What Happens When A Founder Is Fully Vested?
Let’s say you are the founder and CEO of a startup and you have now been at it for four years. The company is doing great, you’ve raised several rounds of financing, you have a product in the market that is solving a real problem, you have a bunch of customers, you have a growing team, and things are stressful but largely great.
And you realize that you are now fully vested on your founder’s stock which means if you were to leave the company tomorrow, you get to keep all of it. What do you do about that?
This is a common question I hear from founders. They ask me what is standard in this situation. And I tell them that not only is there no standard answer, that this is one of the most emotionally charged issues to come between founders and their investors and boards and companies.
This situation also exists for other founders who are not the CEO, and the issues are very similar, but for the purposes of keeping this post as simple as possible, I am going to focus on the founder/CEO role.
Here are some, but not all, of the issues that come into play in thinking about this:
1/ If a founder/CEO were to leave their company after they become fully vested on their founder’s stock, the company would have to go out and hire a new CEO and that new CEO would get an equity grant that would be between 2.5% and 7.5% of the Company, depending on the value of the business. So one could certainly argue that the founder CEO ought to get similarly compensated.
2/ But that argument about how a new CEO should be compensated essentially puts on the table the question of whether the founder CEO is actually the best person to run the Company right now or if there is someone better suited to do that who could be recruited for a new market equity grant. It is often not in everyone’s best interests to have that conversation.
3/ Many founder CEOs four years in still own a lot of their companies. A typical range would be between 10% and 40% depending on if there are co-founders and how much capital had to be raised in the early years and at what valuations. For most situations, an equity grant that would be made to a new CEO is actually a relatively small percentage of the overall equity ownership of a founder CEO and in the context of that, it is not as valuable to the founder CEO as many other things.
4/ However, the founder CEO is subject to additional dilution in subsequent rounds so a new grant would at least partially offset future dilution and that is quite attractive to founder CEOs.
5/ One of the most valuable things to a founder CEO is having a large unissued equity pool from which to hire talent into their company and any allocation of that pool to the founder CEO reduces that asset.
6/ It is generally a good practice to have all executives vesting into some equity compensation. It standardizes the executive compensation program and aligns incentives.
7/ Refresh grants for executives are not usually equal to their sign-on grants. They are usually some percentage of the sign-on grant. So the same should be true of a founder CEO getting a refresh except that they never got a sign-on grant.
8/ Investors bet on the appreciation of the equity they already own not the issuance of new equity. A founder is aligned with the investors when they too are focused on making the equity they already own more valuable.
9/ When founders get diluted below double-digit ownership, they begin to see themselves as employees, not owners and that is bad for the company, the team, and the investors. For some founders, they start to feel that way at below 20% or 15%.
10/ It is hardly ever the case that what happens after a founder is completely vested is negotiated ahead of time, during the various rounds of financings, and priced in by the investors. If a founder was to pre-negotiate a new “market grant” for themselves once they are fully vested, and that was included in the size of the option pool that is set aside and baked into the pre-money valuation, investors could model that future dilution and build that into their valuation models and price that into a round. But nobody does that because founders want to maximize valuation in the financing rounds and investors assume that the founders will be happy with their initial grant or will not be around to earn it. Both parties either naively or purposefully kick the can down the road until the issue rears its head and then the emotions come out.
So what happens in practice?
It depends entirely on the situation at hand.
If the founder CEO owns a large percentage of the business, a new grant is rarely made because the value of it pales in comparison to the annual value that their founder’s equity is increasing organically.
If the founder CEO has been massively diluted and owns a small percentage of the business, a new grant is often made.
If the business is performing very well, the likelihood of a new grant is higher.
If the business is performing poorly, the introduction of the idea of a new grant can be very destabilizing and can actually precipitate a larger conversation about who should be running the company.
A common area for compromise is a new grant to the Founder CEO that is some percentage of what a “market” grant to a new CEO would be and that percentage ranges from 20% to 50% depending on the situation. The less a founder owns of the company, the higher the percentage will be and the more a founder owns, the less that percentage will be. If a Founder owns more than a quarter of the business, this is almost never done. I certainly have never seen it done for founders who own more than a quarter of the business.
I have two suggestions for how entrepreneurs should handle this issue.
The first suggestion is that you might want to
The second is that if you wait to raise this issue once you are fully vested, do it carefully and delicately. If it is seen as a demand, it will not go well. If it is seen as a discussion about what is in the best interests of the company, it will go better.
