Term Sheets – Negotiation and Tips – Part 2

NEGOTIATING FOUNDER VESTING CLAUSE IN EARLY STAGE TERMSHEETS

In Part 1(refer to http://novojuris.wordpress.com/2013/08/27/term-sheets-negotiation-and-tips-part-1/), we pointed out on negotiating a few ‘commercial’ aspects. In this post we detail Founder Vesting. Please note, that Founder Vesting is a clause one would see in early stage investments, since the bet is on the jockey (founders) more than the horse (startup).

In early stage, specially so in the technology space, where the founders would have spent time on building the POC or got early customer traction, the cash investment ‘may be’ very small.  Also, the investment is based on the execution capabilities of the founders and the startup team. When an investor is taking the risk, he would like the founders to be tied in to the startup as well. If the founder has invested substantial money, then he/she should think through, if a vesting clause is required at all.

While ‘vesting’ typically is used to express ownership in shares over a period of time, you will note that founders are already ‘owners’ of the shares, when the investor takes a stake. So, this clause on vesting describes treatment of shares if a founder leaves the startup.

Some details of the clause before we delve into negotiation tips:

  • Vesting period: The years that vesting would be spread over and points in time (monthly/ quarterly / annual)
  • Percentage of shares vesting.
  • An exiting founder: Treatment of shares on who would hold / transfer. Would the reason of leaving important in determining the pricing?
  • Accelerated vesting events.

VESTING PERIOD: Here are some of our experiences:

Majority of the cases, the vesting is a 4 year period. A friendly investor typically does a three year vesting.

Tip: If the founder has been working on the startup for a while (more than 1-2 years), then it’s a good point to ask for an upfront vesting of about 25% to 50%. We have seen between 20% and 35%, being accepted by most early stage investors.

Tip: Annual vesting is logistically easy to implement / understand.  We believe that since the founder already owns the shares, the logistics of ‘vesting’ do not need any additional step other than the arithmetic calculation should an exit situation arise. A monthly vesting should be okay(i.e. an equal number of shares over the vesting period which might read as 1/36th or 1/48th number of  X shares.)

Tip: While all the math and formula is in place, please try and get a table which describes the exact number of shares in the shareholders’ agreement.  While you may think this is just a presentation, we have found that it provides complete clarity.

If the founders already have a founders’ agreement, most investors would like to honor it. Also, a founders’ agreement has really helped in sorting co-founder issues very amicably.

Now, for the tough one, TREATMENT OF SHARES:

A key component of the ‘vesting clause’ is determining the treatment of shares, should a founder leave during the vesting period.

Statistics as per our database (it may be skewed and may not be a good representation of the Indian scenario):  Nearly 8-10% of the investments at some point face co-founder issues. The percentage is very low / negligible before investment. Most cases arise, when there is traction by investors and prior to investment. It raises its ugly head again, prior to Series B or when progress (scale) is not as expected.

We will share our experiences of the many reasons for co-founder issues, very shortly.  For this post, we would like to broadly classify the reason as Good Reason or Bad Reason (Cause). ‘Cause’ is generally defined and includes acts such as misconduct, absenteeism, embezzlement, theft, abetting strike and the like. ‘Good Reason’ is that which is not a ‘cause’ and intended to cover change in the founder’s role, pivot of the company business which may mean founder’s skill irrelevant or not the right person. The biggest discussion typically is classification of ‘non-performance’ of a founder, which we believe is subjective.

This is what we generally see in early stage investments.

Cause Good Reason
Vested Unvested Vested Unvested
Treatment Transfer to  remaining shareholders Transfer to the  employee welfare trust The Promoter can retain or sell  to remaining shareholders Transfer to the employee welfare trust
Price At face value At face value At fair market value At face value

TIP: Since investor’s stake holding is a function of valuation, then an exiting founder’s shares should go to continuing founders or ESOP? The argument is around the increased risk of the investor and therefore the claim of the investor to be eligible for a percentage of such exiting founder’s shares. Founders need to think about having the shares available to remunerate new hires or a replacement. Hence, it’s a good idea to have an ESOP Trust to hold the shares.

Founders’ Agreement, which clearly details the vesting schedule, has saved the company from letting the founder walk away with a big chunk.

ACCELERATION: Termsheets do provide for acceleration of vesting in cases of acquisition, merger and sale of business. There would be some detail for untoward incidents of death / disability.

Here are some examples of the clauses:

The shares held by the Founders would get unlocked in equal annual installments over a period of 4 years from the Second Closing by the Investors. If a Founder decides to leave the Company at any time before such period, the locked shares would have to be sold at face value to the existing shareholders and that the Investors will be given the first option to purchase the said shares.  Should Investors decline to purchase the shares, such shares shall be sold to the other shareholders, in proportion to their shareholding. Such shares, at the Investors’ discretion, may also be placed into an ESOP trust to be made available as incentive for attracting other senior employees that may be required to take the company forward.

The Shares held by the Founder shall be locked in for a period of 3 years. 25% of the Shares held by each Founder shall vest on the execution of the Definitive Agreement (“Released Shares”) the remaining 75% of the shares held by each Founder (“Restricted Shares”) shall vest monthly over a period of 3 years (“Restriction Period”). The treatment of shares in case of determination of the Founders employment during the Restriction Period shall be detailed out in the Definitive Agreement.

It is important to recognize that the vesting clause works for both – the founders, as well as the investors.

Disclaimer:  This is not a legal opinion and should not be construed as one.  Please speak with your attorney for any advice.

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