Every startup should have a vesting agreement, a startup’s equivalent of a pre-nup agreement, right from the beginning to protect the interest of the shareholders, investors and employees alike.
For every startup that raises funds and takes off or goes on to become a successful household name, there are thousands more that fail to do so. Aside from the common pitfalls that affect startup founders – like new teams that have previously not collaborated before, founders’ inexperience in validating the market or inability to execute – you’d be surprised to find that many teams do not protect themselves properly by managing their and shareholder interests by having a founder vesting agreement.
In this article, I would like to explore what happens when a co-founder leaves, and how a vesting agreement protects the remaining co-founders who stay from equity dilution.
In my observation, startups in South-East Asia rarely start off their ventures with what is considered an equivalent of a “prenuptial agreement for startups.”
One of the best practices of high-growth startups in the US these days is having the co-founders and early employees adopt a vesting schedule that protects all parties involved. This is done to provide upfront transparency into agreed upon rules of engagement, and is designed to reward those who stay on to develop a financially successful startup.
What are common vesting schedules between co-founders in a startup?
Let’s say three friends, Ali, Bala and Chan, decide to start a company at equal stakes of 33.33% each. They agree to go on a four-year vesting schedule. This means that if all three of them are able to work full-time for four years, they would eventually receive the full 33% of their shares over the four-year period on a monthly vesting basis.
A vesting schedule like this allows the company to have a fair split – should Bala decide to leave the company at the one-year mark, he would only end up owning 8.33% of the company, unless he decides to sell his vested shares back to the company or to Ali and Chan. The 8.33% figure is calculated by dividing 33.3% by four (according to a four-year vesting schedule) and then multiplying by one (since he left after one year).
Another observation that is common of startups in this region is that there are many co-founders who are only working part-time. In a situation where Chan is only able to work part-time throughout the four-year period, say 20 hours a week, the vesting schedule would mean that he would only end up with half of 33.33%, which is 16.65%, at the end of the vesting period.
Chan would essentially have to work 20 hours a week for 8 years to fully vest or own the 33.33% shares.
Of course, the details of the vesting agreement are entirely up to the co-founders and should be negotiated upfront. However, most co-founders aren’t even aware that this is one of the most important foundations to ensure healthy shareholder value within the company.
The reason it’s crucial for founders to have this is because if, say, Bala is doing a terrible job and he really wants to leave after only 12 months with the company, you wouldn’t want him to walk away with 33.33% of the company’s shares but only a quarter of that, as would be proportional to his length of service.
Imagine if there were no vesting schedule in place, the company would end up having 25% of its shares as “dead weight,” meaning a large percentage of the company has gone to someone who will no longer contribute any further to the value of the company.
With a vesting schedule, that same 25% will be re-absorbed into the company when Bala leaves, so that Ali and Chan can entice another potential co-founder or other important employees with the remaining equity to join the startup. That’s a nice bonus for the founders, VCs and employees who are there to stay because you get a reserved dilution.
There’s also something called a “one-year cliff”, meaning that if you leave the company less than one year in, then you do not get any shares at all. This is to protect the company from freeloaders who jump around startups hoping to get a small piece out of every venture they start. A minimum commitment of one year is very fair to get any amount of shares at all.
While you always hope that none of your co-founders ever leave your company, statistics from startups in Silicon Valley show that 20% of startups will have one founder leave the company at some point.
The adoption of vesting agreements in this region would definitely be a positive way forward, as there are too many cases of founders being promised shares in return for their effort, only to have these promises reneged upon once the company has had financial success.
The monthly vesting schedule also aligns the interests of the founders. Founders are more incentivized to address issues that pop up quickly and try to work things out amicably instead of allowing passive aggressiveness to brew and destroy the company culture, and eventually the business.
The local startup ecosystem here is a small one. If the founders agreement is fair and enables founders to exit gracefully, it’s worth setting it up and getting it done right from the beginning.
If you’d like to learn more about structuring a vesting schedule for your company, MaGIC’s Accelerator Program (MAP) will have support from ZICOLAW on hand to help you learn how to structure a vesting schedule that prepares your company for the longer term. To find out more about the programme, visit http://map.mymagic.my.