The short answer is, it depends…
This is a follow-up post to the one I wrote on vesting, if you haven’t read that then I’d recommend starting here.
Now it’s pretty much universally accepted in early-stage financings that vesting is a crucial term to include and get right. However, following numerous discussions with founders we have backed recently, it seems that there remains confusion around how the mechanics of vesting play out in the event that a founder leaves. We hope this mechanism never needs to get used but shit happens and I always encourage founders to clearly understand each and every term on their term sheet so there are no unnecessary surprises down the road.
As ever, exactly how it works is dependent on the specific terms but broadly speaking there are a few ways that I’ve seen this structured in practice and they often hinge on the question of whether the founder is a good leaver or a bad leaver.
The most typical elements (note: this is not an exhaustive list) that these key concepts cover are:
- Good Leaver – A founder who leaves in circumstances where they are generally not at fault e.g. death, permanent incapacity or where they are wrongfully terminated
- Bad Leaver – A founder who leaves in circumstances where they have done something wrong e.g. gross misconduct, criminal offences like fraud or other termination with cause
Once you’ve determined if they are a Good or Bad Leaver, then the question becomes how much have they vested?
A Good Leaver will usually be required to transfer the shares they have vested and are entitled to to the company when they leave and will receive “market value” for the shares they transfer. Alternatively, they may be allowed to retain their vested shares. This is seen as fair because they have built value in the company and should be entitled to such value and the way they have left is through no fault of their own.
A Bad Leaver is generally, as a default position, required to transfer the shares they have vested back to the company at nominal value (often a very small amount, e.g. £1). This is sometimes limited to the most serious type of bad leaver scenarios and there is usually some discretion of the board/company built in.
How is this actually achieved by the company in practice?
The mechanism of how the company deals with the transfer of such shares is set out in the company’s articles. Shares could be bought back by the company, transferred to an option pool, made available to a new hire / joining founder (maybe via the option pool), or offered to the other shareholders. I often see Bad Leaver shares automatically converted into worthless deferred shares. I understand from counsel (although tax advice should be sought) this can be helpful, as it is tricky to transfer shares to employees below market value without creating tax issues.
What about the unvested shares?
The default position is that all unvested shares are treated as worthless regardless of how the founder leaves the company. Again, there could be some discretion available to the board that they may look into in the event of a Good Leaver.
The caveat to this is in the case of an acquisition, where there may be an acceleration of the vesting schedule so that a proportion or in some cases all of the shares become vested. Often not only the acquisition but also the firing/departure of the founder is required to “trigger” the acceleration. This is referred to as “double trigger acceleration” (acquisition + leaving). The theory here is that this is fair because if there is an acquisition and the founder is fired/asked to leave etc. then they have done nothing wrong and should be entitled to all their shares. Also, the double trigger ensures that there is a mechanism to protect the acquirer from having a disincentivised management team in the event they don’t fire them and want them to continue to work in line with their vesting schedule.
Anything else to consider?
Lots! The above is a framework and sets out the basics of how the good leaver and bad leaver provisions interact. Its a basis to start from and often negotiations, either at the term sheet stage or when a founder is departing will lead to variations of the above.
Firstly, I truly believe that any vesting schedule should be seen as not only an investor protection provision but also a founder protection provision (i.e. something that protects founders from each other). My view is that investors can provide frameworks but it is crucially important that founders buy into the benefit and structure of any vesting schedule. A well-designed vesting structure and leaving mechanic puts the company in the best possible position to weather any future storms. I generally recommend a clean and concisely drafted version of the “Good Leaver, Bad Leaver” mechanism as the best approach. This appropriately recognises work done by founders by allowing the retention of some or all vested equity whilst also providing an approach should founders leave before a startup’s journey is complete.
Originally posted on Medium.