by Scott Kupor
In most founder cases (and for most employees who receive stock option grants as part of their compensation package—more to come on this later), full vesting is often achieved at the end of four years from the date of the option grant. We’ll talk more about the origin of that four-year practice and why it may no longer make the most sense.
When we say a founder is half-vested in her shares, whether or not she is employed by the firm, that means that she has the rights to the economic interest of only 50 percent of her shares. If she wants to sell the shares to someone else and monetize their value, then she can only sell what is in fact vested.
As a result of this in particular, founders understandably want to get full credit toward vesting of their founder shares from the first conceivable time they began working on the new idea. It is often the case that by the time founders raise their first institutional financing round, they may be as much as 50 percent vested, assuming that they have been working on the company for at least two years prior to the time they raised financing. However, with companies staying private demonstrably longer these days, the work required to build the business into a successful venture has really just begun.
Unfortunately, we often see cases where a cofounder leaves—whether voluntarily or otherwise—once she has fully vested, leaving the other cofounder to bear the brunt of managing the business and building long-term shareholder value for many years to come. And, although the remaining cofounder may receive incremental equity grants from the board over time for her continued service, the likely financial value of her new equity pales in comparison to the value of the fully vested equity the former cofounder has realized.
The conversation with the remaining cofounder is the same each time: “I’m here every day working hard trying to build long-term equity value for my employees and investors while Joan [names have been changed to protect the innocent] is living the celebrity party scene.”
So what can you do?
More about Vesting
At a minimum, most founders vest their shares over a four-year period. But given the much longer runway most private companies will have before they get to their public market debut, founders should think about whether four years is enough time. Equity is intended to provide long-term incentives, so the question is whether the definition of “long-term” needs to change. Admittedly, this is a hard thing to change because most companies want to have consistent vesting policies for both their founders and the rest of the employee base. And the market for employee vesting largely remains at four years. But as a founder, it’s worth considering whether you should have longer vesting periods for founders given the likely longer time period which it may take to build value and get to a liquidity event.
Leaving the Business
Think about the circumstances under which you and your cofounder can be removed from the business. In many cases, founders control the board of directors, meaning that they have a majority of the seats on the board and thus can be removed only with the agreement of the other cofounder. That is, the VCs or other board members do not have sufficient votes to remove the founders from their roles. Given that, in most cases the only way a cofounder can be removed from her role in the business is if she voluntarily decides to leave. But that’s not likely a good position to find yourself in if one cofounder is not performing at the level required to make the business a success. So you may want to consider at the time of founding the company how you and your cofounders will govern such situations.
Removing a cofounder from her executive role is one thing; removing her from the board is another. Often we see companies where the cofounders have what are called “hardwired” board seats. This means that each cofounder has the right to be on the board, regardless of the function she is performing in the company and, often, regardless of whether she is still even employed by the company. The genesis of this is understandable: founders are often worried about VCs amassing a majority of the seats on the board and potentially voting to remove one or more cofounders from the board.
However, in doing so, cofounders are creating a risk of “ruling from the grave”—having a cofounder who is no longer employed by the company remaining on the board and potentially interfering with the company’s ability to move forward. To deal with this situation, you will want to make sure that board seats are conditioned upon continued service to the company as an employee, not simply granted to someone as a function of having been a cofounder. This is a simple thing to implement as of the founding of the company, but an often overlooked one.
Ultimately, this is about making sure that founder equity serves its purpose—to create long-term incentives—and that the economic rewards of success accrue to those who are remaining with the company over the long term to help increase shareholder value. And incentives are perfectly aligned here between you (as the remaining cofounder) and your VCs: the company retains valuable stock to grant the remaining employees who are actually contributing to the growth of the business.
Transfer Restrictions
Imagine that your cofounder has not only left but is now sitting on hundreds of millions of dollars in vested stock and wants to sell the stock privately. Plus, you’re in the middle of trying to raise money for your business—and your cofounder’s secondary stock is competing for that demand.
What do you do?
The right answer is to have instituted blanket transfer restrictions on stock sales from the founding of the company. A blanket transfer restriction means that shareholders cannot sell without some form of company consent—often the board’s consent is required to do so. And since founders control the board in many cases of venture-financed companies today, this is a relatively innocuous provision to implement: if the remaining cofounder wants to permit her former cofounder to sell, she will often have sufficient board votes to do so. Transfer restrictions are designed to be permanent, but, as with most governance provisions in private companies, they can be removed by the company with a majority board vote and shareholder vote.
