Founder Vesting and Lock-In in a Shareholders’ Agreement

In the dynamic landscape of startups and entrepreneurial ventures, the journey of founding a company is often marked by passion, innovation, collaboration, and shared vision. However, the journey of growth is never linear and founders should be equipped with the tools to anticipate and address potential challenges that may arise along the way. 

One such crucial aspect is founder lock-in and founder vesting, a mechanism usually incorporated into shareholders’ agreements (hereinafter “SHA”) when an investor comes on board, with the goal of safeguarding the interests of all stakeholders and ensuring the sustained commitment of founders towards the company’s long-term success.

What is a Shareholders’ Agreement?

The 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.

Importance of a Shareholders’ Agreement 

The SHA is a vital roadmap for any startup. It establishes clear rules for company governance, prevents disputes from derailing progress, and assures investors of a transparent and stable organization. By outlining share transfer restrictions and founder commitment mechanisms, the agreement safeguards the interests of all parties and paves the way for long-term success.

1. Governance & Control:  Imagine the SHA as a company rulebook. It lays out how the company will be managed, outlining voting rights, decision-making processes, and the roles of shareholders and directors. This clarity prevents confusion and power struggles down the road.

2. Shareholder Stability: The SHA restricts how shareholders can buy and sell shares. This prevents unwanted dilution (loss of ownership stake) and potential instability caused by sudden ownership changes.

3. Dispute Resolution:  Disagreements are inevitable. The SHA establishes a clear process for resolving disputes between shareholders or between shareholders and the company. This saves time, money, and acrimony compared to drawn-out legal battles.

4. Transparency & Trust: By outlining shareholder rights and obligations, the SHA creates transparency. Investors and banks see this as a sign of a well-organized and accountable company, making them more likely to invest.

5. Founder Commitment: In some cases, the SHA can include founder lock-in and vesting schedules. This means founders accept a transfer restriction on their shares and gradually earn ownership over time, incentivizing them to stay committed and build long-term value.

What is Founder Lock-in and Founder Vesting?

Founder lock-in simply means restricting the founders from transferring their shares to any third party. This is a contractual transfer restriction and is typically instituted to prevent share transfer by a founder while the investor is a shareholder and/or for a specified period, without the investor’s express consent.

Founder vesting refers to the process by which founders gradually earn full ownership of their shares over a specified period, typically contingent upon their continued involvement with the company. This arrangement mitigates the risks associated with founders departing prematurely or losing motivation, thereby protecting not only the investors’ interests, but also the integrity and stability of the business.

What is the difference between Founder Lock-in and Vesting?

Particulars	Lock-in	Vesting
Primary Purpose	The primary purpose of a promoter lock-in provision is to ensure that the promoters do not exit or liquidate their holdings in the company prematurely.	The primary purpose of a vesting schedule is to determine the actual share entitlement of the promoters at the time of their exit from the company.
Duration	Absolute restriction usually till the time the investor holds shares in the company or for a specified period of time typically 3-5 years.	Gradual earning of the shares over a period of time. This is usually pegged with the lock-in period to maintain uniformity.
Trigger Event	A lock-in is triggered upon initiation of the transfer process of shares by the promoters, i.e., the promoters are required to procure express consent of the investors before actually transferring the shares.	Any exit of promoters from the company, i.e., termination of their employment with the company due to a ‘bad leaver scenario’ such as fraud//wilful default, resignation without consent of the board, etc. or a ‘good leaver’ scenario such as resignation with approval of the board, or any other scenarios wherein the exit of the promoter is amicable.

How do Founder Lock-in and Vesting relate to each other?

Vesting of founder shares or more precisely a reverse vesting provision is a concept that signifies founders ‘earning’ their equity over time. This mechanism requires all the shares held by the founder to be subject to a virtual reverse vesting schedule, wherein the shares of the founders are virtually released to such founder, over a period of years or when specific milestones are reached. This flows from the concept of the founder lock-in, where the founder agrees to subject their shares to the reverse vesting schedule. 

Founder vesting is a contractual arrangement commonly used in startups and early-stage companies to ensure that founders’ ownership of the company’s shares is tied to their continued involvement and contribution to the business over time. Under a founder vesting agreement, founders typically agree to a schedule over which their ownership of shares gradually vests, often over a period of several years. This means that although founders may initially receive a portion of their shares when the company is founded, they must earn the right to fully own all of their shares by remaining with the company for a predetermined period. In other words, when a founder agrees to such a mechanism, the majority of their shares are locked away and thus cannot be transferred or transacted with. They fully regain such rights and “unlock” all their shares only upon completion of the vesting schedule, wherein a fixed amount of shares is periodically unlocked at predetermined, contractually agreed intervals.

Why is Founder Lock-in and/or Vesting required?

The purpose of founder vesting is to align the interests of the founders with the long-term success of the company. By requiring founders to earn their ownership stake over time, founder vesting incentivizes founders to stay committed to the company and actively contribute to its growth and success. It also helps protect the company (and by extension the investors and other shareholders) in case a founder decides to leave prematurely, by ensuring that unvested shares can be reacquired by the company or redistributed to remaining founders or new employees. 

