One of my first posts from 2013 was on how founders should allocate equity among themselves. In summary, I stated that dividing founder equity in equal amounts according to the number of founders is rarely fair. A healthier approach is to evaluate the responsibilities and relative contributions of each founder to the business and to allocate equity accordingly.
That post looked at one dimension of founder equity, namely the amount of equity that each founder receives. This post will look at a second important dimension regarding equity allocations: the timing of when founders receive their equity.
Many startups choose to give each founder their full equity stake the day that they join the company. For example, if a founder owns 25% of the company, they earn the full 25% the day they start working.
The problem with this approach is that on the day that they join the company, the founder hasn’t put in any material effort towards the business yet. In theory they’re receiving equity for the future contributions that they will make, however in practice their equity is granted before they make any contribution.
As we have seen in several of our startups, there can be many reasons why a founder does not make the future contributions necessary for them to earn their equity ownership. The founder may have health problems, may voluntarily decide to pursue an outside opportunity, or may simply not be fulfilling the role’s requirements. In these cases, if a founder has already been given their full equity allocation, it’s challenging to get them to return part of their equity so that it can be used to motivate future contributors to the company.
In order for these challenging situations to not arise in the future, founders need to make sure that they earn the right to their equity only as they contribute to the company across time. This is a practice called vesting. A healthy standard is for the founder to earn their equity quarterly across 4 years, without earning any equity until they have completed their first year of work. This is called 4 year vesting with a 1 year cliff.
For example, if a founder owns 25% of the shares of the company, they earn 25% / 4 = 6.25% of these shares each year over the next 4 years. They earn the first 6.25% of their shares when they complete their first full year of work as this minimum time commitment is required to really begin contributing to the company. A founder leaving after less than a year of work is unlikely to have had enough time to make an important contribution to the business. After their first year of work, the founder earns 6.25% / 4 = 1.5625% of their equity on a quarterly basis over the next 12 quarters, earning their full 25% equity only after 4 years have gone by.
Vesting is necessary to align a founder’s equity ownership with their contributions to the business. However, many founders encounter the practice for the first time in their investor discussions, and their initial reaction is to think that vesting is a way for investors to hold back equity from founders. This is very far from the truth.
In reality, vesting helps founders just as much, if not more, than it does investors. When one of your cofounders needs to or chooses to leave your startup or is simply not performing at the level that’s necessary for the business to be successful (these situations occur a lot more often than founders think they will), vesting makes it much easier for you to agree on the terms of their departure. Since the founder hasn’t earned all of their equity, the company simply takes back the unvested equity which reduces the number of shares outstanding in the company, or uses it to reward other existing or future employees. The faster you can organize a healthy departure for your cofounder, the more time you’ll have to focus on your real goal of building a successful company.