06 June 2022
In this very brief article, let’s understand a very important clause that is a part of almost all Shareholders Agreements (“SHA”), which is the vesting clause.
To understand this in detail let us first understand what an SHA is.
An SHA is an arrangement among a company's shareholders that describes how the company should be operated and outlines the shareholders' rights and obligations. The SHA is intended to make sure that shareholders are treated fairly and that their rights are protected.
There are a multitude of reasons why an SHA becomes one of the most important legal agreements that any startup enters into, as it covers several important issues, such as:
Some of the other prime things that are incorporated in an SHA are how shares are transferred in a scenario where the investor comes along and a shareholder refuses to sell or dilute their shares. It also specifies the case where a shareholder wanting to sell their shares has to offer his shares to the investors before they offer them to anyone else.
Now that we have a basic understanding of what an SHA is and why it forms an essential agreement for a startup, let’s move on to understand what promoter vesting means and why it’s important to be included in an SHA.
What is Founder Vesting?
Founder vesting is the process by which a founder ‘earns’ his shares in the company over a period of time. The terms of such vesting are determined in accordance with the specific clauses inserted into the SHA, but the vesting usually takes place either over a period of years or when a specific milestone is hit. The purpose of having such a provision in the SHA is to prevent the founders from selling their stake in the company so long as the investors hold any shares in the company.
To understand how founder vesting works, let’s take a small example:
Say in the SHA there is a four year vesting period for the promoter’s shares and 25% of the shares to vest every year. The founder will not receive the right to sell his 100% of his equity upon signing the SHA. Instead, he will receive 25% equity for four consecutive years, totalling 100% of his shareholding over the four year vesting period.
A ‘cliff’ on the other hand means the time period between the signing of the SHA and the first vesting date, within which the founder shall not have any access to his shares. So taking the same example as above, let’s add a one year cliff to the four year vesting period. In this case, during the first year from the date of signing the SHA, the founder will not be able to sell any of his equity. After the first year, the founder’s vesting period will begin. In years 2-5, the founder will earn 25% equity each year, totaling 100% equity after five years with the company.
Let us also understand why it is important to have such a vesting clause in the SHA.
Startups have limited capital and rely majorly on the founders’ efforts to work and stabilize the company and by vesting their shares over several years, a startup can motivate founders to stay and continue their efforts to grow the business.
It is a market practice for professional investors like venture capital firms or angel investors to demand vesting of founders’ shares before committing to their investment. It is a practical way to ensure the commitment of people involved in the company, and also to protect them from departing.
Thus, as we can see from the above, inserting a founder vesting clause in an SHA is of utmost importance as it protects the interests of both the investors as well as the founders. It enables the investors to safeguard their investment in the company by ensuring that the founders stay committed to their goals for the startup. On the other hand, it acts as a motivator for the founders to put in the work necessary to increase the valuation of the company.
Ultimately, it safeguards the best interests of the startup by acting as an insurance policy against a founder who ultimately isn’t a good fit for the company. Without share vesting, a founder could walk away (or even be terminated) from their service commitment but remain a partial owner of the company. To provide for such cases, the vesting clauses in SHAs often deal with provisions related to exit of the founders during the vesting period, which provide for how the founders’ unvested shares are going to be dealt with.
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