This is Part II in a series from Daniel Devoe, co-founder and director of marketing at LegalHero, which provides experienced, vetted attorneys at affordable, fixed prices. You can read Part I here: How to Split Equity Between Cofounders [Framework Template]
While determining the actual equity split is critical, many co-founders make the mistake of ignoring important structuring considerations. In the best case scenarios, not thinking through how to structure co-founder equity can lead to resentment and dead equity (equity that is owned by people no longer affiliated with the business that could have been used to incentivize current and future employees). In the worst case scenario, not thinking this structuring through can lead to company failure and lawsuits.
Today, we’ll go over some of the most commonly used structures that help protect you, your co-founders, and your company.
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Most co-founders of businesses would never consider issuing options to an employee without attaching some sort of vesting schedule, but so many issue themselves stock outright with no vesting. This is a huge risk, because it creates the possibility that a co-founder who works on the company for a very short period of time walks away with a massive chunk of equity. To understand this (unfortunately not uncommon) phenomenon, we first have to understand what vesting is.
Vesting is the process by which a founder accrues non-forfeitable rights over stock. Vesting generally conforms to a schedule, which defines the time period over which the stock will vest in installments. For example, if stock vests on a monthly basis over a 4 year period, then that means that, each month over the course of the 4 years, 1/48th of the total stock grant will vest, so that 100% of the stock is vested after 4 years. Sometimes, there is a “cliff” attached to the vesting schedule, which is the time period that must pass before any of the stock vests. Using the example above, if we add a one year cliff, then 25% of the stock will vest after one year (the cliff), and then 1/48th of the stock will vest during each month for the remaining 3 years.
Without vesting, all co-founders receive their full grant of equity (most likely restricted stock) on the date of the grant. That means that, even if a co-founder changes her mind the very next day and decides she doesn’t want to devote herself full-time to the business, she still owns her full, allotted share of equity. I think we can all agree that that’s a horrible position to put yourself in, so why do so many co-founders resist vesting anyway? The answer is simple: many co-founders want to avoid imposing those same vesting provisions on themselves, and they can’t ask their co-founders to do something they themselves won’t do.
That said, there are a couple of reasons we think this avoidance doesn’t make a ton of sense. First, if you’re raising venture money, your investors will want to see that you’re subject to vesting and will often require it. Second, if you’re worried about not being fully vested at the time of a liquidity event or when you leave the company, you can address these concerns with accelerated vesting provisions in the Restricted Stock Agreement that cause your stock to become fully vested upon certain events. For example, you may provide that you and your co-founders’ stock immediately becomes fully vested upon an acquisition, so that you can enjoy the fruits of your hard work. Or, if you’re worried about being fired for no reason, you can provide for acceleration upon firing without cause.
In any private company, owners like to have a say over who owns the stock, because nobody wants a stranger out there controlling a significant stake in the company. Founders’ and Restricted Stock Agreements also often contain transfer restrictions, which prevent any co-founder from transferring stock to any third party except for certain enumerated cases (such as to heirs in the case of death).
Rights of First Refusal (ROFRs)
Rights of First Refusal, or ROFRs, give other co-founders the right to buy stock that’s being transferred to a third party. It works by giving the non-selling co-founders the right to match the price that’s being offered by the third party buyer.
Repurchase rights give the company the right to buy back any vested and unvested stock from a departing co-founder. Usually, barring unusual circumstances (like being fired for cause), vested stock is re-purchased at fair market value, while unvested stock is re-purchased at cost.
We know that these structuring legal terms can be a bit tough to understand, so we thought we’d provide a simple example to illustrate what a difference they can make.
Let’s imagine that Mary and Joe are starting a skateboard hovercraft business together, and that they used our calculator to help them determine a fair and reasonable split of 60/40, which Mary owning 6,000 shares, Joe owning 4,000 shares (and total issued shares of 10,000).
- Universe 1: In one universe, Mary and Joe just distribute the equity without any additional agreements.
- Universe 2: In our other universe, Mary and Joe agree to a monthly vesting schedule of 4 years, with a 1-year cliff. They also sign a Founders’ Agreement and Restricted Stock Agreements, which include transfer restrictions, a ROFR, and repurchase rights.
After 12.5 months, Joe decides that he’s no longer of that much value to the hovercraft business and that he should focus his efforts elsewhere.
In Universe 1, Joe walks away with 4,000 stock of the business and the full rights associated with it (including being able to sell it to anybody else).
In Universe 2, Joe has vested in 1,000 shares of his stock (he passed the one year cliff, so 25% of his 40% vested at 12 months, but he didn’t reach the end of month 13, so no more has vested). At this point, Mary has some options: she can go ahead and repurchase the unvested stock at cost (this gets wiped off the cap table), and she can choose whether to repurchase Joe’s vested stock at fair market value. Let’s imagine in this case that she’d like to keep Joe involved because he knows so much about the business and so decides to waive the company’s repurchase right on the vested shares.
At this point, the cap tables look like:
Universe 1: Universe 2:
Mary: 6,000 (60%) Mary: 6,000 (86%)
Joe: 4,000 (40%) Joe: 1,000 (14%)
After 3 years, Joe now decides that he’s going to sell his stake in the business to a third party investor, Kevin, who has taken an interest in hovercraft skateboards and thinks they’re the wave of the future.
In Universe 1, Joe can sell his stock and Mary would have a stranger (Kevin) as a 40% stakeholder in the business.
In Universe 2, Mary can prevent this transfer entirely so long as it is not a specifically enumerated exception to the agreed-upon transfer restrictions. And even if the transfer is allowed under the agreements, then Mary can exercise her ROFR if she chooses to match Kevin’s price, thereby preventing Kevin from becoming a shareholder at all.
As you can see, structuring equity thoughtfully is just as important as splitting it among co-founders. A few small words in an agreement can go a long way to protecting you and your company.
Starting a company should be an exciting endeavor and you should focus on the most important things to make the business work. With these tips, hopefully some of the things that can get in the way don’t have to.
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