When you found a startup, some may assume that you immediately gain ownership of it in the form of stock. If you are a single founder, this may in fact be true, and you will often vest (that is, receive) all of your stock immediately.
However, in the more common situation of multiple co-founders, it is customary that the stock given is subject to a vesting schedule in the stock purchase agreement. The main reason is simply that founding teams might not stay intact.
Take startup Fundco:
Fundco has four co-founders. They decide to split the ownership equally, and each receive 25% of the outstanding common stock. However, they use no vesting provision, instead opting on a handshake agreement that, declaring they are each “All in.” Two weeks later, they fight over the creative differences, and two of them leave.
This means that 50% ownership of the company is held by non-employees, who have no vested interest in the success of the company. This also means that they’ll own 50% of the company without having put any additional work in, other than being present in the beginning.
If that weren’t bad enough, many corporate actions require shareholder approval. This makes Fundco extremely unattractive to potential investors, as 50% of the shareholders of them cannot be relied upon.
What should Fundco have done?
Fundco should have issued stock according to a vesting schedule, similar to the standard (and abbreviated) provision below:
All stock issued to employees, directors, consultants and other service providers will be subject to vesting provisions below unless different vesting is approved by the majority consent of the Board of Directors:
25% to vest at the end of the first year following such issuance, with the remaining 75% to vest monthly over the next three years.
The outstanding Common Stock currently held by _________ and ___________ (the “Founders”) will be subject to similar vesting terms provided that the Founders shall be credited with one year of vesting as of the Closing, with their remaining unvested shares to vest monthly over three years.
This provision states that employees will receive 25% of their stock only after having worked at Fundco for one year. This requirement is known as a cliff. After that point, they will receive 1/48 of their stock monthly.
Of note, this provision provides a different schedule for founders, and eliminates the cliff requirement for them. This is sometimes done to recognize that the founders have already put in substantial work before the issuance of shares, and thus deserve compensation for it.