Embarking on a new business venture is thrilling yet laden with challenges. A crucial challenge is ensuring the long-term commitment of the founders. Here’s where vesting agreements and leaver clauses come into play.
Vesting agreements are agreements between the founders and sometimes the investors that make sure shares are earned over time, encouraging everyone to stay and help the company grow.
But what happens if someone leaves the company early? That’s where leaver clauses play a crucial role. They set the rules for what happens to that person’s shares if he or she leaves.
In this article, we’re going to break down these complex topics into simple terms. We'll talk about different types of leaver clauses – good, bad, and (not often used) medium leaver – and explain why they matter. Whether you’re starting a business, investing in one, or just interested in how it all works, this article is meant to help you understand these important concepts.
Vesting and Reverse Vesting Agreements
In the world of vesting agreements, you can distinguish between vesting agreements and reverse vesting agreements.
- Vesting Agreements are contractual arrangements which outline the conditions (or vesting schedule) under which a person may exercise options or may benefit from phantom stocks or virtual shares. After satisfying the conditions in the vesting schedule, the beneficiary may receive certain rights.
- Under a typical vesting agreement, the recipient earns his or her rights to shares or virtual shares gradually, ensuring they remain committed to the company’s growth and success for a set duration of time. For example, a four-year vesting schedule with a one-year cliff means that the recipient will not be able to exercise the right to shares until the end of the first year, but will then earn 25% of these rights, with the remainder vesting monthly or annually over the next three years.
- Reverse vesting agreements are used with regard to shares that are already issued and in the possession of a shareholder and which are subject to a repurchase right (usually) by the company if certain conditions are met. In these cases, a shareholder already owns the shares at the start, but the company retains the right to buy back a portion of those shares at nominal value if the individual leaves the company or fails to meet specific performance benchmarks within a designated vesting schedule.
In Switzerland, founders are usually subject to a reverse vesting agreement. To illustrate, consider a startup where a co-shareholder is holding 20% of the shares which are subject to a four-year vesting schedule and a one-year cliff.
- If the founder decides to leave after six months, he or she would forfeit the entire equity stake and the company (or sometimes the other co-shareholders) would have a purchase right with regard to all shares of the leaving founder.
- If the founder stays for one year, he or she would earn 25% of his entire equity stake (which equals 5% of his or her equity), with an additional 5% vesting at the end of each subsequent year in case of a yearly vesting. If the shares are vested, they are usually not subject to a purchase right anymore.
This reverse vesting agreement ensures that the founder is incentivized to contribute to the company’s success over an extended period, aligning their interests with those of other stakeholders.
Vesting Provisions – Options and Variants
While the standard vesting schedule is a four-year vesting with a one-year cliff, vesting provision can take other forms.
Some options are:
Time-Based Vesting
Time-based vesting is a common approach where equity vests at a consistent rate over a predetermined period, often with an initial “cliff” period during which no vesting occurs.
For example, in a four-year vesting schedule with a one-year cliff, the founder would not earn any equity in the first year but would then vest 25% of their total equity at the one-year mark, with the remainder vesting monthly or annually thereafter.
Milestone-Based Vesting
Milestone-based vesting links the right to shares to specific goals or performance benchmarks, ensuring rewards are directly tied to meaningful contributions to the company. This could include hitting revenue targets, launching a product, or achieving user acquisition milestones, providing clear motivation, and aligning individual success with that of the company.
An example for a milestone-based vesting could be the following:
In a software startup, a key engineer's equity is tied to crucial development milestones as follows:
- Prototype Completion (10% Equity): The engineer vests 10% of her total equity upon completing a functional prototype.
- Beta Launch (20% Equity): An additional 20% vests when the software enters beta testing, ensuring the engineer stays committed to refining and improving the product.
- Full Product Launch (30% Equity): With the successful market launch of the software, the engineer vests another 30% of her equity, marking a major step in establishing the company’s market presence.
- Revenue Target (40% Equity): The final 40% vests once the company hits a specific revenue target, tying the engineer’s long-term rewards to the product's and the company's financial success.
Vesting Acceleration
Very often, the vesting provision contains clauses for a vesting acceleration under certain conditions enabling quicker right to equity.
Potential options are the following:
Single Trigger Acceleration
With single trigger acceleration, a specified event such as an acquisition, change of control or merger can lead to immediate vesting of all or part of an individual’s equity, ensuring they are compensated even if the company undergoes significant changes.
Having a founder’s shares vest immediately upon change in control of the company requires the new owner to find alternative ways to retain and incentivize the team (who, depending on their ownership percentage and the value of the deal, may now be very rich). This need to provide new incentives may be thought of as an additional transaction cost by the purchaser, which could have the effect of driving down the overall deal price. Single Trigger Accelerations may therefore have negative consequences.
Double Trigger Acceleration
Double trigger acceleration is triggered in certain instances if (i) there is a change of control, sale, or merger of the company, and (ii) within some period of time thereafter, the respective shareholder is terminated without cause (or leaves the company with good reason). The Double Trigger Acceleration therefore requires two (2) events
The reasoning behind the Double Trigger Acceleration is the fact that the shares of a shareholder should only be subject to immediate vesting if a change of circumstances beyond the shareholder’s control resulted in his or her departure.
