Legal issues can arise in startup share vesting for founders, it is best to set things in black and white from the outset

Lee Bagshaw
co founders and share vesting legal issues

Vesting is not just an issue to consider with investors on financing rounds — rather it is relevant from the outset as between founders. Tech start-up and VC lawyer, Lee Bagshaw from Simmonds Stewart, looks at the issues to consider

Vesting can have a big impact on founders. Leave the business too soon and you might find that you lose shares in your own company. You get nothing!

1. What are vested shares?

In simple terms, these are shares issued to founders or other individuals which can be clawed back from the holders in certain circumstances. Founders’ shares are often subject to a vesting schedule allowing the company to repurchase the unvested portion if they leave before an agreed date. In the US, this is typically documented by way of a restricted stock purchase agreement. In Southeast Asia, it may have a different name, but the principle is the same – shares progressively vest and become unrestricted (i.e. they can no longer be repurchased by the company on the founder’s departure).

2. Whose shares should vest?

Anyone you want to incentivise to stay in the business for a certain period.

It is not just founders whose shares are vested. Very senior non-founder employees, such as an incoming CFO or CTO may be awarded vested shares, as opposed to being granted options. Advisors to companies sometimes seek equity as part of their fee arrangements. In each case, the company will not want large shareholdings being held by individuals who have ceased to work for, or provide services to, the business. Vesting is therefore a useful tool to ensure key people stick around to deliver what they agreed.

Also read: Pro bono: Legal advice for closing an acqui-hire deal

3. When should start-ups think about vesting?

From the outset.

Roles constantly evolve and people can move on early on in a startup’s life. Founder vesting is particularly useful for a team that have come together through an accelerator programme or where the individuals have no long-term relationship. It is always easier to document what happens to a departing founder’s shares in advance when relations are good, rather than deal with the issue once the person has exited. Without a binding vesting agreement, you cannot force a shareholder to sell shares simply because he or she no longer works for your start-up.

4. Investor-imposed vesting

As investors invest partly on the quality of the founder team, when it comes to capital raising transactions, they often look to impose vesting mechanisms to claw back shares from founders if they leave early. On subsequent financing rounds, investors sometimes even look to fully or partially reset existing founder vesting schedules. One of the benefits of putting in place sensible vesting schedules from the outset is that incoming investors may be happy with these, and not impose more onerous arrangements as a condition to closing a financing round.

5. How long, and how many shares?

The Silicon Valley model has typically been four years with a one year cliff. This means that after 12 months, 25 per cent of the shares immediately vest with the remaining 75% progressively vesting on a monthly or quarterly basis over the following 3 years. Vesting schedules vary for each company, but often in Southeast Asia the period is either 3 or 4 years including a similar one year cliff. Founders who have worked in the business for a significant period may argue that they have already earned their shares. In which case, it may be fair that only part of that founder’s total shareholding be subject to vesting.

6. Other issues to consider

Whilst a vesting agreement is a relatively simple document, there are still a few things to consider:

Remember the shares have already been issued to the holders. This contrasts with options granted under employee share option plans (ESOPs), which also typically include a vesting element, but which are much easier to cancel if the holder leaves the business.

Also read: 12 legal considerations when drafting your ESOP

Vesting arrangements normally involve the buy-back by the company of shares of a leaver. Check the legal requirements for a company share repurchase under both the constitution of the company and applicable law. In some cases, a mechanism whereby shares of the leaver are instead transferred to founders, or to other shareholders, on a pro-rata basis may be used.

There are different ways in which individuals can cease working for your business. A founder may be guilty of gross misconduct or fraud, or have caused damage to the business in some other way. In those circumstances, there is an argument that even vested shares be forfeited to remove the bad leaver from the share register.

If a founder leaves, consider whether the board should be able to issue new shares up to the amount that have been repurchased by the company, outside of any right-of-first-refusal (pre-emptive) restrictions. For example, through an increased allocation to new hires, or by issue to the remaining founders.

Just as with an ESOP, the document should address what happens if the company has a liquidity event (e.g. an exit) in terms of acceleration of the vesting schedule, either fully or partially.

7. Documents

We see different types of founder vesting agreements. A short form document is most common and works on a simple time basis with progressive vesting. We are sometimes asked to put together a long form agreement, which sets out the contribution that is required from the founder, employee or advisor. If a company is dissatisfied with the performance, this could trigger the repurchase option without necessarily dismissing the individual under his employment contract. The benefit is that shares could be clawed back more easily without the interference of local employment laws.

Conclusion 

Vesting is not just an issue to consider with investors on financing rounds. Rather it is relevant from the outset as between founders — both from a company and a personal perspective. Founder relations are normally great when you start out, but disputes can arise if the business struggles to gain traction. Equity is precious — shares held by someone who is no longer contributing to the business could be otherwise reallocated to new hires. Vesting agreements can facilitate this.

Equally if you are a founder, make sure that you are comfortable with how it all works from a personal perspective. This includes the length of the vesting period, the implications of leaving, the price to be paid for vested or unvested shares if you do depart, and how a change of control impacts it all. If you are forced out of the company for alleged poor performance, the agreement may provide that you are a bad leaver. This may result in you losing shares for nominal value. Something clearly not to be taken lightly!

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Lee Bagshaw is a corporate lawyer at technology and VC law firm, Simmonds Stewart. The firm advises investors, start-up and high growth companies on venture capital financing and tech M&A deals across Asia Pacific. Simmonds Stewart opened their Singapore branch office in March 2017.

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