The acquisition of company shares by employees and investors is commonly facilitated through the utilization of vesting provisions or by outright purchase of equity. In contrast, the founders of a company typically possess equity in the company from its inception. So, most of the founders’ absolute control over the shares is done through founder agreements or VC term sheets, including reverse vesting provisions. Thus, reverse vesting in a company occurs when the founder of a company receives their shares and the ownership interest upfront. This exchange type is very similar to the vesting of employee stock options. If the founder leaves the organization, the company may repurchase a particular amount of those shares.
In reverse vesting, the company’s founder already has all the shares, and he may be forced to sell a certain percentage of it for no profit if he leaves without completing the vesting period. Reverse vesting defines a situation where any independent contractor or employee gets stock that is subjected to the company to repurchase at a cost that lapses the vesting period. This contradicts the normal situation where a service provider has the right to buy stock or an option but can only use this right when it is vested in the provider. In companies, many investors or employees earn shares by staying in the company for some time as per the vesting provision or buying equity. Still, the company’s founders have the advantage of having equity from the beginning.
However, many VC term sheets or founder agreements do not allow the founders complete control of their shares if they terminate their employment with the company before the end of the vesting period, i.e., four years. In such a case, the company can buy back the rights of the shares that are not mature for a small fee or even, at times, for free. This means they only get some of their claims at a time but can purchase them in small amounts at different times within those four years.
Talking about a company’s stock options keeps the company motivated since stock options are often vested, and their absolute value gets broken down into installments for each month. Thus, this encourages the company’s employees to stay in it for longer, as they know that the longer they will be there, the more options they will have for buying shares. Thus, vesting lets company employees control their claims whenever the vesting period is over.
Having reverse vesting provisions in any VC term sheet or founder agreement is to protect the investors by ensuring that the founders have incentives that encourage them not to terminate their employment with the company. This also restricts the founders from suddenly leaving the company and taking a substantial number of shares. A reverse vesting agreement is often signed whenever the first significant investment is in any startup. But often, what happens is that the founders include these provisions in their founder’s agreements, receiving assurance that the founders and the co-founders will be committed to the company. Reverse vesting usage establishes a certainty to this situation. The best way of ensuring the reverse vesting protection is to involve shareholdings since the company places a set amount of shares in a trust for the co-founders, and then a schedule is set up which turns full ownership of the shares to the co-founder. This can be done monthly or annually.
Although reverse vesting is a very convenient tool for the protection of the company, preventing it from having any substantial loss, attracting more investors for having a better chance over higher ownership interest, encouraging employee loyalty towards the company to stay in the company, there are still certain reasons as to why it should not be considered to be used all the time. Since the company’s founders determine the rules about the reverse vesting agreements, it gives them less control over the business they have. Thus, it should be left at some point. Also, the risk in using reverse vesting is high since, if the company is a startup, any early setback becomes very harmful for the founder, especially during the reverse vesting period.