legal, equityWe are working on a shareholders agreement for a technology startup. We have all shareholders having the same equity. Is it a standard thing to have something in the shareholders agreement that will cause a shareholder to lose his equity if they no are longer interested to work on the project?
In order to build the product and start the business, all shareholders are required to invest their time and do a significant amount of work. We have no investors, i.e. shareholders that would get their equity by putting money or something else then their own time and work into the project.
Now, here is an example of undesirable situation. Say we work together for couple of years and then, for whatever reason, one of us won’t be able to continue. Others will still have to work hard to keep the business running and growing.
Does it make sense that the one who stops working (not temporarily, like for couple of weeks, but permanently) on the project loses his equity at some point (after some time, or over the time, or alike); or does it make sense that this shareholder will continue to keep his equity (forever)?
We have two opinions in the team. One is that the shareholders should never lose the equity regardless of how much they contribute. The other is that without such a motivation, if someone stops contributing, the whole project inevitably dies or has to be sold because all others will lose their motivation (why would you want to work to earn money for someone else who has the same equity as you and does nothing anymore…).
There are two types of risks that you want to cover in the shareholder agreement:
Vesting is your friend as already stated. More often than not, that’ll mean a 4-year vesting period with a one-year cliff - i.e. if you part ways before a year you get nada.
But vesting is not good enough. Picture yourself working hard for almost a year, getting the boot shortly before you vest (it happens…), and learning later on that your former colleagues strike it rich with you having nothing to show for it. You want the agreement to protect against that too, so that it’s fair for everyone.
To cover the latter edge case, also include a founder salary. It gets paid in the form of an IOU until the company can (if ever) backpay those salaries. Likewise for expenses - if a founder throws extra money to the pot to purchase, say, a copy machine, they get an IOU in return (rather than extra shares) if the company can’t cover the expense.
Further, make this IOU a senior debt to avoid dirty tricks between ex-cofounders: should the company ever raise money, the funds should cover the former cofounder IOU balances before they can get used for anything else. That way, former cofounders can’t get screwed over by accounting tricks.
Suppose, for the sake of keeping things simple, that there 480 shares per founder, a vesting period of 4 years with a one year cliff, and that each gets $5k/month (plus interest).
If all goes well, everyone gets 120 shares after year one, and 10 extra shares per month for the next three years. And in case you’re not breaking even yet, the company also owes everyone $60k worth of salaries (or the balance thereof if they got paid).
If one of the founders leaves after 6 months for any reason, they get zero shares and $30k worth of salary as an IOU (or the balance thereof if they got paid).
If one of the founders leaves after 18 months for any reason, they’ll have earned 180 shares and $90k worth of salary as an IOU (or the balance thereof if they got paid).
In all three cases, the IOUs will only ever get paid if the company turns a profit or raises money down the road.
Last point that you want to have in mind as an aside: worry in advance about hostile dilutions. It unfortunately happens: long-gone founders sometimes get screwed over by their former partners, with the latter adding money to the pot at a low valuation so as to dilute their former partner’s shares into nothingness. To work around this, require 2/3 majority for fund raising rounds, make it so that all existing shareholders get notified long enough in advance when they occur, and make it so that they’re all entitled to participate in any such round at that round’s valuation.
Further reading on a related topic:
What you’re looking for is vesting, this article has a lot of useful information on it: http://thestartuptoolkit.com/blog/2013/02/equity-basics-vesting-cliffs-acceleration-and-exits/
Basically you all agree on a cliff, for how long the founder has to be tied to the company to get the first part of their shares and a duration on over how long period the shares are “vested”
Vesting makes sense on a lot of start-up projects :)
Follow-up answer to your edited question:
Unassigned shares: In case of co-founders, the unvested shares go back to the founders shares pool. There’s many ways you can reclaim them, you can split the unassigned shares equally between all remaining founders. Or what I would do is have each of the founders get shares based on their equity shares. Let’s say you have 3 founders each with: 40%, 35% & 25%. Now when the 25% one leaves and all of his/her shares go back to the founders pool, the 40% founder would get 53&1/3% of the 25% = 13&1/3% of the company, so he’d end up with 53&1/3% of the company and do the math for the other. I took as basis that 40+35=75 which is equal to 100% and see how big pieces 40 and 35 make out of it. Do remember this has to be all pre-set in your contracts.
Un productive founder elimination: Your contracts should state assignments and responsibilities for each. Based on that if one isn’t fulfilling their duties according to contract, they can be legally eliminated.
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