Having a co-founder has many clear benefits but it also brings with it complex questions around the future and what if a co-founder wants to leave, and in particular, what should happen to a co-founder’s shares if they leave? One strategy that can help to safeguard a startup's future and ensure founder commitment to the cause is reverse vesting.

What is Reverse Vesting?

Reverse vesting is a mechanism where founders are granted their shares upfront (for example, when the company is incorporated), but their right to retain these shares is earned, either over time or based on performance milestones. The general rule is that if certain conditions are not met, such as a founder leaving the company before a specified period, the company can reclaim the unvested shares, and sometimes also some or all of the vested shares​​ where the vesting rules require a minimum period of service or the co-founder is leaving as a ‘bad leaver’ because they have done something seriously wrong. This ensures that founders are incentivised to remain with the company and contribute to its long-term success.

Vesting vs. Reverse Vesting

The concept of vesting involves earning shares over time or based on achieving milestones, but the key difference lies in how and when the shares are issued:

• Vesting: Shares are not issued upfront. Instead, the individual earns the option to receive shares over time or upon reaching specific milestones set out by the company.

• Reverse Vesting: Shares are issued at the beginning but can be reclaimed by the company or the remaining co-founder(s) if the individual does not meet the agreed conditions​​.

The choice between (a) granting an option to receive shares in future with vesting and (b) issuing shares up front with reverse vesting, generally depends on who is receiving the shares. Vesting is typically used when granting share options to new employees or advisors, ensuring they are aligned with the company's long-term objectives before receiving the shares. This gradual allocation aligns their interests with the company’s growth. Conversely, reverse vesting is appropriate for where shares are issued upfront, generally where the shares are issued to co-founders when the company is incorporated. This safeguards against the risks of a co-founder leaving early or not fulfilling their agreed expected contributions, ensuring that only those who remain committed and productive retain their shares.

Shares are like currency

It is common for startups to use equity (i.e. shares) like currency, sometimes to help make up for a lack of cash to pay people, and sometimes to compete with corporate salaries to attract the best talent. In that sense, equity can be used as fuel to help turbo-charge a company’s growth and success, in the same way as spending money on it can do the same, if spent well.

Therefore, it’s generally important to ensure that anyone departing from the business early or unexpectedly, including a co-founder, isn’t holding too much of that valuable currency that could otherwise be used to turbo-charge growth.

Where a departing founder holds a significant portion of shares whilst no longer having any operational role within the company, this is the same as having ‘dead’ currency in the business. At this point, instead of the shares being held by someone with no involvement, they could be used for a replacement or as options for other team members.

Should Founders Implement Reverse Vesting Proactively?

Even if investors do not demand it, implementing reverse vesting can be beneficial for the founding team. It protects the interests of all founders by ensuring that if one leaves, the remaining shares can be returned to the company or redistributed among those who continue to contribute to the company's success.

We have seen many examples where no reverse vesting is implemented and then when one co-founder plans to leave, they presume they have the right to keep their shares for the work they have done, with no legal requirement to return them. This puts the remaining co-founder(s) in a very difficult position, without any legal grounding to require the departed co-founder to return their shares.

What happens in those situations?

In such situations, there is no get-out-of-jail free card and a bespoke solution needs to be agreed to keep the company alive at that point. For companies looking to fundraise, a departed co-founder holding a significant portion of the Company’s shares is a major red flag. Equally, the remaining co-founder is typically unwilling to continue putting in tireless work to help enrich the departed co-founder when things go well in future. Meanwhile, the departed co-founder wanting to retain their shares would do well to remember that if the situation persists, then their shares which they want to retain will not be worth anything if the situation persists. There is often an impasse which needs to be resolved, and founders should seek legal advice at the time to find a resolution in each specific case.

Is Reverse Vesting Required as Part of a Funding Round?

While not mandatory, reverse vesting is often required by investors when the investor’s decision to invest is strongly linked to the founding team, and their perception is that founders are critical to the company's success. Investors want to ensure that key stakeholders within the company remain committed to the company's growth and are protected against scenarios where a founder might leave prematurely​​. This is a point that can be negotiated at the time, with the reverse vesting clock usually starting from when the investment round closes.

