Founders of a start-up enterprise are often so consumed with the numerous issues related to the operation and financing of their new business, that they fail to carefully consider key issues related to the Founders’ relationships with each other. However, it is important for the Founders to address certain critical issues early on in order to avoid undesirable consequences or disputes at a critical point in the future.
One of the most important issues for the Founders to discuss is the initial capital structure of the company, and in particular, how the Founder shares will be allocated among the Founders. Essentially, the Founders need to decide upon an equitable distribution of the Founder shares based on the contributions that each Founder will be making to the company. Sometimes the Founders will decide to split the Founder shares equally based on the assumption that each will contribute equally to the business, however, there are numerous ways to slice the pie and the Founders should consider which allocation works in their situation. The Founders should also discuss a variety of matters associated with the Founder shares, such as transfer restrictions and vesting requirements. If a Founder holds unvested shares, such shares are essentially earned over time, such that they are subject to the company’s buyback right (typically at cost) in the event that the Founder’s service relationship with the company ceases. Vesting requirements specify how unvested shares become vested, or earned shares.
Founders may want to voluntarily subject their Founder shares to vesting to ensure that the members of the founding team remain committed to the company, as in the absence of vesting the Founder would have the right to retain his or her shares following a departure from the company. Various types of vesting schemes can be employed to ensure that the founding team’s objectives for a particular Founder are achieved. If the main concern of the Founding team is that a certain Founder remains committed to the company for a specified period of time, that Founder’s shares would be subject to time-based vesting, where the shares would vest over a specified period of time (for example, a period of time between three to five years is common) for so long as the Founder maintains a business relationship with the company. If, however, the main concern of the founding team is keeping a certain Founder motivated until a particular milestone is achieved (for example, until an investigational new drug application is filed in the case of a biopharmaceutical company), the Founders’ shares would be subject to performance-based vesting, where some or all of the shares would vest upon the occurrence of such milestone so long has the Founder remains employed with the company through such milestone.
A combination of time-based vesting and performance-based vesting can also be used. The Founders should also consider if the vesting of the Founder shares would be accelerated in certain circumstances. Oftentimes, accelerated vesting will be granted in connection with a sale of the company (single-trigger acceleration) or within a certain number of months after a sale of the company if the purchaser terminates the Founder’s business relationship within such period of time (double-trigger acceleration). If the founding team plans on raising a financing round for the company in the near future, it is likely that the financial backers will want to ensure that the Founders are committed to the company, and therefore may impose vesting requirements on previously issued Founder shares, if such restrictions are not already in place. In addition, if the investors believe the existing vesting terms are too “rich”, they may insist that the Founders restate those terms prior to their investment.
This post on Start-up Issues was authored by Laurie Burlingame.