Many first-time founders are surprised to learn that, even if they are a solo founder, they are expected to have a vesting schedule for their founder equity.
This is something that investors expect to see, and, if you don’t have a vesting schedule in place by the time you raise a priced round, you will often be forced to add vesting to your founder shares by investors, as part of the terms of the round.
Because investors need to know you are committed to your venture for the long haul and won’t walk away with a huge equity stake before the company has fully developed.
In growth stage companies, when the board approves additional equity awards to the founders, these will typically be tied to a new vesting schedule or milestones for the company’s growth.
Let’s break down what this means for founders who are just setting up their startups.
Vesting schedules: The industry standards
The norm for founders – and all startup employees – is to have a 48 month vesting period with a one-year cliff.
What does this mean precisely?
- At the 12 month anniversary of your employment with the startup, ¼ of shares (or 12 months worth) will vest.
- Then, on each subsequent monthly anniversary, another 1/48th of the shares will vest, until your shares are fully vested at 48 months.
It is fine with investors (and may even be better for aligning incentives among the founding team) to have a longer vesting period for the founders. However, a shorter vesting period may raise eyebrows and is likely to be renegotiated during a future financing round.
What happens if you walk away from the company with unvested shares?
The company can take possession of these shares as you do not own them. With common and restricted share awards that have a vesting schedule, the company can exercise a repurchase option for the unvested shares and you, as the shareholder, pre-authorize the repurchase of any unvested shares when signing for the initial grant.
There is typically a 90 day window after you stop working at the company for the repurchase right to be exercised.
Investors do not want to see dead equity on the cap table – meaning they do not want shareholders with large ownership stakes in the company on the cap table if these shareholders are not actively contributing to the further development of the company’s product and the growth of the business.
If you or one of your co-founders leaves the company with 30% of the equity, the incentives are misaligned for the future growth of the company. Preventing these sorts of situations is exactly why investors want founders on a vesting schedule in the first place!
To be frank, it is not only investors who should care about founder vesting. If you are working on your startup with co-founders, you will want to have each of the co-founders on a vesting schedule to avoid nuking your cap table with dead equity in case of a co-founder dispute.
I've already worked on my startup before incorporating, do I need a vesting schedule for my equity?
Yes, in these circumstances, you will want to have a vesting schedule in place as a matter of corporate legal hygiene and to signal to investors that you are in it for the long haul. If you have co-founders, then this is doubly important, so that the company can carry on without dead equity on the cap table should one of you choose to leave the startup.
Because you worked on the company before incorporating, it may be justifiable in some cases to make one modification to the standard vesting for your founder equity. Namely, you could make a certain percentage of your shares *not subject* to vesting, like 10% or 20%. However, even this small change may raise eyebrows from investors during diligence.
Investors tend to discount most work that founders do on a startup when it is still a side project, especially if the founding team are not all working on the startup full-time.
What happens to your vesting schedule when your startup raises a Series A?
When you raise your Series A financing round, a few things will change with your cap table.
- You will often negotiate over the size of your employee stock option pool. Typically investors will ask to increase the size of the option pool, so that there are enough shares set aside to incentivize key hires as the company scales. This is an additional source of dilution of the founders’ ownership stake, so founders and investors typically haggle over the size of the option pool before finalizing the term sheet for the investment.
- Depending on how many shares you will have already vested by the time of the financing, you may be asked to change your vesting schedule.
What I have heard from venture lawyers is that investors want founders to have vested a maximum of 40% of their initial share award by the time of series A. If you have vested more by the time you raise your Series A round, then investors may want to alter the terms of your vesting schedule as part of the financing.
Keep in mind that if you enter the Series A negotiations, and all 100% of your founder equity award has already vested, there is little doubt that you will be asked to add a vesting schedule at this point.
You want the financing negotiations to be as low friction as possible, so, as a founder, it is usually easier to set up your cap table the way that investors expect from the get go, rather than doing things in a non-standard way and fixing them after the fact.
One thing many founders do not realize is that they are on the hook for their investors’ legal fees as part of equity financing rounds. Every time a startup does something non-standard, they effectively pay 3x for legal fees.
How is this the case?
The startup pays its lawyers to draft non-standard contracts at the outset. Then, the startup pays their investors’ lawyers to notice the non-standard contracts during diligence. Finally, the startup will pay their own lawyers to fix the non-standard contracts to avoid the financing deal falling apart at the last minute.
What happens to unvested shares when you sell your company?
When a startup sells early to an acquirer and the founders have unvested shares, the process is simple – the founders are typically the board members and they can sign off to accelerate their own stock vesting prior to the completion of the acquisition of the corporation’s stock by the acquiring company.
A common misconception among founders is that, if they sell their company, only the already vested shares will be used for calculating the payout to the founders and other shareholders.
Founder equity awards are not typically done as options; instead, founders purchase common shares when first setting up their company, and the way the vesting schedule works in this case is that the shareholders pre-authorize the repurchase of any unvested shares should they leave the company prior to being fully vested.
In case of an early acquisition, technically what happens is that the company’s board of directors simply chooses not to repurchase the unvested shares from the founders prior to the acquisition.
- Founders typically set up a vesting schedule when they set up their companies, even if they are solo co-founders
- Investors want founders to have a vesting schedule so that they are incentivized to work on the business in the long-term
- A typical (minimum) vesting schedule for a founder is 48 months with one-year cliff, but vesting schedules of 5 years or more are becoming increasingly common
- When you raise your Series A round, your vesting schedule may end up getting renegotiated with investors depending on what percentage of founder shares are already vested at the time of the financing
- If your company is acquired early before your shares are fully vested, the fully vested ownership % of each founder will normally be used for determining the pro rata payout to common shareholders
Written by Greg Miaskiewicz
Security expert, product designer & serial entrepreneur. Sold previous startup to Integral Ad Science in 2016, where he led a fraud R&D team leading up to a $850M+ purchase by Vista in 2018.
We cover all the important steps founders should take before incorporating their startup: choosing business entity, state of incorporation, name, board of directors, splitting equity between founders & more.