Vesting-Schemes

Vesting Schemes

As an essential tool for Founders

1. Starting Point

The founding team has found each other, the tasks have been distributed and the company can now be founded. The founders have agreed on the UG (limited liability) or the GmbH as the typical legal form for start-ups and a notary appointment is quickly arranged. After the company has been entered in the commercial register, the company is up and running and each of the founders has become the owner of shares in the company, in accordance with the division that the founders have agreed with each other.

2. The Problem

Each of the founders can freely dispose of their shares. For example, a founder who wants to push ahead with a new project or simply no longer feels like working with the other two founders can sell his shares to a third party. On the other hand, the founders who remain in the company have no right to demand that a founder who wants to leave the company return his shares to the team.

If the situation arises that the founding team falls out and, for example, one of the founders no longer wants to work in the start-up, the person simply terminates his service or employment contract. The shares held by him remain his property. The other founders are now faced with the problem of having to replace the terminated founder and his expertise in the team. In addition to the actual difficulty of finding a suitable new co-founder, there is also the problem of how this new co-founder should participate in the start-up: Actually, he should be entitled to the part that was held by the departed founder. But since the departing founder is still the owner of these shares and, as already mentioned above, the remaining founders are not entitled to have the departing founder transfer his shares back, the new co-founder must either receive shares directly from the two remaining founders or a correspondingly large option package, or he must be incentivized by means of a higher salary (this third option is usually ruled out because there is simply not enough money to pay a new co-founder a high salary).

In addition to the resulting heavy dilution of the two founders who continue to work for the start-up, the departed founder still retains his shares in the company - so he does not suffer any dilution, even though he is no longer even part of the team. An unfair situation that threatens the existence of the start-up!

Founders´ Vesting – Concept briefly explained:

Term: Vesting period, typically 3 to 4 years. Deviations upwards or downwards possible depending on the case. Method: Mostly linear, i.e., at monthly or quarterly intervals. Cliff: Should the departure of a founder occur within an initial period, the vesting may provide that all shares in the business must be returned. The cliff period is usually between 6 and 12 months. Accelerated Vesting: In the event of an exit, this provision results in an early vesting of the shares: regardless of the term, all shares vest at the time of the exit. Good Leaver / Bad Leaver: The departure of a founder triggers the obligation to return as the decisive factor. However, the departure may be through no fault of the founder (“Good Leaver”) or it may be that the founder has set a reason (with “cause”) for the departure (“Bad Leaver”).

3. Vesting scheme as a solution

In a vesting scheme, it is agreed that the individual founder is obliged to transfer a certain proportion of his shares to the company or a third party within a certain period (the term of the vesting; typically, three to four years). The number of shares to be transferred is determined by the date on which the founder leaves the company. The founder vests his shares in monthly or quarterly steps. With regard to vested shares, there is no longer a retransfer obligation. At the end of the term, the founder has vested all of his shares and there is no longer any retransfer obligation.

Example:

Three founders (A, B and C) have founded a GmbH (limited liability company) on 1January 2022. Founder A holds 50% of the shares (i.e. 12,500 shares). The founders have agreed on a vesting that extends over a period of three years. The arrangement provides for linear vesting in monthly periods with no cliff.

If Founder A leaves the Company in July 2022, he will have vested for six full months under the vesting arrangement. This means that he has vested 2,083 shares (12,500/36*6) and is obliged to transfer 10,417 shares back to the Company or to founders B and C (depending on the agreement).

Founders B and C now have the opportunity to look for a replacement for founder A. The 10,417 that Founder A had to return are available to you for this purpose.

4. Are we doing a future investor any favors?

Many founders do not include a founders' vesting in the contracts when setting up their company. In addition to other reasons, the model protocols for the formation of a UG (hb) or a GmbH do not provide for such very specific regulations. For this reason, the inclusion of a Founders' Vesting is not advantageous, at least initially, from the point of view of costs when forming the company.

Another argument that is often mentioned by founders against the inclusion of a founder's vesting is that this would be doing a favor to a future investor: an investor in the start-up naturally has a high interest in the founding team remaining in the company. The investor therefore uses a vesting arrangement. From his point of view, vesting serves to keep the founding team and their know-how in the company. The investor thus uses vesting to secure his investment in the start-up.

It is true that investors will always insist on a vesting arrangement. For an investor, the vesting provision serves to secure his financial commitment to the company. This can be ensured with a vesting provision.

However, the advantages that a vesting arrangement offers to the founders and which are mentioned above under 3. still apply. Regardless of whether an investor will invest in the company or is needed at all. The positive aspects for the founders to hedge against each other remain. Thus, while it can be said that a vesting arrangement is an investor-friendly instrument, it also serves to safeguard the founders.

For any questions, please reach out directly to our legal experts from ICADIA Legal under office@icadia.de