But most of all, remember that there is no “one size fits all” solution for this situation and that you and your board will have to figure it out on a case by case basis.
As a lowly executive, some of the best advice I got early in my career was to look for companies whose boss was NOT the owner.
I always interpret a founder’s asking for additional share grant after his shares are fully vested as a sign of “lost heart” because in a way it feels as if he was willing to put the company at risk (by leaving the company) in exchange for more financial benefits. Somehow, once I have to see a founder more as a hired professional manager, the trust goes down the toilet. It is a situation that creates enormous emotional complexity. In China, it is not uncommon that every round of investments asks for a fresh cycle of founder share vesting because no one wants to deal with this kind of situation. If the founders account for a significant portion of the valuation, they just have to stay on. If they are no longer fit to do their jobs, they have to leave a significant portion of their equity behind for new hires.
as a sign of “lost heart” because in a way it feels as if he was willing to put the company at risk (by leaving the company) in exchange for more financial benefits.You could also look at it as being savvy enough to know how to play a situation to their benefit … and that skill is a benefit to the company. They are not trying to leave they are trying to get more of the gold for themselves. Leaving and bluffing to leave are two completely different things.
Similarly you could have “bad” or inexperienced investors who don’t know the game well, not understand their own hand or the quality of hand the founder/CEO has and holds. Founders, and likewise investors, will develop this to whatever level their intuition and experience allows for – and for whatever tolerances or boundaries they realize they have. If there’s trust and confidence on both sides and greed isn’t too heavily a factor (or not at all) then everything will balance out according to the perceived level of future success. If you’re investing in a passionate fighter, you better be strong too (including emotionally) – and then it’ll feel like friendly sparring (a good workout) and conversation than unexpected trauma or shock.
What is the motivation of a founder to accept money from those investors if its shares unvest? Do you draw any distinctions based on the company as a going concern?
Seems to me #2 is the biggest driver of how negotiations play out … if the company is doing well investors will want to incent the Founder / CEO to stay. If not, the CEO is opening the door to an uncomfortable (albeit, likely inevitable) conversation.Question … how often do founders have anti – dilution specified in their employment agreement?
Never Unless it is a newly hired CEO and they are being protected from a round that is about to happen. Then it is very common
I know I say this as a “comment” and not the real world, but to me it should be the way you treat all employees. As companies grow, some team members grow and scale with it; those employees should get new refresh grants and all other market perqs; those that do not grow, scale or do not want to should not receive those grants and their roles (as I’m sure at good companies) are re-evaluated at each stage of growth. The same should apply to all team members including the CEO. In the CEO’s case however, I’m guessing that many intangibles will play into that evaluation.
I agree with your assertion
Some companies do grant ownership or profits share to all of their employees so your sentiment is shared (at least minimally) in the real world. I did it at my last company and will do it with my current company.
Seed stage investors potentially have some pretty adverse dilution consequences in a refresh depending on how their term sheets were written
Practically speaking if you’re the CEO of a startup doing well, you could probably hold the investors hostage a little bit ala asking for higher comp or cashing some out.Yes they could find another CEO, but they really don’t want to get the rep of replacing founder CEOs of well performing startups.Founders take higher equity risk so when they earn the milestones needed to fully vested, and great jockeys are hard to find, they’d probably win most of those negotiations.
For successful CEOs you got to learn and know finance before you get fleeced
Is it really getting ‘fleeced’? If you are playing sports (correct me if I am wrong) the opposing team does not help you with your decisions or strategy. It’s up to you to protect yourself and drive the vehicle over the finish line. ‘Fleeced’ isn’t even close to correct. I don’t even like ‘taken advantage of’. I am sure the same people automatically know that the car dealer isn’t acting in their best interest. And some might even know the local realtor isn’t in all cases either.People getting angel and VC funding tend to be either highly intelligent, highly motivated, academically gifted or all three.  As such it’s up to them to know and understand enough to not get ‘fleeced’. We are not talking about payday lenders in the hood is my point.TMI time: When I got remarried I got a pre-nup drawn up. I told my wife specifically that I wanted her to hire someone to review it (was not obvious to her I might add) and I didn’t want her to trust me. As much as I was trying to be fair I wanted another set of eyes to give it a once over. I take exception with words in a business setting that indicate that someone is getting taken advantage of except on rare occasions. Definition of ‘fleeced’ appears to be “to deprive of money or belongings by fraud, hoax, or the like; swindle” And some are even really good looking. (Both men and women..)
