Management Equity

This is general information, not legal advice

At goodcounsel, we believe in keeping things simple. However, by necessity, there are some complexities involved when founders and employees hold company stock. The most important of these are the fraternal though not identical twins: vesting and repurchase.

Let’s say that Able, Ben and Claire are the founders of Delta, Inc., with ownership shared equally among them. They hire a lawyer to draft Delta’s organizational documents and sign the necessary papers. After just one day of work, Ben decides he’s contributed quite enough, quits the venture and heads off to a tropical retirement in Tahiti. He wishes Able and Claire good luck running the company, and says he’ll check back with them a year’s time to see how they are doing with “their” company. 

Can Ben really walk away the day after the company’s founding, taking his one-third ownership stake with him and leaving his co-founders high and dry? Not if the founders and their attorney had any sense in the structuring of the founder/management equity. 

Typically, if a founder like Ben walks away from his company responsibilities so soon, he would either forfeit his equity, or be compelled to sell it back to the company for his cost or “fair market value” (which, under the circumstances, are both quite likely zero). If this seems at all counterintuitive with regard to founders, consider that founders are employees of the company with substantial responsibilities, and — if there are partners or investors involved — they should no more be able to walk away from their responsibilities while holding on to their ownership than an employee would.

If one imagines Ben leaving the company after two years, then the story plays out differently. This is where the concept of “vesting” comes in. Founders (and other employees) are typically issued equity (or options to purchase equity) that vests over time or based upon the achievement of important milestones. A typical time-vesting arrangement might involve equity that vests one-third each year over the course of three years. If Ben had such a three-year vesting arrangement and quit after two years, he would be two-thirds vested in his ownership. At that point, upon terminating from Delta, he would either be able to hold on to his vested equity or be bought out of his vested shares at fair market value – depending on Delta’s policies and the provisions of his employment agreement.

This example illustrates why it is critical for founders, like all management, to have employment agreements. It is to their common benefit, as well as expected by future investors, for founders to define their relationship to the company  in terms of equity and in a variety of other important areas.  

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