What is Founder Vesting and how does it work?

Founder vesting is the process by which the founders can earn their company’s stocks over time depending on their performance and their commitment to the startup. It is a process of acquiring the share gradually over time.

This specifies a certain percentage of stock that founders may own even after leaving the company. Or, it may also be specified that shares go back to the company in case a founder chooses to leave the startup. It all depends on the vesting schedule. While raising capital, the investors pay a lot of attention to the Founder vesting agreement.

Index:

Why do co-founders leave a startup?

There may be many reasons why a co-founder chose to leave a startup. Broadly, we can classify those reasons into 4 parts:

  • A co-founder may be dismissed on the grounds of legal matters, misconduct, fraud, or violating important clauses.
  • The co-founder may be dismissed due to some good reasons as well. The company may grow to such a level that the board may feel like the co-founder’s skills are not adequate enough to hold that position anymore.
  • The cofounder may voluntarily resign from their post for various reasons.
  • The cofounder may need to leave his position in case he falls seriously ill or he dies.

Why is founder vesting important?

  • Ensures long-term commitment:

Founder vesting ensures that the founders stay and provide efforts to grow their startup and to receive their allotted share in return.

  • Minimizes damages:

Without vesting, if a co-founder leaves the startup, he still owns his share of the company and the right with regard to management decisions. A vesting agreement minimizes this damage by taking a part of the shares back in case a founder chooses to leave.

  • Investors protection:

Many investors demand vesting provisions from founders before investing in the company. It ensures the growth of the company and protecting of stocks in case someone departs from the company. Investors prefer to invest in a startup with a vesting structure. Moreover, after a few years, while seeking funding again, it might be difficult to attract investors if a co-founder has a significant share left.

  • Ensures fairness:

It is unfair to other co-founders if one of the co-founders leaves and still retains his part of the startup without contributing to the growth of the company. Vesting ensures that the co-founder is compensated for the time they had contributed to the startup and not once they stop.

  • Equity present to hire a replacement:

A replacement would of course want equity or a share of the company. If a person has significant equity leaves, it would be difficult to provide enough shares to attract a replacement.

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How does founder vesting work?

It is done according to a vesting schedule. A vesting schedule is a preset time period that determines how the co-founders will acquire their shares.

Founder vesting is usually done at the earliest period of the founding of the startup. Founder vesting usually has a time period after which the company has no right to repurchase the shares. This means that after the time period has passed the founder fully owns his or her part of the share.

The most common time period for a vesting schedule is 48 months and 1/48th of the share is vested every month. But to make sure that the founders stay for at least one year the shares are not vested in the first year. Instead, they are vested at the end of the 1st year. The founder acquires 25% of his share each year and if in case he decides to leave, say, in the second year, then the rest 50% share will go back to the company.

How much should be vested?

Normally 100% of the company’s shares are not vested if founders have been in the industry for several years and have a good reason why 100% shouldn’t be vested. In most cases, 50 to 70% of the shares are vested and not 100%. However, this value may change a lot depending on various reasons.

How long should the vesting period be?

Vesting periods are normally 3 to 4 years long. Moreover, some shares are vested after the completion of 12 months and are balanced within the next three years. This however has plenty of variations.

Conclusion:

Founder vesting should not be seen as a penalty rather it should be seen as a backup in case one or more founders have to leave. The shares can be re-issued to the new co-founders. Though, if the founders have been working together for a long time and have invested some money themselves in the business, it may seem a bit harsh to them to lose their shares. In such cases, fewer of their shares should be vested in the first place.

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