First Round Funding Terms and Founder Vesting

Posted on Aug 17, 2009 | 11 comments


legal docThis is part of my ongoing series “Pitching a VC“.

There’s a great meme developing this morning on the need to simplify funding terms and documents.  The meme was kicked off by Chris Dixon with this post saying that term sheets need to be simplified and align investor / founder interests.  That prompted Fred Wilson’s blog post appealing to the industry to make these simplified term sheets standard.  Last to weigh in was Brad Feld whose blog post argues that the only 2 terms that should be negotiated are amount raised & valuation.

I totally agree but want to cover a different issue.  If you’ve read any of my blog posts before you’ll probably recognize that I’m from this school of thought where founders & investors need to be more aligned and I’ve been very cynical of historic VC practices.

2006 was the last time I went out to raise venture capital.  I had multiple term sheets to do my Series A financing.  Many had the typical investor-friendly terms where entrepreneurs would get screwed and not even understand how they got screwed until many years later.  This was pre Venture Hacks so not a lot of help on terms on the Net.  The best series was done by Brad Feld on his blog here.   But it was my second company so I had already learned all o f the lessons the hard way.

There was one firm that offered me an entrepreneur friendly “vanilla” term sheet and that was True Ventures, which is why I believe they are attracting great early-stage entrepreneurs.  They said they believed in aligning investor and entrepreneur incentives.  I told another potential investor that I was accepting True’s term sheet.  They immediately agreed to match True’s terms.  I thought to myself, “OK, you were willing to F me when you thought I didn’t understand these terms and now you’re going to be friendly?  I wonder what will happen 3 years from now when we hit our next contentious issue?”

I believe that there is a new breed of VC emerging including True Ventures, Founder’s Fund, Union Square Ventures, Foundry Group and several others that have this founder / investor alignment ethos.  I have this mentality, too.

One very important item from Chris’s original post that wasn’t picked up by Fred or Brad is founder vesting.  Chris writes that early-stage deals should have:

Founder vesting w/ acceleration on change of control.  I talk about this in detail here.   If your lawyer tries to talk you out of founder vesting (as some seem to be doing lately), I suggest you get a new lawyer.

I totally agree.  Unfortunately I’ve lost two deals in the past 18 months over this issue.  I don’t think that entrepreneurs properly understand the issue.  Having spent way more time on the entrepreneur side of the table I believe I am a good arbiter of the issue.  I sum it up here (but read Chris’s link above)

  • I’m putting millions of dollars in your company.  My thesis is YOU.   I need some protection that you’re not fully or mostly vested where you could simply walk away with a large stake in the company, screwing not just me but the entire employee base of the company.  I’m not Sequoia.  I’m not looking to bring in a new team to replace you.  If you leave my thesis is largely out the door.
  • Without proper vesting you also place a risk on all other co-founders.  In my first company there was no vesting in the seed round.  One of  the co-founders walked within the first year.  He walked with 1/3rd of the company.  It was naive and stupid on my part.  I didn’t understand the issue back then.
  • I do believe in protecting the founder.  The most common way is to grant acceleration on change of control.  That means if the company is purchased all of your shares become fully vested.  Usually it is done as a “double trigger” meaning if your company is bought AND you’re asked to leave the company.  Chris described the “single trigger” scenario.  I regularly bring this up with founders as I want them to be protected.
  • You can also cement rights for yourself in the case where you’re fired without cause to protect some or all of your shares.  In my experience this issue is likely to be a source of negotiation.
  • If you have founder vesting and protection on change of control + protection against losing your shares of you’re fired then we’re completely aligned.  I’m protected against your walking (as are your co-founders protecting each other).  You’re protected against my asking you to go or a company buying you and taking away your value.

I tried to argue my views on vesting to a company I tried to invest in 2 years ago.  It was an A round deal but the founder was already 75% vested.  They had brought in a new CEO who was 66% vested.  They eventually took money from non-traditional VC based in the UK.  Founder vesting was one of the emotional hot buttons for them.  When the markets turned sour and they didn’t hit their objectives the non-standard investor decided not to follow its investment.  They now own 100% of worthless stock.

I more recently lost another deal where this was a major issue.  So I’m trying to reconcile it all in my head.  I believe the trade I described above is not only fair but protects everybody’s interests.  If you feel differently, please weigh in with comments.

  • http://www.walkercorporatelaw.com scott walker

    Mark – As a corporate lawyer who has been doing deals for 15+ years, I am surprised that founder vesting is such a big issue. Indeed, I always advise my clients to impose vesting restrictions on the stock issued to them at the time of incorporation for two important reasons: (i) a vesting scheme will be required by the investors, and if a reasonable scheme has already been established, it is more likely that the investors will simply keep it in place; and (ii) it makes good business sense because, in most cases, the stock has been issued not only for services or property relating to the conception of the venture, but also for the founders’ continuing commitment and efforts — it would be inherently unfair for one of the founders to leave the venture after a few weeks/months, but still be permitted to keep all of his/her shares. Keep up the good work. Thank you.