Once the genie is out of the bottle on this one, it’s very hard to put it back—why? Because you can’t just implement it at a later date and impose it on all existing shareholders. To implement transfer restrictions post hoc requires consent of the shareholder; you’re unlikely to get that because you are asking her to give up a valuable right that she already has.
While most companies we see have not instituted blanket transfer restrictions, it is the case that most companies have a right-of-first-refusal (ROFR) agreement. The ROFR agreement means that if someone (in this case, a cofounder) is trying to sell her stock, the company has a right to match any offers received and effect the purchase. This is a good right to have, but it is often insufficient because this alone does not prevent cofounders from selling stock. Rather, it gives the company an option to buy the shares itself, but doing so requires that the company utilize its existing cash to do so. In most startups, this is not the highest and best use of cash, and as a result, most companies waive this right and permit the third-party sale to go through.
Acceleration of Vesting
In most cases, of course, founder stock vesting is tied to continued employment with the company. Remember, the whole idea of vesting is that you want your team to contribute to the success of the company by helping to grow the business, and you are all rewarded over time with increasing ownership positions in the equity you helped create.
But what happens when your cofounder leaves? Should she continue to vest her stock or get her vesting accelerated? “Accelerated” means that you elect to increase her vesting of stock beyond the point at which the time-based vesting would otherwise permit. What if you sell the company while your cofounder is still there, but she refuses to join the acquirer—should her vesting accelerate?
As long as you and your cofounder have agreed on the circumstances under which either of you can be removed (and you are comfortable that the decision to do
so is governed by a fair and deliberate process), you may not want to provide for accelerated vesting on termination of employment. You are likely better off being able to use any unvested equity to incent other employees who are still contributing to the long-term success of the business.
How does this work? Equity that is unvested at the time a cofounder or employee leaves essentially expires. However, that expired equity can be returned to the company in a manner that permits shares to be reissued to someone else who is currently employed by the company. For example, if your cofounder leaves when she is 50 percent vested and therefore surrenders her remaining 50 percent of shares—assume for the sake of this conversation that there are one million surrendered shares—those one million shares can now be regranted by the company to another current employee of the company, thus providing her an economic incentive to increase shareholder value.
However, in the acquisition scenario, founders will often have single-trigger or double-trigger acceleration provisions. In a single-trigger provision, the founder’s stock is accelerated upon the closing of an M&A event; in a double trigger, both the closing of the deal and the acquirer’s decision not to retain the founder in the new entity are required for acceleration.
A single trigger is suboptimal for the company for the same reasons that accelerating vesting post-employment without an M&A event is: you are consuming equity for an individual who is no longer contributing to the success of the company. And in the event that your cofounder elects to stay with the acquiring company as an employee, the single trigger is equally problematic. The acquirer will of course want to have an economic incentive in the form of equity to entice your cofounder to stay with the new company, but because her original stock vesting was accelerated, creating this incentive will require the issuance of additional shares. This has an economic cost to the acquiring company that they would rather not incur. If your cofounder has the option to accelerate on a single trigger, the acquirer will need to offer additional cash/equity incentives to retain your cofounder. There are no free lunches: that additional consideration must come from somewhere when the purchase-price pot is fixed.
A double trigger solves that problem. If the acquirer wants to retain your cofounder, they can just continue the vesting of her original shares as a condition of her continued employment. And, if the acquirer decides not to extend an offer to your cofounder to be part of the post-acquisition team, the double trigger will protect the cofounder by fully accelerating her stock vesting. It’s only fair in this case that she not be penalized by losing unvested equity since she was not given the option to stay on as an employee with the acquiring company.
Intellectual Property
Before your head starts spinning, let’s take a break from talking about equity for a second to talk about intellectual property. (We’ll come back to employee equity in a minute.)
Intellectual property is the lifeblood of most startup companies, so we need to protect it carefully.
Since many startup founders are coming from an existing job, we need to make sure that there is no entanglement of the intellectual property with the previous employer and that the startup owns all the inventions. Mechanically, we do this by having founders sign what’s called an invention and assignment agreement. Basically, this agreement says that the founder is assigning to the company the creations that she has invented, other than an enumerated list of prior inventions that the founder claims for her own.
But how do we know that our founder didn’t start working on these inventions while she was still at her prior employer, and thus we might find ourselves fighting an intellectual property lawsuit five years down the road when our technology gets bought by Google for $2 billion? This is part of the due diligence process that good lawyers will do when they form the startup and that venture capitalists will do when they invest in the company.
