Free Riding is a Serious Problem

Hypo:  3 co-founders start a business with Joe initially owning 35%, Lisa initially owning 35% and Steve initially owning 30%.  Joe is CEO/Leader, Lisa is tech/science and Steve handles finance and marketing.  For purposes of this post, the roles are actually irrelevant.

Lisa came up with the core idea and the 3 of them form the business and create a legal entity (corporation typically).  Exciting times all around.

One of my biggest concerns in this incredibly common situation is protecting each founder from the other founders’ free riding.  I call this the “Pig on a Motorcycle” problem.  Specifically, you don’t want one founder to leave the business (for any reason) with his/her full equity slug and simply thereafter benefit (i.e., ride around on a motorcycle) from the hard work of the continuing founders.  Here is an illustration to drive the point home:

The only way to truly protect the founders from each other in this situation is by making sure that the equity owned by the founders reverse vests.  The typical vesting period would be 3 years.  Think of reverse vesting as each founder owning their shares outright, but with a risk of forfeiture of any unvested portion if they leave the company prior to the vesting period expiring.   Things to consider:

1.  How long is vesting period?  As I just stated, typical would be 3 years, but this is negotiable among the founders.  I would not recommend less than 2 years.  Longer is better, and I have seen 4 years used often.

2.  What are the vesting increments?  I recommend vesting monthly over the vesting period.   So, if the period is 36 months, and the founder leaves after month 11, he would be 11/36s vested and would forfeit 25/36s of his shares.

3.  How does the forfeiture actually work?  It is typically stated that unvested shares are subject to a right of repurchase by the company and continuing founders at a price equal to that originally paid for the stock.  And, what is that original price?  Typically ZERO.   Do not unintentionally get caught in the trap of having the repurchase price equal to fair market value on the date of repurchase.  That can be disastrous and defeats the whole point of the vesting.

4.  What happens if there is a change of control (think sale of company) prior to the expiration of the vesting period?  If written properly, a change of control has no impact on the vesting because, unlike a stock option, the founders own their shares outright.  The change of control does not cause any forfeitures and they each get their stated share of the sale proceeds.

5.  Should the forfeiture be tied to the cause of the founder leaving?  In my mind the answer is absolutely NOT.   I don’t care if the founder was fired without cause; I don’t care if the founder became disabled; I don’t care if the founder died.  Ok, obviously I care about these things from a human compassion standpoint.   I don’t care if the founder quits and goes to work at another company or decides to quit to stay home to take care of the kids.  I don’t care if the termination is voluntary (as in “I quit) or involuntary (as in “you are fired”).  The point, however, is that the vesting should be designed specifically to enable the continuing shareholders to show someone the door and always avoid the free riding problem.  Plain and simple.

6.  Is there cliff vesting?  Cliff vesting (for example, the first year of vesting does not occur until the actual passage of 12 months and thereafter vesting is monthly) is not that common for the vesting of founders stock.  I don’t recommend it.

7.  Does this post have anything to do with venture capitalists requiring requiring reverse vesting of founders’ shares?  Not much at all.  I am really focusing on protecting founders from each other right from the get go.  One benefit of putting in place the founders’ vesting right away is that sometimes VCs will just go along with the existing schedule and not impose additional vesting time periods (no guaranty of course).

Happy to answer any questions on this critical topic.  I will likely do another post on some exceptions to imposing vesting on all founders.