    Scott Edward Walker
    Walker Corporate Law Group, PLLC

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  • http://www.ringrevenue.com Jason Spievak

    As an entrepreneur and CEO of a GRP-funded company, I can concur strongly with Mark on founder vesting. Resistance to vesting/revesting of founders’ shares with a reasonable trigger structure should raise at least a yellow flag for a potential investor. And it also has the effect of binding the founders even closer together. An outside financing event should be cause for introspection as you commit to an open-ended span of your life spent dedicated to maximizing long-term shareholder value. Revesting of founders’ shares prompts essential alignment discussions to take place among founders prior to taking in outside capital.

  • http://lmframework.com/blog/about David Semeria

    Hi Mark,

    I’ve got some philosophical issues with things like founder vesting, liquidation preferences etc.

    I believe these issues stem from the different ‘tangibility’ of startup assets. I see tangibility as a sort of spectrum with the most tangible asset being cash, all the way to to the least tangible – ideas. The less an asset is tangible the harder it is to value correctly (so you can view intangibility as a form of valuation volatility).

    Although the basis for these ideas did not come from option theory, they do share some common ground. In fact, it’s possibly no coincidence that investors frequently talk in terms of options when describing their (early stage) investments.

    Any option price can be divided into two chunks. The ‘intrinsic value’ (what it’s worth right now) and the ‘time value’ (which basically translates into potential volatility).

    The same basic framework can be applied to startup assets. The invested cash basically equates to the intrinsic value, and the founders’ assets generally equate to potential volatility. Volatility is good, because it is what makes a $100k investment in GOOG potentially worth millions in the future.

    If the difference in tangibility of the assets conferred by founders and investors were always perfectly clear cut, the logic behind founder vesting and liquidation preferences would be unassailable – but that’s not always the case.

    What if the founders conferred some genuine IP, or a valuable code base? These are tangible assets in their own right.

    If a founder decides to leave early, it seems right to me that he/she should at least receive equity in proportion to the tangible part of their contribution. Along the same lines, if a company is forced into a fire sale, I see no reason why the invested cash should be be viewed as more ‘valuable’ than the similarly tangible assets conferred by the founders.

    I hope this makes some sense, and I apologize for the length.

  • http://www.echosign.com Jason M. Lemkin

    Mark as always I agree with you, but will provide an anecdote on the other side.

    In the last company I co-founded before EchoSign, because we were a quasi-spin out, we had the pain in the Series A of a “third party” to deal (the company we were licensing technology from) with which was very complex for valuation and terms (as the licensor only had one bite at the apple).

    In the end, the VCs proposed 100% vesting, but less equity, for all the initial team at “founding”. While we had worked together for years, the NewCo was indeed a new entity and we started 100% vested on Day 1.

    I don’t think the VCs proposed this b/c they thought it was a great idea. In fact, I’m not even sure why they proposed this (we took it). I suspect the reason was since the founding team was left with a suboptimal equity position in the spin-out, it was an attempt to increase the value of the employees’ equity to make a deal work for all 3 parties.

    Details aside, the lesson was that despite conventional VC/valley attorney wisdom, it simply wasn’t that big of a deal. No one — not a single employee — quit b/c they were 100% vested at founding. There was too much to do to create value.

    I think the ex-founder issue you note above (who leaves with 1/3d of the company) is a huge problem that has to be dealt with. It’s a huge loss for everyone when that happens.

    But if the team has been in place for a while, and is executing, and committed, I’m not sure the concerns are quite so black-and-white. Or that it really matters.

  • marksuster

    Thanks for the comment, Jason. In your case the founders were committed enough without the extra incentive to stay. In my view that is true 80+% of the time – maybe higher. I think of Founder Vesting purely as insurance. On the VC side of the bargain they know that you’re tied to the company and won’t leave easily. That shouldn’t be a big issue if you’ve just raised a few million bucks. On the entrepreneur side of the equation you need to protect that you also don’t get screwed. You can do this by having “acceleration on change of control” AND “acceleration on termination without cause.” Therefore neither side loses and both sides have insurance. I think founder vesting is really just an emotional issue and unfortunately not well enough understood by founders.

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  • erikcaso

    What you describe here, and in general having read your attitude on things, is perfectly acceptable. As an entrepreneur, being one who believes he is fair, I am fine with investors protecting themselves as long as they are amenable to reciprocating protection to the people committing so much of their lives to the success of the business. If this were a more common approach, VC might be met with much less contentiousness.

    Great post. Thanks.

  • http://bothsidesofthetable.com msuster

    thanks for your feedback. much appreciated.

  • Erik Caso

    What you describe here, and in general having read your attitude on things, is perfectly acceptable. As an entrepreneur, being one who believes he is fair, I am fine with investors protecting themselves as long as they are amenable to reciprocating protection to the people committing so much of their lives to the success of the business. If this were a more common approach, VC might be met with much less contentiousness.

    Great post. Thanks.

  • Erik Caso

    What you describe here, and in general having read your attitude on things, is perfectly acceptable. As an entrepreneur, being one who believes he is fair, I am fine with investors protecting themselves as long as they are amenable to reciprocating protection to the people committing so much of their lives to the success of the business. If this were a more common approach, VC might be met with much less contentiousness.

    Great post. Thanks.

  • http://bothsidesofthetable.com msuster

    thanks for your feedback. much appreciated.

  • http://bothsidesofthetable.com msuster

    thanks for your feedback. much appreciated.

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