A founders agreement is undoubtedly one of the most important agreements that must be present when starting a business with more than one person. The agreement itself contains duties, responsibilities, assignment of intellectual property, vesting and much more. A vesting clause can be found inside the founders agreement and can save many founders from potential problems with equity down the line.
These problems occur very commonly and are attributed to some of the top 5 reasons for why startups fail.
What Does Being Vested Mean?
Let’s start by explaining the purpose of a vesting clause. A vesting clause is a section in an agreement that refers to equity. More precisely, the vesting clause outlines how the equity of a business will be handled. Vesting clauses require that founders or employees work for a certain amount of time for their equity. The standard vesting period is four years, with a one-year cliff period. For further understanding of what vested means, please refer to the example below:
Suppose there are two founders starting a brand new marketplace company. They agree that each founder will get 30% equity. The founders sign an agreement containing a vesting period clause. The clause states that the vesting period will last four years, with a one-year cliff period. This means that the founders will need to work five years before they each can receive their 30% equity.
The one year cliff period means that the founders must work one full year before they can start to earn their equity. Hence, the vesting clause means that the founders will work the first year without any equity and then, each year after that, they will receive ¼ of their 30% equity. A total of five full years must pass in order for them each to accumulate their whole 30% equity share.
Why Is Being Vested Important?
It is important because having the vesting clause will save founders from disputes that might arise with people owning equity. Here are two more examples highlighting how vesting clauses can help a founder.
1. Two founders have an argument about the future of their company
The discussion turns more hostile and one of the founders decides to quit. Each founder had a 40% equity stake in the company that has been operating for only one year. No vesting period has been agreed upon. Thus, the founder could exit the company with his 40% and there isn’t much the remaining founder can do.
The remaining founder could try to buy back the equity from the exiting founder or go through a lengthy legal battle that will leave the company destroyed. However, if there was an agreed upon vesting period, the existing founder would leave the company with 0% equity stake after only one year.
2. Suppose there is one founder and one employee
The founder offers the employee 2% equity, which the employee accepts along with a vesting period agreement. The vesting period is for four years and a one-year cliff period. The employee eventually decides to leave the company after working three years. Thanks to the vesting period agreement, the employee will only get ½ of what was promised, in other words a 1% equity stake.
This equals one year of employment without any equity plus two years of employment, or half the term of service, for half the share of equity promised.
Final Words: Explaining Vested
So what does vested mean? Hopefully, by this point, you are able to answer this question and understand the importance of vesting clauses in a founders or any other agreement that handles equity. Whenever going into an agreement with another founder or an employee, always make sure both parties sign an agreement with a vesting clause.
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