REVERSE VESTING: A MECHANISM THAT HELPS RETAINING FOUNDERS

As we have already discussed in our previous publications, the process of raising investments to a company may require several important legal documents to be drafted and agreed upon, including an investment agreement, shareholders or investors rights agreement, bylaws and a revised articles of association or a certificate of incorporation of a company, depending on the jurisdiction and customary standards, that change from time to time.

These documents usually contain different mechanisms to protect the different parties’ interests. Another agreement, usually required in companies raising funds in their Series Seed through C (although can be found in later stages as well), is a reverse vesting agreement (aka “repurchase agreement”) – will be explained in this article.

When founders seek to solicit investments for their company, they should consider that many sophisticated investors may set a share-buy-back condition, in order to keep them retained. This is what a reverse vesting basically means.

But to understand reverse vesting in detail, let’s first look at what is vesting.

Vesting in general means earning of a right to purchase a share in a particular company. In other words, vesting is a promise to receive shares to a person after certain conditions are met or predetermined results are achieved (usually working at a startup for a certain period). Vesting is usually applicable to equity options, whereby one receives a number of options that he or she can exercise into shares, but that right to exercise “matures” or vests ratably, when the vesting terms are met.

Reverse vesting can be defined as a mechanism that creates an obligation for the founders of a startup to sell some or all of their shares (usually for a nominal amount) or to transfer them to other co-founders or the company if they leave the company before a certain period of time. This means that, under the reverse vesting agreements, founders do not effectively have full control over the shares they own if they leave the company before the end of the vesting period. This concept assumes that the founders’ ownership of the company is earned by them over time (e.g. salary). Of course, unlike options’ vesting, founders or share recipients own the shares from the start. But depending on when the original owners want to leave, they may have to sell (or transfer) all or part of their shares back to the company or other shareholders.

The length of the founders’ vesting period varies by company, but the most common is a four-year period after the startup is established.

The reverse vesting clause usually also contains a one-year cliff condition. With a one-year cliff, the company or shareholders may buy back or trigger the transfer of all shares if the founder withdraws from the company before the end of the first year. This also applies to the transfer of shares to an employee.

The main idea behind the reverse vesting clause is to protect the company or investors, and to tie the founders (who can also be key employees) to the startup. The purpose of implementing this mechanism is to create an incentive for all shareholders of the company to work for its success and maintain a high interest in its development.

What may happen to a company if reverse vesting is not implemented and founders decide to quit?

For example, assume that some of the founders leave in a short period after the creation of a company and want to sell their shares. In this case, a key founder may receive money, but the startup may fall apart. And the exit of such a founder can also prevent the company from attracting future investors, as they have to suffer dilution caused by attracting key employees and paying with equity.

Or assume that one of the founders leaves, but still holds a big share in the company. Let’s say, 30%. What happens next? Assume that other shareholders take over the company, invest more of their time in it, or just hire some good employees, and in a few years a startup reaches great success. But if the company is later sold after such success, the founder may still be entitled to 30% of proceeds. And that may not be a good scenario for the investors or the other shareholders, and the founder’s equity is usually referred to as “dead equity,” equity held by founders who have no meaningful influence over or that do not contribute to the company.

To prevent such consequences, investors can require one or more key founders to sign a reverse vesting agreement. In that case, any such founder can be required to stay with the company for 4 years to completely own or vest his 30% share. If the reverse vesting period is standard (4 years with a 1-year cliff) the founder will “earn” 7.5% each year, and by the end of the fourth year will finally own his 30%. But if he leaves after 2 years, he will own only 15% of shares by the end of the second year and so on. And this can thus be fair to all interested parties.

Thus, reverse vesting agreements can be beneficial for companies as a whole, as well as for the interests of all shareholders.

Of course, such an agreement requires the parties to specify a number of important conditions. First, the main issue of discussion is the timing and period of reverse vesting: the parties must agree on how many years it will take for the transfer of rights and how much capital is earned each year. Secondly, it is necessary to decide who has the advantage in the event the shares get repossessed (who buys the shares or otherwise becomes the owner in the event of a founder exit). Terms may be standard, but it is important that both investors and founders agree on these key issues and bring them into line with their interests.

Founders can negotiate vesting acceleration events, such as leave for a “good reason,” like substantial reduction in salary or stature, the closing of an IPO or M&A, and alike.

Typically, the moment when a reverse vesting agreement is signed is the time when an investor enters the company (a venture capital set of documents usually includes reverse vesting clauses). But sometimes it can be implemented when the company is created. Of course, if there is only one founder at the beginning, this provision may be redundant.

Entering into a reverse vesting agreement at the company’s establishment may award the founder a better tax treatment, and should be carefully considered. 

Incorporating a reverse vesting mechanism into your investment documentation requires special attention. The legality of this clause may be in question in some regions, so all conditions must be fully consistent with local laws and jurisprudence.


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