The founders of an early stage company are typically compensated in some combination of cash and stock. In so much as most early stage companies have more of the latter than the former, frequently founders will only be compensated with stock of the company for a period of time, and that’s usually done under a founder restricted stock agreement.
Type of Stock
When a founder receives stock, what they typically receive are shares of the common stock of the company. The common stock of the company is the most basic, vanilla, ownership unit the company will ever have, and it generally plays by all of the default rules set up for the stock of a company by state statute. As a company grows and matures and takes investment, the investors will typically get preferred stock, which comes with additional rights and preferences attached that make it better, and potentially more lucrative for investors, than the common stock of the company.
For many companies, and certainly for any company that intends to take investment, the founders are going to receive their shares of common stock subject to a Founder Restricted Stock Agreement. This agreement is also frequently called a “vesting” agreement. As a general matter, if two people found a company, split up shares of common stock evenly, and don’t execute restricted share agreements, then one of those founders could theoretically decide to run off and abandon the company, but maintain their ownership interest, and then come back and cash-in when their partner makes the business a success. In such a scenario, the remaining founder wouldn’t have any recourse to take back the other’s shares. In reality the scenario is rarely so dramatic, but frequently one founder will stop showing up as much, or their work will slip, or any of a million other things will happen to reveal that they’re just not a good fit for the company.
How it Works
This is where the restricted stock agreement comes in. Under a restricted stock agreement, a founder’s shares “vest” over time, meaning that they have to keep working for the company, and performing adequately, in order to actually get full ownership of their shares. If they take off before shares vest, or the company decides it’s not a good fit and the founder is fired before the shares vest, then the company gets those unvested shares back. This helps to ensure that founders, particularly ones who are being paid below market on the promise of a return down the line, are incentivized to keep working hard for the company. Investors usually require that these agreements be in place for all founders prior to investment, because they want to make sure that the key team members are incentivized to stick around and make their investment successful.
From a mechanics perspective, the vesting works like this:
- The founder receives all of their unvested shares upfront;
- The company keeps a right to repurchase unvested shares for some nominal amount in the event the founder stops working for the company;
- As shares vest, the company loses its right to repurchase those shares, and the founder gains exclusive ownership.
The period of time over which a founder’s shares vest is typically referred to as a vesting schedule. A vesting schedule can be whatever a company wants it to be, and may change depending on the particular founder, their role, how long they’ve been working on the company and what other kinds of contributions they’ve made (including cash or equipment contributions) to the Company. In fashioning a vesting schedule, typically a company will have shares vest over a specific period of time, in line with certain performance milestones, or some combination of the two.
For example, for a CTO, it may sometimes make sense to have a certain number of shares vest each month or each quarter, and then have the vesting of more shares tied to certain development milestones, like a beta launch, full launch, certain number of users, etc.
There is, ultimately, no “normal” or “standard” vesting schedule, each company should come up with a schedule that works for them and that they can adequately explain to any future investors, but to the extent there’s a default option, it’s a four year vesting schedule with a one year cliff. This means that shares would vest over the period of four years, but no shares would vest until the founder had been at the company for one year. Generally, 25% of the shares will vest on the one year anniversary, and then equal amounts of shares will vest every month or every quarter thereafter. The “cliff” then, describes the period before the initial vesting event.
The goal of many new companies is to get to a point where they either get acquired, or partake in an IPO, and a restricted stock agreement should, and usually does, reflect this. The way an agreement deals with this is typically through “acceleration.” Acceleration means that if the company is acquired or undertakes an IPO, but all of your shares have not yet vested, those unvested shares will vest immediately before the closing of the acquisition or the IPO. In other words, acceleration means the founder gets the full value of all of their shares in the event of an acquisition or IPO, not just their previously vested shares.
Termination is dealt with in many different ways in restricted stock agreements. At one end of the spectrum, a restricted stock agreement may state that a founder can be terminated from the company at any time by the board of directors, for any reason or no reason at all, and that shares stop vesting immediately upon that termination. At the other end of the spectrum, the agreement may provide that a founder can only be terminated for cause, that all unvested shares will accelerate if they’re terminated without cause, and that some or all of their unvested shares will accelerate if the founder themselves quits with cause (like a reduction in salary or the company moving offices across the country). In between those two extremes are a myriad of options governing termination, which can be negotiated and tailored in the same manner as an employment agreement. In the event the founder also has an employment agreement that contains termination provisions, the restricted share agreement may simply reference the employment agreement, and piggyback on those provisions to determine vesting.
Whenever the agreement is terminated, and some shares remain unvested, the company will repurchase those shares. Typically, this is for a nominal value set out in the restricted share agreement, and must be completed by the company within some specific time frame. Frequently, to prevent an unhappy former-founder from slowing down the process, the restricted stock agreement will state that all unvested shares are held in escrow by the company until they vest, and that the company is named as power of attorney to execute any documents needed to effectuate the repurchase. Language to that effect means that the company doesn’t have to chase down a disgruntled former founder for signatures, but can instead effectuate the transfer on their own.
Sometimes the restricted stock agreement will allow for company repurchase of vested shares as well. Unless otherwise set forth in a shareholder or other agreement, once a shareholder owns vested shares the company can’t do anything to make them sell those shares. Particularly for small, closely-held companies, this can become an issue if one or more founders, whose employment has been terminated, retain some sort of ownership interest and therefore must be kept in the loop and consulted on certain matters. Some restricted stock agreements deal with this issue by giving the company the option of repurchasing vested shares at market rate upon termination. As with unvested shares, the company will have to exercise the option within a certain period of time. Unlike with the unvested shares, there will have to be a mechanism for agreeing on what market value of the shares at the time of termination. Where a company has this option, the payment terms should allow for payment over time via a promissory note, so that the company’s options aren’t limited by their cash-on-hand.