Reverse Vesting: Everything You Need to Know
Reverse vesting occurs when a company's co-founder receives shares and ownership interest upfront. This exchange is subject to vesting like employee's stock. 5 min read
Reverse Vesting: What Is It?
Reverse vesting occurs when a company's co-founder receives their shares and ownership interest upfront. This exchange is subject to vesting similar to employee stock options. If the co-founder leaves, the company may repurchase a set amount of those shares.
What Is a Restricted Stock Purchase Agreement?
When a company wants to initiate a repurchase of the co-founder's stock, it uses a process called a restricted stock purchase agreement. It's a specific term that reflects the type of stock, a restricted class, and the type of contract.
The purchase agreement is the agreement between the co-founder and the company that the latter party can buy back the stock. The transaction isn't guaranteed. They're simply holding the right to do it if the situation arises.
The business keeps the restricted stock in escrow until it vests. Should the co-founder leave suddenly, either by quitting or getting fired, the ownership interest is in unvested restricted stock. The agreement determines the specifics of the transaction.
Why Is Reverse Vesting Important?
To a business, reverse vesting is a form of protection. The fear exists that a co-founder could leave the company while maintaining a large ownership interest. By using reverse vesting, the company establishes rules to avoid this scenario.
The best way to add this protection involves shareholding. The company agrees to place a set number of shares in a trust for each co-founder. Then, they set up a schedule that turns full ownership of the shares over to the co-founder. In many cases, the shares change hands on a monthly or annual schedule.
The agreement usually states that if the co-founder exits the company early, the unvested shares return to the business. This protection stops co-founders from keeping a large number of shares when they leave.
Reasons to Consider Not Using Reverse Vesting
- Less control: Since the founders of the company determine its rules, they should keep in mind that using reverse vesting hurts them. Should they leave at some point, they'll have less control of the business they started.
- More risk: An early setback with the company is much more harmful to a founder when reverse vesting rules are in play.
Reasons to Consider Using Reverse Vesting
- Many investors require reverse vesting: During the early days of a startup, the strongest selling point is the team that founded it. They have the ideas that drive a company's growth. Reverse vesting increases the likelihood that the co-founders don't leave. It also protects investors. If a co-founder does leave, they'll lose their ownership interest, increasing the shareholder power of investors.
- Attracts more investors: The co-founders of a business wield all the power in the early days. They own the company. With reverse vesting in place, investors know they have a better chance at a higher ownership interest. Should a co-founder leave, that ownership interest disappears, adding to the value of other investments.
- Tax benefits: As the company increases in value, shares appreciate in worth. A founder's worth goes up without their receiving additional income. Reverse vesting lessens the tax burden since the shares aren't owned until a later date.
- Encourages employee loyalty: Turnover is a major factor at most businesses. That's definitely true when someone has made a lot of money on their shares. If the company can take those back, the employee has less to gain by leaving.
How Reverse Vesting Works
This strategy protects a company from the sudden exit of a co-founder. Should someone with a large ownership interest leave, reverse vesting gives the company the ability to buy back the owner's shares. That way, someone outside the company doesn't have a large ownership stake.
With reverse vesting, an owner has incentive not to leave. Should they do so, their money and influence within the company will lessen. As long as they're with the company, they maintain the voting interest of all their shares. The catch is that the founder doesn't own them until after a set time.
A founder must agree to reverse vesting. When they do, either some or all of their shares are subject to reverse vesting. The standard ratio is 75 percent, meaning a founder keeps 25 percent ownership. The other 75 percent reverse vests over time with one exception. If a founder has run the company for an extended period, they may reverse vest more quickly.
The founder of a startup will generally reverse vest their ownership interest over a period of two to three years. When the owner reaches a milestone like six months or a year, they gain possession of a portion of the stock.
For an owner with 75 percent reverse vested over a three-year span, they'll work on a schedule where they earn back 25 percent of the ownership stake each year. Some agreements are monthly or quarterly instead. In those situations, the founder would regain a little more than 2 percent of their stock for each month they stay at the company.
Frequently Asked Questions
- What are good-leaver clauses?
An agreement must provide a fair balance between founders and investors. The good-leaver clause is the method to do so. The term is what it states: A founder leaves in a good way. As long as that's true, the founder won't lose unvested shares.
Should a founder quit, they give up unvested shares. Should the person get fired, they keep their unvested shares except in one instance. A founder fired for cause again loses their unvested shares. The goal is for a founder's exit from the company to not damage the reputation of the business. As long as that happens, they keep the unvested shares.
- Do reverse vesting agreements usually have cliffs?
Each agreement is different, but the answer is sometimes yes. The ones that do have cliffs use set terms. In a one-year cliff, the company can repurchase all shares if the co-founder leaves prior to the end of the first year. One-year cliffs are more common for employees than for founders.
- What happens during a merger or acquisition?
Most reverse vesting programs include a clause to address mergers and purchases. The co-founder is subject to forfeiture of shares. These situations are change of control events. The vesting speeds up in such instances. The two speeds are:
- Single-trigger: Some or all of a co-founder's stock vests during a change of control event.
- Double-trigger: It's the same as single-trigger with one addition. Some or all the stock vests during the event and the co-founder gets fired.
Both versions have pros and cons for the co-founder, the company, and investors. You should discuss them with a lawyer to decide what's best for your needs.
If you need help with reverse vesting, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.