Working with start-ups in San Jose, I have often had to counsel founders on the intricacies of business law as it relates to issuing stock. A large part of initial discussions with the founding group involves the funding needs of the new corporation, how shares will be divided, and the best way to provide equity incentives to founders, advisors, and new employees.
As I discussed in my last blog, one of the key issues involved in issuing stock to founders is how to incentivize them to stay with the new corporation. One mechanism discussed is reverse vesting, where the corporation can repurchase a founder’s shares of company stock at their original purchase price when certain events specified in a contract occur.
A typical reverse vesting structure is to allow the corporation to purchase a declining number of a founder’s shares at their original purchase price as time goes on. Typically the number of shares the corporation can repurchase will reduce on a straight-line basis over the course of three or four years.
Time may not be the only factor, however, to contribute to the growth of a company. The success of a new venture may be measured by its ability to develop something new and different, or to access markets others have failed to access. Accomplishing this often requires a number of milestones to be met, with many intermediate steps along the way. Because of this, some companies have adopted vesting schedules that allow shares to vest only when the corporation satisfies a particular goal.
As with anything, there are advantages and disadvantages to this approach. One disadvantage is that the milestones that the corporation believes are important at the outset become less critical, especially if the corporation has had to pivot its product or service offerings. Amending stock purchase agreements may not be easy down the line due to founder resistance, among other things. Recognizing this, valuable talent may not be disposed toward accepting stock with this kind of structure and may seek greener pastures. Another disadvantage is that the growth path for the venture may be so uncertain that it is very difficult to define the critical tasks that allow the stock to vest. This is especially true here in Silicon Valley where technology advances and competition often require shifts in start-up strategies. This may result in stock becoming vested on an event that does nothing for the corporation.
There are some important advantages to vesting by milestone. The first is that it could prevent a founder, who contributed little to the corporation’s growth, from having a large interest just because he or she stuck around. In those cases where a founder has since left the corporation but still maintains a sizeable interest, management may not have the flexibility to increase the corporation’s stock option pool because investors may believe that they have already suffered too much dilution. The solution may be for the remaining founders to reduce their interest, at least on a relative scale, to be able to have a meaningful stock option plan. A well thought out milestone vesting structure can help prevent this from happening.
A second advantage to vesting by milestone is that it forces the founders to really think through their business plan, and to set up a milestone schedule that is objective and attainable. Investors can be comforted by this approach because it shows that the founders have a plan over which success can be measured. This may prevent investors from increasing the time for shares to vest as a condition of their investment.
A third advantage to using milestones rather than time for stock to vest is that it assists in keeping founders focused on the particular goal because of the strong reward provided in reaching that goal.
So what is the bottom line here? Basically, if you have a start-up where technology and market development can be objectively defined, and there is a little risk of a pivot, then milestone-based vesting may be the way to go. Otherwise, you are probably best to use a time-based vesting and staying on top of each founder’s efforts to make sure an adequate contribution is made to the venture.
The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.