(i) Retention of Founders: By subjecting founders’ shares to a vesting schedule, the investors safeguard their investment by ensuring that founders do not prematurely exit the company by selling their shares. This commitment from founders is vital to maintain investor confidence and support the company’s long-term vision and growth.

(ii) Facilitating Transition: In the event of a founder’s departure, the vesting schedule provides a structured mechanism for the remaining founders to onboard new talent or co-founders. This ensures continuity in leadership and mitigates the disruption that could occur from the departure of a key team member.

(iii) Equity and Fairness: Co-founder vesting prevents departing founders from unfairly benefiting from the ongoing efforts of the remaining team members who continue to build the business. It ensures that all founders earn their ownership stake based on their ongoing contributions, promoting fairness and equity within the founding team.

Moreover, co-founder vesting acts as a safeguard for investors, signaling founders’ commitment to the company’s success while incentivizing them for their continued dedication and effort in growing the business. This alignment of interests between founders and investors is essential for fostering a collaborative and mutually beneficial relationship, ultimately driving the company towards its strategic objectives and maximizing shareholder value.

Understanding Cliff Period, Upfront Vesting and Vesting Schedules

In the intricate realm of founder vesting within an SHA, several key concepts play pivotal roles in shaping the dynamics of equity ownership and commitment among founders. Among these concepts are the Cliff Period, Upfront Vesting, and Vesting Schedules. These elements form the bedrock of founder equity arrangements, providing essential structures that balance the interests of founders, investors, and the company itself. Understanding the nuances of these components is crucial for founders and stakeholders alike, as they navigate the complexities of startup governance and strive to foster a culture of accountability, continuity, and alignment within the organization. Let’s delve into each of these concepts to unravel their significance and implications in shaping the trajectory of startup ventures.

• Cliff Period: The cliff period refers to an initial period of time during which no vesting occurs. Instead, upon completion of the cliff period, a significant portion of the shares (often 25% to 33% of the total shares subject to vesting) becomes fully vested. The cliff period is typically set at the beginning of the vesting schedule, and it serves as a threshold that founders must cross before they begin to earn ownership of their shares. The purpose of the cliff period is to ensure that founders are committed to the company for a minimum period before they are entitled to any ownership rights. It helps prevent situations where founders might leave shortly after the company is founded, without having contributed significantly to its growth.

• Upfront Vesting: Upfront vesting refers to the immediate vesting of a portion of the founder’s shares at the inception of the vesting schedule, often occurring concurrently with the cliff period. This upfront vesting provides founders with some degree of ownership rights from the outset, while still incentivizing them to remain with the company for the duration of the vesting period. Upfront vesting is commonly used to recognize the contributions and risks undertaken by founders in the early stages of the company’s formation, while still ensuring that their continued involvement is incentivized through the vesting of additional shares over time.

• Vesting Schedules: Vesting schedules outline the timeline over which founders earn ownership of their shares. These schedules specify the rate at which shares vest, typically expressed as a percentage of total shares subject to vesting that becomes eligible for ownership over regular intervals, such as monthly or annually. Vesting schedules can vary widely depending on the specific circumstances of the company and the preferences of the founders and investors. Common vesting schedules include linear vesting, where shares vest gradually over time in equal installments, and accelerated vesting, which may occur upon certain triggering events such as a founder’s departure or the company’s acquisition.

Treatment of Shares

Typically captured in the SHA and the corresponding founders’ employment agreement, treatment of shares is dependent on a “good leaver” or “bad leaver” scenario:

Good leaver – A good leaver generally retains all equity that has vested up to the point of departure. For example, if a promoter’s vesting schedule is at 4 years with a 1-year cliff, and they leave after 3 years, they would retain 75% of their equity (the portion that has vested). The treatment of unvested equity can vary, but in many cases, the shareholders’ agreement might allow for accelerated vesting of a portion of the unvested equity, depending on negotiations and company policies.

Bad Leaver – A bad leaver typically retains only the equity that has already vested, up to the point of departure. For example, if a promoter’s vesting schedule is 4 years with a 1-year cliff, and they leave after 2 years but are deemed a bad leaver, they would retain only the portion of the equity that has vested (50% of the granted equity). The company usually has the right to impose/initiate the transfer of the unvested shares at a nominal price or at a predetermined percent of the fair market value, depending on the terms outlined in the SHA.

Points of Concern to an Investor

(i) Premature exit: The vesting and lock-in provisions are essentially included to ensure that the promoters have enough skin in the game. This is especially important in early-stage companies with minimal traction as the promoters are the sole driving force for such companies.

(ii) Obligation to transfer: In the event any promoter prematurely takes an exit from the company, the investor should ensure that the provisions in relation to the mandatory transfer and/or repurchase of promoter shares are in place. Further, the obligation of departing promoters to sell their shares to remaining promoters/incoming promoters ensures that adequate headroom is created on the cap table for promoter holdings.

(iii) Duration of the vesting schedule: The length of the vesting schedule should be sufficient to ensure the promoters remain committed to the company’s long-term success.

