Key Takeaways:

  • Reverse vesting secures a company’s interests by ensuring founders and key stakeholders stay engaged for a defined period.
  • It differs from traditional vesting as the shares are owned upfront but can be reclaimed if terms aren’t met.
  • Essential elements of reverse vesting agreements include cliffs, repurchase rights, and accelerated vesting clauses.
  • The practice benefits investors, attracts funding, and maintains founder alignment with company goals.
  • Reverse vesting agreements must balance fairness and tax implications for founders and companies.

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.

Key Elements of Reverse Vesting Agreements

Reverse vesting agreements often include several critical terms that dictate the co-founder’s rights and obligations:

  • Cliff Periods: A standard one-year cliff prevents the co-founder from retaining any shares if they leave within the first year.
  • Vesting Schedule: Shares typically vest over 3-4 years, either monthly, quarterly, or annually.
  • Accelerated Vesting: Trigger events, such as mergers or acquisitions, can accelerate the vesting schedule, ensuring founders don’t lose unvested shares during significant corporate changes.
  • Repurchase Rights: The company retains the right to repurchase unvested shares at a nominal cost if the co-founder departs prematurely.

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.

Differences Between Reverse Vesting and Traditional Vesting

While traditional vesting involves earning ownership over time, reverse vesting starts with full ownership that can be reclaimed. The main distinctions are:

  • Ownership Timing: Reverse vesting gives immediate ownership, subject to clawback, while traditional vesting requires earning shares incrementally.
  • Applicability: Traditional vesting is common for employees, whereas reverse vesting targets founders to align long-term incentives.
  • Flexibility: Reverse vesting agreements often include founder-specific terms like performance benchmarks and negotiated buy-back rates.

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.

Common Misconceptions About Reverse Vesting

Despite its benefits, reverse vesting is often misunderstood:

  • Myth: Founders Lose All Shares Upon Departure
    Truth: Founders typically retain vested shares and voting rights unless specifically stated otherwise.
  • Myth: It Creates Unfair Conditions
    Truth: Reverse vesting protects equity distribution and ensures founder commitment, which investors value.

Clarifying these misconceptions helps founders and teams navigate agreements confidently.

Legal and Tax Considerations

Reverse vesting agreements must comply with legal and tax regulations to avoid unintended consequences:

  • Legal Balance: Agreements should balance founder and investor interests to avoid claims of coercion or unfair treatment.
  • Tax Treatment: Unvested shares are often considered restricted stock, impacting the founder’s taxable income. Section 83(b) elections can mitigate tax liabilities but require early filing.
  • Jurisdictional Variations: The enforceability and terms of reverse vesting agreements may vary based on local corporate laws.

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.

Key Clauses in Reverse Vesting Agreements

Reverse vesting agreements include several critical clauses designed to balance the interests of founders, employees, and investors:

  1. Cliff Periods: Often set at one year, cliffs ensure founders must stay for a minimum duration before vesting begins.
  2. Accelerated Vesting: Common in acquisition scenarios, this clause allows a founder to vest unvested shares partially or fully when control changes hands.
  3. Good-Leaver and Bad-Leaver Terms: Founders who leave amicably or are terminated without cause often retain some rights, unlike those dismissed for cause.
  4. Repurchase Rights: These give companies the ability to buy back unvested shares if a founder departs prematurely.

Each agreement varies, making it essential to tailor clauses to your business's and founders' needs.

Common Scenarios for Reverse Vesting

Reverse vesting agreements address several potential challenges in startups:

  • Founder Departures: Prevents founders from retaining disproportionate equity if they leave early.
  • Performance Issues: Ensures equity aligns with contribution, allowing buybacks if founders fail to meet performance expectations.
  • Investor Requirements: Protects investors from diluted equity by ensuring co-founder alignment with the company’s long-term vision.

Best Practices for Structuring Reverse Vesting Agreements

When creating reverse vesting agreements, companies should consider:

  1. Tailored Terms: Customize vesting schedules and cliffs to suit the founders’ roles.
  2. Performance Metrics: Incorporate benchmarks to incentivize founders effectively.
  3. Legal Counsel: Engage experienced legal advisors to ensure agreements comply with regulations.
  4. Clear Communication: Outline all terms explicitly to prevent disputes.

FAQ Section:

  1. What are good-leaver clauses?
    An agreement must balance the interests of founders and investors. A good-leaver clause ensures that a founder who exits on good terms keeps their unvested shares. Founders dismissed for cause may lose them.
  2. Do reverse vesting agreements usually have cliffs?
    Yes, many agreements include cliffs, commonly set at one year. If a founder leaves before the cliff ends, all shares may be repurchased. Cliffs ensure commitment early on.
  3. What happens during a merger or acquisition?
    Reverse vesting agreements often address these changes with accelerated vesting:
    • Single-trigger: Some or all shares vest when control changes.
    • Double-trigger: Shares vest if control changes and the founder is terminated.
  4. How does reverse vesting differ from traditional vesting?
    Traditional vesting grants ownership over time, starting from zero shares. Reverse vesting starts with full ownership but subjects unvested shares to repurchase rights.
  5. Why do investors require reverse vesting?
    It ensures founders stay committed and protects equity distribution. It also signals stability and fairness, attracting further investment.

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