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. 8 min read
2. How Does Stock Options Vesting Work?
3. What Is a Restricted Stock Purchase Agreement?
4. Why Do Reverse Vesting Provisions Exist?
5. Why Is Reverse Vesting Important?
6. Reasons to Consider Not Using Reverse Vesting
7. Reasons to Consider Using Reverse Vesting
8. How Reverse Vesting Works
9. Frequently Asked Questions
Updated October 15, 2020:
Reverse Vesting: What Is It?
Reverse vesting occurs when a company's co-founder receives his or her 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.
The founder already owns all the shares with reverse vesting and may be forced to sell a specific percentage of them for no profit if the complete vesting period hasn't been finished. Reverse vesting is a term used to define a specific situation where an independent contractor or an employee gets stock that's subject for the company to repurchase at-cost. The right to repurchase lapses the vesting period.
This is the opposite of a normal situation, where a provider for a service gets the right to buy stock or an option, but he or she can't use that right until the provider vests. Many investors and employees must earn shares by staying with the company for a while through a vesting provision or from buying the equity. Founders have an advantage over them, as they get equity with the company from their first day of employment.
Many VC term sheets and founder agreements won't allow founders complete control of their shares if they terminate their employment before the reverse vesting period is over, which is often four years. These agreements let the company buy back the rights to the shares that aren't yet mature for a small fee, or sometimes for free.
Management and founders of startups often receive their options and shares on a vesting schedule. This means they won't get all their shares at the same time. Instead, they can purchase small portions of shares at different times. A founder who has 16,000 shares might want to get them every quarter for the next four years. This means he or she will get 1,000 shares every quarter.
How Does Stock Options Vesting Work?
Stock options are a way of keeping a company's workers motivated. These are often vested, meaning the full amount of options gets broken down each month into installments. An employee is motivated to continue working for the company, as he or she knows that the longer the employee works there, the more options he or she will have to buy more future shares. Vesting lets employees control their shares after a specific period has gone by.
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
- 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. The company's simply holding the right to do so 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 Do Reverse Vesting Provisions Exist?
The reason for reverse vesting is to keep the investor and the shareholders protected by making sure the founder has an incentive that will encourage him or her not to terminate employment with the company. Reverse vesting agreements are in place so founders can't leave a company suddenly while taking a substantial number of shares.
A founder will be the owner of the shares that may be subject to reverse vesting during the reverse vesting period.
The voting rights of the founder are retained in addition to his or her right to dividends (although this is not common in startups), along with any other right related to the shares. Reverse vesting agreements are most often signed as part of the first big investment in a startup. However, founders sometimes anticipate them and include them in their founders' agreements. Each founder receives assurance that his or her co-founders are committed to their company.
They also let the founders have a chance to define what their terms of reverse vesting are so it will be favorable for them. When this happens, there isn't a guarantee that an investor in the future won't require the change of agreements. While these agreements have been around for years and are commonly used, there are several problems with them. Some argue they may be in violation of a law from 2012 that doesn't allow employers to have guarantees from an employee to ensure the employee continues to work there.
There's also the question if the actual repossession establishes a tax event for the founder who has his or her shares being repurchased. It's assumed that the answer to both of these questions is negative when it comes to the normal circumstances that are around reverse vesting. There may be some indications, particularly regarding the tax issue, that show the market is correct. However, there isn't any certainty when it comes to either issue.
The terms tend to be standard, but it's important to fine-tune. This includes:
- The vesting schedule and period.
- How many shares are subject to reverse vesting.
- Who has the advantage if shares get repossessed.
- Other issues.
The fine-tuning should be completed at the term sheet stage. Legal advice should also be sought before the issue is agreed on.
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 situation.
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, it sets 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 an 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, he or she loses 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 him or her 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 in most businesses. That's definitely true when someone has made ample money on his or her 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 a co-founder's sudden exit. 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 an 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 founders don'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, he or she may reverse vest more quickly.
The founder of a startup will generally reverse vest his or her ownership interest over a period of two to three years. When the owner reaches a milestone, such as six months or a year, he or she gains possession of a portion of the stock.
For an owner with 75 percent reverse vested over a three-year span, he or she will work on a schedule where the owner earns 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 his or her stock for each month the founder stays 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, he or she gives up unvested shares. Should the person get fired, he or she keeps the unvested shares, except in one instance. A founder fired for cause again loses his or her 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, he or she can 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 before 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 legal need 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, Menlo Ventures, and Airbnb.