Founder Vesting & Cliffs: Earning what you already own

This guide aims to break down the “Founder Vesting & Cliff” clause, helping you understand its implications, common variations, and what to watch out for to protect your interests.

Definition

Founder vesting is a mechanism where a founder’s equity (ownership shares) in a company is earned over a defined period of time or upon achieving specific milestones. While founders may initially hold shares, vesting ensures they “earn” ownership over time, demonstrating a continued commitment to the company. Think of it like a pay check for your ownership – you don’t get it all upfront, but rather earn it as you continue to work and contribute.

Reverse vesting is often the practical application, where shares are issued to founders upfront but are subject to repurchase by the company if the founder leaves before their shares are fully “vested.” This means unvested shares can be clawed back.

A cliff is an initial period within the vesting schedule (typically one year) during which no shares vest. If a founder leaves before the cliff period is completed, they forfeit all their unvested shares. After the cliff, shares usually begin to vest incrementally (e.g., monthly or quarterly) over the remaining vesting period. The cliff acts as a probation period, ensuring that founders are truly committed before they start earning significant equity.

Imagine you’re building a house. Vesting means you get the blueprint (all your shares) on day one, but you only truly “own” each brick (a portion of your shares) as you lay it over time. The “cliff” is like the first year of building – if you stop working on the house before the year is up, you don’t get to keep any of the bricks. But once you pass that first year, you start keeping a portion of the bricks you lay each month.

Why it matters?

Founder vesting and cliff provisions are fundamental in venture capital deals, serving to align incentives and safeguard the company’s equity structure for both investors and founders.

• For Investors:
  • Ensures Commitment: Vesting incentivizes founders to remain dedicated to the business for the long term, as their full equity ownership is contingent on their continued service.
  • Protects Equity Structure: If a founder leaves early, unvested shares can be reacquired by the company and used to attract new talent or be reallocated, preventing “dead equity” on the cap table (equity held by non-contributing individuals).
  • Mitigates Risk: Investors are backing the future success of the company, and vesting provides a safeguard against a founder walking away with a significant equity stake after a short period.
• For Founders:
  • Aligns Interests Among Co-founders: A clear vesting schedule ensures that all co-founders contribute equitably over time. If one founder leaves, it prevents them from retaining a disproportionate share of equity without ongoing contribution.
  • Clarity and Fairness: It establishes clear expectations around equity ownership and ensures that those who continue to build the company are properly rewarded.
  • Demonstrates Professionalism: Having a well-defined vesting schedule in place, even before seeking external investment, signals professionalism and foresight to potential investors.

Common Variations

While a four-year vesting period with a one-year cliff is considered the industry standard, there are several variations founders might encounter or negotiate:

• Vesting Period Duration:
  • Typically 3-5 years, with 4 years being the most common. In some cases, for very mature businesses or founders with significant prior contributions, a shorter period or immediate vesting of a portion of shares might be negotiated.
• Cliff Period:
  • While one year is standard, variations can include shorter cliffs (e.g., six months) or, less commonly, no cliff.
• Vesting Frequency After Cliff:
  • After the cliff, shares usually vest monthly or quarterly in equal instalments over the remaining period.
• Good Leaver vs. Bad Leaver Provisions:
  • These clauses define what happens to vested and unvested shares if a founder departs, depending on the circumstances of their exit:
    • Good Leaver: Typically applies when a founder’s employment is terminated by the company without “cause” (e.g., performance-related, but not misconduct) or in cases of death/disability, or voluntary termination approved by the board. Good leavers generally retain their vested shares, and sometimes unvested shares may be repurchased at fair market value.
    • Bad Leaver: Applies when a founder is dismissed for “cause” (e.g., fraud, gross misconduct, breach of duty) or leaves voluntarily without board approval. Bad leavers typically lose all unvested shares, and their vested shares may be repurchased at a nominal value or forfeited entirely.
    • Intermediate Leaver: Some term sheets include this category for scenarios falling between good and bad leaver, with consequences tailored to the specific circumstances (e.g., voluntary resignation without breach).

• Acceleration of Vesting:
  • This allows a founder’s unvested shares to vest immediately upon the occurrence of specific events.
    • Single-Trigger Acceleration: Vesting accelerates fully upon a change of control of the company (e.g., acquisition, IPO).
    • Double-Trigger Acceleration: Vesting accelerates fully only if two events occur:
      • A change of control AND
      • The founder’s termination without cause (or resignation for good reason) within a certain period (e.g., 12-24 months) following the change of control.

