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A word about Vesting

One of the central provisions of any investment and participation agreement is the vesting provision. Despite their importance, we see many such provisions, which work for neither the founders nor the investors and which rely on customary terminology, but use this terminology incorrectly. That is why it is time for “A word about Vesting”:

Sense and purpose of vesting

The founders are the real assets of any start-up. They developed the business idea and should naturally continue to develop this idea after one or more investment rounds.

It is a major disaster for any start-up and thus for any investment in a start-up when a founder – for whatever reason – is no longer involved or no longer wants to be involved in the day-to-day business of the start-up. It is therefore crucial – not only for investors, but also for founders – that there is a link between a founder’s position as a shareholder on the one hand and their role in the day-to-day business of the start-up on the other. Vesting provisions will do this. Ideally they will be agreed between the founders when establishing the company and every investor will insist on such vesting provisions.

The basic function of a vesting provision is easy to explain:

Level 1: For the case that one of the founders ceases his active role in the operative business of the start-up during an agreed vesting period, the founder will offer to transfer his shares (in whole or in part) to the company, the investors and/or the remaining shareholders in exchange for vesting consideration in accordance with the shareholders agreement. In addition, with the exception of investments made at very early phases of the start-up, it is generally agreed that the number of shares, which are subject to vesting, will reduce over the vesting period. This will generally be a linear progression in agreed steps (e.g. monthly or quarterly steps), while a cliff period is normally agreed for early financing rounds, which initially postpones the linear reduction. If a founder repurchases (all or some of) his shares over the vesting period, these are “vested shares”. The vested shares are excluded from the initial transfer offer. Accelerated vesting is when it is agreed that all shares become “vested shares” in the case of an exit.

Level 2: The differentiation between a good and a bad leaver introduces a second level into the vesting provision. While a good leaver has left the start-up for reasons that are not his fault, the bad leaver stole the “silver spoon” and is responsible for the reasons for his exit. On this basis, the good leave receives a settlement, based on market value, and the bad leaver receives a settlement based on the book value of the shares.

However, it starts to become confusing when level 1 and level 2 are blended: regularly, this will involve the variant in which a bad leaver has to relinquish all shares, including the vested shares upon exit. While this rule is rather harsh for the founders, the risks are predictable as long as good and bad leavers are clearly defined. In contrast, the terminology is incorrect when vesting provision speak of vested shares but do not properly “vest” those shares and instead merely defer the amount of the settlement over the vesting period. In such cases, experienced advisors should to advise the founder of the actual function of a vesting provision and, where necessary, correct the provisions.

In addition to these conceptual inaccuracies, too little energy is often invested in the legal effects of any vesting provisions. A case of vesting can frequently see a start-up skate into a real crisis where the start-up is not able to afford the transfer of the surrendered shares even at book value. It is therefore particularly important to ensure that the respective founder can be paid their settlement in numerous instalments that are as low as possible, and that the shares can lose their voting rights, regardless of the payment of the settlement.

Christian Kalusa
(Lawyer)

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Start-up Venture Capital