This article is the second of a three-part series explaining the key terms you'll need to negotiate when raising money.

As a recap, Part One explored the key economic issues of valuation, dilution and anti-dilution and liquidation preferences. Part Two, this article, will explore founder vesting and repurchase agreement, and Part Three will cover terms relating to control.

Avoiding the time sink

In my role as COO, I've reviewed hundreds of term sheets for early-stage companies. Few terms are negotiated more passionately than the clauses that define founder vesting and the repurchase agreement––this is understandable; these terms define the schedule of ownership and payout for founders if they, or their co-founders, separate from their company, amicably or otherwise.

In this article, we'll explore why it's essential to include these terms, how to structure these terms to ensure the long-term success of your company and best practices. Taken together, this will save you time and stress during fundraising and in future.

Repurchase agreements: framing

You have likely come across "repurchase agreements", which describe all the circumstances where a repurchase of shares from a founder may occur. This term is heavily negotiated, and rightly so, in my view, as founders do not want to give up shareholding in the company they have built. So, why do investors demand them? 

It can take a decade or longer to build and scale a startup into a globally successful company. Over that journey, there will likely be a change in the relationship, commitment and input of one or more co-founders and the business; this commonly takes the form of a co-founder stepping down after a few years to pursue another idea or area of interest.

In my experience, even in the best of breakups, co-founder separations are complex, time-consuming and emotionally fraught experiences. They are also not uncommon experiences.

Consider a few different scenarios:

  • Your co-founder suffers from a long illness and decides to step away from the business.

  • You want to leave your current startup to pursue a new startup idea.

  • You and your co-founder irreconcilably disagree on the strategic vision of the company.

  • Your co-founder leaves to join a competitor.

  • A co-founder commits fraud.

In one or more of these scenarios, now imagine that the outgoing founder takes a significant portion of the company with them; this could leave the company in a highly precarious position.

While founders (and investors) are natural optimists, it's crucial to consider the impact of a founder leaving your company mid-journey with a significant chunk of equity.

Agreeing upon a vesting schedule and a repurchase agreement in advance of a founder leaving will also help define an objectively fair outcome for everyone, helping to keep the negotiations clean, fast and straightforward. Importantly, it will also allow critical team members of your team to refocus on the business.

Founder vesting

Underpinning an appropriate repurchase agreement is a founder vesting schedule.

In the same way that key staff have vesting conditions when awarded employee share options or shares, we expect that founders' shares will also have vesting conditions.

From a founder's perspective, it can be challenging to agree to put your shares at any risk. After all, you've built the company, it's your vision, and you've given up so much already to get to this point.

But in my experience, founders rarely have issues with a vesting schedule in practice as they appreciate the benefits of having one in place. On the other hand, it is sometimes a red flag when a founder pushes back on this condition, even after a lengthy discussion.

As founder vesting often resets with every round, and we empathise with the need for founders to want certainty when building their company, depending on the traction and stage of the company, we will often relax the requirement so that less than 100% of the founder's shares are subject to vesting.

As to the condition of the vesting itself, vesting is for four years with a 1-year cliff, though it can vary between 3-5 years. The 1-year cliff means that nothing vests for the first 12 months, then at the 12-month mark, 12 months vest. After that, the equity vests in a linear manner, usually monthly for the next 36-month period.

Now comes the tricky part – what happens if you leave whilst shares are still unvested? This is where any 'good leaver' and 'bad leaver' definitions come into play. 

Bad Leaver

Definition: Our definition of a 'Bad Leaver' is very strict and narrowly defined, only covering those situations that will have a material impact on the company.

We haven't had a bad leaver at a Square Peg portfolio company, and I sincerely hope we never do as the consequences are severe for everyone: the company, the continuing founders, the team and the Bad Leaver. Given actions of the bad leaver are likely to result in economic loss for the company, there is also an economic loss for the founder. 

Typically, unvested shares are lost, and vested shares are bought back at a discount to fair market value. The discount varies between markets and investors in the widest possible range of 100% to 0%. We sit squarely in the middle, with a discount of 50%, although in many negotiations the discount ends up closer to 0% than 50%. We counsel founders that these terms are to protect those left behind and penalise those who act badly. It's those that remain that must repair any damage done for the benefit of all, including those that have caused any damage to the company. Square Peg gives the option to the founders to buy back the leaver shares (whether bad leaver or good leaver) or for the company to buyback and add to the ESOP pool. 

Encouragingly, our bad leaver provisions are being increasingly adopted by founders as most understand the negative consequences of not doing so.

Good Leaver

Definition: Generally, if you are not a Bad Leaver, you are a Good Leaver.

Good leaver is much simpler but also has some variation between investors. If you are a good leaver, any unvested shares are lost but you keep your vested shares. Of course, there are always some exceptions where an acceleration of unvested shares occurs–this is usually in the case of death, ongoing serious illness or by special decision of the board. It is also quite common to see 100% acceleration of vesting where the board has terminated the relationship with the company without cause. Square Peg terms usually have full acceleration on sale of the company or IPO such that 100% of the founder's shares are deemed to have vested but, in most cases, at this stage of the company's lifecycle, the founders' shares have fully vested, so it's a moot point.

Some founders will argue that in a good leaver situation, the founder will keep unvested shares in addition to vested shares, but we don't see the logic in this. Not only have we invested in the founder's long-term vision and commitment at high growth valuations, but we also query the purpose of vesting if unvested shares fully vest when a founder leaves voluntarily.

The takeaway

Founder vesting and repurchase arrangements are complex issues and we acknowledge that some have contrary views to mine.

If there is one thing that you take away from this article, it's that your time is precious.

Suppose you find yourself in a founder breakup and do not have terms defining the outcome in place. In that case, I can guarantee you will lose a ridiculous number of hours and much emotional headspace getting to a resolution, and you may not like the result. 

I strongly suggest you spend the time now setting up a framework that rewards good behaviour and incentivises those focused on adding value. As always, alignment is key.

In Part Three, we will discuss terms that relate to control, another component of the term sheet that is passionately negotiated.

If this article has helped you get a grasp on the important terms you can subscribe to All Signal, where we share long-form content and insights. Part Three will be published there, first–sign up and you'll get it sent to your inbox the moment it's published.

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Square Peg Capital Pty Ltd (ACN 164 352 229) is an Authorised Representative of Victoria Capital Pty Ltd (ACN 159 228 314) AFSL 428989