Dead equity makes your company uninvestable

Get this wrong, and you may be digging a grave on your cap table

TL;DR: If you don’t have a vesting schedule, your co-founder can call it quits the day after you start the company… and keep their entire stockholding. That chunk of stock will become “dead equity”, making your company uninvestable.

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40%? For what?!

You and your co-founder are super-pumped about starting a company. You shake hands, form the company, and dive headlong into changing the world.

Three months later, your co-founder asks if you guys can chat.

“Man, this is much tougher than I thought,” he says.

“I know, right?! Such a steep learning curve,” you respond.

“Yeah… I kinda miss my old corporate job,” he shares, looking away.

“Really? You were happy to be done with it.”

“I know, but… living off of savings… it’s scary,” he says.

You kind of feel what’s coming.

“I want out,” your co-founder says, looking at you.

You drop your gaze. “I mean, you gotta do what you gotta do. Hand back your shares, and we’ll just do a clean break,” you mumble.

“Hand back my stock? Why? I started this company.”

“Yeah, but you’re quitting! Why should you keep 40%?”

“What do you mean? I came up with the name!”

“You’re kidding me, right? 40%, just for the name?!”

Well, that escalated quickly…

Talk about vested interests

This nasty argument (and we’re seeing just the tip of the iceberg here… this can blow up big time) could have been entirely avoided if the founders had talked about – and implemented – vesting schedules before starting the company.

What is vesting?

It has absolutely nothing to do with garments. When a right “vests”, it means the person who holds that right gets to take advantage of it. I like to use the term “inalienable” – when a right vests, it becomes your inalienable right; nobody can take it away from you.

Let’s apply that to stock. If someone’s stock is subject to vesting, that means that as the stock vests, it becomes theirs to keep – their inalienable property. But until it vests, it can be taken away from them, particularly if they leave the company.

What’s a vesting schedule?

This is the schedule – or timeline – based on which a person’s stock vests, or becomes their full, inalienable property. It’s normally expressed as a function of time (aka “time-based vesting”), although it can be attached to milestones as well (“milestones-based vesting”).

The idea here is that the person earns their stock over time – presumably because the more time that passes, the more work they have done for the company, and the more compensation they should receive in return (in this case, in the form of stock).

What’s a typical vesting schedule?

For founders and employees, a four-year vesting schedule with a one-year cliff is typical. Let’s break down each of those two elements.

Four-year vesting

This means that the founder is going to get their stock over a period of four years, and it’s usually spread out in equal monthly increments. Since four years has 48 months, we would divide the entire number of shares that they’ll be getting by 48; we’ll then round down the resulting quotient.

This is the number of shares they’ll be vesting each month.

One-year cliff

Adding a cliff means that the founder won’t vest anything until the first anniversary that they’re with the company. On that one-year anniversary, they’ll vest 1/4th of the entire number of shares they’ll be getting. This is logical, because they’re supposed to get it all over four years – so in one year, they get 1/4th of that.

Why is this such a big deal?

Let’s put it into perspective by looking at another kind of compensation: cash.

Assume you’re hiring someone. You expect them to work for your company for four years. You offer them a yearly salary of $100,000… but you pay them their four years’ salary in advance, all on the first day they start working.

Now, imagine on Day 2, your hire walks in the door and says “I quit!” The $400,000 is already in their bank account – they’ve already been paid for four years of work, even though they’ve worked only a day.

Sounds pretty unfair, if not borderline ridiculous, right? This is the outcome we get if we grant stock to someone without vesting.

Equity is your company’s most precious currency

Cash is infinite (potentially). Equity is finite. There’s only 100% ownership. There’s no such thing as 120% ownership (not in this universe, at least…). So, the most potent way for attracting talent and capital is through equity, because it is so scarce.

When 40% of your company’s ownership is with an ex-cofounder who only came up with the name, that leaves you with only 60% of equity with which to craft relationships. That 40% is dead equity.

But to go a step further – in the previous example, the hire got $400,000, and the “damage” they caused the company ended there, with that dollar tag attached to it. That’s not the case with equity – if someone has equity in a company, the “damage” they’re causing to the company (the value they’re “stealing” from the company) potentially doesn’t stop increasing. The more the company grows, the more valuable their equity becomes, and so the larger the “damage” they’re causing to the collective venture.

