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August 17, 2005

Entrepreneur’s View of Vesting

Reader Jeremy asked in a comment whether it is normal for entrepreneurs to agree to terms under which they can lose all their shares after being terminated without cause.  He was referring to Brad Feld’s post on vesting which I somehow missed.

My first reaction was that this is outrageous and I would never agree to such a thing.  Then I read Brad’s post over again and realized that it all depends.  I hate be wishy-washy but sometimes things are complicated.

Vesting, unlike no-shop which I blogged about last week here, is one of the most important provisions of a term sheet.  Vesting is about who owns the company; it is about what happens when founders leave; it is about control.  The no-shop is gone when the deal is closed. Initial vesting is with you for the first four years of a company’s life.  Initial vesting is a BFD.

Under the standard terms which Brad describes, founders’ stock and options vest over a period of four years.  So, if a founder leaves before two years are up, only one-quarter of her stock and/or options are vested.  The value of the remaining three-quarters is essentially reallocated among all the remaining stockholders.  This gets particularly dicey if the founder is asked to leave, especially without cause.  Whether it is the other founders or the VCs who orchestrate the exit, all of them share in the value of the forfeit shares.  The terminated founder may well suspect that desire for her interest in the enterprise was a reason for her dismissal.  She may be right.  The vesting clause can be a litigation opportunity.

Certainly VCs would not agree that their shares should vest over time.  They can’t be fired.  They also can’t quit in the sense of taking their money out (prior to a liquidity event) and going home.  They certainly can stop being helpful and constructive and there certainly are times when you would like to fire your VCs and take their stock back – but you can’t.

So is this lack of symmetry and reciprocity fair?  It depends.

The vesting terms SHOULD depend on how much of a company there actually is at the time the VC financing happens.  That makes all the difference.

One extreme:  the founders really are entrepreneurs; they started the company two years ago and have supplied all of the cash needed as well as working for peanuts or nothing (why take your own cash out?).  Their investment has actually created value in some measurable term whether it’s technology, traffic, buzz, or cash flow.  They are clearly selling a part of THEIR company to the VCs.  After this transaction, the founding entrepreneurs ought to still be holding real fully-vested stock representing the value of the company they built as a fraction of the now-funded company.  It’s the way of the world that this stock will be common and the VCs will have preferred (there’s actually good reason but not in this post).

Of course any stock or options granted AFTER the funding transaction should be subject to the same type of vesting arrangements that stock given to new employees will be.  Note that in this case there may already be some employees besides the founding entrepreneurs.  Whatever deal was made with them by the founders has to be honored (or bought out) but, if they were receiving a salary and didn’t invest actual money, than they are certainly not entitled to have stock vest by virtue of the funding getting done.

The other extreme:  the founders have been working nights for the last six months to put together an exciting business plan which they are now bringing to the VCs for funding.  They were earning their living at their day jobs.  They’ve invested lots of sweat and creativity and a small amount of cash; they’ve prepared impressive PowerPoint presentations; now they’re looking to the VCs (or angels) to get the company off the ground.  They will draw salaries after the funding (which will be less than they would get if they weren’t in a startup, by the way).

These founders aren’t really entrepreneurs; they haven’t invested significantly; they have an idea but not a company.  And – although I’d probably argue the other way if I were them, it’s fair if all equity they have after the funding closes is subject to vesting.  Looked at another way, they haven’t created any reservoir of value.  If they don’t perform, it will be very hard to salvage any of the VCs’ investment.  If one of them doesn’t perform and the other does, she the performer won’t want him the nonperformer diluting her equity.

Lots of deals are in the middle and so flexibility is needed in negotiating this term.  The principal is easy: the more of a demonstrable asset (PP presentations don’t count but cash does) the founders bring to the deal, the more nonforfeitable equity they are entitled to.

Brad has suggested a couple of flex points which are good.  Giving founders (and other employees) vesting credit for years already served is a reasonable middle ground.  Spelling out in advance that there will be an extra year of vesting in the event of a merger or acquisition AND termination without cause is another compromise Brad proposes.  If I were the founder, I’d argue for the single trigger of termination without cause.  That might be a good thing for VCs to give in on to avoid wrongful termination lawsuits by having a specific remedy.

Jeremy, it was a good question.  Sorry the answer’s not simple.

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