Vesting and reverse vesting of founding partners

Vesting and reverse vesting of founding partners

In a new blog article we will discuss vesting and reverse vesting of founding partners, mechanisms that are fundamental and should therefore be included both in the partners’ agreement and in an eventual ESOP plan.

Due to the difficulties many startups face in offering competitive salaries to their employees, it is necessary to look for alternatives to attract and retain talent. Among these options are the initial grant of company shares, phantom shares or stock option plans.

Often, they are a key strategy used by startup founders to attract and retain talent in high demand in the market, usually key workers for the proper development of the startup, and through them to generate a sense of belonging, commitment and identification of staff with the company.

Precisely because of the purpose of these mechanisms, it is equally important to establish clauses in ESOP or phantom share plans to prevent certain key employees from leaving the start-up shortly after receiving these incentives. This is done by regulating consolidation commitments (known as vesting).

Basis of vesting

When we incorporate a clause that contemplates a vesting period in a shareholders’ agreement or in an incentive plan, the employee does not consolidate his or her stock options/phantom shares at the same time they are awarded, but rather the company keeps in its possession its own shares and releases them exclusively to the founders or employees according to the fulfilment of a period of time (normally not lasting more than four years) or linked to the fulfilment of milestones or goals of the start-up. 

Let’s take an example of vesting: in the case of an employee who has received 1,000 stock options subscribed between the employee and the company that recognises a vesting period of 4 years with annual consolidation periods at a rate of 25% each year, the employee will consolidate his stock options in the following way:

• Year 1: 250 SO
• Year 2: 250 SO
• Year 3: 250 SO
• Year 4: 250 SO

In this way, the employee will consolidate 250 stock options corresponding to each annuity year by year. In order to finally vest his 1000 stock options, he will have to wait until 4 years have elapsed since the start of the vesting period.

Therefore, if the employee decides to leave the company after only two years have elapsed since he/she started working there, he/she will only have vested 500 stock options.

In addition to the above, when vesting is set in an incentive plan or in the shareholders’ agreement, it is common for it to be accompanied by a cliff. A cliff is defined as a period of time (usually 1 year) before vesting of the phantom shares/stock options begins, but this does not preclude the period from being shorter or longer as negotiated between the parties or the company. 

For example, an employee who has a vesting period of 4 years with a 1 year cliff period means that he/she will have 0% vesting of his/her shares until the 1 year period has elapsed.

Founding shareholders and reverse vesting

In contrast to employees, founding shareholders are already owners of the company’s shares, and therefore the concept of vesting, as described above, does not apply to them. In these cases, what is known as reverse vesting comes into play.

Reverse vesting consists of the granting by the founding shareholder of a call option on his shares in favour of the company or the other shareholders. Thus, if the founding shareholder leaves the company before reaching the agreed minimum period of permanence, he will be obliged to transfer to the other shareholders or to the company itself (depending on what is agreed) those shares that he has not consolidated. In other words, in contrast to conventional vesting, the shares are owned by the shareholder and will remain so if they comply with the agreement. 

As with vesting, reverse vesting usually has a cliff period, and the commitment may be renewed in each financing round. For example, if a startup raised a round 2 years ago and applied reverse vesting to its founders, it may be forced to renew the commitment if a new investor asks for it. In that case, the founders would start again from scratch.

At Letslaw by RSM we are specialists in the incorporation of vesting and reverse vesting clauses in incentive plans and shareholders’ agreements, so our teams of commercial lawyers can advise you on everything you need.