Founder vesting arrangements

Vesting of shares is a popular concept with emerging companies. When instigated by an investor, the main goal is to ensure that founders (or managers) are incentivized to remain with the company for a certain amount of time. When agreed between founders it is a way to conditionally slice the pie,

meaning that shares in a company are issued, but ownership only becomes permanent once certain conditions have been met. This condition usually being the same: that a founder stays on at the company (as manager) for a certain number of years and does his work properly. Vesting arrangements can either be concluded in a shareholders’ agreement between founders at incorporation, or at a later stage when an investor participates in the company.

Employee stock option plans often include a vesting scheme as well. I will not address this version in this blog, but note that the concept is pretty much the same for employees as for founders.

In this blog I will set out the most commonly used vesting scheme in the Netherlands and the different interests of such schemes for founders on the one hand and investors on the other.

Vesting explained

The parties to a vesting scheme wish to make the shareholding of certain shareholders (the founders or managers) conditional to their loyalty to the company. If the founder stays with the company for the agreed upon period, all agreed shares vest in that founder. Usually vesting is done in equal monthly, quarterly or even yearly installments of shares and parties agree on a cliff. A cliff meaning that vesting (in equal installments) only starts after a certain period of time, very often 1 year. During a cliff period either no shares vest at all or a certain part of the vesting shares vest all at once upon completion of the cliff period.

In the Netherlands every issuance of shares is done by a civil law notary executing a notarial deed of issuance of shares. In my example of a linear monthly vesting scheme over three years, it could be rather costly and time-consuming to keep up with all these changes. Instead the option of reverse vesting is therefor usually used.

Reverse vesting

With reverse vesting all shares are issued at once to the founder, but a vesting scheme is agreed upon, which is usually combined with a (good/bad) leaver arrangement. The founder that leaves the company before the total vesting period has expired, usually has to transfer all the unvested shares back to the company, against no consideration. Usually the founder is allowed to keep the vested shares (albeit sometimes the voting rights are then removed since it is often undesirable that a founder who has left still has a vote on important matters) or he has to offer these to his co-shareholders for market value.

An example vesting clause[1] with a one year cliff and linear quarterly vesting over the next three years:

The Shares will vest as follows:

 

  • during the first year after the Effective Date, none of the Shares will vest;
  • at the first anniversary of the Effective Date (“One Year Cliff Date”) [25%] of the aggregate number of Shares will vest;
  • for the remaining [75%], the Shares will vest starting on the One Year Cliff Date on a quarterly basis, effective as per the last day of the last month of each quarter (each such date a “Relevant Vesting Date”), for a period of 36 months, resulting in a vesting of 6.25% of the total Shares per quarter, provided that the Founder is still in function as an [Employee/Manager] of the Group in the 1 month period preceding the Relevant Vesting Date; consequently, as from the fourth anniversary of the Effective Date, 100% of the aggregate number of the Shares shall have vested;
  • in the event of a Liquidity Event all Non-Vested Shares will vest automatically.

If the above clause applies and the founder leaves after 20 months, only 37.5% of his shares have vested. The other 62.5% of his shares have not vested and so the Founder will not receive any compensation for the larger part of his shareholding in the Company.

It is important to note that, in principle, reverse vesting does not affect the control or voting rights of the Founders on unvested shares. To take the example above, in month 20 the Founder can vote on all of his Shares in a shareholders’ meeting, even if on leaving after said month he only receives compensation[2] for 37.5% of his shares.

Why do founders want it?

Why investors want to include a vesting scheme in the arrangement with the founders is obvious. They want to make sure that founders are not leaving the company shortly after the investors have stepped in. But why would founders want it as well between themselves?

Picture this: you have started a company with another founder, both holding 50% of the shares because you envisage and expect both of you to work equally hard to make the company a huge success in the coming years. Your co-founder however soon falls in love with someone abroad and decides to quit the company after one year to follow his heart. It would in that situation of course not be reasonable for you to keep on working your butt off for a lousy salary for years, until you finally succeed in making the company worth millions of euros, your co-founder all the while freeloading and becoming a millionaire on his 50% shareholding thanks to your efforts.

In summary

Vesting of shares can be a very useful concept to prevent founders leaving the company prematurely. If one of them does so anyway, a vesting scheme helps to come up with a reasonable shuffle of shareholdings. As reverse vesting does not affect the control or voting rights, the balance of power does not change during the vesting period, resulting in a transparent shareholders’ situation.

[1] This draft clause is based on the Capital Waters Stock Appreciation Rights Plan and Stock Appreciation Rights Agreement version 1.0: www.capitalwaters.com.

[2] Compensation for the vested shares can be limited (to for instance the nominal value of the vested shares) if a bad leaver clause applies and the Founder qualifies as such.

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