Venture Finance Terms: What is Reverse Vesting?

Fighting Over DollarIf your startup company is seeking venture capital funding, one major factor to consider is the impact the financing will have on the value of equity held by founders and management. Many VC term sheets include a provision requiring reverse vesting. In this post, I’ll explain what this means and the impact it can have on your equity stake.

Founders and management of startup companies typically receive their shares / options on a vesting schedule. This mean that instead of receiving all of their shares at onces, they are given the option to purchase shares a little at a time. For example, a founder with 16,000 shares might receive them on quarterly intervals over four years, meaning he gets 1,000 shares each quarter. After 4 years, he is fully vested, meaning he has received all of his shares or options.

Now suppose that the above founder, after he is already fully vested, decides to seek VC funding. The investors may include a term requiring reverse vesting, meaning the founder must relinquish his shares and then re-earn them on a new vesting schedule.

At first, such clauses may seem extremely unfair to founders and management. Sometimes these clauses do indeed cause problems, but a lot depends on the specifics. Generally, the purpose of reverse vesting is to prevent founders at newly funded startups from leaving the company with their shares. This helps VCs protect their investment, but it also helps the co-founders and the company in general. The loss of a founder or other key person can often doom a company, leaving the investors and other company founders in the lurch.

On the other hand, fairly written reverse vesting terms should have some indication of the conditions under which a founder can or can’t leave with his shares. Such conditions are known as “good-leaver” clauses. Generally under such clauses, if a founder leaves on his own or is fired with cause, he loses some or all of his non-vested shares. If he is asked to leave without cause, he keeps his shares. Without such clauses, the founder can be fired at will, and the other shareholders (VCs and other management) will reclaim his shares.

In summary, reverse vesting may seem unfair to founders or management, but if structured fairly such terms can benefit both investors and the company itself. As with every term in a VC deal, the devil is in the details.