Each year, thousands of companies are started in Québec. The majority of these new businesses’ founders will sign a stockholder agreement during the incorporation process. During negotiation of the agreement, the co-founders will determine their ownership percentage amongst themselves, based on the value of the assets they bring to the company (capital, ideas, expertise, network, intellectual property, customers etc.).
In the frenzy of the early days, however, it is easy for an entrepreneur to forget a very important legal clause which could cause him nightmares in the years to follow.
What is this clause? It’s a clause that restricts vesting of shares by establishing a grant period of several years. In short, this clause prevents one of the co-founders from leaving the company while continuing to retain the totality of his shares.
The runaway co-founder
Let’s take the example of 3 co-founders who start a business ABC Inc. in February 2015 with equal participation, i.e. 1/3 equity per stockholder. In October 2015, less than a year after the founding, one of the co-founders,Marc, informs the two other co-founders of his intention to decamp to Thailand for at least 6 months to avoid another cold winter in Québec. He also mentions that he wants to fully enjoy his trip and will not be able to contribute to the company during his absence!
These two other co-founders are devastated. They were relying on Marc’s experience and effort to help them start their business. Overnight, their company is running on one engine less, and its risk of failure increases. However, given that no share restriction clause was added upon the signature of the stockholder agreement, Marc will now be lying in a hammock on a Thai beach with 1/3 of the equity in ABC Inc. legally in his name. Thus, despite the fact that he will only have worked about 6 months at ABC Inc, Marc will own 1/3 of the profits in the future work of his two co-founders, who for their part will continue to work full-time in the business.
This problem can occur for various reasons. In fact, Marc could have announced his departure to join Google in California. Marc could have also decided to leave ABC Inc. due to interpersonal conflicts with the other co-founders, a situation still very present in start-up companies. In all of these cases, Marc would lose his salary but retain his stockholder status in the company.
Protection for both investors and founders
Why is this clause really so vital? It’s crucial because the departure of a founder can deplete the company of a significant portion of its equity. According to Adam Saskin, a partner at Spiegel Sohmer and expert in business law who often advises start-ups, this staggered vesting clause “helps ensure that founders fulfill their obligations to the company over the long term”. Moreover, he adds, “A co-founder’s departure often results in the need to find a replacement, and part of the equity held by this co-founder will often be necessary to hire and retain the replacement.”
Therefore, it’s quite easy to understand why venture capital investors will generally insist on such a provision. Having the company’s long-term interests in mind, they will want to protect themselves against a harmful early departure of one of the co-founders.
Moreover, forgetting about this clause can also bring catastrophic consequences for subsequent financing rounds. It is likely that many angel investors or venture capital investors will simply refrain from investing in a startup when confronted with such a situation. After a co-founder’s departure has made a dent in the equity, they often consider that the firm will lack the internal capital to be viable in the event of expansion, and/or that the other co-founders will not have sufficient interest to continue developing their company after their future dilution in subsequent rounds.
How to structure the clause
So how should one structure this restrictive vesting clause? According to Sohmer Spiegel partner Adam Saskin, who generally recommends that founders incorporate this clause into their shareholder agreement, current practice is to “allow vesting of shares to occur over a period of 4 years, where 25% of the shares are vested at the end of year 1, while the remaining 75% of the shares are vested monthly over the following three years”. As such, if there is a hasty departure in the first year, the co-founder will receive nothing. Upon the co-founder’s departure, the portion of equity that has not been granted will become subject to repurchase by the company, typically at the original purchase value. This clause is also often used to engage the company’s first key employees beyond the co-founder team and to promote loyalty for new hires thereafter.
What motivates me to write this article? If I am talking about this, it’s because we did not include such a clause during the incorporation of our company. In our original agreement, given that I had known my co-founders for 15 years and that we shared a lot of trust, we had decided not to avail ourselves of this clause. That said, we quickly rectified this later (without consequences, fortunately!) during our first round of funding at the request of our investors.
Since then, through my mentoring activities in different programs, I’ve recommended to a number of young founders to include this clause in their shareholder agreement, for their own good. I’ve also suggested that they explain to their co-founders that it is a protection that will benefit them all. So I hope this article will also help many other entrepreneurs to avoid this classic startup mistake.
Curtailing freedom to ensure harmony
Often, we associate entrepreneurship and freedom. However, when working in a team (and studies have shown that venture capital investors prefer to invest in teams of 2–4 founders with complementary talents), it is often important to accept certain protections that restrict our freedom in order to align the group’s interests and maintain long-term harmony.
Building a successful business can take 5 to 10 years. Young entrepreneurs should understand that instead of just receiving their equity upfront, they may have to be willing to work to earn it over time.
[Note: This article was originally published in Les Affaires.]
Photo credit: Breather