Welcome everyone to another edition of my Global Tech Law Newsletter. This week, a quick note about founder shares, specifically whether they should be on a vesting schedule or not. And whether they should be subject to “clawback” provisions. This is something that has come up a lot for us recently with our clients, so it's time to do a post on it.
On vesting, its not something that is so obvious to founders when they begin. Everyone agrees on an ownership of the new enterprise based on their perceived value and (time) contribution. Sometimes founders simply default to roughly equal percentages, say 1/3 each for 3 founders.
But what if six months into the venture, one of the founders voluntarily leaves or cannot continue to work for medical or other reasons? Should they still own 33.3% of the company? Of course not, right?
One of the concepts that founders don’t automatically wrap their head around is the idea that founder equity is not compensation for work done today, and for heavens sake not just for who had the idea for this or that part of the business. Founder equity is “sweat equity”, and its called that because its equity you still have to earn after Day 1 to slave away with all your heart to make the business a success. Its compensation for future effort not present day standing.
A vesting schedule, where that initially 33.3% vests over 2, 3 or 4 years is the solution. Often times there will be a “cliff”, meaning that nothing vests until the end of the first year, and then vesting occurs monthly on a pro-rata basis. The cliff is there to address the idea that if someone leaves after 6 months, he or she probably didn’t have time to do enough to make any meaningful contribution.
Also, in many ways it pays to get ahead of the curve on vesting in preparation for negotiations with VC investors. If sophisticated outside investors see founders with most of their equity already completely locked in, they often will compel founders to have shares re-granted and go back on a vesting schedule. A pre-existing vesting schedule stands a better chance of being left intact by investors, and also prevents the clock from starting over on the 5 year waiting period for the Qualified Small Business Stock tax benefit for founder stock (a subject that deserves its own future post!).
Going a step further than vesting schedules, clawback provisions require a departing founder to sell back shares at a pre-agreed (often low) price or forfeit a certain amount of equity if the founder departs before an “exit”, such as a trade sale of the company to a buyer. A departing founder in this case being one who voluntarily leaves or one who is terminated for cause.
Without a doubt, to some it can seem punitive, and in many ways it is. Therefore, some founders refuse to have these provisions included. Yet it can be a useful tool for removing a founder who is acting recklessly, utterly mismanaging an aspect of the business, or in extreme cases, engaging in fraudulent or criminal behavior. Because that person likely will have to be replaced with someone who will also command an equity grant, it can be justifiable in circumstances like these to have a clawback provision to remove the original founder now holding “dead equity” on the cap table to make room for the new person.
Okay that’s it for this week’s newsletter blog! I am going to continue to write about things I see, particularly that cut across all geographies. Stay tuned for another post next week and be sure to subscribe!
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