The most important legal term: Founder vesting

The most important legal term to worry about in your start-up is founder vesting.

Founder vesting means that all the founders work out as equal partners (or however you have divided up the initial equity) if everything goes right, but allows for the share register to gracefully rebalance if it doesn’t.

Let’s use a simple example to illustrate how vesting works. I’m starting a business with you and we are each issued 50 shares a piece. But we want to subject them to vesting in case I flake out in a year or maybe you’re offered a dream job at Facebook or for whatever other reason.

The way vesting works is that we don’t both get 50 shares right away. We might get say 10 a piece and then have the rest vest over four years. At the end of year one, we’ll both have 20 shares a piece, by the end of year two, 30 a piece and so on.

By having this ticking clock, if I leave after year two (when we both have 30 shares a piece) and you keep growing the business and driving it forward, then by the end of year four, you’ll have 50 shares and I’ll still have 30. This means that at the end of four years, you have 62.5% and I have 37.5%.

In the US, it is common for vesting to occur over four years and have a one year cliff. A cliff means that if somebody leaves within the first year they get nothing. In Australia, our less-than-ideal corporate law and tax regime make it difficult to implement the one year cliff and usually the founders get something even if they leave on day two.

Another silly but significant tax nuance means you want to structure your initial shares as purchases rather than rewards for founders’ employment. Options are harder in this respect but founder vesting can usually pass this test fairly straightforwardly.

When you begin your start-up, all you can imagine is success and how great things will work out, but if there is one thing to get right with your legal structure it’s to have founder vesting. Without it, the company may end up crippled if something goes wrong and there is little you can do at that stage.