In his famous “To Be or Not to Be” soliloquy, Hamlet anguished over whether his future was worth living.  Hopefully, private company founders picture a future less bleak than Hamlet’s grim outlook. When the founders of fast-growing private companies accept new investment capital, however, they need to consider the future of the resulting ownership structure of the business, particularly when the financing involves issuing new company shares.
When a private equity investment is made in a private company, a balance must be struck between the competing interests of the company’s founders, on one hand, and the private equity or venture capital firm (the “PE investor”) on the other. From the PE investor’s perspective, an investment in a private company makes sense only if the founders maintain their continued commitment to the company’s success. Once the investment is made, founders will want to make sure they have an exit plan in place that provides them with ample rewards when they depart based on the financial success (hopefully) they helped the company to achieve.
This balancing of interests between founders and PE investors is often handled through a vesting process regarding the founders’ stock or equity ownership. This post, therefore, focuses on the use of vesting schedules by private companies when issuing stock. Ideally, the use of vesting schedules that apply to stock ownership is complimented by buy/sell exit planning, i.e., founders will want to secure some type of a buy/sell agreement that permits them to monetize their interest in the company at the time of their exit.
What is a Vesting Schedule?
Put simply, a vesting schedule gives the company an option to repurchase for a set period of time and for a negligible price shares allotted to the founders (generally, par value, usually a penny or less), and this purchase right is triggered after the founders leave the company. As the shares “vest” over time, they are released from the repurchase option, and the company loses the right to repurchase the shares for a low price. Obviously, the founder prefers for vesting to take place as quickly as possible so that the ownership rights become fixed, while the investor wants to prolong the vesting period to keep the founder on board as long as possible.
Vesting schedules are often used with startup or emerging growth companies, but the same concepts apply to all private companies issuing new stock (or equity generally if dealing with an entity other than a corporation). In addition, while this discussion refers to equity and shares of stock, vesting schedules also can, and generally do, apply to options to purchase equity or shares of stock, and not just to actual shares of stock themselves.
Just as Hamlet pondered his future, founders also need to consider the future implications of their company ownership structure, and whether to adopt vesting schedules and, if so, how the vesting schedules will operate and to whom they will apply. This requires founders to weigh the pro and cons of an uncertain future when decide whether and how to apply vesting schedules.
What is a Typical Vesting Schedule?
Vesting schedules vary widely from company to company, but a “typical” vesting schedule provides for a four year timetable with a 1-year “cliff.” In practical terms, what this means is that during the founder’s first year, the company’s repurchase right applies to 100% of the founder’s equity, but after the first year of the founder’s employment, twenty-five percent (25%) of the equity promised to the founder vests and is released from the company’s repurchase right. Over the remaining three years of the founder’s time with the company, the equity generally vests at the rate of 1/48th of the shares per month, although some vesting schedules provide for vesting on a quarterly or annual basis.
While this is a “typical” vesting schedule, the schedules used for vesting are flexible and can be drafted to meet any situation. For example, it is common for vesting schedules to begin, and for equity to start vesting, as soon as the founder has any involvement with the company even it took place before the company was incorporated. In these circumstances, the vesting schedule may be back-dated so the vesting start date (the date on which the equity begins to vest) may be different from the date on which the equity was issued. For example, if the founder joined the company on January 1st but the company was not yet formed, and the stock was not issued to the founder until April 1st, it is not uncommon for the vesting start date to be the original January 1st date so the founder is given credit (or “time served”) for the date on which he or she actually started working with the company.
From the PE investor’s standpoint, if the investment takes place later in the company’s lifecycle, the PE investor may request that a percentage of the founder’s equity become subject to vesting even if the founder’s equity had already fully vested. In other words, the PE investor may insist that, as a condition of making the investment, the founder(s) step back and agree to make his or her equity subject to vesting again, or for the first time, to ensure that the founder has a renewed commitment to the company during the vesting period.
Balancing Founder and PE Investor Financial Goals
The founder must evaluate his/her short and long term goals in negotiating the vesting schedule. If a founder plans to stay with the company for the long haul, that long-term perspective is likely to be aligned with the investment objectives of the PE investor. But, if the founder desires to exit the business early in the company’s lifecycle, vesting schedules are not ideal because the founder will then be departing before the vesting period has concluded and before receiving payment for the full complement of the shares that were subject to vesting.