VCs will ask whether you developed the technology during work hours at your last employer, whether you used company property (e.g., your company-issued laptop) to develop the technology, and whether you downloaded anything from your employer (documents or source code) that may have influenced your startup’s technology. So the best thing you can do if you are thinking about starting a company is to invest in a real “clean room” in which to develop your foundational intellectual property.
The recent Uber case brought these hazards to light. Anthony Levandowski was an employee of Google working on its autonomous driving initiative (Waymo). In 2016, Anthony left Google to start a company called Otto, which was intending to build an autonomous trucking company. Shortly after its founding, Otto was acquired by Uber to help expand its own autonomous driving initiatives.
But Waymo alleged that Anthony had downloaded a large volume of proprietary documents before leaving the employ of the company and that those documents had found their way into Uber. More specifically, Waymo alleged that the Uber CEO had conspired with Anthony to induce him to steal the intellectual property and provide it to Uber and, in effect, that the creation of the separate Otto company was largely a sham to enable Uber to acquire Waymo’s intellectual property. The case dragged on for a while and was eventually settled for $245 million in Uber equity paid to Waymo.
The central question in the case was less about whether Anthony had downloaded the documents—that seemed largely agreed upon by both sides—but whether the documents had in fact found their way to Uber. This was a tough case for Uber to prove: they were in the position of trying to prove a negative, which is generally not a good place to be when fighting a lawsuit.
However, the key lesson for entrepreneurs is to really be careful when starting a new company on the heels of just having left your former employer. What may look like an innocuous downloading of documents that you just want to have because they represent work you did at your prior employer can quickly turn into an allegation of theft of intellectual property.
And in most cases, these claims coincide with a good event—likely an acquisition. That is, your prior employer might not notice or even care too much about this when you are just starting your company, but when there is potential money to be had, these claims can often be raised many years in the future. Careful planning up front can save you a lot of headaches, even heartache, down the line.
Employee Option Pools
Okay, back to equity! The final piece to consider about company formation is the creation of the equity compensation model the startup wants to pursue. As we discussed, in most cases startups want to have their employees incented in the form of equity stock options. That way, if the employees do great work that increases the value of the company, the employees participate in that upside. Incentives align.
The way startups do this is to create an “employee option pool.” Assume the founders of our company have decided that they each want to own 50 percent of the company. At the outset, then, the equity is owned fifty-fifty between the two cofounders. They then realize that they want to be able to hire employees to whom they want to grant equity.
To do this, the founders put in place an employee option pool equal to 15 percent of the company. (I somewhat arbitrarily picked 15 percent, but this does tend to be the standard size of an initial employee option pool in a startup.) As a result, the ownership of the company has changed: the two cofounders are splitting 85 percent of the equity, and the employee option pool comprises the final 15 percent. This is just simple math.
But let’s start at the beginning—what are “stock options”?
Stock options are a contract that gives the option holder the right, but not the obligation, to purchase the stock at a future date, at a specified price. That price is called the “exercise price.” So, if a startup gives you an option to purchase one hundred shares of stock at an exercise price of one dollar per share and that option is valid for ten years, that means that any time over the next ten years, you can pay the company one dollar per share of stock (or one hundred dollars
for the full option exercise) and therefore own the stock.
So why would you do this?
Well, if you joined the company when the stock was actually worth one dollar per share and, say, four years later the price of the stock has increased to five dollars per share, you are “in the money.” That is, you can pay only one dollar per share for stock that is worth five dollars per share—that’s a deal you want to do all day, every day. The act of buying the stock at the exercise price is called “exercising” the option. If, however, the stock is worth only fifty cents per share, you would never pay one dollar to buy the stock and then lose money by selling it at fifty cents per share. Thus the “option” gives you the choice to not buy the shares as well.
There are two types of stock options that startups can issue.
One is called an “incentive stock option,” or ISO. In general, ISOs are the most favorable type of options. With an ISO, the employee does not have to pay taxes at the time of exercise on the difference between the exercise price of the option and the fair market value of the stock (though there are cases sometimes where the alternative minimum tax can come into play). This means that an employee can defer those taxes until she sells the underlying stock. If she chooses to hold the stock for one year from the exercise date (and at least two years from the date on which she was granted the option), the gains on the stock qualify for capital gains tax treatment, which is significantly lower than the tax rate on ordinary income.
“Non-qualified options,” or NQOs, are less favorable in that the employee must pay taxes at the time of exercise, regardless of whether she chooses to hold the stock longer term. And the amount of those taxes is calculated on the date of the exercise, so that if the stock price were to later fall in value, the employee would still owe taxes based on the historic, higher price of the stock.