The Importance of Co-Founder Vesting

Because life happens, co-founder vesting of equity is critical for a young high-potential startup.

Inexperienced founders sometimes think it is “fair” to allocate equity equally and have ownership with no vesting. This plan often will not survive the realities of life.  Building a successful startup usually takes years of hard work.  And rarely are the relative contributions of all co-founders, including capital contributions, skills, network, experience, responsibility/role in the startup, and other factors, equal. 

I cannot tell you how many times I have spoken to eager founding teams and been told that the multiple co-founders have equally divided the equity, and all are 100% vested.  This is especially true of student-led entrepreneurial teams.  And this is a foreseeable disaster in the making because life happens. 

Despite everyone’s best intentions, no one can predict how life will impact team members over the years required to build a successful startup. Here are some examples of what I mean by life happens to startup co-founders:

• A co-founder needed to move out of state to take care of an ailing parent, and could not continue to be engaged in the startup’s operations.
• A co-founder did not scale well with the company as it grew and ultimately was asked to leave.
• A co-founder decided that they were tired of working on the startup’s business and wanted a “regular job.”

These examples and others like them happened either directly within startups that I was leading or happened to other startup CEOs that I was mentoring. The common theme is that, for whatever reason, a co-founder opts out of the startup early.  

This can create a problem for the startup if the co-founder’s stock is NOT subject to vesting for the following reasons:

• It feels unfair to the other co-founders. When a co-founder leaves early in a startup’s life, the remaining co-founders and other team members are often disappointed and frustrated if the person who is leaving retains all of their original equity allocation without continuing to contribute to building the value in the company.  Vesting ensures that the co-founder is compensated for the time they were contributing to the startup, but not once they stop. 

• Limited equity is available to hire a replacement.  Vesting allows for a team member’s contribution to be recognized while preserving equity for hiring a replacement if it becomes necessary.  Equity is precious.  Hiring a replacement leader will usually involve an equity component.  If a significant equity stake is in the hands of the person who just left, then it can be hard to allocate the stock options needed to attract a well-qualified replacement.
  
• It makes investors uncomfortable. Potential investors do not like to see a capitalization table with a former co-founder as a major investor. At one of my startups, to address a departing co-founder without vesting situation, the Board members at the time all personally contributed several thousand dollars each to buy out a portion of the departing co-founder’s equity to reduce his position on the capitalization table.  It did not feel good at the time, but it was necessary.

The solution is to avoid the problem in the first place. When forming a founding team and allocating founders’ stock, it is essential that all co-founders’ stock vests, typically over a period of four years. Vesting is a graceful and straightforward way to ensure that the company co-founders – and every new person who joins and gets stock options after that – are rewarded for their contribution to the company’s success, while not getting an unfair windfall if they depart. 

The time to do this is while everyone is aligned at the beginning, not once interests have come into conflict because someone needs to or wants to leave. Consult your experienced attorney on how to set it up. It is not difficult to put a stock restriction agreement in place or to impose vesting on stock options.

If you do not put it in place yourself, you can count on sophisticated investors demanding it as a condition of their investment. Show the investors that you are sophisticated and understand how equity should be handled by putting vesting in place upon founding.  Then you can set reasonable vesting terms and get the vesting started right away rather than waiting until you take your first significant investment.