Negotiating and structuring vesting and leaver clauses for founder shareholders give rise to heated disagreement. These are important terms for investors and help protect against loss of value caused by an early departing founder. For founders, they come across as highly personal matters and potentially open to manipulation.
Navigating a fair and balanced set of provisions for dealing with founder shares requires sensitivity and experience. Reliance on inflexible arguments based on market practice can lead to an unhappy group of founders just at the wrong time in the company’s growth cycle.
This article offers guidance on what to consider as you approach negotiating these terms.
What is the purpose of founders’ shares vesting over time?
The commercial rationale for founders’ shares to vest over time is based on several connected reasons:
- a founder should earn shares over time by being incentivised to remain with the company as the business develops and the company grows in value. The founder’s share of the overall value of the business increases depending on the founder remaining involved during this period
- an investor’s valuation of the company and shareholding is based on future value. To reflect this, the founder’s shareholding percentage should be reduced (and the investor’s percentage increased) if the founder leaves earlier than anticipated
- should a departing founder be permitted to retain a disproportionately high shareholding, this acts as a disincentive to the remaining founders, whose future efforts will cause a corresponding increase also the value of the departing founder’s residual holding of shares
- vesting and leaver provisions allow for equity to be made available to replacement management and executives without further diluting the investor’s shareholding
Approach to negotiating founder share vesting and founder leaver clauses
There is no single, one size fits all, solution to how founder share vesting clauses and founder leaver clauses should be structured and worded. Good and bad leaver provisions for founder shareholders are likely to be different than equivalent provisions for employee shareholders who are not founder shareholders. Whilst market practice is a relevant consideration, the provisions need to be considered also in light of factors including:
- each founder’s role in the company, including whether they have been involved from the outset and their shareholding percentages
- whether the founders have invested their own money in the company
- whether the founders are paid a market salary
- any applicable provisions which already apply, for example because of a previous investment round
- whether the company is a start up business, a company raising money as part of a seed or other investment round or a buyout vehicle for an existing business
These factors will determine how the vesting and leaver provisions should be structured and how much the founders will be able to negotiate their terms. They are usually first proposed by the investor, either in a draft term sheet or in the first drafts of the full form investment documents.
Legal principles to think about
- issued shares: shares which have been issued to a founder will not just disappear if the founder leaves – there needs to be a legal mechanism for taking them away from the founder. In particular, a company is not permitted to buyback its own shares unless it complies with the legal requirements applicable to share buybacks under the Companies Act 2006
- share options: by contrast, incentives in the form of share options are over shares which have not yet been issued. Share options can disappear (ie lapse) if the founder leaves without a separate legal mechanism
- decision making: leaver provisions are usually triggered by a defined leaver event and a determination of the board or specified shareholders. If the founder(s) control the business and its decision-making (with the investor(s) having only approval or veto rights), the documents will need a process by which the investor(s) can activate the leaver provisions, otherwise they could end up being worthless
Other things to consider
Founder share vesting period
As a starting point, consider what is the correct vesting period for each founder’s shareholding. Questions are:
- over what period should unvested shares become vested shares
- should a portion of the founder’s shares be vested shares from the outset
- should there be an initial minimum period, say 12 months, during which no unvested shares will vest
Founder leaver events
Secondly, specify the trigger points for the leaver provisions:
- principal leaver event: the founder ceasing to be employed for any reason (including giving or receiving notice of termination of employment)
- additional leaver events: irrespective of termination of employment – criminal conviction, bankruptcy, breach of restrictive covenants
- good or bad leaver: define what constitutes founder good leaver events and what constitutes founder bad leaver events, typically:
- good leaver: death, illness, dismissal without cause
- bad leaver: dismissal for cause, voluntary resignation, criminal conviction, bankruptcy, breach of restrictive covenants
- intermediate leaver: consider whether there should be an intermediate leaver events, for example voluntary resignation after a specified period
Leaver price
Next, agree what price should apply to the vested shares at the trigger point of the leaver event, which might be:
- good leaver: fair value, with a mechanism for agreeing or determining fair value (including whether a minority discount should be applied)
- bad leaver: lower of fair value and price paid/nominal value
- intermediate leaver: whether the price for a portion of the vested shares should be fair value
Agree also a period of payment, especially for good leaver events – this could include the deferral of the founder receiving payment in instalments, over a period of time or on the occurrence of an exit event.
Leaver mechanism
Finally, specify in the shareholders agreement and, crucially, the articles of association the process for dealing with a leaver’s vested and unvested shares.
- unvested and vested share calculation: specify how the number of unvested and vested shares will be determined, usually by reference to the period since closing of the investment and, after any agreed initial period of no vesting (with a catch-up right), vesting monthly over time
- unvested shares: these will usually be converted into worthless deferred shares, with a mechanism for the company to buy them back when possible
- vested shares: typically, unvested shares will be acquired at the specified price either by the company, offered to new shareholders or offered to existing shareholders
Tax
Advice should be taken on the potential tax consequences of the adopted structure, including:
- stamp duty for a company buyback or transfer to a new or existing shareholder
- potential adverse tax consequences for an employee or director acquiring shares at less than market value
PaperRock shareholders agreement templates
Our selection of template shareholders agreements and articles of association for use in connection with investment transactions contain vesting and leaver provisions, with clear explanatory guidance on the potential alternatives.
Each template is written in plain English and available for instant download as a single purchase or as part of a subscription. For more details, visit Investing in a Company.
