There’s already a wealth of information out there on the basics of term sheets and startup vesting—things like valuation, option pools, and SAFEs—so there’s no need to go over it again here. Instead, I’m going to illuminate some of the subtleties involved in negotiating term sheets as an entrepreneur. First and foremost: founder vesting agreements, followed by pro rata rights.
Why founder vesting agreements matter
It’s extremely rare for founders to get their shares right away. Instead, institutional vendors generally tend to ask for some type of initial startup vesting. This is something a lot of founders don’t like, but the reality is that startup vesting terms are there for everyone’s protection; that includes you.
Say you’re part of a three-person team that’s just raised its first successful round, and all of your shares have been set to vest immediately. Then, the next day, one of your co-founders spontaneously decides to try something new and joins a big tech company, leaving you and your remaining co-founder to build the business yourselves. After months of backbreaking 80-hour workweeks, the two of you find success—and your erstwhile co-founder gets to reap the same reward as you. Scenarios like this are what founder vesting agreements are designed to avoid. Establishing a startup and building value should be a team sport: if someone decides to leave, there should be a plan in place that outlines how to handle equity in a way that’s fair for everyone involved. Waiting for a scenario like the one above to make a decision is a bad idea: inevitably, emotions come into play, and the departing co-founder isn’t really incentivized to help you arrive at a fair outcome.
Venture investors go into business with founders in the hope that they’re going to build a company together. They don’t want to be left holding the bag if an entrepreneur decides they don’t want to continue the journey for whatever reason. This does happen, and it can be for any number of completely legitimate causes:
- They may stop getting along with a co-founder or other executive
- Personal circumstances may arise: a spouse has to move to accept a job, or a family member requires long-term medical care
- Burnout is always possible
There’s often no need to demonize a founder who decides to walk away, which makes the founder vesting agreement even more critical because it formalizes the process. It’s very rare that a company starts out with a massive executive team; more commonly, everyone ends up wearing multiple hats. The loss of a founding member creates a difficult vacuum to fill, and having substantial equity available to someone who can do the job will act as a strong incentive for a new person to come on board.
Startup vesting schedules can create the impression that investors are troublesome and controlling. The reality is that terms can be abused by both sides of the table; building trust is essential. My advice for any startup is to build and start a vesting schedule for your options before you even start looking for funding. By the time you come to the table, potential investors can see your vesting schedule at work. This can be a nice way of showing you’ve been thoughtful about building your business, and will help put them at ease.
A word on re-vesting
Founders understandably get nervous when asked to re-vest some portion of their shares. The fear is that an investor will put money into the business and then remove the founders in favor of people they believe are better for whatever reason. While there might be some bad actors out there, speaking personally as an early-stage investor, the last thing I want to do is remove founders; the whole point of investing is that we’re betting on the team’s ability to execute—finding someone else willing to take a risk on your product vision is next to impossible. If I had questions about a founder that made me think about replacing them, I would simply not invest in the first place; this is fairly typical of early-stage investors.
No founder should ever be asked to re-vest their shares without significant protections in place against removal for some random reason. In many cases, an investor doesn’t have the ability to make changes (a subject for another post perhaps), but sometimes they do. It’s reasonable to expect that a founder would give their shares back if they leave on their own, but it’s not fair to make a founder re-vest their shares if they could be fired at the whim of their board. This is a conversation worth having with investors; there are ways to address everyone’s concerns. You can re-vest some of your shares and be protected from bad actors at the same time. In the vast majority of situations, we don’t ask founders to re-vest their shares, but sometimes when things are early and everyone needs to be aligned, it’s an ask we make carefully, because we know it can be easily misinterpreted.
When pro rata rights are trashed
Over the years, I’ve observed a growing trend in the realm of pro rata rights. Venture capital pro rata rights define an investor’s ability to participate in future financing; they allow the investor to maintain their ownership percentage as the company moves forward, and equally importantly, invest more money in future rounds. It’s an option with real economic value to VCs: having the ability to invest in future rounds at the same level is a meaningful way to increase returns to our LPs.
I’ve seen pro rata rights get more and more contentious year on year. In the scenario I see most often, a heavy-handed late-stage investor (typically larger funds in the $500M-plus range) sees a company they want to get into, and wants to stake out as much ownership as they can. So they offer to put up a substantial sum at a great valuation, but with the proviso that the other investors in the round have to give up their pro rata rights. From their point of view, this makes complete sense. From the perspective of the company and the founders, it makes sense too: great investor at an even greater valuation—what’s not to love? However, it creates problems for early-stage investors, who are forced into the position of having to waive their pro rata rights, pitting their interests against those of the company. Conventional wisdom might dictate that if the early-stage investor has a great relationship with the founders, it wouldn’t be an issue, but unfortunately, that’s too simplistic a perspective. When significant differences in dilution are at stake, it’s all business, and business can be messy.
One way for a company to get around this dilemma is to take the big fund’s money, let the earlier investors keep their pro rata rights, and simply raise more in the round. This happens fairly often, which is why you see investment rounds grow and grow before they close, especially in later stages where dilution from raising additional dollars is less impactful on the company. At lower valuations, it becomes a much bigger issue.
Unfortunately, I don’t have a magic answer to this problem. I understand the different perspectives; I think it’s important for everyone to start off with the same understanding.
The best way to work with challenging non-valuation terms
I encourage founders to have a conversation with any investor asking for controversial terms and try to understand why they’re being requested; an answer from an investor along the lines of “This is what we always do” is garbage without context. As a founder, you deserve to understand why the investor is asking for a particular term, and they ought to be able to explain their thinking without repeating what someone told them or parroting what their attorney thinks. Don’t settle for explanations that sound like they were read off a cereal box or impenetrable legal babble; everyone should be talking in business terms, not technical legal issues.
This consideration goes both ways. As with many things in life, trust provides the core foundation in relationships. Discussing terms with your investors—challenging and otherwise—is a great way to start.
Ryan Floyd is co-founding MD of Storm Ventures, host of the #AskAVC Video channel, and podcast. This article is based on an episode of the MintzEdge podcast hosted by Jeremy Glaser, Co-chair of the Mintz Venture Capital & Emerging Companies practice.