Founder Vesting is A-Changing– The New 10-Year Founder Vesting Period

Founder vesting periods are usually around the four-year mark, but this could be changing. The unspoken rules around profitability, exits, ownership, and founder vesting are up for amendment.

Many comparisons have been drawn between starting up a business, and marriage. It hurts when your partner leaves, but move on you must. Having a founder vesting schedule is one way to be better prepared in the event of a split.

Founder vesting is a structure by which founders accumulate rights to their stock ownership in the company. The founder vesting schedule represents the years over which these rights accrue. At any point of departure before these rights have fully accrued, founders walk away with only that percentage of vested stock.

Founder vesting clauses also typically include a ‘cliff’. A cliff represents the period before founders can walk away with equity. If a founder leaves before the cliff period ends, they lose the right to exercise any stock options.

Industry standard has historically been to have one-year cliffs with a four-year vesting period.

The origins of four-year vesting are unclear. Some suggest that it is four years because that’s about the amount of time it took for a startup exit to take place in the 1990s. Some others say that the four-year period may date back to pre-1980s U.S., where pension plans with a five-year vesting period were popular.

Either way, a growing consensus within the startup community is that four years is a redundant timeline for vesting founder stock.

It takes time to build a company

Partner at Matrix Partners Jake Jolis suggests in a blog that it takes eight years to “build something big.” Others within the startup community have echoed Jolis’ perspective.

For instance, serial entrepreneur Wil Schroter notes in an article that it takes about four years to realistically get started and grab a foothold in any given industry. This is the amount of time companies will need to refine their business building processes – in order to hit real benchmarks for success, he estimates they’ll need about 7-10 years.

Last year, the startup failure rate in the U.S. reached 90%. 21.5% of startups fail in the first year and 30% in the second year. In the fifth year, 50% of startups fail, and a telling 70% of startups fail at the end of a decade of operations.

This isn’t to say that startups are built to fail, but that building a startup is much harder work than one would expect. Bad partnerships between founders were one of the reasons behind the U.S.’ high startup failure rate. This calls for a committed founding team that is willing to stick with the company, especially through the trough of sorrow.

A longer period of vesting acts as an incentive for a founder to hold to their commitment. It gives them motive to stay with the company despite challenges in their own professional and personal lives.

On the flip side, it is also unfair to use vesting as leverage to forcefully retain founders. A balanced vesting period must consider the preferences and commitments of all founders. That’s true for shorter timelines as well; four-year vesting periods are too short to fairly reward all founders for their contributions.

Time

Time to exit has expanded

Time to exit at startups have stretched. Amazon went public in 1997, within three years of founding. Netflix was founded in that year, and went public five years later in 2002.

Previously, ecommerce companies took about five years to exit. Content distributors took seven on average. SaaS companies took as many as nine years for an exit, and hardware companies went as far as 16 years to exit.

Now, a company can take about seven years (average) to exit via IPO. Some can stretch as far as 11-14 years.

The current environment surrounding IPOs is cloudy, especially for Chinese companies. The U.S. crackdown on Chinese companies listing in U.S. markets has put Chinese companies on the back foot. Moreover, Ant’s recent failed IPO signals that home markets are risky bets too.

IPO numbers were already moving downwards. Even as startup culture is booming around the world, companies are wanting to stay private for longer. The number of listed companies fell 52% between the late 1990s and 2016.

2020 has seen a spurt of IPO activity due to increased liquidity and an IPO rush from Chinese companies. Direct listings and SPACs are also picking up in popularity as IPO alternatives.

This could represent an inflection point for dipping IPO numbers in recent years. It may also have a long-term impact on founder vesting periods, which may increase in tandem with the average length of time companies stay private.

An M&A exit, too, could take place in as little as two years in the 2000s. It can now take up to 8-10 years for a successful exit by acquisition, or 6-7 on average.

Dead equity can weigh you down

Dead equity is equity that a co-founder takes with them on exiting the startup. It’s called “dead” equity, because it cannot be redistributed. It takes a permanent spot on the cap table and reduces the amount of equity that can be put to work.

In the early days of building a company, when significant equity has not yet been given away to investors or employees, the cap table is balanced to the benefit of the founders. They hold much more equity than they will later, after raising funds, hiring talent and growing the company.

When a co-founder exits in this early period, they walk away with a much larger chunk of equity than they would later.

Jolis points out in his blog that this can lead to resentment from the remaining founders. Further, it also hinders the startup’s ability to hire talent, raise capital, or get another founder on board, for which they need equity to give away.

Increasing the vesting period, Jolis suggests, can remedy this while still giving the exiting co-founder their due. They’ll walk away with a percentage commensurate with their time at the company, and the company reduces its dead equity.

The thing about founder vesting is that it can complicate relationships among founders and employees. No one wants to book less than they deserve – even if their tenure lasted only a few years, the contributions made by exiting founders must be acknowledged. But this is true for all stakeholders in the company.

Founders who stay back to weather the long haul may have larger personal stakes in the company. New founders joining the team or investors pouring in capital will also need to be rewarded, not to mention employees who dedicate significant years to a company that, statistically, is very likely to fail.

Derailing the cap table is not an option, but discussions around founder vesting need to be undertaken with sensitivity as more players join the fold. Balancing present and potential interests, giving credit where it’s due, and coming from a place of trust is a good place to start.

Photos by 8photo on Freepik and NeONBRAND on Unsplash

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Sharon Lewis
Sharon is a Staff Writer at Jumpstart

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