In M&A transactions, it is quite common to encounter contractual clauses whose content does not derive directly from any statutory provision, but which emerge through repeated use and eventually become almost standard market practice. This is particularly striking in European jurisdictions, where company law is relatively heavily regulated. However, investment transactions involve an extraordinarily wide range of circumstances (no statute can anticipate them all), and the longstanding practice of importing drafting conventions from common-law jurisdictions means that these contractually created clauses ultimately become part of day-to-day corporate transactions.
One such clause, increasingly common in shareholders’ agreements, is reverse vesting. The concept may sound perfectly intuitive to an entrepreneur, yet its terminology can be troublesome for those with a more rigid legal mindset because it rests on a technically inaccurate assumption: that founders do not yet own their interest in the emerging company (they do) and must ‘vest’ it over time.
Why include vesting in a shareholders’ agreement?
Every entrepreneur has experienced the same reality: the launch of a project is the point at which the founders’ vision and commitment are at their strongest. Everyone is pulling in the same direction and towards the same goal, trusting that the figures in the spreadsheet will be borne out in practice.
At that stage, it can be difficult to imagine enthusiasm waning or one of the founders losing interest in the project. Yet that moment may come. The demands of day-to-day operations can cause wear and tear (and often do), particularly in the early stages, when positive results almost always take longer than hoped. Discouragement can then replace the initial excitement.
That loss of motivation may lead one of the founders to seek to bring forward their departure from the project, before the time originally envisaged or agreed. Personal financial pressures, a departure from the original concept, loss of confidence or simply a later misalignment among the shareholders… many factors can quickly turn a motivated founder into a disillusioned one.
When this happens, the shareholders who remain committed to the project are left on their own and in a clearly disadvantaged position: they lose some of the momentum needed to achieve the emerging company’s objectives while also assuming a greater share of responsibility.
For this reason, it has become common practice in the entrepreneurial ecosystem for founders to give reciprocal commitments to remain involved in the project for a minimum period and, as a logical consequence, to include provisions in the shareholders’ agreement that make those commitments effective. Reverse vesting is one such provision.
What is reverse vesting?
Reverse vesting simply establishes, in a shareholders’ agreement, a minimum period during which the founders must remain with the emerging company (typically the period considered sufficient to determine whether the venture is viable). The agreement treats the founders as having full and unrestricted rights over all the shares they subscribed for on incorporation only once that period has expired.
In the meantime, the passage of time (the ‘vesting period’) gradually ‘releases’ those shares in the proportions and subject to the conditions agreed in each case. Once the vesting period ends, the founder is deemed to have vested 100% of their shares and may therefore participate fully in an exit transaction. By contrast, an early termination of that period at the initiative of a founder, whether for justified or unjustified reasons, will trigger certain economic consequences, usually an obligation to transfer the shares to the other shareholders or to the company at a pre-agreed valuation.
This is a creative and unquestionably effective way of addressing the issue. It is reasonable for the founders of an emerging company to require the same degree of commitment from one another and, accordingly, to limit the economic upside available to a shareholder who does not remain involved for the agreed period.
The legal curiosity, and apparent contradiction, albeit contractually valid and widely recognised by the courts, lies in the use of the term ‘vesting’, when in fact there is nothing left to vest. Under the Spanish Companies Act, a shareholder acquires full and unrestricted title to all shares upon subscribing for them in the deed of incorporation. Therefore, any variation of that statutory position agreed among all founders, such as reverse vesting, must be express, written, clear, precise and unequivocal if it is to be valid as a shareholders’ agreement (that is, an agreement not originally incorporated into the articles of association but entered into by the shareholders and therefore binding on them).
How does founder vesting work?
The vesting period is the period over which the founders’ shares vest in accordance with the agreed schedule. It will usually last between three and four years, although it may be shorter or longer depending on the circumstances.
Once the vesting period has been completed, the founder is deemed to have vested all of their shares, although, as noted above, they already own them as a matter of law. If the vesting period is not completed, or is only partially completed, the economic consequences discussed below will apply.
What is a vesting cliff?
Vesting may commence upon incorporation or be deferred by the founders until a later date, such as the signing of the shareholders’ agreement, the closing of a funding round or simply the expiry of an agreed period. The period between incorporation and the start of vesting is known as the cliff. If a founder leaves the emerging company during the cliff, none of their shares will have vested and all of the shares subscribed for under the notarial deed may therefore become subject to a transfer obligation.
Vesting schedules and accelerated vesting
Once vesting has commenced, with or without a cliff, each founder’s shares vest in accordance with a time-based schedule. The arrangements vary considerably, but the most common points to address include:
- Annual vesting (25% per year for a four-year vesting period, 33.3% for a three-year period, etc.) or monthly vesting (1/48 per month for a four-year period, 1/36 for a three-year period, etc.). Vesting may also occur quarterly or every six months.
- Vesting at the end of each period (at the end of the relevant month or year) or at the beginning of the period (on day one of each period).
- Whether a founder’s departure during a vesting period results in the relevant shares vesting, which will normally depend on whether vesting occurs at the beginning or end of the period.
- Acceleration of vesting upon the occurrence of a liquidity event, which is particularly relevant if a funding round takes place.
- Whether a cliff applies and, if so, its duration.
- The possibility of a non-linear vesting schedule, for example 40% in the first year and 20% in each of the following three years.
What happens if a founder leaves the emerging company before completing the vesting period?
Moreover, a penalty refers to the consequence borne by a founder who leaves before the minimum commitment period has expired. As noted above, this will usually take the form of an obligation to transfer the relevant shares to the other shareholders, to the company where legally permissible, or to a previously identified or objectively identifiable third party, at a pre-agreed price. The parties may even agree that the transfer will take place at nominal value, meaning that the founder merely recovers the amount invested.
Good leavers/bad leavers: 2 ways to implement reverse vesting
Finally, reverse vesting is closely connected to another common provision in shareholders’ agreements: good leaver/bad leaver. This distinction alone would justify a separate article. For present purposes, it is enough to note that not all founders leave a company on the same terms. Leaving as a result of a breach of the shareholders’ agreement or directors’ duties is not the same as an amicable departure arising from differences over business strategy or personal reasons unrelated to the company. A reverse vesting arrangement should also address this distinction so that, even where a departure is early, it occurs on reasonable terms consistent with what the shareholders agreed at the outset of the project.
↳ Discover more content in the section Insight.
↳ Do you want to stay up today about the sector related news? Follow us on LinkedIn.
