• Mentorship

  • Leadership

  • Entrepeneurship

  • Mentorship

  • Leadership

  • Entrepeneurship

  • Mentorship

  • Leadership

Copyright 2017 - © Frank Design. Please be sure to read our Privacy policy, Disclaimer and Terms Of Use documentation.

 

When we start companies, we seldom foresee the ups and downs, the good and the bad, the frustrations and celebrations, and more often than not it is the strength of your partnership that pulled you through these difficult times and focused on the end goal.

But …

What happens if you and your partner has a fallout over the direction of the company and he/she decides to leave?

What happens in a year down the line your partner decide that the business is not doing as well as he/she expected and has decided to take on a full time job, but promises to work weekend, while you have to work full time?

These types of actions often negatively affect the company, by someone who is likely your friend and who owns a large chuck of your business. We never plan these things when we enter into a partnership, and it’s impossible to plan this 6 months or 2 years in advance.

The way to prevent this, or rather minimize the impact to your company, is to implement a vesting terms and schedule into your partnership agreement for all partners in the business. If you have ever dealt with VCs, you will often find this is a term they insist on in their agreement with you.

A Vesting Term in the simplest form, is a term in the partner’s agreement/s that specifies a period over which the partner will get his/her shareholding, whether it’s time based on deliverable based. This means that you will earn your equity over a period or until certain deliverables have been met, and not before.

 

Standard Equity Split without Vesting Terms

Here is a simple example, pre-outside investment, based on all the partners owning equity, without a vesting schedule:

Partner

Year 1

Year 2

Year 3

Year 4

Total

Founder 1

40%

     

40%

Founder 2

40%

     

40%

Founder 3

20%

     

20%

Totals

100%

     

100%

 

Table 1: Equity without Vesting Terms


This means that upon signing of the partnership agreement or incorporation of the company, all partners own their shares in full.

In the event of a fallout 6-months down the line, and Founder 2 deciding to leave for whatever reason, the company would be required to pay Founder 2, 40% of the valuation of the company. Now what happens if Founder 2 was in charge of development and now leaves you with an unfinished prototype? Can you company afford that as well as the cost of paying him out?

That is where Vesting Terms come into play.

 

Equity Split with 4-Year Vesting Terms

Should we now implement a vesting schedule based on equal splits over a 4-year term, it would look like this:

Partner

Year 1

Year 2

Year 3

Year 4

Total

Founder 1

10%

10%

10%

10%

40%

Founder 2

10%

10%

10%

10%

40%

Founder 3

5%

5%

5%

5%

20%

Totals

25%

25%

25%

25%

100%

Table 2: Equity with 4-year Vesting Schedule

This means that each founder will get an ¼ of their shareholding, per year, till the end of the 4-years.

This is the most common form of Vesting Terms you will be asked for by VCs, and should be something you implemented when you started the company. If you haven’t, speak to your partners, and have it implemented.

 

Equity Split with Deliverable Vesting Terms

You can also base a vesting schedule based on deliverables, rather than a period, as the table below illustrates.

Partner

Incorporation of Company

MVP

US$1m Revenue

US$10m Revenue

Total

Founder 1

10%

10%

10%

10%

40%

Founder 2

10%

10%

10%

10%

40%

Founder 3

5%

5%

5%

5%

20%

Totals

25%

25%

25%

25%

100%

Table 3: Equity based on a Deliverable Vesting Schedule


In this example, each founder only receives a percentage equity when the company is incorporated, and then a percentage when each deliverable is met.

This can be dangerous if the targets aren’t well thought through, which is a mistake made by most entrepreneurs.

 

 

Equity Split with Time & Deliverable Vesting Terms

This is a personal favourite of mine, as it allows for different vesting schedules for different partners.

As an example, you can have a vesting schedule look like this:

Partner

Incorporation of Company

Year 2

Year 3

US$10m Valuation

Total

Founder 1

10%

10%

10%

10%

40%

Partner

Incorporation of Company

MVP

Year 3

Year 4

Total

Founder 2

10%

10%

10%

10%

40%

Partner

Incorporation of Company

Year 2

Year 3

Year 4

Total

Founder 3

5%

2.5%

2.5%

10%

20%

Table 4: Equity based on a Mixed Vesting Schedule


In the above example we have Founder 1 who is the CEO of the business. His vesting terms are over a 4-year period, with the final part of his equity being based on reaching a specific valuation. Founder 2 is the developer, and his vesting terms are based on reaching certain objectives (defined from the onset) over a period. And Founder 3 is the CFO and his vesting terms are based on the period, though different percentages per year.

If you do decide to implement vesting terms based on deliverables, you need to be clear upfront (fully documented), in terms of what those deliverables are, and specifics. You can’t just say you want a MVP (Minimum Viable Product) by “x” date, you need to list the functionality that MVP needs to have to be considered a MVP.

Not all partners need to have the same vesting schedule. Some can be based on deliverables and some based on periods, some can even be a mix. However, the vesting schedules need to be fair and accepted by all partners.

The Cliff

The Cliff is another important term that goes hand-in-hand with the Vesting Schedule. The Cliff refers to the period before vesting begins. This is specifically relevant to key employees you offer equity shareholding too. This is to ensure that a partner or employee lasts a specific period as defined by The Cliff, before they can start earning equity.

I personally don’t implement Cliff terms for the original founders of the business, but do use it when bringing on-board key employees or new partners in an established company. The reason for me not recommending implementing Cliffs in a start-up is that if we had a 12-month Cliff, meaning we won’t earn equity shares till the end of that period, then what is the motivation not to throw in the towel if things aren’t going right 6-months down the line.

Remember, not everyone is as committed to your brainchild as you are.

What happens when the company is sold before the end of the vesting term?

In the event that the company is sold before the end of the vesting term, whether period or deliverable based, the full equity the partners would have been entitled to at the end of their vesting term would come into play.

That means, based on the examples above, that should the company be sold for US$5m at the end of Year 2, Partner 1 would receive 40% (US$2m), Partner 2 would receive 40% (US$2m), and Partner 3 would receive 20% (US$1m).

Essentially, you as a partner will not lose your equity in the event that the company is sold.

 

Summary of Vesting Terms & Schedule

Vesting Terms are an important aspect of your partnership agreement for anyone sharing in equity in the business, and will be a mandatory term when speaking to most investors, so get it in from the onset.

Based on the questions we asked in the beginning of this article, you and your business would now be protected should any of those scenarios come into play.

Often entrepreneurs look at it as a bad thing, but remember it is there to protect you and really does not affect you unless if you planning on leaving the business before the end of the vesting period, in which case you already have an issue. Vesting terms are there to protect the company, and force entrepreneurs to act in the best interests of the company.

There are of course variations in wording of these vesting schedules, some which can give the founder from the start (incorporation) full voting rights and dividends based on his full shareholding he would hold at the end of the vesting term, but should he leave before that term for whatever reason, he would be paid based on the vesting schedule.

At the end of the day, you and your partners decide what is fair within a partnership agreement, just remember that investors have certain expectations.

 

arrow Book now for a 1-On-1 Business Mentoring Programme here.


You have no rights to post comments

Please be sure to read our Privacy Policy, Terms of Use and Disclaimer documentation.