Lateral Capital Management, LLC

What Happens When a Founder is Fully Vested?

by Fred Wilson, Union Square Ventures (NYC)
Here is some great perspective from Fred Wilson on a subject of great importance to founders. While this is discussed mostly in financial terms, it is part of a much bigger question: What should the founder do after he or she is vested – and/or a non-control shareholder? Let’s say you are the founder and CEO of a startup and you have now been at it for four years. The company is doing great, you’ve raised several rounds of financing, you have a product in the market that is solving a real problem, you have a bunch of customers, you have a growing team, and things are stressful but largely great. And you realize that you are now fully vested on your founder’s stock which means if you were to leave the company tomorrow, you get to keep all of it. What do you do about that?

This is a common question from founders. They ask me what is standard in this situation. Not only is
there no standard answer, that this is one of the most emotionally charged issues to come between
founders and their investors and boards and companies. This situation also exists for other founders who are not the CEO, and the issues are very similar, but for the purposes of keeping this as simple as
possible, this is focused on the founder/CEO role.

Here are some of the considerations that come into play in thinking about this issue:
● If a founder/CEO were to leave their company after they become fully vested on their founder’s
stock, the company would have to go out and hire a new CEO. That new CEO would get an equity
grant that would be between 2.5% and 7.5% of the Company, depending on the value of the
business. So one could certainly argue that the founder CEO ought to get similarly compensated.
This question of how a new CEO should be compensated also puts on the table the question of
whether the founder CEO is actually the best person to run the Company right now or if there is
someone better suited to do that who could be recruited for a new “market rate” equity grant. It is not
always in everyone’s best interests to have that conversation.
● After four years, many founder CEOs in still own a lot of their companies. A typical range would
be between 10% and 40% depending on whether there are co-founders and how much capital had to
be raised in the early years and at what valuations. For most situations, an equity grant that would be
made to a new CEO is actually a relatively small percentage of the overall equity ownership of a
founder CEO. In this context, it is not as valuable to the founder CEO as many other things. However,
the founder CEO is subject to additional dilution in subsequent rounds so a new grant would at least
partially offset future dilution and that is quite attractive to founder CEOs.
● It is generally a good practice to have all executives vesting into some equity compensation. It
standardizes the executive compensation program and aligns incentives. And its very valuable to a
founder CEO to have a large unissued equity pool from which to hire talent into their Company. Any
allocation of that pool to the founder CEO reduces the power of this tool.
● Refresh grants for executives are not usually equal to their sign-on grants. They are usually
some percentage of the sign-on grant. So the same should be true of a founder CEO getting a
refresh except that they never got a sign-on grant.
● Investors bet on the appreciation of the equity they already own, not the issuance of new equity.
A founder is aligned with the investors when they too are focused on making the equity they already
own more valuable. When founders get diluted below double-digit ownership, they tend to begin
seeing themselves as employees, not owners. For some founders, the “employee feeling” begins
when their ownership falls below 15-20%. In every case, this is bad for the company, the team and
the investors.
● What happens after a “vested” founder leaves is rarely discussed during the various rounds of
financings, nor is it priced in by the investors. If a founder were to pre-negotiate a new “market grant”
for themselves once they are fully vested, and that was included in the option pool that is baked into
the pre-money valuation, investors could model that future dilution and build that into their valuation
models. But nobody does that because founders want to maximize valuation in the financing rounds
and investors assume that the founders will either be happy with their initial grant – or not around to
earn it! Both parties either naively or purposefully kick the can down the road until the issue rears its
head and then the emotions come out.

So what happens in practice? It depends entirely on the situation at hand. If the founder CEO owns a large percentage of the business, a new grant is rarely made when the founder vests. This seems reasonable to the Board because the value of any new option grant would pale in comparison to the value of the founder’s newly vested stock.

● If the founder CEO has been massively diluted and owns a small percentage of the business, a new
grant is often made.
● If the business is performing very well, the likelihood of a new grant is higher.
● If the business is performing poorly, the idea of a new grant can be very destabilizing; often precipitating a larger conversation about who should be running the company. A common compromise is a new grant to the Founder CEO that is some percentage of what a “market” grant to a new CEO would be – in a range of 20% to 50% of a “new CEO” grant depending on the situation. The less a founder owns of the company, the higher the percentage will be. The more a founder owns, the less that percentage will be. If a Founder owns more than a quarter of the business, this is almost never done. Here are two suggestions for how entrepreneurs should handle this issue. First, you might want to raise this issue with your investors before you take money from them, and understand how they feel about this issue and what their expectations are so that you know that ahead of time. Do not wait until the moment you vest to find out what everyone’s feelings are. The second is that if you wait to raise this issue once you are fully vested, do it carefully and delicately. If it is seen as a demand, it will not go well. If it is seen as a discussion about what is in the best interests of the company, it will go better.

But most of all, remember that there is no “one size fits all” solution for this situation and that you and your Board will have to figure it out on a case by case basis.

Source: This material is a lightly edited version of material that came from the Union Square Ventures website [].

IMPORTANT DISCLAIMER – This material is not tax, legal or accounting advice. It is not tax or
legal advice. Readers should consult the appropriate experts before taking any action.