Market Standard Vesting and Cliff Periods

The most common vesting schedule is four years with a one-year cliff, but each company should consider the right vesting period for them based on their growth plans. In our experience, it is an industry myth that the 4-year vesting/1-year cliff model is the market standard, especially for co-founders - it is not, and it is often an illogical vesting schedule. Founding teams can consider practically, based on their circumstance, what is going to work best for them.

How does the vesting schedule work?

• The vesting period is the period in which the shares are earned. For example if the vesting period is 6 years, shares are earned over the 6 year period.

• The vesting can be proportionate throughout the 6 years (e.g. an equal amount every month or quarter), or the vesting period can be weighted towards the end, so that more shares vest towards the end (e.g. 50% vests across the first 4 years, and then 50% vests in the final 2 years).

• If there is a cliff period, the end of the cliff period is like a checkpoint where shares only vest at the end of the cliff period, so if a person leaves before the end of the cliff period, then no shares vest.

• Depending on the company's stage and strategic goals, vesting schedules can be tailored. For instance, if the company is planning for an exit in 7 years, then consider a 7 year vesting schedule.

What Happens if a Founder Leaves During the Vesting Period?

The outcome depends on the agreed reverse vesting terms. Typically, the departing founder forfeits any unvested shares, which can be reclaimed by the company or redistributed among remaining founders or reserved for new key hires. This ensures that the company's equity remains with those actively contributing to its growth​​. We typically see that founders are keen to ensure that unvested shares of a departed founder go back to the remaining founder(s) to ensure that the block of shares held by founders together remains the same. Otherwise, a founder leaving can result in this block of shares very suddenly being cut in half.

Impact on Shares and Voting Control

When shares are reclaimed by the company, it can affect the remaining founders' control. Ideally for the remaining founder(s), reclaimed shares can be redistributed among the remaining founder(s) or reserved for future co-founders to maintain balance and control. This approach helps prevent significant dilution of control and ensures continuity in leadership​​.

Importance of Agreeing What Happens to Unvested Shares

It is essential to write into legal documents with investors what will happen to founder shares which do not vest and are subject to a reclaim. The default expectation is that they will go back to the company or be converted into worthless shares known as deferred shares. However, when we work with founders who want to take a proactive approach to ensure that this does not happen, we need to work together to agree on the mechanics of this process in advance. We then draft specific terms into the shareholders agreement and articles of association to agree the terms in advance, which all investors agree to at the time of signing the relevant documents.

Practical Considerations for Founders

1. Pro-actively Consider Reverse Vesting Before Fundraising: In our experience, showing a pre-agreed commitment to reverse vesting enables founders to demonstrate their commitment to their investors early, and this can support negotiations to complete an investment round smoothly.

2. Negotiate Terms: Ensure that the vesting schedule and cliff periods are tailored to your company’s specific needs and growth plans. Founders should discuss and agree on these terms early to avoid conflicts later. There is no one-size-fits-all.

3. Legal Assistance: Work with Accelerate Law to draft clear and enforceable reverse vesting terms in legal documents, including what happens to shares which have not vested. There are various elements to the legal drafting which generally require expert support and advice.

4. Transparent Communication: Discuss the terms and implications of reverse vesting with all co-founders to ensure mutual understanding and agreement. Clear communication helps build trust and prevents misunderstandings.

5. Failure to Act can be Costly: If a co-founder is leaving without any reverse vesting terms or mutual understanding, this can result in significant, expensively, slow, frustrating conflicts, which can make a company uninvestable and ultimately bring it down. It’s better to be pro-active.

Reverse vesting is a powerful tool for startups to ensure long-term commitment and protect the company's interests. By understanding and implementing effective reverse vesting terms, founders can safeguard their positions and maintain control during the crucial early stages of growth. This mechanism not only aligns the interests of founders and investors but also ensures that the company's equity is held by those who are actively contributing to its success and used as fuel to incentivise them to do that.

Accelerate Law provides flexible strategic and legal support to startups end-to-end through angel investment rounds and VC funding rounds, which includes supporting with SEIS and EIS matters, flexible funding for example through Advanced Subscription Agreements, and drafting and negotiating investment terms from term sheets through to completion. Accelerate Law also specialise in EMI Schemes for startups. Contact us here to find out more.