How Might an Investment Affect my Ownership Stake in my Startup?

Question: How might an investment affect my ownership stake in my startup? 

Answer: As the founder of a startup your vision and expertise are vital to the company’s success. As such, investors will seek to incentivize your continued participation.

One of the ways in which investors achieve this is through reverse vesting. Put simply, reverse vesting involves granting the company the right to buy back your shares at their issue price if you decide to leave. Over time this right gradually diminishes, reducing the number of your shares the company can buy back and giving you a greater unrestricted ownership in the company. The purpose of reverse vesting is to ensure that if you leave early in the startup’s life cycle you can’t take your entire ownership stake with you.  The shares that are bought back can then be issued out of treasury to attract new talent. The typical reverse vesting schedule is three or four years in length, contains a one year “cliff” followed by monthly vesting, as well as acceleration events, or “triggers”.

Key characteristics and conventions of most reverse vesting structures include:

1) Cliff: A cliff is a period of time at the beginning of the vesting period during which the company can repurchase all of your shares if you leave. This is done to ensure a minimum period of continued contribution and to avoid creating trivial ownership interests.  In situations where the founders have started the company a year or more prior to the investment, they may receive one year of vesting credit and vest the balance of their shares monthly over three years.

2) Single Trigger: A single trigger is an event whereby the company loses its right to repurchase your shares, effectively accelerating your vesting.  A typical single trigger is the sale of the company to a third party. On the happening of this kind of event, you would be able to keep your shares even if you resigned.  Single triggers are more commonly used in cases where the individual in question is not a key member of management and therefore less valuable to an acquirer.

3) Double Trigger: In contrast to a single trigger, a double trigger requires two events to occur before the company loses its right to repurchase your shares. Often the first event is the sale of the company and the second event is the founder being let go without cause (and sometimes only within a certain period of time). Double triggers are more common than single triggers because investors/acquirers want an incentive for key personnel to stick around post acquisition.

4) Good Leaver: Fairly written reverse vesting provisions contain a “good leaver” clause that sets out conditions under which the company loses its right to repurchase your shares. The typical example is if you are fired without cause.

To illustrate, assume that after receiving funds from an angel investor you maintain a 50% share in your start-up subject to a four year reverse vesting schedule with a one year cliff and a double trigger. If you leave at any time before the first year, the company will have the right to repurchase all of your shares. If you leave after two years the company’s right to repurchase your shares will have reduced by half, leaving you with a 25% stake (assuming no additional shares have been issued).  If, on the other hand, the company is taken over after two years and you are fired six months post acquisition, your vesting will accelerate and you will be able to keep all of your shares.

At first glance the concept of reverse vesting may seem like a scary proposition for most entrepreneurs. It is important however to understand how reverse vesting can be used to your advantage. At the early stages, the value in your startup is derived directly from your ideas and expertise. As such, you can maximize your startup’s value, and therefore the interest you receive from investors, by showing a willingness to commit to the long-term success of the company through reverse vesting. Investors will most likely demand some form of reverse vesting anyway, making it vital that you understand how to best protect your interests when negotiating investment terms.  

In summary, if structured fairly, reverse vesting terms can benefit you, your company, and your investors.  But as with anything, the devil is in the details.

(Note: this is not legal advice. Make sure you have a clear understanding of corporate law or consult a professional before entering any agreement.)