When launching a start-up, the founders of the company are typically allocated a certain percentage of the initial shares of the company. While the allocation of shares is expected to compensate each founder for their expected contribution to the company, circumstances can change over time and it is important to address expected contributions and the consequences of early departure amongst the founding team up front. As an example, if a founder decides to leave the company for another opportunity, in the absence of a reverse vesting arrangement, the departing founder does not have a legal obligation to return any un-earned portion of his or her shares to the company. This can leave the company and the other founders in a difficult position because: (a) the other founders are forced to work for the disproportionate benefit of the departed founder, and (b) the company and its shareholders will have to incur further dilution in order to provide equity as an incentive for another person to replace the departed co-founder’s skillset.
A reverse vesting arrangement sets the expectation for how long a founder must stay engaged with the company in order to earn his or her shares, and gives the company the contractual right to repurchase any un-earned shares at a nominal price if the founder leaves the company prior to fulfilling his or her full commitment to the company. As an example, in a typical four year reverse vesting arrangement, if a founder leaves the company after two years, he or she would be obligated to return half of his or her shares to the company. A typical reverse vesting term is three to four years, and, while most arrangements call for pro-rata vesting over the entire vesting term, some arrangements will have a “cliff” which requires a founder to remain with the company for a certain minimum period of time before the vesting begins.
Overall, a reverse vesting arrangement allows each founder to maintain legal ownership of their shares from the outset and as the company grows, which results in favourable initial tax treatment, long-term capital gains treatment and voting rights. This is accomplished while still protecting the interests of the other founders and the company in the event of early departure of a founder. As part of their due diligence, investors will also often look to see if reverse vesting arrangements are in place, and having arrangements in place in advance of a first financing gives the company and founders a better chance to dictate the terms rather than having terms imposed upon them by investors.
Ally Bharmal is a Partner and business lawyer at Fasken Martineau DuMoulin LLP. His practice focuses on corporate and commercial business advice for a variety of clients, with an emphasis on the technology and agri-business sectors. For more information about reverse vesting arrangements or other legal matters, contact Ally at firstname.lastname@example.org