Founder Stock Vesting: What It Is and Why It Matters

A key step in forming a company is issuing equity to the Founder(s). This equity is commonly referred to as “Founder’s Stock.”
 
When issuing Founder’s Stock, it is important to consider whether a vesting schedule should apply. This may seem like an easy “no” for a Founder—“why would I subject my stock to vesting if I don’t have to?” However, there are (at least) a few scenarios when it may make sense:
 

• Multiple Founders. A vesting structure is a retention tool that incentivizes a Founder to stay and grow the equity value of the business (just like a vesting structure used for employee incentive equity generally, like stock options). Granting Founder’s Stock to multiple Founders without a vesting schedule can lead to inequitable/frustrating results. As an example: Put yourself into the shoes of a Founder who started a company with a “50/50” Co-Founder, who then abruptly leaves the company soon after its founding. As you are left to pick up the pieces and push the business forward alone, you are also stuck with the realization that the departing Co-Founder who is willingly walking out the door will nonetheless own an equal amount of the company and reap the rewards of the company’s success without contributing to it.

 

• Outside investors. If the Founder anticipates raising money from outside investors (like VCs), it is common for a VC to insist that, as part of an early-stage investment, the Founder’s Stock must be subject to a vesting (or “re-vesting”) schedule to ensure alignment between the VC and the Founder. If there is no vesting schedule at all, the investor is likely to insist on its “form” proposal for Founder vesting (which could be relatively onerous). However, if the Founder’s Stock is already subject to a vesting schedule at the time of investment, the investor may deem that schedule to be “good enough” for its purposes (even if it is less onerous than what it would otherwise propose with a blank slate).

 
If Founder’s Stock becomes subject to vesting (whether in connection with formation or in connection with a fundraise), here is a summary of the legal mechanics involved:
 

• Repurchase Right. A “vesting schedule” is implemented by granting the Company the right to repurchase from the Founder the “unvested” portion of the Founder’s Stock, in the event that the Founder no longer provides services to the Company (as an employee, consultant, etc.). The customary terms are set forth below:
  • Vesting Schedule
    • In some instances, the vesting schedule for Founder’s Stock will simply match the customary schedule for stock options to employees generally—monthly or quarterly vesting over a period of four years from the date of issuance, with a one-year “cliff” (meaning that no portion of the Repurchase Right will “expire” at all until the first anniversary of issuance).
    • However, the possibilities are endless, and the appropriate vesting schedule for a particular Founder (or Founders) is usually a negotiated and bespoke arrangement:
      • Some Founders successfully insist on receiving retroactive credit for the time already spent developing the business. If, for example, one Founder created the material intellectual property (IP) of the business during the year before the Company was actually formed and the Founder’s Stock was issued, then that Founder can argue that the appropriate vesting period should be shorter than the vesting period applicable to the other Founder(s), and/or no cliff should apply.
      • Another driving consideration is the level of trust among Co-Founders. As an example: A group of Co-Founders who recently met each other online through a Co-Founder matching platform should arguably be more focused on a relatively long vesting schedule, as compared to a group of Co-Founders who have successfully worked together for years on prior projects.
  • Price. If the Repurchase Right is exercised, the “price” paid to the Founder is customarily the lesser of (i) the current fair market value of the “unvested” stock that is being repurchased and (ii) the cost that the Founder initially paid for such stock (usually a nominal amount). It is important to note that this “price” will be paid by the Company in cash, even if the Founder initially “paid” for such stock by contributing IP (not cash) to the Company. In other words, no IP will revert back to the Founder upon exercise of this Repurchase Right.

 

• Acceleration
  • Just like stock options, the vesting schedule applied to Founder’s Stock can be “accelerated” upon the occurrence of certain events, including (i) the Founder dying or becoming disabled, (ii) the occurrence of a “Liquidity Event” (i.e., “single-trigger” acceleration), and/or (iii) the occurrence of a “Liquidity Event” and subsequent termination of such Founder’s employment without “Cause” within a certain period of time after that Liquidity Event (i.e., “double-trigger” acceleration).
  • As you can imagine, if the parties agree to these types of acceleration, the devil is in the details regarding how terms like “Liquidity Event” and “Cause” are ultimately defined.

 
One final (and potentially very material) point, which is also covered in our Post-Incorporation Checklist: If a vesting structure for Founder’s Stock is used, it almost always makes sense for the Founder to file a Section 83(b) election with the IRS within 30-days of the issuance. The timely filing of this election can result in big savings in the future, and we strongly recommend that Founders consult appropriate legal and tax advisors when considering this issue.