I think that getting fleeced legally also exists.Being clear and transparent from the beginning is the key. Clear expectatives, agreed financial and growth goals and what if scenarios, in advance. No surprises. Get a JLM.
Also get a ‘Morty’.https://avc.com/2018/03/not…A ‘Morty’ is someone who may not specifically know but is cantankerous enough to not be afraid to ask some questions.This is actually a bit of a trojan horse strategy. You let the other side think you don’t know what they are doing and you use it against them and surprise them after they think they are taking advantage of you (if they are of course).
That’s why you need to know the rules of the game. Otherwise playing at major disadvantage
Yes and the first rule is to recognize that it is a game.
Make your own game that people want to play – with rules you set. Tolerable boundaries will change with economies of scale in mind, with abundance in mind rather than scarcity and fear. It’s kind of funny how people always say “think outside the box” – however then the VC model is always trying to fit and select for everyone inside a specific box, not accounting for nuances – out of mostly planning and accounting for the value of economies of scale for the VC model to work.
.In life, you do not get what you deserve, you get what you negotiate.JLMwww.themusingsofthebigredca…
Your negotiating skills dictate what you deserve, just saying.. and your negotiation skills depend on clarity of thought, feeling – ability to navigates these, etc. Patience is important, too, when it comes to negotiating.
.The ability to negotiate is like any other intellectual skill or physical skill — you have to learn it — hopefully, from someone who is good at it.it is also something you can delegate to an attorney or other rep. I have directly assisted countless persons in negotiations.There is no excuse for not getting a well negotiated outcome. It is intellectual laziness to think otherwise.JLMwww.themusingsofthebigredca…
would have to go out and hire a new CEO and that new CEO would get an equity grant that would be between 2.5% and 7.5% of the Company, depending on the value of the business.Interesting. There is a time to get up to speed for anyone new but by the same token the ‘unknown’ could also be a great opportunity for new ideas. However by the same token also the disruption of someone new (who could fire existing staff or hire new staff to their liking) and 100 other things can could swing a situation. So unfortunately numbers are only one part of this.Seat of the pants it seems strange to me that the fact that having to hire someone new and giving them grants is a reason that the current CEO should get more as well. What if this happened with existing and regular employees? They come to the manager and say ‘well I not only want a raise but I want to be paid the amount you will have to pay a recruiter to replace me, the attorney to review a contract, and I also want the same signing bonus you’d give a new recruit as well’. Nobody does that or thinks of doing it right? So for whatever reason there is social proof with startups that allows this behavior then.
They come to the manager and say ‘well I not only want a raise but I want to be paid the amount you will have to pay a recruiter to replace me…’ Isn’t that the same behavior we see with Fortune 500 CEO comp? You are hired and receive an immediate incentive package, then if you leave, you receive a golden parachute.On the other hand, isn’t it just severance? And it’s more likely than not, cheaper severance than cash. As JLM said, that stuff should be managed in an executive employment agreement.
Being fully vested doesn’t equate to being fully liquid. If a good founding CEO leaves, and a less successful CEO comes in, and the company doesn’t do as well thereafter, then that would be a bad decision. But if a less successful founding CEO leaves, and the company does better after, then everybody benefits.
there is no direct correlation between being vested and being liquid at any time that I can think of.connected but completely separate.
How about the case where the departing CEO gets to cash out part of their vested equity? That’s another possible scenario.
.Another reason why a well-crafted Employment Agreement is critical to align short term and long term interests.This is the kind of thing which could be covered in a “resignation” or “termination, not-for-cause” provision.In many ways, a company should want to re-acquire its equity from a departing CEO if the future of the company is bright.JLMwww.themusingsofthebigredca…
Yup. Exactly. But the founding ceo prob didn’t have an employment agreement, unless they put one in place later.
So what would be the best situation for a successful 4 year company?- CEO/Founder in control and running the company.- Investors in control, CEO/Founder and board running the company.- Investors in control and running the company through a professional CEO.- Other..
.Totally depends upon which side of the table you are sitting on.JLMwww.themusingsofthebigredca…
If the company is successful (eg cash producing and/or lots of money in the bank), what about increasing cash comp? (Tons of scenarios here but generally how does the conversation go when transitioning from illiquid equity comp convos to liquid/cash based comp convos).
