Why Reverse Vesting is Important for Startups
Reverse vesting is an agreement between a startup and its founders that is designed to increase loyalty and protect the company
When founders launch a startup, they immediately get equity. Reverse vesting ensures that if a founder leaves the company before the specified period is over (usually four years), the company can purchase its share of equity for little to no cost. During the reverse vesting period, the founders retain all the rights that come along with shareholding, but if they leave the company before the period is over, the shares and rights are relinquished.
Conversely, the vesting refers to an agreement for employees to acquire rights to company shares that have not yet been issued. In an ESOP — employee stock ownership plan — employees can acquire these shares by reaching certain conditions, like working in a startup for a certain number of years or meeting specific goals. Vesting allows employees to control their shares once the conditions are met.
Why Is Reverse Vesting Important?
The purpose of reverse vesting is clear — it ties founders to their startups and protects the company, co-founders, and investors. If founders were to leave and take their portion of shares with them, the startup could quickly tank. It could also prevent the company from attracting future investors.
Many reverse vesting agreements include a clause to protect founders who get dismissed from the company without cause. The “good-leave clause” states that founders must surrender their non-vested shares if they leave of their own accord or are fired with cause. In any other situation, founders can retain their shares.
Other components of a reverse vesting agreement include:
The names of the people participating — founders or cofounders
The portion of the shares that must revert to the company — usually, founders do not need to give back all their shares. The standard ratio is 75%-25%. The company gets back 75% of the founders’ shares and they keep 25%.
The reverse vesting period — usually four years but may vary
The price of shares should the founder leave before the period is over
Benefits of Reverse Vesting
Reverse vesting is designed to protect the future of a company, whether it remains connected to its original founders or not. Benefits of reverse vesting include:
Founder commitment — A reverse vesting agreement motivates founder commitment. Founders know that the only way to hold on to their shares is to continue with the company for four years.
Real interest in the company’s success — Not all startups last four years, but a founder who is invested in the company will work hard to ensure its success. A founder who leaves after four years can still hold on to his shares, which means that the success of the company is in everybody’s best interest.
Keeps ownership within the company — Without a reverse vesting agreement, a founder who owns the majority of shares and leaves would essentially dismantle the startup. With a reverse vesting agreement, however, a founder can leave and the majority of equity would revert back to the company, thus protecting other investors and employees.
Tax benefits — With reverse vesting, the founder doesn’t take ownership of the shares until the waiting period is over. This reduces the tax burden on the founder, since the shares are acquired at a later date. It also means that the founder’s worth can go up as the shares of the startup increase in value.
How Does Reverse Vesting Protect Investors?
Many investors will only consider startups that have a reverse vesting agreement in place. In fact, many startups launch without a reverse vesting agreement in place but draft one as soon as they start their first round of funding. Why is a reverse investment agreement so important to investors?
In many cases, startups and their founders are marketed together. Investors are attracted to strong leadership as much as they are to specific products. A reverse vesting agreement increases the likelihood that a founder will stay with the company, which is what investors want. Additionally, it ensures that if a founder leaves in the early years of the startup, the company will be able to continue without losing a big chunk of its shares.
If you are launching a startup or kicking off your first round of funding, having a reverse vesting agreement in place is crucial for making your company an attractive investment choice.
