When launching a high-growth startup, one of the most critical decisions founders face involves dividing equity among the founding team. While it might seem fair to allocate ownership based on initial expected contributions, what happens if a founder leaves early or stops contributing? Enter reverse vesting arrangements: a mechanism designed to protect the company and its remaining shareholders, while also incentivizing founders to stay committed over the long term.
This article will explore what reverse vesting is, why it’s a common practice in startups, and the key considerations to keep in mind when implementing such an arrangement.
What is a Reverse Vesting Arrangement?
A reverse vesting arrangement is an equity structure where a founder initially receives full ownership of their allocated shares, but these shares are subject to a vesting schedule. This means that the founder has all of the economic and voting rights associated with these shares, but the company retains the right to repurchase unvested shares at a nominal price if the founder leaves or is otherwise no longer involved with the company. Over time, as the founder continues to contribute to the business, the shares "vest," reducing the company’s ability to reclaim them.
Unlike traditional employee stock vesting, where shares are granted incrementally over time, reverse vesting begins with the founder owning all their equity upfront, which then "vests in reverse." This structure is particularly popular in high-growth startups, including because it aligns the founders’ interests with the long-term success of the company and offers potential tax benefits to founders as briefly outlined below.
Key Considerations for Reverse Vesting Arrangements
When deciding whether to implement a reverse vesting arrangement, the following factors should be carefully considered:
1. Aligning Incentives
One of the most important reasons for implementing reverse vesting is to ensure that all founders remain equally committed to the company’s success. Startups often face years of hard work, financial uncertainty, and operational challenges. If a founder leaves prematurely, it can create an imbalance in allowing them to retain significant equity while no longer contributing to the company’s growth.
Why It’s Important:
Reverse vesting ensures that each founder earns their equity over time, based on their continued involvement. This helps avoid resentment among remaining founders and ensures the equity distribution reflects actual contributions.
2. Attracting Investors
Sophisticated investors, such as venture capitalists, often expect reverse vesting arrangements to be in place before they invest. Investors want to ensure that the founding team is incentivized to stay and grow the company, rather than leave with a disproportionate share of equity.
Why It’s Important:
If a startup doesn’t have reverse vesting arrangements, it may raise red flags for investors. By proactively implementing a fair vesting schedule, founders can make their company more attractive to potential backers and demonstrate a commitment to long-term value creation.
3. Structuring the Vesting Schedule
The specific terms of the vesting schedule are critical to its effectiveness. A typical reverse vesting schedule might include a three to four year vesting period.
For example, if a startup issues 1,000,000 shares to a founder with a four-year vesting period, and the founder leaves after one year, the startup can repurchase three-quarters, or 750,000, of the unvested shares. The founder retains the 250,000 vested shares.
Why It’s Important:
The vesting schedule should strike a balance between protecting the company and fairly compensating founders for their contributions. A well-structured schedule also reduces the risk of disputes if a founder departs, as the terms are clearly defined from the outset.
4. Addressing What Happens in the Event of a Departure
Reverse vesting arrangements should also outline what happens to unvested shares if a founder leaves voluntarily, is terminated, or is dismissed for cause. These scenarios may require nuanced treatment to ensure fairness. For example, a founder dismissed without cause may retain more favourable terms than one who is terminated for misconduct.
Why It’s Important:
Clarity in the treatment of unvested shares can minimize disputes and legal complications. Founders should work with legal counsel to draft agreements that fairly address potential departure scenarios.
5. Tax Implications
The issuance of founder shares and grant of equity incentives to founders can have significant tax consequences which vary by jurisdiction.
In Canada, a reverse vesting structure is often a more favourable structure from a tax perspective as compared to other structures such as issuing shares to the founder over the course of the vesting period or granting stock options with an equivalent vesting schedule. By issuing the shares at the start of the engagement, the valuation of the shares is often lower (or nominal), which reduces the impact or risk of an employment benefit. This early issuance of all founder shares can also help to achieve other desirable tax benefits that require the founder to hold the shares for a certain period of time – for example, the Lifetime Capital Gains Exemption and the 50% reduction of employment benefit under paragraph 110(1)(d.1) of the Income Tax Act.
While this approach is in many cases the most advantageous, the actual tax impact in any given situation will depend on the circumstances of both the founder and the company. For example, whether the company qualifies as a “Canadian-controlled private corporation” for tax purposes will have a significant impact.
Why It’s Important:
Tax planning is often overlooked but can have a major impact on a founder’s financial outcomes. Consulting with tax professionals early in the process can help founders avoid costly surprises.
Conclusion
Reverse vesting arrangements are a powerful tool for high-growth startups, ensuring alignment among founders, protecting the company’s equity structure, and creating a foundation for long-term success. While the specifics of each arrangement will vary, founders should carefully consider the terms of their vesting schedules, consult legal and tax advisors, and ensure their agreements are tailored to their unique business needs. By taking the time to implement a fair and thoughtful reverse vesting arrangement, founders can build trust among their co-founders and investors and position their startup for sustained growth and investment.
Navigating the complexities of reverse vesting arrangements requires careful legal drafting and strategic foresight. Fasken offers tailored solutions to these challenges. As a Canadian leader in advising startups, Fasken has extensive experience structuring founder equity arrangements and has drafted thousands of reverse vesting agreements to help companies succeed. If you wish to learn more, contact Ally Bharmal ([email protected]) or Geoff Pedlow ([email protected]).