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Why do VCs insist on founder vesting and why should you as a founder agree to it? After all, you are the founder and this is your company!
What is it?
Founder vesting is the concept that a founder’s total ownership in a company is agreed to in the present and earned over time, not that much unlike a salary or other time-based compensation. If a founder leaves a company, the unearned portion of their ownership is cancelled or returned to the company.
When fundraising from early-stage institutional venture capital firms, expect to run into vesting requirements.
Two founders start ACME Inc and own 50 percent each. Founder A and B earn that ownership 10 percent per year (typical vesting occurs monthly, but for simplicity, this example uses yearly). For whatever reason, Founder A leaves after the second year of their own accord. They weren’t forced out of their own company. Their vested portion is 20 percent and unvested portion is 30 percent. That remaining 30 percent is returned to the company, typically into the options pool. Founder B still owns 50 percent, 2/5ths of it vested.
Let’s back up a step. You have two lenses through which to see your company: Founder and shareholder.
Founder vs. shareholder
As a founder, your incentive is to own as much of your baby as you possibly can. This is fundamentally an emotional decision, not an economic one. As a shareholder, your decisions should be economic in nature. Your total value of ownership tomorrow should be greater than the total value of ownership today.
When you receive a term sheet that insists on founder vesting, it’s fine to rage against the machine for a few hours.
Founder vesting is fundamentally a shareholder decision. The experience of almost every investor, venture capital or otherwise, is that in early-stage businesses if you have a key founder leave the business you’ll need to replace him or her with an equally key hire. If the company doesn’t, experience tells us time and time again, that the company is very likely to fail.
Using our initial example above, if the company fails, that 50% equity stake is worth $0.
If the company is able to use the 30% returned equity to hire an impressive key employee, not only can that individual help keep the company alive they will hopefully make it thrive. That 20% is likely to be worth something! And something is definitely greater than $0.
The need for founder vesting becomes even more critical in startups with multiple co-founders. If one co-founder leaves the company early on and keeps the same amount of equity without putting any time and effort into building the business, it’s fundamentally unfair to the other founders. Take the example of ACME Inc above. If A and B didn’t have any founder vesting and A left after two years, and B builds an impressive business over the next five to eight years — explain to me why A should own half the business?
Founder vesting is a protection for all shareholders, yourself included, in the event of an utterly unexpected life event.
For the amount of work they are going to continue to put in, and for the risk they will be taking, founder vesting agreements are nothing more than a prenuptial agreement outlining and protective all parties against negative scenarios that might occur in the future. No one wants the negative scenarios, but they happen to some startups. We collectively just don’t know which ones.
As previously mentioned, when a co-founder departs, you’ll likely need to replace them for the same reason, as described above, as for a solo founder. How can you run your company without a CTO? How can you continue to execute the business plan and lead a team without a CEO? As with any employee, you’ll need to offer shares to attract and retain the new key hire.
In our experience, a substantial amount of startups go through these changes. Just because life happens! It’s worth mentioning that founder vesting is only triggered in unusual circumstances when the founder is volunteering to leave or fired for cause (a very high bar, usually related to outright fraud or criminal behaviour). In our experience, departures of founders have been entirely voluntary based on utterly unplanned life occurrences. This is the stuff you just can’t predict.
So when you receive a term sheet that insists on founder vesting, it’s fine to rage against the machine for a few hours. That’s you reacting emotionally and it’s healthy.
The economic rational decision is an obvious one. Founder vesting is a protection for all shareholders, yourself included, in the event of an utterly unexpected life event.
Similar to ESOP: Three to four years vesting period with a 12-month cliff.
Single or double trigger provisions: accelerated vesting in the event of a sale of the company before the end of the vesting period
Sweat equity: investors recognize the amount of work and risk put into the business before the funding by the founder(s) and allow them not to be subject to a complete reset on ownership. A.k.a. partial vesting.
Lastly, the simple fact is the vast majority of founders stay with their companies well past their vesting periods and fully vest all their ownership. Going into a deal, that’s what every VC wants.
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