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10 Jun 2024

Founder Vesting in a Shareholders’ Agreement

10 Jun 2024

What is a Shareholders’ Agreement?

A Shareholders’ Agreement (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:

1. regulation of the management of the company;
2. control over shareholders’ transfer of shares;
3. prevent disputes between shareholders and the company (and manage the process in the case it occurs);
4. prevent shareholder uncertainty by providing clarity as to the rights and obligations of the shareholders to the company and each other;
5. assist in raising finance from investor and banks by showing a clear demonstration of the affairs of the company;

 

What is Founder Vesting?

Vesting of founder shares or more precisely a reverse vesting provision is a concept that signifies founders ‘earning’ their equity over time. The mechanism of founder equity vesting or reverse vesting 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.

 

Why is Founder Vesting required?

The intent of subjecting the founders’ shares to a vesting schedule is multi-fold:

(i) ensure that as long as the investors retain their shares of the Company or up to a specific period of time, the Founders do not exit the Company by selling their shares;
(ii) in case one of the co-founders were to part with the company, the vesting schedule enables the non-exiting founders to create provision for on-boarding a new founder;
(iii) co-founder vesting also guarantees that a departing founder doesn’t gain unjust advantages from the efforts of the remaining team members who continue to build the business.
Co-founder vesting allows startups to build safeguards for the investors by ensuring the founders’ commitment to the company, at the same time ensuring that the founders are incentivised for their continued effort in building the business of the company.

 

Cliff Period, Upfront Vesting and Vesting Schedules

For early-stage startups, investors might require that the vesting of the founders’ equity be subject to a cliff period ranging from 6 months to a year following their investment. On the other hand, more established startups with a few years of industry experience may have the leverage to negotiate for a portion of their shares to vest immediately at the time of the investment.
There is no guiding principle for a typical vesting schedule for founders, however, we see in many investment deals, a four-year vesting schedule (the duration depends on the negotiation between the founders and the investors), with 25% of shares vesting every year. This means, a founder will have access to 25% of the total shares held by him for four consecutive years, totalling 100% of their shareholding at the end of the fourth year.
Inserting a founder vesting clause in a shareholders’ agreements acts as an insurance policy against a founder who ultimately isn’t a good fit for the company. Vesting clauses in shareholders’ agreements often deal with provisions related to exit of the founders during the vesting period, which provide how the founders’ vested and unvested shares are dealt with.

 

Conclusion

In conclusion, including a founder vesting clause in a shareholders’ agreement is essential as it protects the interests of both investors and founders. It encourages founders’ long-term commitment safeguarding the investor’s investment in the company.

 


FAQs about Founder Vesting in Shareholder Agreements

Q. What is Founder Vesting?

A. Founder vesting or co-founder vesting is a process by which a founder earns shares in a company over a period of time. No separate founder vesting agreement is required to be executed for the terms of such vesting and they are determined according to the specific clauses inserted into the shareholders’ agreement.

Q. Why is Founder Vesting important?

A. Founder vesting is important because it ensures the investors’ investment in the company is safeguarded by making sure that the founders stay committed to their goals for the startup. It also motivates founders to increase the value of the company by putting in the necessary work.

Q. 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.

Q. 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.

Q. What is a vesting schedule?

A. Think of it as a roadmap to full ownership. This schedule outlines how much of your stock options or benefits vest (become yours to keep) over a specific period, often years. It’s like having a progress bar that fills up as you stay with the company.

Q. Why do I need a vesting ESOP grant letter?

A. This letter spells out the details of your stock options grant, including the vesting schedule and other critical terms. It’s your official document proving your ownership rights as they vest. Consider it your treasure map to those stock options!

Q. What is a 1-year cliff vesting?

A. Here’s the cliffhanger: in this scenario, you don’t own any options until you hit the one-year mark. After that, the options typically vest gradually over the remaining years of the schedule. Think of it as reaching a certain level in a video game before unlocking new rewards.

Q. What are vesting of options?

A. It’s the process of gradually gaining ownership of your stock options. Imagine each option as a seed that needs time to grow and mature before you can harvest its value. Vesting schedules determine how long each seed takes to sprout into a fully tradable share.

Q. What does it mean to have vested ESOP?

A. Once your options are fully vested, they’re yours to keep! You can exercise them (buy the shares at a pre-set price) and potentially profit if the company’s stock value goes up. It’s like finally unwrapping that gift and enjoying its contents.

Q. Why is vesting with a one-year cliff better?

A. It encourages long-term commitment. The one-year wait discourages short-term employees from joining just for the options and leaving soon after. It benefits the company by aligning employee interests with its long-term success

Posted by
Treelife
Last updated on
Jun 10, 2024, 1:49pm

Disclaimer:

The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc. before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.

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