This is generally more founder-friendly as it protects against being terminated post-acquisition without receiving the full benefit of their equity.

• Performance-Based Vesting:
  • Less common for initial founder vesting, but can be used where a portion of equity vests upon the achievement of specific business milestones (e.g., revenue targets, product launches) rather than just time.
• Re-vesting:
  • In subsequent funding rounds, new investors might request that founders “re-vest” some or all of their already vested shares over a new period. This ensures renewed commitment but can feel unfair to founders who have already earned their equity. Negotiation is key here, often aiming for a portion of shares to be re-vested or for new shares issued in the round to be subject to a new vesting schedule, leaving existing vested shares untouched.

Let’s understand with the help of a common examples:

Example 1: Standard Vesting with Cliff

• Scenario: A founder is granted 1,000,000 shares subject to a 4-year vesting schedule with a 1-year cliff.
• Year 1 (Cliff): No shares vest. If the founder leaves within the first 12 months, they forfeit all 1,000,000 shares.
• After 12 months (Cliff crossed): 25% of the shares (250,000 shares) vest.
• Remaining 3 years: The remaining 75% of shares (750,000 shares) vest in equal monthly instalments over the next 36 months. This means approximately 20,833 shares vest each month (750,000 / 36).
• Departure at 2.5 years: If the founder leaves after 2.5 years (1 year cliff + 1.5 years of monthly vesting), they would have vested: 250,000 (after cliff) + (1.5 years * 250,000 shares/year) = 250,000 + 375,000 = 625,000 shares. The remaining 375,000 shares would be unvested and typically repurchased by the company.

Example 2: Bad Leaver Scenario

• Scenario: A founder with the same vesting schedule as above is terminated for “cause” (e.g., misconduct) after 2.5 years.
• Outcome: As a “bad leaver,” they would likely forfeit all their unvested shares (375,000 shares) and may have their vested shares (625,000 shares) repurchased by the company at a nominal value. The exact terms depend heavily on the specific “bad leaver” definition in the term sheet.

Evolv’s Recommendation

• Understand the “Why”: While vesting can feel punitive, especially if you’ve put in significant work pre-investment, understand that it’s a standard practice designed to protect both investor and co-founder interests. Acknowledge the investor’s need for long-term commitment.
• Standard vs. Negotiable: The 4-year vesting with a 1-year cliff is widely accepted as the market standard. Be wary if an investor proposes a significantly longer vesting period (e.g., 5+ years) or a longer cliff, as these can be less founder-friendly.
• Negotiate “Good Leaver” and “Bad Leaver” Definitions: This is critical. Ensure “good leaver” definitions are fair and encompass scenarios like termination without cause, disability, or death. Push back on overly broad “bad leaver” definitions that could unfairly penalize you for minor infractions. Aim for clear, unambiguous language.
• Push for Double-Trigger Acceleration: While single-trigger acceleration is great, double-trigger offers more robust protection. It prevents a scenario where your shares vest on acquisition, only for you to be terminated immediately afterwards without cause, leaving you with little ongoing involvement or compensation beyond the initial vested shares.
• Consider “Prior Service” Vesting: If you’ve been working on the company for a significant period before the investment, you might negotiate to have a portion of your shares immediately vested or to have the vesting commencement date backdated to reflect your past contributions.
• Align Vesting with Company Milestones (if applicable): While time-based vesting is standard, if there are critical, measurable milestones that genuinely signify a significant value creation, you could explore a hybrid approach where a portion of shares vests upon hitting those milestones.
• Impact of Re-vesting in Future Rounds: Be aware that investors in future rounds might request re-vesting. Plan for this possibility and be prepared to negotiate. Often, a reasonable compromise involves applying a new vesting schedule only to new shares issued in that round or for a smaller percentage of existing shares to be re-vested.
• Tax Implications: Vesting has significant tax implications. Consult with a tax advisor and legal counsel to understand how vesting and any acceleration events will affect your personal tax situation.
• Get Experienced Legal Counsel: This cannot be stressed enough. A lawyer specializing in venture capital deals can help you understand the nuances of the term sheet, identify red flags, and negotiate favourable terms. Do not try to navigate this complex area without expert legal guidance.
• Don’t Lose Control of the Narrative: Even if the overall terms are not entirely in your favour, ensure the term sheet doesn’t undermine your ability to lead the company. Balance financial terms with control provisions.
• Maintain Clarity: Ensure all vesting terms are clearly documented in definitive agreements (e.g., shareholders’ agreement, articles of association) to avoid future disputes.