Your morale will plummet…

Think of it this way: someone has 40% of your company by doing nothing for your company. So, for every dollar that you and your team bring to the company, 40 cents of it is going to someone who can just sit at home and watch Netflix all day. How would that make you feel?

…and no investor will want to invest.

Along the same vein, investors want to team up with teams that can make the best use of the capital and ensure top ROI. If 60% of the company’s ownership is putting in money and effort to make things work, and 40% is free-riding, that sounds a lot of like selfless altruism, and, fundamentally, that’s just not the way business works.

Can this be fixed?

It can, but not without quite a bit of headache and hefty payouts (to your lawyers, to the ex-cofounder… or both).

Settlement

This would be the most amicable solution (if it’s possible to part on amicable terms after what would probably be a nasty back-and-forth). The ex-cofounder agrees to sell their shares, the company agrees to buy them, they come to terms on the price, and call it a day.

Dilution

Assuming the company hasn’t appreciated much, the company can go ahead and authorize and issue lots of new stock, all of which would be distributed to the existing stockholders except for the ex-cofounder. This would result in the ex-cofounder’s ownership stake in the company dropping significantly.

Asset transfer

The current company’s assets can also be sold to a new company, the ownership of which would be different than the current company (the ex-cofounder’s stake wouldn’t be as prominent –or would be nothing).

Creating new problems

But wait – do the latter two options remind you of the lawsuit by one of Facebook’s founders? Well, that’s because they are potent ground for litigation – which would take you back to square one, settlement. These options also assume that the ex-cofounder can’t block them from happening.

Let’s see vesting in action

Let’s assume that:

• there are two founders, each with 4,000,000 shares,

• they start their company on January 1, 2024, and

• they’re on a four-year vesting schedule with a one-year cliff.

They don’t get vest anything until…

January 1, 2025, since they have a one-year cliff. On that day, they’ll each vest 4,000,000 shares divided by four = 1,000,000 shares.

And then each month they vest…

4,800,000 shares divided by 48 months = 83,333.333 shares. Round that down, and you get 83,333 shares per month. This amount vests on the first day of each month, because they started working on the first day of January. Had they started on January 15, then they would vest on the 15th of each month, and so forth.

So what happens if a founder leaves early?

Let’s look at a few scenarios:

• If they leave by January 1, 2025, they get nada.

• If they leave by, say, April 15, 2025, they get 1,249,999 shares, which equals:

  • 1,000,000 shares, since they crossed the one-year cliff, plus

  • 83,333 x 3 = 249,999 shares, since three monthly anniversaries would have passed after the cliff (February 1, March 1, April 1).

Can stock be taken back even after it vests?

In rare circumstances, and if the stock documents so provide – yes. For example, if the cofounder tacitly competed with the company or shared confidential information with a competitor, this may be ground for the company to take back even vested shares.

And they fully vest on…

If a founder sticks it all the way through, they’ll vest all their stock on January 1, 2028 – or four years after the vesting started.

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Startup Ecosystem Member Highlight

Over the past years, I’ve had the opportunity to meet with amazing people who are super passionate about startups. I’d love to introduce them to you through this newsletter, as they can be helpful to you as you start, grow, and scale your startup.

Meet Tim Cason

Tim is the COO/CMO of CTRL Collective, a beautiful co-working space located in the heart of Old Pasadena.

The startup ecosystem is driven by fostering relationships and creating value, and CTRL Collective encapsulates this spirit beautifully. Through selfless effort, Tim has created a corner where entrepreneurs and professionals can connect, collaborate, and learn from each other: a community in the true sense of the word. By the way, it also has an awesome podcasting studio if that’s your thing!

I was fortunate to learn about this space through a networking event and have been working out of this vibrant community for two months now.

You can connect with Tim on LinkedIn and check out the space here.

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Until next time!

Stepan

A bit about me: I’m a former corporate lawyer with 10+ years of experience helping 100s of companies navigate the legal journey, including early-stage startups and unicorns. I quit my private practice to start Corpora and help founders raise money faster by automating the legal backend. Let’s connect on LinkedIn.