Founder share vesting and clawbacks
Within the context of a start-up, the term ’founder shares’ refers to the company’s shares that are issued to and held by the founders on or around the time the company is formed, and in some cases, shares held by senior executives arriving after the company’s formation but who are considered of equivalent seniority to the co-founders.
Founder share vesting is distinct from the ubiquitous employee share option plan (ESOP) whereby employees are offered options to purchase shares in the future, often at a discounted price and subject to various vesting requirements.
While traditional ESOPs and their associated vesting mechanics aim to reward ongoing commitment to the company with equity, founder vesting mechanics remain distinct in that, rather than being forward looking by issuing further options or shares to the founder as time passes, they acknowledge that 100% of the founder’s shares are registered in the founder’s name at the outset while nevertheless ‘vesting’ over time.
The founder’s unvested shares can be repurchased (or ‘clawed back’) by the company or existing shareholders once a founder leaves the business. In the context of founder share vesting, the term ‘vested shares’ refers to shares held by the founder that can’t be clawed back, while ‘unvested shares’ refers to shares that may be repurchased by the company or other shareholders.
In the case of founders, granting share options rather than issuing shares directly is uncommon, as conventional wisdom provides that the founders were the original creators of the business, having funded and scaled the business themselves at its earliest stages, and should therefore retain the decision-making power attached to share ownership.
However, this exposes investors, co-founders and the business to equity concentration risks arising from a founder leaving the business (or being required to leave) while holding a significant portion of the company’s equity upon their departure. Moreover, remaining co-founders often find that such circumstances disproportionately and adversely affect them, as the leaving founder maintains their ownership percentage and realises the upside from the growth of a business which they had no part in creating.
From an investor perspective, this is a rather dangerous outcome that doesn’t future proof the business, as the founder who leaves the business or is dismissed would hold significant decision-making power due to the voting rights attached to his or her shares, which may result in the power to adversely disrupt company governance.
To mitigate these risks, investors and founders typically implement a vesting schedule and impose a repurchase mechanism on founder shares. Investors, particularly during early-stage funding rounds, require founder vesting as a pre-condition to their investment.
When formulating founder share vesting and share repurchase provisions, there are two overarching elements to consider:
The vesting schedule
The leaver provisions
The vesting schedule
The leaver provisions
A vesting schedule is typically comprised of a cliff and an incremental vesting period. The cliff is the period before the first significant increment of founder shares vest in the founder’s name. The incremental vesting period sets out the length of time during which the shares vest after the cliff, typically, on a monthly or quarterly basis over three or four years.
As an example, let’s look at a vesting schedule in which the founder shares vest in equal amounts over four years; with a one-year cliff and an incremental vesting period of three years with shares vesting on a quarterly basis. In this case, the company will have the right to repurchase the entirety of the founder shares should they leave within the first year, 75% immediately upon the first anniversary of the vesting period (and the satisfaction of the cliff), with a pro rata reduction each quarter thereafter for the remaining three years.
Ultimately both the cliff and incremental vesting schedule are negotiable with no fixed position. It's not uncommon to forego the cliff, effectively giving the founder credit for work already completed.
The leaver provisions, as the name suggests, determine what will happen to the founder shares if a founder leaves the business prior to the completion of the vesting schedule. When a founder leaves the company, the starting position is to have the unvested portion of their shares returned to (by being repurchased by) the company either automatically or at the option of the company for nominal or nil value. Any vested shares remain property and under the full control of the founder, subject to the constitutional documents of the company.
In practise these provisions are often heavily negotiated. What happens if the founder is forced out or leaves for an entirely valid reason? What happens if the company is sold or becomes publicly listed before the vesting schedule expires? In such circumstances, does the founder then lose the right to any unvested shares? The leaver provisions effectively reconcile this position.
Common practise is to negotiate objective scenarios where the founder is a 'bad leaver' or a 'good leaver’, the determination of which establishes the portion of the founder shares subject to any repurchase right and crucially, at what price.
Examples of what may constitute a bad leaver include being fired for cause, such as fraud, theft, dishonesty or a material breach of a founder's employment contract, or voluntary resignation by the founder before the expiry of the vesting schedule. A good leaver could be a founder who leaves for ‘good reason’ due to sickness, disability or family-related emergencies or is simply designated a good leaver by the directors of the company.
There are several variations to the standard approach to clawbacks. For example, in certain circumstances vested shares may still be repurchased if the founder is a bad leaver for a fair value or a discount. In other circumstances if the founder is a bad leaver, investors may require that the company has the option to purchase the entirety of the founder’s equity for nil value, regardless of whether any of the founder shares have vested or not, although this approach is heavily contested by founders.
What happens when a founder's vesting schedule is fundamentally interrupted? The most common example is where the company is acquired prior to the completion of the vesting schedule. In such circumstances, most recognise that the founder has taken the company through its life cycle and should be rewarded. To accommodate this, all remaining unvested shares will immediately vest subject to a triggering event. There are two varieties of founder vesting acceleration, aptly known as single trigger and double trigger acceleration.
Single trigger accelerates the vesting schedule upon the occurrence of a single event, most commonly being the sale of the company. Double trigger, as the name implies, requires a second triggering event, typically the termination of a founder's employment by the company within a fixed amount of time from the first trigger.
Until recently, double trigger acceleration was primarily used in US-led transactions, however it's become more utilised as the market becomes more investor friendly. The underlying principle is to incentivise a founder to stay with the company post-acquisition in order to ensure that the business will be maintained as a going concern after it is acquired, thereby enhancing the appeal of a given business to potential acquirers.
Founder share vesting and repurchase provisions are often one of the most contentious items negotiated at any investment round given the difficulty of striking a balance between a founder’s ability to realise a return on what could be years of hard work invested into the growth of a business, with the long-term alignment between the economic and governance interests of the existing shareholders.