When you decide to co-found a business, it’s important you protect the company’s equity in order to raise capital if needed and to prevent one of the other founders from screwing over the company through poor performance or an early departure. To do this, one of the business contracts you may want to put in place at the beginning of your venture is an equity vesting agreement.
What Is An Equity Vesting Agreement?
This contract between the startup entity and the co-founders delays the vesting of some or all of the founder equity over a period of time.
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The goal is to reward good behavior by each founder who contributes toward the growth of your startup.
Without such an agreement in place, one of your co-founders could quit shortly after you launch the venture but still retain his portion of the founder’s equity to sell to third parties or make unreasonable demands for buying back his piece of the action.
Even worse, the co-founder could simply slack off, waiting for a big pay day on his equity while his presence is a toxic poison to your company’s work environment. This is very common where a co-founder has misrepresented the skills he brings to the venture and is in over his head…or he’s just lazy and wants something for nothing.
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Your vesting agreement can prevent these scenarios by limiting how much equity the co-founder owns before departure and require the sale of his equity back to the company or to you and the other co-founders on terms that are favorable to you and your venture.
How To Structure The Agreement
There are many ways you can structure an equity vesting agreement to protect your interests and those of your new company.
Acquisition Or Continued Private Ownership
One common method is to set up vesting over a four-year period. This method is ideally suited for a startup you intend to keep ownership of as a privately held venture or you expect to be acquired quickly by a larger company.
At the beginning, none of the founder equity vests. This encourages everyone to work hard while making it easier for you to identify any co-founder who is a bad apple and get rid of him without losing equity in the process.
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Having had an opportunity to identify and weed out any problems during the first year, at the end of that year, 25% of each founder’s equity vests. The first year of working without vested equity is known as a “cliff.”
Similarly, at ends of years 2, 3, and 4, each remaining co-founder has 25% equity vested.* This means that at the end of the fourth year of working on your startup, the equity is fully vested.
If your goal is to take the startup public (a very popular goal for tech companies), it will likely make sense to stretch out the vesting schedule over 5 to 8 years instead of 4. This provides more of an incentive for the founders stick around until the startup’s initial public offering (IPO).
Your equity vesting agreement can contain certain triggers that speed up vesting.
Using the preceding example, let’s say it’s been 13 months since you set up the company. Each of the co-founders has 25% of their equity vested at the end of the first year with 75% remaining unvested.
An event occurs that constitutes an acceleration trigger. Under your agreement, some or all of the remaining unvested equity will vest because of the triggering event(s).
The most common triggering event is acquisition of your startup by a larger company.
You and your co-founders can set up the accelerated vesting to occur based on one event (single trigger acceleration), such as an acquisition…or you can require two events to trigger accelerated equity vesting (double trigger acceleration). For example, your equity investing contract could require both the startup to be acquired and you to be terminated from the business before vesting would accelerate.
Milestone Vesting Schedule
If you want to tie equity vesting more closely to the startup’s performance than to the amount of time the founder has been working to build the company, you may want to set up the vesting agreement based upon milestones instead of an annual or other time-based schedule.
There are many different milestones that can be used for valuing and vesting equity that are unique to the goals you and the other founders have for the startup.
For example, if you plan to take the company public, it may make sense to value and vest stock at each venture capital funding round.
However, if you plan to retain ownership of the startup, different milestones may be more important (e.g. number of paying customers, hitting an annual revenues target, etc.).
Where Do You Get A Vesting Agreement?
If you’ve retained an experienced business lawyer to set up your company, that attorney should be able to draft all of the contracts you’ll need, including an equity vesting agreement.
* The agreement can alternatively provide that once the initial equity vests at the end of the first year, there’s a different schedule instead of annually for the balance to vest over the next three years (e.g. monthly, quarterly, semi-annually).