As discussed in our previous articles in the VC and Founder's Insights series, investments in early-stage businesses come with risk, for both founders and investors. Investors not only commit capital but also place their confidence in the founding team's ability to scale the business to exit. As such, term sheets typically include mechanisms designed to align founder incentives with long-term company success. Two critical mechanisms in this regard are Founder Vesting and Leaver Provisions.
This article provides an overview of these provisions, their purpose, and key considerations for founders and investors when negotiating term sheets.
What is Founder Vesting?
Founder vesting refers to a structure whereby a founder's equity ownership in a company is 'earned' over time. There are two 'forms' of founder vesting, reverse vesting and standard option vesting. Reverse vesting occurs where the founders already hold a significant percentage of the company's issued share capital (often from incorporation). Reverse vesting allows the company to 'claw back' some (or all) of the founders' shares if they leave before a certain period (often 4 years) following an investment round, by requiring the founders to sell back their shares to the company or other shareholders, or have them converted into worthless deferred shares. Standard option vesting, on the other hand, is where the right to exercise options over to-be-issued (future) share capital in the company is earned over time.
Why Is Vesting Important?
Investors invest in people as much as they do in ideas - this is particularly the case in early-stage companies. If a key founder were to leave the business soon after a funding round closes, they could walk away with a significant equity stake while contributing no further value. This may not only demotivate the remaining team but also deter future investors. Founder vesting therefore provides assurance that equity is earned through long-term commitment to the company and value creation, and generally helps to align founder and investor interests.
Typical Vesting Schedules
The 'standard' reverse vesting schedule in Venture Capital (British Venture Capital Association standard) deals is four years with a one-year 'cliff'. In short, this means:
- no equity vests during the first year;
- after one year, 25% of the founder's equity vests; and
- the remaining 75% vests monthly or quarterly over the following three years.
Where a founder has already run the company for a long time prior to investment, or has previously had their shareholding subject to a reverse-vesting period, they may look to negotiate accelerated vesting or a 'carve out' from vesting of a portion of their equity, to reflect their prior contributions. However, investors will generally look to ensure there is sufficient disincentive against founders leaving, which can be achieved by granting additional 'standard' options.
Where a company has multiple co-founders, it is often also in the founders' interests (collectively) to ensure there is a clear agreement around what happens if a founder leaves.
Leaver Provisions: Good Leavers vs. Bad Leavers
While vesting governs the timeline over which equity is earned, leaver provisions determine what happens when a founder leaves the company, voluntarily or otherwise.
Definitions Matter
Founders can leave a company for many reasons. The leaver provisions in a term sheet categorize these departures into:
- Good Leaver: A founder who leaves under circumstances beyond their control, such as illness, death, or being terminated without cause.
- Bad Leaver: A founder who resigns voluntarily or is terminated for cause (e.g. gross misconduct or fraud). Noting that in some circumstances a 'voluntary leaver' can be separately defined.
Consequences of Leaving
These definitions have direct implications on the treatment of equity:
- Good Leavers typically retain their vested shares. They may even receive accelerated vesting in some scenarios, such as a change of control or sale of the company.
- Bad Leavers may forfeit all or a portion of even their vested shares or be forced to sell them back to the company at nominal value.
Negotiating Fairness
Leaver provisions must strike a balance between protecting investors and being fair to founders. Too harsh a regime may discourage key personnel or create distrust. Founders should therefore seek clarity from investors regarding their expectations and obtain reasonable protections in the definitions of 'good' and 'bad' leavers; for example, cause for termination should be narrowly defined and subject to procedural safeguards, such as additional approval requirements or opportunities to remedy breaches.
The Interplay Between Vesting and Leaver Provisions
Together, vesting and leaver provisions work in tandem to create 'incentives' for founders to stay in companies:
- vesting ensures founders earn their equity over time; and.
- leaver provisions determine the consequences of departure.
Together, they provide a disincentive to founders leaving and, where a founder does leave, mean that additional options and/or shares may be available to hire in new talented individuals and minimise disruption to the business.
From a legal perspective, careful attention should be given to ensuring consistency between the company's constitutional documents and the founders' employment/service contracts, particularly in the definitions and mechanics of leaver scenarios to avoid unwanted and costly disputes.
Conclusion
Founder vesting and leaver provisions are important tools in venture capital term sheets to protect investors against early founder departures, and ensure that continuing founders (or other key staff) are not demotivated if a founder does leave. Thoughtful negotiation of these clauses, with clear definitions and balanced outcomes, can foster trust and ensure that both founders and investors are positioned for long-term success.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
