‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from VCs. Further information about The VC Series can be found here.
This article looks at one of the most emotive terms for a founder to negotiate – the vesting of their shares. The next article will look at another emotive issue – leaver provisions.
What is Vesting?
Vesting is a concept whereby founders ‘earn’ their equity over time and is a common feature of venture capital investments.
What is the Significance of Vesting?
Where a founder’s shares are subject to vesting, then if the founder leaves the company before the shares are fully vested, then the company will be able to either (i) buy back the shares for a nominal amount, or (ii) convert the shares into worthless deferred shares.
This can often be hard to stomach for founders for a couple of reasons:
- firstly, because the founders might understandably wonder why they should have to ‘earn’ the value of their shares given the blood, sweat and tears they have already put into establishing and growing the business; and
- secondly, because they may have already agreed a vesting schedule (whether between the founder group or on an earlier fundraise) that they have reached the end of, so why should they have to start again?
Whilst these are understandable reactions, it is important for investors to feel that founders are fully committed to the business, with a mechanism in place to discourage a founder from ever leaving.
How do Founder Shares Vest?
The basis on which founder shares vest is a matter of negotiation and will depend on a number of factors, including how long the founder has been running the business, whether the founder has previously been subject to vesting, the shareholder of the founder at the time of investment, and the valuation at which the investment is being made.
The key factors to consider when negotiating founder vesting provisions are:
- Number of Vesting Shares: the starting position of a VC will often be that all of a founder’s shares are subject to vesting. However, depending on some of the factors listed above, it might be that a founder is able to negotiate a position whereby a proportion of his or her shares are deemed fully vested from day 1.
- Length of Vesting Schedule: the most common way for founder shares to vest is over time – the period of time is open for negotiation, but we typically see 3 to 4 years. Vesting can though be based on the hitting of certain KPIs and milestones – this is though more common with employee incentives (such as EMI schemes) and is not something we would expect a founder to be signing up to.
- Cliff or not to Cliff: vesting often occurs on a ‘cliff’ basis, whereby a portion of shares might not vest until the anniversary of the investment. Alternatively, a straight-line approach means that the shares begin vesting immediately at the agreed frequency (see below) – the latter is the more founder friendly approach.
- Frequency of Vesting: this describes how often the shares vest over the length of the vesting schedule. After any ‘cliff’ vesting period, you would expect shares to vest on a monthly basis until the end of the vesting schedule.
The VC Series – Next Article
The next article in The VC Series explores leaver provisions.
You can find details of all the different articles in the VC Series here.
If there is anything that we have not covered which you would find useful, then please let us know.