The excitement of a startup often clouds founders thinking. They are amped up to go into business with friends, or at least with people they think they can be successful with in the future.
If the founders are able to decide on an appropriate split of equity, they go off on their merry way. If they work with good startup counsel, they will be told they need to put founder stock restriction agreements in place. These are agreements that make all founder stock subject to vesting over time, meaning that while they might own these shares in principle, if they leave the company, the unvested shares will be forfeited. The standard vesting schedule for these agreements is four year vesting monthly with a one year cliff, meaning after one year founders will vest in one fourth of their shares and the remaining three fourths will vest 1/48th per month over the next three years. There are variations to this schedule, but you get the idea.
The reaction is often, “This is MY company. I came up with this concept. Why should I put my shares at risk?” The blinders have kicked in. A year is a long time, especially in a startup. What if your 20% partner gets tired of eating canned tuna fish and macaroni and cheese after nine months, and bails back to a job at BigCo? Three years later, after a lot more tuna fish and macaroni and cheese, you sell GreatIdeaStartUp Co. for $50 million dollars. Your buddy back at BigCo just pocketed $10 million (probably a lot less, since he certainly got diluted over time, but still, he’s going to pocket a bunch of money). You think, a big chunk of that $10 million should be mine. THAT’s why you should have founder stock restriction agreements.
At the outset, these kind of agreements put founders to the sword. They show who is really committed to the deal. If they won’t sign one and you will, that tells you something. If you are queasy about signing one, that should tell you something as well. Either you aren’t fully committed to the concept, you aren’t fully committed to your future partners or you aren’t committed to tuna fish and macaroni and cheese for an extended period of time.
Another reason why these agreements are important is that investors, especially institutional VC’s, expect them. They expect them for many of the same reasons founders should have them. One, they, like founders, don’t want to see a startup partner benefit in a disproportionate manner if they leave the venture in its formative period. Two, they want to see that founders are willing to put themselves at risk for the benefit of their venture. A third, less benevolent reason is they often have the leverage in these relationships because of their funding capacity and they can simply get away with it.
Institutional VC’s, even more so than individual investors or founders want to see the standard four-year vesting schedule. Why? Partially it’s sheep mentality. Institutional VC’s, just like founders, don’t want to do things that might discourage future investors, and if you go off the reservation, you might do that. Another reason is the belief that the first year of a startup is mostly formative and most value is generally created after that period, so the stock vesting should match.
Now let’s talk about some more esoteric provisions in a standard stock restriction agreement: acceleration, lockups, and rights of first refusal.
Acceleration is the right of the founder to have all or some of the unvested shares vest upon certain events, usually a change of control of the company. Acceleration clauses usually come in two forms, “single-trigger” and “double-trigger.” Let’s take double-trigger first. The two triggers are the change of control and the involuntary termination of the founder in some specified time frame. Single trigger is just the change of control itself. While founders might like single-trigger, investors prefer double trigger, as it makes the company more salable, since the founder remains tied to the company and the vesting schedule even after the company is sold.
A lockup is the requirement that founders not sell their shares in an initial public offering and for a specified period of time thereafter (usually 180 days). It may seem crazy to worry about an IPO this early in a company’s formation, but ultimately, if the company goes public, the underwriter will demand this provision, so it’s often done just to get it out of the way, though it is often handled at the time of Series A level investment.
A Right of First Refusal is just what it sounds like; the right of other founders, the company itself, or all such parties to purchase the vested shares of another founder if they leave the company under certain circumstances, usually a voluntary termination by the founder themselves or a termination for cause by the company.
There are certainly more provisions that might be found in a restricted stock agreement, and there is much more nuance to some of the concepts described. If you are interested in learning more about these concepts, please contact us.