Background
In most investment agreements, the investor requests (and usually receives) different rights intended to ensure, as much as possible, effective supervision of the company’s management and the manner in which it promotes its business, out of the intention that the funds he invests in the company will be managed wisely and not wasted.
One of the most significant factors for which an investor is willing to invest in a company, apart from the product itself, and even beyond it, is the company’s human capital, namely: the founders. Therefore, one of the investor’s clear interests is to ensure and preserve, as much as possible, the founders and key persons in the company staying in the company.
Over the years, several mechanisms have taken root, intended to attempt to guarantee preserving the company’s key persons, when the primary ones are: the first, limiting the founders’ option to transfer their shares in the company to a third party in a set period of time; and the second, subjecting the founders’ share capital to a mechanism of repurchasing via reverse vesting. It should be noted that these mechanisms operate alongside other acceptable mechanisms between the parties, such as: right of first refusal, right of forced sale, right of tag-along and such.
The first mechanism we have stated above, in fact sets a limited period, usually 24 months, during which the founders are not entitled to transfer their shares in the company to any third party. The effectiveness of this mechanism mostly depends on the company’s stage in which the investment in the company is received. If the company is during its initial stages, this mechanism’s effectiveness is lessened since at this stage, the chance of a founder to be able to transfer his shares to a third party is improbable.
The main mechanism which may keep the investor’s interests in preserving founders in the company, is therefore the second mechanism, in which we will focus in this paper, which is the reverse vesting mechanism (hereinafter: “the RV Mechanism”).
The Reverse Vesting Mechanism
This mechanism subjects the founder’s holdings to his remaining in the company, and in case the founder chooses not to stay in the company, the investor could purchase the founder’s holdings without consideration. This is a relatively drastic mechanism, since it deals with a founder who has established the company, has capital share in the company, and then an investor poses a condition for investing in the company, which in fact provides that the founder’s holdings in the company are subject to him continuing to work for the company.
In most cases, the limitation on the founder’s holdings is gradual and diminishes with time (apart from exceptions which will be specified below). This is a gradual vesting of the share capital over pre-determined periods of time, when shares which have not yet been “released” continue to be subject to the right of repurchase without consideration by the investor/investors (according to their relative hold in the company). In other words, the founder’s capital share, in whole or partly, is subject to the investor’s right to purchase the part of the shares not released from the limitation, for no consideration.
It is possible to set a linear mechanism, namely a quarterly or monthly vesting over two years, or setting a non-linear mechanism, for example vesting over a period of two years when half of the shares are released only at the end of the first year (a one-year cliff) and the remaining shares are released equally at the end of each quarter of the second year.
For example, a founder holds 240,000 company shares.
For the sake of the example we will assume that the entire founder’s holdings are subject to a two-year vesting mechanism with a one-year cliff and monthly vesting during the second year.
In the aforementioned example, the founder’s shares will be released in the following manner:
At the end of the first year, 120,000 shares will be released;
And in the second year, 10,000 shares will be released at the end of each month.
Purchasing Shares for No Consideration
In case, before the end of the vesting term, the founder has decided to leave the company, so that some of the shares in his possession have not yet been released, it should be determined who has the right to purchase the shares – the company or the investor.
There are limitations by law for the company purchasing its own shares for no consideration, and if the company does not meet the conditions provided by law, it cannot purchase such shares. We shall note that one of the conditions set by law for a company wishing to purchase its shares, is that the company, upon purchasing the shares, can distribute dividends. Since in most cases of startup companies, at the stage when the investor enters and during the vesting term the company is not profitable, namely the company does not meet the conditions for distributing dividends, the meaning is that the company cannot purchase the shares which have not yet been vested.
Therefore, it is customary to rule that shares which have not yet been vested, the right to purchase those shares for no consideration will be given to the company, and if the company fails to meet the conditions provided by law for purchasing the shares, the investor will have the right.
Acceleration Clauses in the RV Mechanism
Another mechanism which is acceptable to provide with the RV are acceleration clauses, namely cases where even if not all shares have been vested, the vesting will be accelerated and all shares will be considered “vested” and the mechanism will not apply to them. Thus, for example, in case of an exit and IPO. In these situations, we will assume that the company is selling the entire share capital (exit) after a year and a half from the beginning of the vesting term. If we follow the example above, allegedly the founder has 60,000 shares which have not yet been released (10,000 shares for each month). In case of an exit, even if all the founder’s shares have not yet been vested, there will be an acceleration of the vesting term, and the 60,000 shares will also be considered as vested, so that the founder could sell his entire share capital in the exit transaction.
Another case where it is customary to accelerate the vesting term is in case of terminating the founder’s employment in the company. It is customary that in case the company is the one choosing to dismiss the founder from his position, for certain reasons determined in advance, there will also be an acceleration of the vesting term. There could also be cases when the termination of employment by the founder will grant him an acceleration of the vesting term, with the prominent situation being a significant reduction in the founder’s position in the company.
The Factors Affecting the Mechanism’s Variables
As stated above, the RV mechanism changes from case to case, from founder to key person and such.
As stated, usually one of the factors affecting the mechanism is the stage in which the investor has entered the company. If it is during the initial stages, the investor will request a longer vesting term and a longer cliff term.
Another factor affecting the RV mechanism is the level of the founder’s contribution to the company. If the founder is active and his contribution to the company is more crucial, the investor will wish to ensure the founder remains in the company for as long as possible. Therefore, the investor will probably request a longer vesting term (sometimes even 4 years), often while guaranteeing additional options for the founder.
Naturally, these things chance from case to case, and at the end of the day, the parties’ ability to bargain will rule. It should be remembered that the ability to maintain a balance between the different interests is what will lead to the most appropriate mechanism.
Summary
We believe that the RV mechanism is an appropriate mechanism which guarantees both the investor’s interests and the company’s interests. In light of the fact that the founder’s role is crucial and material to the company’s promotion and success, in case a founder decides to leave the company after an investor enters, it will worsen the investor’s condition as well as the company’s.
We will also note that a balance should also be maintained between the interests of the parties, namely the company and the investor on one hand and the founder on the other hand. A mechanism should be set which will take into account different factors, such as the company’s stage, the time invested by the founder prior to the investor’s entrance, and more.