Founder vesting terms are one of the most-negotiated terms in early-stage venture investments (next to economic terms such as valuation). As a founder-turned-VC, I have been at both sides of the table during such negotiations. These experiences have taught me the importance of having good founder vesting terms at early-stage companies, both for the founders as well as the investor(s) of the company. Scroll down to the end for the TL;DR 😉
My personal vesting story
In 2015, marketplace models were popping up for all kinds of services around the house. There was Movinga/Movago for moving, Thermondo for technical installations, HomeBell for all-round craftsmen, etcetera. These industries had previously been fully offline or – at best – dominated by online lead generation models. Supply was (and still is) very fragmented and typically not very tech-savvy. This meant there was room for an online (managed) marketplace.
The painting market in Germany was no different. After some research and brainstorming, my friend and former Rocket Internet colleague Alex launched a WordPress page and the first ad campaigns. The idea for Weissmaler was born. A few weeks later, I joined Alex as a cofounder.
We found that most painters did not know how to effectively attract customers through online advertising. This made it easy for us to find potential customers through channels like Adwords. We wanted to offer more value than just lead generation, so we built a pricing model in Excel. Rather than sending phone numbers of painting companies, we would provide customers with quotes. If a customer accepted our quote, we would find the right painter to carry out the paint job for us.
We got some early signs of traction and the unit economics looked good. A business angel showed a keen interest in our company, and we raised a pre-seed round. As part of the investment terms, we agreed to a four-year vesting schedule.
Fast forward to late 2016. The business was doing well and the number of jobs per month had grown into the hundreds. However, we weren’t making any money so we were in the process of raising a second seed round, this time from a group of angels. Throughout this process, Alex and I had various discussions about our plans and ambitions for the company. Without going in too much detail here (perhaps an interesting topic for another article) we came to the joint conclusion that I would leave the company.
Easier said than done. I owned ~40% of the shares in the company. How would we deal with this situation? Luckily for all parties involved, we had a founder vesting clause in our shareholders’ agreement to help us out.
Founder vesting: the key terms
Most early-stage investors, be it angels or venture capital funds, ask for founder vesting terms when they make an investment. A vesting clause ensures that the founders stay committed to the business for a certain period after the investment. The investor invests money into the company, and the founders commit to investing their time.
The key terms of the vesting clause are:
- the vesting period: this is the period that the founders have to stay committed to the business. During this vesting period, the founders “earn” or vest their shares. If they leave before the end of the vesting period, they typically lose (part of) their shares. In early-stage investments, this is typically 4 or 5 years. In later stages (late Series A, Series B) this is typically reduced to 3 years.
- the vesting scheme: in most cases, you’ll see that the founder vests their shares on a linear monthly vesting scheme. In a five-year vesting schedule, this means that a founder vests 1/60th of their shares at the end of each month. Other alternatives are quarterly or non-linear vesting (e.g. vesting more in the first or last year of their vesting period).
- the cliff: oftentimes, the investor will negotiate that the founder(s) need to stay at least one (or two) years after the investment. Should the founder leave within these first 12 months, then none of their shares will vest. They will lose all their (unvested) shares. After the 12th month, 12/60th of their shares will vest immediately.
These vesting terms will result in a vesting schedule. Such a schedule gives an overview of how many shares have vested per which date. See an example of a vesting schedule below and via this link.
Founder vesting: balancing interests
If all goes well, the founders and investors will never look at the vesting clause again after the investment. However, circumstances may change over time causing a founder to leave the company. In this case, the vesting clause should balance the interests of the parties involved: the departing founder, the remaining founder (for simplicity let’s assume there are two founders), and the company (which includes the investors).
When discussing vesting terms, founders often reason from the perspective of the departing founder. Naturally, they want to protect their own interest in case they will leave the company during the vesting period. However: where one founder departs, the other founder remains. The remaining founder now suddenly has to run the company alone, without their trusted counterpart.
Imagine a company with a commercial founder and a technical founder and the latter leaves. The commercial founder now also has to oversee product, development, etcetera. This will likely have a negative impact on the company as a whole. The vesting clause, therefore, needs to balance these interests carefully. Does the departing founder get to keep their shares? Should the company get these shares back, so they can attract new talent?
Founder leaver scenario’s: the Good, the Bad and the Early
The answers to the questions above depends on the circumstances under which the founder leaves. It’s one thing if a founder simply “quits”, but it’s another if they leave the company because they get fired for something like fraud. Most vesting clauses distinguish three types of leaver scenario’s:
Bad Leaver: when a founder damages the company
If a founder intentionally hurts the company’s interest, breaches its fiduciary task as a board member or breaches a material obligation, they can get fired with cause from the company. Think cases of fraud or theft or a founder who breaks their non-compete clause by starting an adjacent business.
