In our earlier blogs in the "Co-Founders’ Agreement" series, we have discussed the importance of a co-founders’ agreement, factors to be considered in granting a “co-founder” tag, and the pros and cons of granting shares upfront versus granting stock options.
Irrespective of whether you decide to grant shares upfront or grant shares or stock options (or ESOPs, as they are generally called), you need to consider a vesting schedule for such shares / options.
“But if a person is a shareholder, how can there be a vesting schedule?” is a question we get asked frequently. Well, in cases of allotment of shares upfront, the vesting is in the form of a “reverse vest” of shares; but in the VC world, these different types of vesting are all commonly referred to as “vesting”.
So what exactly is vesting? Well, think of “vesting” as earning the economic rights over the shares, in cases where shares have already been allotted to you. Therefore, while you continue to hold the shares and share certificates, you also have the voting rights against these shares, you still cannot sell these shares. Also, if you decide to leave the company, then the “unvested” shares will be considered as shares that have not been earned by you and hence, you may have to sell them at a nominal price.
Simply put, “vesting” is like unlocking the shares. But I typically try to avoid using the term “unlock”, because while you may have shares vested in you, these shares could still be subject to certain transfer restrictions and hence, they effectively continue to be “locked”.
Confused?
Okay, let us take a step back. When you begin your own startup, you typically set a target time frame, say 3 - 4 years, over which you give the startup everything that you’ve got, and if it still does not work out, despite your efforts during the said time frame, you consider abandoning the idea and moving on! Similarly, if you onboard a co-founder, you would typically have similar expectations of him/her, you would want him/her to also be prepared to give the startup four years. Therefore, you and your co-founder would agree to a four year lock-in period.
Now, what is being locked-in here? Well, the lock-in is on (a) each person’s ability to transfer their shares, i.e. for four years, none of you can transfer your shares, and (b) each person’s engagement with the company, i.e. for four years, none of you can take up other engagements, and have to be employed with the company for these four years.
Since the above mentioned rights are purely contractual, how do you enforce them? Well, enforcing the transfer restrictions is relatively easier; you incorporate the same in the Articles of Association of the Company and also add the transfer restrictions on the share certificates. The latter though may not be possible if the shares are in demat form.
Next, how do you enforce the employment lock-in? While there is of course the contractual restriction, but in order to add more teeth to the enforceability of the lock-in, the vesting schedule or the reverse vesting schedule is added.
The co-founders’ agreement can elaborate and lay down the consequences in case of a breach of the lock-in on the vested and unvested shares of the particular co-founder. Similarly, if the co-founder is asked to leave because of misconduct or wrongdoing on his/her part, then the consequences can be different. There can also be accelerated vesting in case of an acquisition.
Set out below are some of the possible consequences that can be incorporated in the co-founders’ agreement:
All shares (vested and unvested) to be sold to the other co-founders at face value.
Vested shares to be sold at fair market value, and unvested shares at face value.
Vested shares to be sold at a predetermined discount on the fair market value.
Do the shares have to be sold mandatorily? Can the leaving co-founder not continue to retain the vested shares? After all, he has earned them. Well, these are all contractual arrangements, and the presumption is that if someone has breached a lock-in or has been asked to leave, the departure may not have been amicable and hence, you may not want the person to continue to be on the cap table!