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.

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7 thoughts on “Free Riding is a Serious Problem

  1. Hi Zach – Robert here from Social Media SEO. We talked last week on the phone (I’m from Georgia) about an idea I had – not sure if you remember me or not.

    Nonetheless, great post and I have a question around this subject:

    I’ve mentioned to you previously, we are launching a new venture and I two partners in this business. We each own 1/3 of the business. I understand the concept of reverse vests if someone leaves the company, but what about it someone doesn’t leave the company, but simply decides to no longer be proactive in the company.

    For example, right now there are 3 of us, and what I decide, after the company is profitable, I decide to head to Hawaii and sit on the beach and do nothing? We would want a way to protect the business from a partner who has disengaged.

    Any thoughts about that?

    Thanks…

    • You raise a good point that I should have hit head on. Going to Hawaii and sitting on the beach is termination – voluntarily quitting. Vesting will stop when you disengage and quit. So, if you departed prior to your vesting period expiring, you would forfeit shares.

      I am going to edit the post to show this clearly. thx!

  2. Pingback: Get a Good Lawyer and Accountant – a Real Warm Body, not Legal Zoom | ithacaVC
  3. Zach,
    Great post here! I was just thinking about how to structure a startup, and recalled from business school of the “free rider” problem that my “Law for High Growth” class professor taught me. Yes, that professor would be you! 🙂 Did a google search and sure enough, your post popped up on the first page results.
    I have a few hypothetical questions on what you covered (that I forgot to ask in class :)):
    1) In the case of a startup with just two founders and a 50/50 split, and one of the founders decided to stop working on the project before the vesting period is up, will the other have any recourse to “fire” the non-performing founder, given that the founders equally share the equity? I understand a 50/50 split may be problematic in other similar ways; however, with two cofounders I am not sure if it is feasible to suggest a different distribution of equity.
    2) What happens after the three year period when founders have fully vested their equity? Is there any way to still prevent the free rider problem?
    3) If there are three co-founders, and there is a potential exit on the horizon (e.g., acquisition) prior to the three year vesting period, might there be an evil incentive for two cofounders to collude and “fire” the third cofounder, so that they can split the pie into two instead of three? I understand of course that the cofounders shouldn’t even be in business together if such malicious intentions were a possibility; however, part of this question is also in relation to whether there is any point in specifying “just cause” (brings a host of other problems I’m sure) or acceleration clauses.

    Thoughts? Thank you.

    • Here are some answers:
      1. If the non-performing founder is just not performing, then firing him is tough if only the 2 founders are on the board b/c then not possible to fire him. The key here would be to have more than the 2 founders on the board. Then the board could fire the non-performer and his vesting would stop.

      2. If the 3 year period is up then no way to get back the vested shares. So yes, the free rider problem will exist. But the guy has worked for 3 years so probably deserves the equity.

      3. Only the board of directors can fire executives (not shareholders). If the board members colluded and fired one founder to screw him then they would be breaching fiduciary to that founder (as a shareholder). The fired founder could sue.

      thx.

  4. Hi Zach, very inspiring post! Good Job!
    I am the CEO and founder (Founder A of the concrete scenario below) of an early stage tech-startup. I found your post very clear and likely to fit to our situation: we are currently starting to develop the product and arranging a fair equity split.

    A= Founder who came up with the business idea, wrote the business plan, spent considerable (full) time (over the past 5 months) researching market data, doing competitor analysis etc. Founder A has a deep knowledge of the industry and he has contacts (including first paying customers) to help the company kick start. A works full-time (80 hrs/week) on the venture and invested seed capital (60k).

    B= B has been asked to join the company as co-founder by A 2 months ago. B works full-time for a leading company belonging to Priceline Group. The startup can definitely benefit of his/her skills and experience (3 years). B did not invest any money and can work approximately 20 hrs/week (part-time) for the startup. B is likely to loose his/Her bonus @ Priceline, given his co-founding role in another company.

    C= C was asked to join the company as technical co-founder (although he/she has good skills as product manager as well). He/She works at Google as full-time developer, therefore his commitment is similar to the one of co-founder B (20 hrs/week). C invested no seed capital into the startup. C is likely to loose his/her bonus as well.

    A, B and C are discussing the ownership scheme before starting the development of the product. The startup will be registered in the US although B and C are in EU. Founder A (CEO) will apply for a business visa and will initially commute back and forth in order to find potential investors.

    B and C bring considerable benefit to the company, but they ask for a big 22.5% chunk of equity each (B+C=45%). A is at his first startup experience (as well as B and C), but he is interested in tech-startups, equity schemes and strongly disagrees with B and C’s proposal.

    A’s idea is to give away a 33% of equity to B and C (16.5% each). According to A’ readings and a fair thinking, part-time co-founders don’t usually get so much equity. Of course there is no magic formula and every scenario is different to the others. But that % of ownership seems fair to A (and to his attorney), given the different commitment (part-time vs. full-time), risk (A lives on his savings whereas B and C’s risk is related to the loss of performance bonus) and seed capital invested in the startup (entirely put by A).

    A is trying to find a sort of compromise to motivate B and C, as he believes in the team potential. Nevertheless, A is reluctant to give away too much equity to part-time co-founders in order to avoid eventual fights and misunderstandings that can jeopardize the company performance (i.e. free riding in primis).

    A’s doubts:
    1) Is it useful to adopt vesting options in this case? (i.e. 3-4 year vesting options, 1 year cliff for A, B and C). Probably, as you pointed out, cliff does not help initially. But vesting options helps avoid bailing in my view. If YES is your answer to 1), would you suggest acceleration in vesting?
    2) Initially only A, B and C will work for the company: is it advisable to set an option pool since the very beginning?
    3) A is discussing with a lawyer whether it makes sense to come up with a founders’ agreement before the company is legally founded.

    I apologize for the long question, but A would be really glad if you could give your opinion (imagine you’re A–> working full time on the project, financing it entirely, being the idea generator etc). A doesn’t want to be out of the picture in the event of an VC investment.

    thanks in advance Zach!
    Edit
    Following Question8

    • The key here is the part time issue. If B and C are in fact only going to work 20 hours a week for the foreseeable future then giving them 33% seems more than fair. You are going to work 4 times as much as that. In terms of options, I think you are on the wrong track. If you are really viewing B and C as co-founders then they should get restricted stock (not options). And the stock would vest over time (that is why it is called restricted). If B’s relationship ends with the company for ANY reason (you fire B, B dies, B quits, whatever), then the vesting stops and the unvested shares simply forfeit back to the company (not to you). Same for co-founder C. If you have a good startup lawyer this is all typical stuff that he/she should know. I suggest vesting over 4 years. In this instance I don’t typically care about a first year cliff vest, but typically just do vesting over 4 years on either a monthly or quarterly basis. Last question: you should definitely come up with the equity split prior to setting up the legal entity. Write it down, specify the vesting and then all sign it. that is called a “pre-incorporation” agreement. Thanks.

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