When founders start a company often their main focus is on product development, customer acquisition, and maintaining a growth trajectory. However, founders should also use this beginning period of the company to make management decisions such as clarifying roles and responsibilities. One question that each startup that has been founded by more than one founder is often faced with how to allocate equity amongst the founders.
Questions such as who gets what percentage of the company or what will each contribute to the firm etc is important. Therefore, allocating stock as the company grows and the shares increase in value will be more difficult down the line.
Thus it is mandatory that founders of the organization should sign a founder's agreement that defines the allocation of shares.
Allocating or distribution of stock refers to how much stock should go to the founders of the company relative to the total amount of stock outstanding. There is no perfect allocation, however, when a company has several founders, it's best to split the stock equally.
If apart from the founders, there are no other investors then in such a scenario, 80% of the stock should be allocated to founders with the remaining as outstanding shares reserved.
Depending on the specifications of the company i.e. number of founders, investors, etc., the allocation may be accordingly done. There’s no right or wrong answer—only a solution that each of the founders can agree with. However, allocating too much equity to a founder whose ultimate contributions will not be equal to other founders or who is looking to work on the startup only part-time, may seem unfair. The rationale is that cofounders almost always bring different contributions to the table.
If the founders find themselves in a situation where an equal split is not just, then usually they tend to consider the following factors while deciding on how to allocate stock:
Formulation and execution of the Business idea.
Expertise in the industry including any connections to venture capitalists or other investors.
Contribution to technology (if the company involves patented technology).
Level of responsibility that the founder will be taking i.e. allocation based on actual work done.
Time allocated by the founder towards the start-up i.e. whether the founder will be working full time or part-time.
When discussing the relative contributions of cofounders, aspects such as effort in prior research, involvement in ideation or intellectual property, past financial and time investments, domain expertise, career risks, and entrepreneurial track record should be considered.
The factor that has been left out is the capital contribution. The capital contribution should not be taken into consideration while deciding the distribution of stock. It’s better to allocate stock-based upon each founder’s actual level of work contribution (called “sweat equity”) and treat financial contributions from a founder the same way that a startup would from an investor. No matter what the allocation is, the founder must be subjected to a vesting schedule. When a company issues stock, it can do so either subject to certain conditions or outright. When the stock is issued subject to vesting, the holder of the stock owns only some stock and other shares are subject to forfeiture or repurchase if certain conditions are not met.
So, what is vesting and why should a founder agree to vest? Vesting of founder's shares is often one of the most perceptive topics. Founders often argue as to why they should wait to receive benefits of shares of their own company. They have earned their shares!
What is vesting?
Startups can either issue stock outright or subject to vesting. A stock that is subject to vesting means that shares issued are exercisable over a while with certain conditions for the option to meet. The stock option becoming exercisable is referred to as "vesting."
Let's say, for example, you have been issued 10,000 shares of common stock. However, initially, not all of your stock is exercisable. Your stock becomes exercisable with 1000 shares every 4 months. That stock option is said to vest concerning 1000 shares every 4 months.
FOUNDER SHARES & VESTING
When starting a company, founders often believe that they should receive the shares without any vesting because they own the company or are the ones working on the company. However, in most situations, having a vesting schedule in place for founder shares is in the best interests of founders for the following reasons:
When a company has more than one founder, there is a possibility of founders developing conflicts over some time. By having shares subject to vesting, if the other founder leaves before his/her shares have vested then the unvested shares can be purchased back by the company. If the shares are not subject to vesting, then the other founder will still own the shares he was issued.
Most VCs or other investors would want to see founders be involved in the start-up, giving their 100 percent. Therefore the VCs usually will not permit a situation where a founder can simply resign at any time and still retain all of the shares issued. Having vesting terms in place depicts to VC’s that the founders have a long term vision for the company.
If the founders wait to add vesting to their stock until they are in discussions with investors, the investors are more likely to dictate the vesting terms (e.g. longer vesting, fewer acceleration triggers).
What Vesting Schedule should be followed?
The length of vesting scheduled as discussed is the period over which the shares will be subject to vesting. So, for example, if you choose a two-year vesting schedule then your shares will vest over 2 years. However, the most common vesting schedule seen is a 4-year vesting schedule.
The frequency of your vesting is often expressed in terms of either a percentage or a fraction of total shares granted. So, for example, it can be that in your four-year vesting schedule with quarterly vesting i.e. 6.25% of your shares vest each quarter over 4 years.
Another important thing to remember is that vesting schedules can have vesting over a cliff or a straight line. Often your shares are subject to vesting schedules with a one-year cliff. What this means is that the person must be at the company for at least a year before the shares vest. Whereas in a straight line, the shares will vest at regular intervals from the vesting date itself!
For example, 100,000 shares are being granted to a founder on December 1, 2019, with a vesting commencement date of January 1, 2020. In a four-year vesting schedule, monthly vesting with one year cliff, your shares will not start vesting until January 1, 2021. On January 1, 2021, 25% of shares will vest immediately, and thereafter the remaining shares will vest in monthly installments until January 1, 2024.
Author: Hrideja Shah (Attorney, Dual Qualified Lawyer India & California & Founder of Legal Sollers, United States)
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