event of an acquisition or change of control of the business and what triggers acceleration of vesting. "Double trigger” has become industry standard, meaning that two things need to happen for full acceleration of vesting. First, there is a change of control, typically an acquisition, of the business. Second, the employee is terminated or not offered a suitable role with the new organization. In this case, both criteria (triggers) have been met for full acceleration of unvested options. Another possibility is that partial acceleration is given on change of control. Brad and Fred elaborate on these ideas in their articles (linked above) so click over there to learn more.

By Josh Guttman

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