Vesting clauses typically have little sympathy for the departing founder in such situations. They have deliberately damaged the company with their actions and should suffer severe consequences. Most vesting clauses, therefore, stipulate that such scenarios are bad leaver scenarios. In these scenarios, the departing founder will have to transfer back all their shares (both vested and unvested) This draconic measure should work as a deterrent mechanism: if a founder deliberately damages the company, they should not get any value out of the company (and possibly a lawsuit on top).
A bad leaver situation should not be taken lightly. To protect the founders from this situation the bad leaver clause is usually linked to the local labor law regarding “dismissal with cause”. If the departing founder gets dismissed as a bad leaver, they can choose to take the case to court. In this case, the final verdict on whether the founder was indeed a bad leaver, is up to the judge.
Early Leaver: when a founder “quits” the company
If a founder voluntarily decides that they want to leave the company and pursue other interests, this typically qualifies as an early leaver (or voluntary leaver). You could think of this scenario as the departing founder who “quits their job”. Imagine a founder who, halfway through the vesting period, wants to take a more secure job at a corporate, for example.
In such a case, the founder typically gets to keep the vested shares, but will likely have to give the voting power on these shares to the remaining founder. This way, the departing founder no longer has a say in the company decision making after their departure. This is especially important if there is some friction between the founders: you don’t want the departing founder to frustrate the progress of the company and the remaining founder.
The departing founder typically has to return the unvested shares to the company (or the other shareholders) for the nominal value. The company will need to replace the departing founder with new talent, and can use the returned unvested shares as an incentive.
Not all vesting clauses include a clause for an early/voluntary leaver. Some investors are more strict on this matter and treat an early leaver similar to a bad leaver (which means they have to give back all the shares). This is more common when dealing with US-based investors. From my experience, this is not market standard in Europe.
Good Leaver: every other situation where a founder leaves
The bad and early leaver clauses only apply to very clearly defined cases. The good leaver clause, however, is a catch-all provision: if a founder leaves and they are not a bad or early leaver, they are a good leaver. It’s important to structure the clause as a catch-all to prevent a situation where a founder leaves, but none of the vesting clauses is applicable.
Some examples of good leaver events are:
- the founder can no longer work due to a permanent disability or illness;
- the founder underperforms and is asked by their co-founders or the board to leave the company; or
- the founder leaves the company after the vesting period.
In these cases, the founder is asked (or in some cases forced) to leave the company, possibly against their own will. This is the scenario that most founders dread when negotiating founder vesting terms. Again, as a founder, it’s important to realize that you may be the one asking (or forcing…) your cofounder to leave.
You want to make sure that you have the right terms in place to protect the long-term interests of your company. We have seen companies where the remaining founders only realized that they negotiated in the wrong direction after one of the founders left with a substantial amount of shares.
A good leaver situation is the toughest case to balance the interests of the involved parties. On the one hand, you want to make sure that the founder who is forced to leave gets a fair deal. On the other hand, you want to make sure that the company can move forward after the founder is gone.
In case of a good leaver event, the departing founder typically gets to keep the vested shares. Again, we recommend assigning the voting powers to the remaining founder to prevent them from obstructing decision making.
The unvested shares should be offered back to the company (or the shareholders), but the question is: at what price? Since the founder is asked or forced to leave the company, their chance to vest the remaining shares is ‘taken from them’. At Peak Capital, our view is that the unvested shares should be offered back to the company at a significant discount to the fair market value. This way, the departing founder is compensated for having to sell their shares, while the company can purchase these shares at a good price and use them to attract new talent.
Next time you’re negotiating your way through a term sheet as a founder, keep in mind that the vesting clause serves two purposes.
- On the one hand it’s meant to keep you and your cofounders committed to the company for the years after the investment.
- On the other hand, it’s also meant to balance everyone’s interest in case a founder does leave.
The departing founder might be you, but it could also be your cofounder. Keep both scenarios in mind when negotiating the clause. The trick is to distinguish the scenarios in which a founder might leave – remember the Good, the Bad, and the Early – and agree on consequences for each scenario.
So what happened to those Weissmaler shares?
At Weissmaler, we had a four-year vesting schedule in place with no cliff. The vesting clause did not include an early leaver clause, which meant that I was a good leaver. This meant I had to forfeit my unvested shares, which were used to hire a new COO, who helped Alex to continue building and growing the business.