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Founder's Equity

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Founder's Equity

Postby Pinskylaw.ca » 03 Jan 2014, 13:30

The subject of founder's equity is one of the more involved aspects of organizing a start-up. Issues to consider include capitalization at the time of formation, division of shares among founders, share transfer restriction agreements, the dilutive effect of the employee pool required by the VCs, and equity budgeting.

Division of Shares Among Founders

The issuance of shares among founders is for the founders to determine, and is typically based on relative contributions to the formation of the company, including:
• The conception of the business idea;
• Leadership in promoting the idea;
• Assumption of risk to launch the company;
• Sweat equity;
• Writing the business plan; and
• The development of any underlying technology.

In addition to pre-formation contributions, the potential for future success in commercializing the business idea may also be a factor, including the background and experience that each person brings to the task.

Basic Elements Regarding Vesting

There are five essential elements to address in a share transfer restriction agreement regarding vesting:
• Duration of vesting schedule;
• Up-front vesting;
• Cliff vesting;
• Acceleration upon termination; and
• Acceleration upon change of control.

Vesting Period

Founders shares generally vest over three to five years. You rarely see five-year vesting requirements any more. Founders with significant bargaining leverage may be able to get a three-year vesting schedule. Four-year vesting seems to be the most common.

Up-Front Vesting

It is fairly common in VC transactions for founders to have some percentage of their shares vested up front. VCs will often agree to this if there has been a significant amount of effort put into the company before funding. The range of up-front vesting typically falls between 10 percent and 25 percent.

Cliff Vesting

Vesting is said to be on a “cliff” basis when a certain minimum period of time must elapse before any additional shares of stock vest. Six and 12-month cliff vesting is fairly common, with the current trend toward the shorter end of that range.

Termination

Any number of circumstances could lead to the termination of a founder's employment. VCs often take the position that the equity must be earned, and that if the founder leaves for any or no reason, no additional stock vests. There are four basic circumstances in which a founder might leave the company:
• Resignation (for no reason and for good reason);
• Termination (for cause and without cause);
• Death; and
• Disability.

Dilutive Impact of Employee Pool Required by VCs

Every VC term sheet includes a requirement that the company put in place an equity incentive plan equal to between 15 percent and 25 percent (sometimes higher) of the common stock of the company on an as converted, fully diluted basis, including for this purpose the entire employee pool even though no awards may have been made at the time of the closing of the venture investment. The more key hires the VCs perceive will be necessary to fill out the executive management team, the higher will be the proposed employee pool. Very few first- time founders understand the important implication that this percentage has for their equity stake in the company.
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