Another key concern arises when the founder has created intellectual property (“IP”) that that was assigned to the company in exchange for an equity in the business. If this equity is subject to a vesting schedule, as is common, and the founder departs early, the founder would leave the company without retaining rights to the IP and before all of his/her shares had vested. In the startup world, new businesses generally have little available cash, and as a result, founders often receive the majority of their compensation in equity. If a founder leaves the company before all of his/her equity has vested, the company is, in effect, taking back part of the founder’s salary for services performed while retaining the founder’s IP.
For all of these reasons, the safest bet for a founder is to have all equity fully vested upon, or as soon as possible after, the founder transfers IP rights to the company. Similarly, the founder will also want to negotiate an employment agreement that prevents the PE investor from terminating, or causing the company to terminate, the founder’s employment except with cause during the vesting period so the founder cannot be ousted without cause and lose all rights to stock in the company that had not yet vested.
From the PE investor’s perspective, the company’s success is closely tied to the founder(s). The PE investor, therefore, wants the founder(s) to remain actively involved with the company for as long as possible, and a vesting schedule ensures that continued connection. In fact, the vesting schedule may be what keeps the founders at the company rather than heading to enjoy a life on the beach (or its equivalent).
In balancing these perspectives, the founders may accept a vesting schedule, but attempt to make it shorter than what the PE investor proposes, or attempt to have less than 100% of their equity subject to said vesting schedule (or at least the majority of it). For example, the PE investor may propose a five (5) year vesting schedule (or longer), and the founders can push back and limit the vesting schedule to three (3) years. Alternatively, the founders can negotiate to secure vesting of the majority of the shares within three (3) years (for example, 80% or 85%) with the balance vesting over a longer period of time or only have a certain percentage of their equity subject to vesting (to minimize risk from the founders’ perspective). That will give the founders the option of walking away before full vesting of all shares has occurred if they receive a more attractive offer or become frustrated with the PE investor’s role in managing the business. In this situation, the founders have left less of the unvested shares on the table when they depart. These are the decisions regarding the future that the founder must make at the time the shares are issued and the vesting schedule is adopted.
The vesting schedule negotiation may also vary based on the buy/sell exit planning and related negotiations with the PE investor as vesting and buy/sell arrangements are closely tied.
Vesting Schedule Takeaways
In the real world, founders and PE investors usually know each other well, either personally or by reputation, and there is often a common belief that they share a common devotion to the success of the business. These circumstances can lull the founders and investors into a false sense of security that a vesting schedule or exit plan is needed, or that the PE investor has the best interests of the founder(s) in mind, because they have known each other for a long period of time, they have worked well together, and are all-in on the project.
For the same reasons, founders will more often than not neglect to seek the opinion of counsel regarding their own interests (as opposed to the company and/or the PE investor). But, this rose colored glasses scenario can quickly turn into a quagmire for all sides if the parties have not worked through both vesting schedules and an exit plan allowing for the founders of the company to cash out for the value of their interest in the business. We have written about the need for an exit plan or a corporate pre-nup in previous posts (see links below).
- The Perfect Buy Sell Provision
- Buy-Sell Agreements: Don’t Leave Home (Or Invest) in a Private Company Without One
From the founders’ perspective, an important takeaway is the need to retain experienced counsel to advise them of their rights as to vesting schedules and their exit from the company.
Hamlet’s baleful glare did not provide him with a clear-eyed view of the future, and while private company founders also lack a crystal ball, they can take reasonable steps to protect themselves when a PE firm invests in the company. These protective steps include negotiating vesting schedules that balance the interests of the founders and the PE investor. A balanced vesting schedule provides the founders with flexibility regarding their future options, including by shortening the length of the vesting schedule, limiting it to less than 100% of the founder’s equity, or by “front-loading” it to allow for most of the shares to vest in the early years. In sum, vesting schedules attempt to solve, or at least moderate, Hamlet’s problem of not knowing what happens after death, or in this case, after a founder leaves the company.
Interestingly, Hamlet does not hold a skull during his most famous “To be or not to be” soliloquy. He holds up the skull when he gives his speech to Horatio and the gravedigger, because the skull belonged to someone he knew as a child, Yorick.