Not vesting their stock is a common legal mistake new startup founders make.

Early on in our funding cycles, I help the founders set up all the initial legal and incorporation paperwork. (I’m not a lawyer, but I’ve gone through it about 60 times by now.) Y Combinator’s philosophy on legal paperwork is that it should be as simple and straightforward as possible. We hate it as much as founders do. When we first started out, we didn’t include vesting in the paperwork because we didn’t want to be overbearing investors.

Boy, am I singing a different tune more than 2 years and 5 funding cycles later. It’s like I’ve taken a “Scared Straight” course in corporate law. I’m exaggerating a bit, but the point is that there are so many disasters looming out there for startup founders, why not arrange to avoid one?

What is vesting? It’s when the founders voluntarily agree that instead of getting all their stock up front, they’ll earn it over time. There's no set rule for vesting schedules, but the most common are 25% per year (vesting monthly or quarterly) over 4 years, or 20% per year over 5. Usually there's a 1-year "cliff," meaning people who leave after less than a year get nothing.

Once you’ve issued your stock, you then need to file a form called an 83(b) election with the IRS. You have 30 days to do this or you can face hideous tax repercussions. Many paperwork oversights can be fixed later, but this one can’t.

Yawn. You must now realize why founders don’t want to deal with all this: it’s boring! Why attend to legal paperwork when you can be working on your software and planning to take over the world? Because if you don’t have vesting and one of the founders leaves with a large chunk of your startup’s stock, you will waste a lot of time and money to fix this situation. One YC-funded startup that didn’t have vesting had one of its founders leave within the first year. Here’s what one of the remaining founders told me about the aftermath:

“The biggest thing by far was the legal and accounting fees we had to incur (+$20k) and the time and stress associated with dealing with something like this.  Hours and hours on the phone, reading over documents that weren't explained well by lawyers, trying to understand from an accounting and tax perspective what we were getting ourselves into, etc.  If we had the vesting agreement, it would have ALL been unnecessary.

Everything is roses when the company is first starting-- you're excited, you're even thinking about the people you're working with differently, i.e. any misgivings you may have you're lessening in a ‘let's see how it goes’ attitude, or ‘things will be fine once we get started’ attitude, so obviously you don't worry about it as much.”


Several of our startups have had founders leave early on. For those groups without vesting, some founders gave back the stock voluntarily and some didn’t. But you don’t want to have to rely on your cofounder’s opinion about how much stock he/she deserves to keep. You want to be clear from the start about what someone will walk away with if they leave.

I couldn’t blame someone for leaving. It usually means things aren’t going well for the startup-- you can’t get users, you can’t get funding, your bank account is dwindling, you are demoralized-- and you need to pay your bills after all. But what about the founder who sticks around, making huge sacrifices to keep the startup alive a la Evan Williams? How would that founder like to be broke and working around-the-clock on the startup while the founder who left is sharing equally in the upside? Kind of embittered I think.

Also, think of your future investors. It will be a major red flag if you have to inform them that someone who owns 25% of the company now works elsewhere and doesn’t have anything to do with the startup. They don’t like it when someone owns a large portion of stock and isn’t “adding value.” They’d want (as you should too) that stock to be motivating a new employee who would be busting his hump on the startup.

Professional investors expect vesting and will likely impose it upon the founders anyway as part of their investment.

If you are lucky enough to afford lawyers to set up your corporation, they will obviously help you with all this. But many founders can’t afford their fees so early on. If you are using online services to incorporate (which I wouldn’t recommend), make sure you set up vesting. If you have already issued stock to the founders without vesting, look into setting it up retroactively. I think it’s pretty easy to do.

Most founders don’t think they are going to need vesting, but roughly 20% of the startups we’ve funded had a founder leave within the first year. So if you are thinking, “We don’t need vesting,” you are in the company of a lot of people who were wrong.

 


Comments

07/22/2007 16:11

Can we do all this without a lawyer?

i.e. is it a 5-step process with 3 standard forms?

If you can point us to where we can learn more on doing this by ourselves, that will be very good.

07/22/2007 17:55

Hi Jessica-

Thanks for the post, definitely going to buy the book. Do you offer initial legal and incorporations paperwork services outside of YC or only for YC start ups?

If not, do you know of any firms or individuals in the bay area (San Francisco to be exact) that are good at this sort of thing?

Thanks again!

Steve Kane
07/23/2007 09:00

The problems you describe are real, but I think the answer is not vesting - -which is a radical ripoff of founders core asset, their equity, and essentially always deprives them of their long term capital gains status (unless they file with the IRS and then wait for one year AFTER the distribution from the liquidity event/exit.

The solution is for founders to issue themselves restricted stock grants, with one restriction being a "vesting" schedule. So if a founder leaves, they only get to keep the restricted shares that have vested, but they get the founders "basis" and tax treatment without any complications.

BTW, I assume given your poistion here that you are also wildly in favor of making VC investors sign up for draconian "pay or play" provisions?

08/09/2007 09:52

So does that mean YC forces the founders to have vesting, or is it still optional.

Glauco
07/29/2008 09:31

I just found a company and I am in the process of putting together our shareholder agreement, at the moment our founders vesting provision. Should I do myself or should get attourney's help?
Thank you


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