Reverse vesting founder shares on FounderCatalyst

In this article, we look at the reverse vesting mechanism implemented within the FounderCatalyst paperwork - why reverse vesting exists, what options are available and what it means in practice.

What is reverse vesting?

Reverse vesting is an obligation on founders and employee shareholders to either resell a part or all of their shares to the other shareholders in the event of them leaving the company, and/or (alternatively) to convert them into worthless ‘deferred’ shares.

Why use reverse vesting?

The following two scenarios are a useful demonstration of why you should consider using reverse vesting:

1. Scenario A - imagine a scenario where you and a co-founder both start a business. You each receive 50% equity (shares) in the business. You both work tirelessly for 6 months, at which point your co-founder thinks that running a startup is too much like hard work and quits to become a City banker. You carry on growing the business and do all the hard work, but your co-founder still has 50% control and 50% economic rights. When you come to sell the business after 5 years, your co-founder takes 50% of the proceeds, even though he has done one tenth of the hard work.

2. Scenario B - two co-founders start a business (again 50% equity each) and subsequently take on lots of investment. Post investment, each co-founder has diluted to 24% and the investors own 52%. After a year, the co-founders realise that running a startup is hard work, so they quit to take up careers on a cruise ship. The investor would look to appoint new members to the management team to replace the (now departed) founders, but the incoming team want shares too, so the investors end up diluting their own equity to accommodate that. Both of these scenarios are manifestly unfair, so startups use reverse vesting to allocate shares based upon longevity of involvement in the business.

Bright legal minds have come up with a neat solution to effect reverse vesting in a mechanically simple, commercially doable and tax efficient manner, via the use of deferred shares.

In short, if a founder leaves before an exit (ie. sale or other realisation) event, then there is an agreement that some or all of their shares automatically convert into a class of shares known as 'deferred' shares.

Deferred shares are still legal shares in the company, but have almost no rights. They won't be eligible to vote, to receive a dividend, or to meaningfully participate / benefit if the company is sold or liquidated. On paper they are still shares, but in practice they are 'junk' shares with no value.

You do still often see another solution to this problem, which essentially requires the leaving founder/employee shareholder to sell some or all of their shares to the remaining shareholders and/or back to the company itself. This can achieve the same result in practical terms, but the mechanics can be more difficult to execute and, most importantly, it creates potential tax and commercial issues that don’t arise in the use of deferred shares – if continuing shareholders are required to purchase the leaver’s shares, they may have to find substantial purchase funds in a short period of time and may also have to pay a substantial amount of tax on the purchase value. By contrast, using the deferred share structure removes both of these problems in one fell swoop.

So, how many shares held by a leaver should convert into deferred shares?

The extent of deferred share conversion directly correlates to both how long the leaver has been with the business (i.e. how much effort they have already put in) and the circumstances in which they leave.

The FounderCatalyst documents (and, specifically, the articles of association) provide, as a starting point, what we consider to be a balanced position in this regard. Our default reverse vesting table within the ‘balanced’ version of our articles of association is as follows:

To help you understand how this applies, here is a basic summary of the different types of leaver:

• A ‘very bad leaver’ is a person who leaves due to fraud or criminal dishonesty.
• A ‘bad leaver’ is a person who is 'dismissed for cause' in line with their employment contract, but not resulting from behaviour applied to a ‘very bad leaver’.
• A ‘voluntary leaver’ is someone who resigns.
• A ‘good leaver’ is anyone not covered by one of the above categories - this would include people retiring at normal retirement age, leaving on health grounds, being made redundant etc.

Any shares held by a leaver that do not convert into deferred shares continue to be held by them, but have no rights except for a right to share in any future exit proceeds. They lose all voting and income (including dividend) rights. As you would expect, a ‘good leaver’ will leave with a much better deal than a ‘bad leaver’. A ‘very bad leaver’ retains no rights at all.

Summary

Although reverse vesting is generally considered to be an investor protection and is usually to be found in legal documents for investors, the protection also benefits the remaining co-founders and all other shareholders. Reverse vesting encourages founders and other key employee shareholders to stick with, and grow, the business for the longer term.