Reverse Vesting of Founder Shares

20 Oct 2016

Investors in a start-up often insist that the founders agree that all or a portion of the founders' shares be subject to reverse vesting
– i.e. that their right to the shares is contingent on their continued service with the start-up.

How does reverse vesting work?

The founder agrees that all or some of his or her shares will be subject to reverse vesting. In the market, it is common for about 75% of a founder's shares to be subject to reverse vesting, though there are deals with more and with less and there are deals with no reverse vesting at all. Especially if the start-up has been up and running for a significant time prior to the investment, the number of shares subject to reverse vesting might be reduced. The investor and the founder also have to agree on the period during which reverse vesting occurs.  Most common are 2 to 3 year periods, though there is variation in that regard as well. By way of example, a reverse vesting agreement might provide that a third of the shares subject to reverse vesting will vest at the end of the first year after closing and that the remainder will vest in equal installments at the end of each three months of the following two years. Thus, in the previous example, if 75% of the shares were subject to reverse vesting, 25% would vest at the end of the first year, and 6.25% of the shares would vest at the end of every three month period for the next two years.  Investors often agree to an acceleration of the reverse vesting in the event of an exit during the vesting period.

Generally, reverse vesting agreements provide that if - during the vesting period - a founder voluntarily leaves the employ of the company (except when his or her employment conditions worsen enough to justify resigning) or is fired for "cause" (the founders have to be careful that "cause" is narrowly defined to include only fairly extreme actions by the founder), the un-vested shares can be re-possessed by the company or by the other founders for a negligible (par value) payment. If they are repossessed by the company, all the remaining shareholders have a proportionate gain in their holdings from the re-possession.  Sometimes, though not too often, an investor will agree that the remaining founders – and not the company - will re-possess the shares and then the gain is shared among the remaining founders with no benefit to the other shareholders. 

The purpose of reverse vesting is to protect the investor and other shareholders by ensuring that the founder has a negative incentive to terminate his or her employment with the company. Especially in the early stages of a startup, the services of the founders are vital to the well-being and continuation of the startup.

During the reverse vesting period, a founder remains the owner of the shares that are subject to reverse vesting. Accordingly, the founder's voting rights are retained, as are the right to dividends (very rare in start-ups, but theoretically possible) and all other rights appended to the shares.

Though, most often, reverse vesting agreements are signed as part of the first significant investment in a start-up, sometimes founders anticipate them by including them as part of founders agreements. In that context, they give each founder some assurance that each co-founder is committed to the company and also give the founders a chance to determine the terms of reverse vesting favorably for themselves.  When they do so, there is no guarantee that a future investor will not require the amendment of the agreements.

Even though reverse vesting agreements are very common and have been for many years, there are several unresolved issues with regard to them: a) are they in violation of a 2012 law prohibiting an employer from receiving guarantees from an employee to secure the employee's continued service? and b) does the actual repossession constitute a tax event (for the founder whose shares are being repurchased).  The market assumes that the answers to both of those questions are negative in the normal circumstances of reverse vesting and there are some indications – especially with regard to the tax issue – that the market is correct.  However, there is no certainty with regard to either issue.

Reverse vesting is a given of most early-stage investment agreements. Even though the terms overall are fairly standard, the fine tuning (number of shares subject to reverse vesting, vesting period and vesting schedule, who has benefit if the shares are repossessed, how is "cause" defined and other issues) is important. It is a good idea to get the fine tuning resolved at term sheet stage and to take legal advice with regard to it prior even to getting to a handshake on the issue.

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