.This is one of those seemingly complex subjects which has a laughably simple solution if one has extensive operating experience.First, let’s remember that the first duty of the board of directors is to retain management to run the company.Shareholders pick the board. The board picks the management. The management runs the company.What is the solution?An EMPLOYMENT AGREEMENT.There are at least a dozen AVC.com persons reading this comment who know the truth of this as I have helped them negotiate an Employment Agreement. I was Skyping with one on Friday.In every instance, that Employment Agreement has answered the vast majority of the questions raised by this blog post.A board of directors has a duty to ensure stable and competent management in the same vein they have the duty to remove incompetent management.How does an enlightened board do that? They enter into an Employment Agreement which creates certain duties of notification which allows the board to replace a CEO in an orderly manner.A smart CEO enters into an Employment Agreement which entails a comp package which includes salary, benefits, short term comp, long term incentive comp, and something special (special is something like “deferred comp”).The “long term incentive comp” is what addresses this subject. The Employment Agreement sets the term of employment thereby removing that uncertainty as well as the conditions under which termination may occur.I have written about this extensively because I was a CEO for 33 years and have been advising CEOs on this subject for the last 6 years.http://themusingsofthebigre…Generally, VCs do not like Employment Agreements, but I argue that is because they don’t really understand how a well crafted Employment Agreement protects the long term prospects of the company.In the last year, I have spent half a day talking to three different VC firms on the subject. In every instance, they have arrived at a “model” document which addresses comp, term, removal for cause, removal not-for-cause, resignation by the CEO, change-of-control provisions, long term incentive comp and vesting — all the subjects which will have to be addressed if a CEO/founder heads for the door.Why not solve these issues up front when everybody is friendly instead of waiting until there is blood in the water?It is a very simple and orderly approach and it has worked for years. Get some advice from a CEO who has successfully done it. It is not rocket science.JLMwww.themusingsofthebigredca…
You did it again, 3 & 3 in the 7 game series, last of the 9th, down three, two outs, three on base, first pitch, “whack!”, grand slam, win the game, the series, the trophy, and maybe waiting somewhere in the stands a girl (PC version, “young woman”), 5′ 6″, 115 pounds, great face and figure, waist length blond hair, REALLY sweet, with nice beef stew and coconut cream pie at home just waiting!!!Again, once again, over again, yet again, one more time, read, kept, abstracted, and indexed!Fred, from what you wrote, my strong reaction was, a great post to have me be sure to remain a 100% business owner and sole proprietor, come hell or high water, the business going bust, whatever. With what JLM wrote, I see that if necessary I could consider a Delaware C corp, a BoD, an equity check, maybe, consider it, as a last option, maybe, not much chance, but couldn’t totally rule it out forever.Last night discovered that Microsoft from only earlier this year athttps://docs.microsoft.com/…has at least a relatively good explanation of ACLs (access control lists, since MIT MULTICS in 1969 the workhorse of computer security that I used at IBM and heavily on Prime) for the Microsoft NTFS (new technology file system, a workhorse, highly admirable, of Microsoft for 20 years) especially for Microsoft’s SQL (structured query language) Server database software. And, right, since I’m finishing up rebuilding my server computer, I need to understand how to work with ACLs for SQL Server. Microsoft’s ACLs are not just like those I’ve worked with before. Indeed, it appears that moving the hard disk that had my software test SQL Server database from my first, old, busted server to my new one has old Windows XP and now Windows 7 treating the relevant directory differently — XP sees the directory but won’t let me see any of the files, and Windows 7 can’t even see the directory and with a lot of requests to run CHKDSK (check disk, fix file system errors) had me guessing that I’d lost the database and would have to return to my last backup and do more ACL magic to get SQL Server to recognize it.The new server is astounding — AMD FX8350 processor, 64 bit addressing, 8 cores with standard clock speed of 4.0 GHz, 16 GB of ECC main memory, etc. Just from simple usage, it’s really fast! Recently got from Amazon two more SATA hard disks at 2 TB each. My back of the envelope arithmetic indicates that I could serve the world with a database of 150 TB; since in production that is nearly all read only, SSD (solid state disks) could go for years without wearing out, and about 10 large SSDs could supply the 150 TB at some astounding data rate and number of users per second, for just one copy, maybe 1000, for monthly revenue of ~$256 million. Ah, and own 100% of it!! “Look, Ma, no BoD! So, they can’t fire me or take my company!!”.
