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Sep 23, 2019

Reverse vesting

How to save a startup from its founders, avoid potential conflicts between people in charge and, above all, how to have the cap table under control since the start to avoid the risk of building an uninvestable startup.

 

In my recent article about the uninvestable startup here, I have defined the most common problems which startups are facing in the regards to their cap and prevention strategies of those problems. One of the preventive mechanisms is reverse vesting.

What is Reverse Vesting?

Reverse vesting (RV) is an obligation of the founders to resell a part or all of their shares (usually for a symbolic amount) to the other cofounders in the event of them leaving the company before a certain period of time (usually 3-4 years after the company was established). During the reverse vesting period, cofounders keep all of their rights tied to their shares, including the right to vote at the shareholders meeting or the right to a dividend.

What is the purpose of reverse vesting?

The purpose of the reverse vesting is primarily to tie the founders to the company to avoid their sudden departure. Such regulation protects the company, other co-founders and investors against the departure of a founder / cofounder with a large share in the company. During early-development stage, startup is heavily dependent on its founding team, who receive equity (shares) in exchange for the full-time involvement. The departure of a cofounder who holds, for example, half of the shares in the company, might preventing the company from raising subsequent rounds of financing (a startup whose half-share cofounder leaves would be uninvestable for most investors).

What is the Difference between Reverse Vesting and Vesting?

Vesting is an acquisition of the not yet issued rights to shares by employees (under the so-called ESOP, i.e. the employee stock ownership plan). In other words, vesting is a promise of transferring / selling shares to employees after reaching certain conditions or performing pre-agreed results (usually working in a startup for a specified period of time, or delivering specific KPIs / goals by a given employee). On the other hand, reverse vesting applies to already existing shares owned by founders and regulates the need to sell those shares in the event of their departure from the company before a specified time.

When should you implement dot reverse vesting records?

The arrangements for reverse vesting should ideally arise immediately upon the creation of the startup (and if at the time of creation there is only one founder, then at the time of joining of the co-founders). Unfortunately, this is a rare practice, especially in Central Eastern Europe. Therefore, reverse vesting regulations are most often implemented only when a professional investor enters (ex. VC). I have not met a startup during my career that would have implemented reverse vesting regulations before the entry of the fund. It illustrates the degree of awareness for such mechanism by founders in Poland and Central and Eastern Europe.

Examples of the Reverse Vesting Regulations:

Reverse vesting agreements may include the following key regulations:

  • List of the company shareholders participating in the program
    • reverse vesting relates to shares held by the cofounders
  • The pool of the shares covered by the program
    • in case, reverse vesting agreements are signed at the very beginning startup founding. Reverse vesting might be applied to the total amount of the issued shares held by each of the co-founders. However, if the reverse vesting agreement had been signed a few years after the startup incorporation (e.g. during the investment of VC fund), the reverse vesting agreement may be partial (e.g. 75-90%). In other words, it might not cover all of the shares held by a given cofounder.
  • Reverse vesting period
    • period of 3-4 years. Usually, reverse vesting contracts have vesting records, i.e. the longer the cofounders work in a startup, the fewer shares they would have to sell at the time of leaving,
  • Sales price in the event of cofounder leaving before the end of the reverse vesting period
    • the most common practice is setting the price at the same level as the nominal price of the shares,
  • ‘Good leave’ records
    • you can often find ‘good leave’ entries in reverse vesting agreements. In this case, a company releases a cofounder (in any other case than acting to the detriment of the company). Cofounder retains all its shares regardless of the remaining duration of the reverse vesting program. These types of provisions are intended to protect the cofounder against the loss of its shares if he/she leaves the company not voluntarily or is released for any other reason than acts to the detriment of the company.
While it is the responsibility of the founders to determine the details of the reverse vesting agreement, I strongly encourage you to engage a lawyer to construct a contract based on it.

 

In conclusion:

  • A reverse vesting agreement is an agreement binding the founders with the company to avoid the situation of their sudden departure.

  • These types of provisions protect the company, other co-founders and investors from the departure of a founder/co-founder with a large share in the company.

  • Ideally, a reverse vesting contract should be established at the time of the creation of a startup, but it is never too late to enter into such a contract.

Paweł Maj

Investment Director of bValue VC

Paweł Maj has over 19 years of experience working on capital markets in the investments (including venture capital transactions, pre-IPOs as well as investing in distressed assets, he participated in dozens of transactions with combined valuation of €25m., several of which ended with successful exits – among them 5 through Warsaw Stock Exchange IPOs) and advisory capacity (including advising with IPOs, SPOs, M&As and debt financing; participated in dozens of projects, with overall transaction value exceeding €180m., the largest and most complex project that he worked on are Konsorcjum Stali S.A. and Gobarto S.A.).