Good, Bad or Medium Leaver Clauses – What makes sense and is customary?
What are Leaver Clauses in general
Leaver clauses are contractual agreements that determine what happens to a shareholder’s equity stake if that shareholder is subject to a vesting agreement and leaves the company. Leaver clauses are usually categorized as ‘good’, ‘bad’, and sometimes as ‘medium’, each with distinct outcomes.
- Good leavers, departing under amicable circumstances, may be treated preferentially, allowing them to retain vested equity or receive full vesting acceleration.
- Bad leavers, on the other hand, could be those leaving under contentious conditions, facing potential forfeiture of vested and unvested equity.
- Medium leavers, not very commonly used, would be somewhere in between, providing a more balanced outcome.
Let’s go into more detail.
The Good Leaver
A 'good leaver' is typically defined as a shareholder who exits the company due to reasons deemed fair and justifiable, such as retirement, ill health, or other personal circumstances. The outcomes for good leavers are usually favorable; they might be allowed to retain their vested shares or sell them back to the company at a fair market value. For instance, a shareholder that leaves the company after more than four years due to health issues would be considered a good leaver and his or her shares would generally not be subject to a repurchase right of the company.
In Switzerland, a good leaver is generally defined as a person whose contractual relationship with the company is terminated by the Company without good reason or by the shareholder due to family reasons or personal health reasons. Please note that the termination by the shareholder due to another reason is often qualified as a bad leaver event (with the respective consequences). The term “good reason” can be defined in several ways but is usually defined as an important reason within the meaning of article 337 para. 2 CO. In case of a good leaver event, the shareholder may usually keep the vested shares. The unvested shares are subject to a repurchase right by the company.
The Bad Leaver
A bad leaver is a shareholder who exits the company under unfavorable circumstances, such as being terminated for misconduct or resigning on their own without a family or health reason. The repercussions for bad leavers are harsh; they might be required to forfeit their unvested shares or sell back their vested shares at a nominal value or the original purchase price, irrespective of the market value.
In Switzerland, a bad leaver is generally defined as a person whose contractual relationship is terminated (i) by the shareholder for a reason that does not qualify as a good reason except for cases where the contractual relationship is terminated due to family or health reasons (ii) by the company for a reason that qualifies as a good cause or that qualifies as a material breach of the contractual relationship of the relevant shareholder.
The Medium Leaver – Necessary?
The medium leaver category falls somewhere in between good and bad leavers, encompassing situations that do not clearly fit into either category. It is not often used in Switzerland and therefore not standard. For example, under the standard leaver clause, a shareholder who resigns for a new job opportunity is usually qualified as a bad leaver. One might conclude that such a severe outcome is not adequate and might qualify a person that leaves due to personal reasons as a medium leaver and define the outcomes for a medium leaver. Outcomes for medium leavers are variable and might involve selling back shares at a price between the nominal value and the fair market value or other negotiated terms. The rationale behind these medium leaver clauses is to provide a fair and balanced approach, recognizing that not all departures are black and white. While these clauses offer flexibility, they can also introduce ambiguity and might even incentivize a shareholder to leave the company early.
Key Considerations in Negotiating Vesting Agreements and Leaver Clauses
When negotiating vesting agreements and leaver clauses, ensuring a fair and balanced outcome for all parties involved is paramount. Both founders and investors need to pay close attention to the details to protect their interests and maintain a harmonious relationship.
- Clearly Define Leaver Categories: Ensure that ‘good’, ‘bad’, and (if you want) ‘medium’ leaver terms are explicitly defined to avoid ambiguity and potential disputes in the future.
- Balance Interests: Strive for a balanced agreement that protects the company and rewards individuals for their contributions. Ensure that vesting schedules and leaver outcomes are reasonable.
- Consider Future Scenarios: Anticipate various future scenarios and how they might impact the agreement. Ensure that the provisions are flexible enough to accommodate unforeseen changes while still protecting the company’s interests.
- Implement Fair Vesting Schedules: Adopt vesting schedules that encourage long-term commitment, including reasonable cliff periods and gradual vesting thereafter.
- Include Acceleration Provisions with Caution: While acceleration clauses can be attractive to employees and founders, use them judiciously and consider implementing double trigger acceleration-clauses to add an additional layer of protection for the company and to ensure a smooth exit.
Conclusion
Wrapping up, getting a grip on vesting agreements and leaver clauses is crucial for any business venture. They’re your go-to tools for keeping everyone on board and making sure shares are spread out fairly. Vesting agreements encourage commitment, making sure equity is earned over time. And when someone decides to leave early? That's where leaver clauses come into play, specifying what happens if someone leaves early.
Disclaimer: The information contained in this article is for general information purposes and does not constitute legal or tax advice. In specific individual cases, the present content cannot replace individual advice from expert persons.