What do you think the market definition of “cause” is within an EA?
.You start with “crimes of moral turpitude” and walk the cat backwards from there.In the #MeToo pogrom, it is difficult to find equilibrium, but any fair arrangement is going to call for a detailed, written notification of wrong doing, an opportunity to confront the accuser, an opportunity to cure the wrong doing, and a clear method of disputation (court of law or binding arbitration).This is why the terms for “not-for-cause” termination are so important why an Employment Agreement is so critical.Most companies would be better situated to exercise their “not-for-cause” termination right and pay either a year’s severance or the balance of the term of the Employment Agreement.Legal fees are staggering and you may face a wrongful termination counter lawsuit which you cannot get clear of.If you have a large D & O policy the company loses the ability to control the litigation.Litigation with C-suite employees is never a good idea. They know too much.It is better to buy peace than to fight over it.JLMwww.themusingsofthebigredca…
How do you “cure” acts like fraud, sexual harassment, being a jerk that causes other people to quit, etc? Why should you be able to cure character flaws that are unlikely to ever truly be cured?
.Not every “cause” is curable.Some causes are still grounds for dismissal even if cured — as an example embezzlement.I am not taking any position on whether something should be or should not be “curable” but you are going to have to specify reasons, give people the right to challenge them, give them the right to cure them, and, only then, dismiss them.That methodology is a “one size fits all” approach which may or may not work based on the specific charge, but it is the basis for most state law.Fail to follow it, and you face a wrongful termination lawsuit.Remember we are talking about “for cause” dismissal under a negotiated Employment Agreement.If the employer and the employee cannot figure it out, they should look for another line of work.The employer is getting something — a clear path on how to get rid of a problem.The employee is getting something — protection from a random act of employment cruelty.JLMwww.themusingsofthebigredca…
Much appreciated. Tho Seems like the EE clearly gets a benefit of certainty. But the employer is just locking itself into financial obligations, knowing non-competes are hard to enforce and the EE could walk if it really wanted to. Seems good for lawyers and an asset for EEs but essentially debt for ERs, no?
.A sophisticated board knows how to craft an Employment Agreement which incorporates terms which can protect intellectual property (confidential, proprietary, trade secret info) as well as provide a basis upon which to re-purchase prior grants of stock and options.A well drafted Employment Agreement is a blank canvas.Non-competes are not hard to enforce, if carefully and skillfully drafted. Where they fail today is the absence of “independent consideration” and the failure to catalog what exactly constitutes competition.The standard duties in an Employment Agreement are faithful work, due care, IP, confidential/proprietary/trade secret info, customer lists, non-hire, non-disparagement, confidentiality, and post employment cooperation.Every “for cause” decision has to be balanced by the cost of “not-for-cause”. Done well, the cost difference is miniscule.JLMwww.themusingsofthebigredca…
I’ll take that to heart if/when I cross that path, thanks for the timely and thorough reply!
Fred how about also reviewing the comp of a ceo with yearly dividends or bonuses of the company is doing OK? Could be an efficient retainer regardless of stock allocation?
Hi Fred, Just wondering, is founder equity vesting a requirement for your investments?And at which stage of investment should investors ask founders to lock up their equity (e.g. Series A or earlier or later)?
“1/…So one could certainly argue that the founder CEO ought to get similarly compensated.”What, in addition to their four year fully vested entitlement? I’d like to hear that argument expanded upon. It sounds like ‘cake and eat it’.
Adjacent to this discussion of what happens after the 4 years of the vesting, i’ve recently ran into founders having 6 or even 8 years vesting on their shares, in order to align with the long term view of the company. Is this something become more mainstream? As this is pushing the discussion of the end of vesting later down the road, and seems to be a reasonable way to align everyone on the long term.
– Best for the company is having the right person at the helm, acknowledging that changing CEO can be quite disruptive in the short term.- Best for founder is to avoid the subject until the last minute so you have all the power.- Best (and correct) for the VC is to insist on a service agreement on the way in and/or during any flat/down-round where they have the power.- Also could be helpful if at the 3 year mark, you have your VC try to offer your competition’s Founder CEO a nice job in one of their portfolio 😉