Points of Concern to a Founder

(i) Extended Vesting Schedules: Typically the vesting schedule should cover a period anywhere between 3 to 5 years. Extended vesting schedules are onerous for the promoters and may pose flexibility/liquidity challenges.

(ii) Permitted transfers: The inclusion of transfers that are not bound by the lock-in restrictions is crucial. Generally, permitted transfers include inter-se promoter transfers, transfers for the purpose of estate planning and liquidity transfers.

(iii) Liquidity: Subjecting all of the promoters’ shares to lock-in may not be practical, hence, promoters may negotiate a certain percentage of their shares as free shares which they can transfer without the consent of investors or without any other transfer restriction (other than transfer to competitors). Liquidity shares usually can be about 5-10% of their own shareholding, depending on the stage at which the company is at.

(iv) Clawback: The clawback provision quite literally means that the shares of the promoter shall be clawed/bought back at the lowest permissible price. The promoters should be mindful that the operation of such provisions triggers only under grave circumstances.

Conclusion

In conclusion, while vesting and lock-in provisions are crucial rights for investors and may also prove to be useful for promoters to ensure that the other promoters are committed enough, it is important for the promoters to be mindful of the construct of this provision. The vesting and lock-in provisions can prove to be instrumental tools to align the interests of the promoters and the investors. However, oftentimes the departure or divestment by the promoters brings in its  own set of issues and the execution is seldom straightforward. In a nutshell, founder vesting within an SHA is a critical mechanism that serves to align the interests of founders, investors, and the company itself. By subjecting founders’ shares to a vesting schedule, the SHA ensures that founders are incentivized to remain committed to the company’s long-term success, while also providing safeguards for investors and promoting fairness among the founding team. Through provisions such as cliff periods, upfront vesting, and vesting schedules, founder vesting strikes a delicate balance between acknowledging founders’ contributions and mitigating risks associated with premature departures. Ultimately, founder vesting fosters a culture of accountability, collaboration, and sustained commitment, laying a solid foundation for the company’s growth and prosperity in the dynamic landscape of entrepreneurship.

Frequently Asked Questions on Founder Vesting

Q1: What is founder vesting?
A: Founder vesting is a mechanism that ensures founders gradually earn full ownership of their shares over a specified period, contingent upon their ongoing involvement in the company. It safeguards against founders exiting prematurely or losing motivation, protecting investors and the company’s stability.

Q2: What is the difference between founder lock-in and founder vesting?
A: Founder lock-in restricts founders from transferring their shares to third parties for a specified period, often tied to investor protection. Founder vesting, on the other hand, refers to founders earning their ownership of shares over time, often linked to continued participation in the business.

Q3: Why is founder vesting important?
A: Founder vesting aligns founders’ interests with the long-term success of the company. It incentivizes founders to remain committed and actively contribute to growth. It also protects the company from founders leaving early by allowing the reacquisition or redistribution of unvested shares.

Q4: What is a vesting schedule?
A: A vesting schedule outlines the timeline over which founders gradually earn ownership of their shares. It often includes a cliff period (an initial period during which no vesting occurs), followed by regular vesting intervals where a certain percentage of shares becomes vested.

Q5: What does a typical vesting clause look like?

A. A typical vesting clause will contain the following broad terms: (i) vesting period; (ii) vesting start date (i.e., the date when the vesting period begins; often the date of the shareholders’ agreement or the employment start date); (iii) vesting cliff; and (iv) vesting frequency. 

Q6: What is a cliff period in founder vesting?
A: The cliff period is an initial time frame (typically one year) during which no shares vest. After the cliff period ends, a portion of shares vests at once (often 25-33%), and then vesting continues at regular intervals.

Q7: What happens to a founder’s shares if they leave the company early?
A: If a founder leaves early, their vested shares may be retained, but unvested shares are typically forfeited. In “bad leaver” situations (e.g., fraud), the company may repurchase the unvested shares at a nominal price. In “good leaver” scenarios, vested shares are retained, and there may be provisions for accelerated vesting of some unvested shares.

Q8: How does founder vesting benefit investors?
A: Founder vesting ensures that founders remain committed to the company’s growth, preventing them from leaving prematurely and diluting their stakes. It protects investors by ensuring that founders continue to contribute to the company’s long-term success.

Q9: What is upfront vesting?
A: Upfront vesting refers to a portion of a founder’s shares that vest immediately when the vesting schedule begins. It is used to reward early contributions and risks taken by founders, while still maintaining incentives for long-term involvement.

Q10. What happens during the cliff phase of founder vesting?

A. The cliff phase on Founder Vesting means a period between the signing of the SHA and the first vesting date, during which none of the shares held by the founder are vested.

Q11. Whom does a Founder Vesting clause benefit?

A. A founder vesting clause benefits the investors by ensuring continued interest and commitment of the founders to the Company. It benefits the founders by incentivising them for their continued interest and commitment to the business of the Company and it also benefits the co-founders by building a mechanism of treatment of an exiting founders’ shares, which allows them to make provisions for a new founder, if any on boarded.