Last month, I’ve written a guide to the vesting schedules (here’s the link to the guide) and an overview of different vesting schedules for startups and about reverse vesting. This time, this post will supplement the earlier discussion as I will explain how you can save your startup from being ruined and avoid potential conflicts between the founding team in charge, and above all, how to have the early shares cap table under control from the start to ensure the risk of having an “uninvestable” startup.
In my experience as a startup lawyer, Malaysian founders tend to get confused with the Silicon Valley terminologies when it comes to vesting (more on this below). Unfortunately, phrases like “restricted stock” and “stock repurchase” do not exist here in Malaysian companies’ law context. So reverse vesting is the most common vesting set up in Malaysia where company’s co-founders receive upfront shares in exchange for the usual vesting schedule (like employees shares option)). Here’s the explanation to help you understand the differences.
Vesting 101: What is vesting?
At the initial stage of a startup’s growth, a startup is dependent on its founding team to grow and run the business. If a company is bootstrapping, all founders tend to receive equity (aka shares) in exchange for their involvement in the company (usually on a full time basis). A vesting agreement allows co-founders to align their interests towards the long term goals of the company.
Vesting is important to align the interests of the founders to the company (eg, avoiding their sudden departure from the company).
Why is vesting is important for startups?
Additionally, investors tend to compel co-founders to agree on a vesting period to manage their downside risks before investing in a company. Imagine if a co-founder who has, for example, half of the shares in the company decides to leave a company suddenly.
Reverse vesting vs normal vesting: What are the differences?
Vesting is an acquisition of a number of issued rights to shares by a person (eg, an employee or a third party like a mentor or adviser) under the so called ESOS, i.e. the employees shares option scheme. Essentially, vesting is a contractual agreement of transferring or selling shares to employees after such employee achieving certain conditions or achieving certain pre-agreed results (like working in a startup for an agreed duration or achieving certain KPIs or goals by an employee)). Additionally, eligible employees get to have a stake in the business and stay in the company with the opportunity to exit if the company gets sold or listed in the stock exchange someday.
If you want to have more discussion on vesting especially illustrations on a typical vesting schedule in Malaysia, please read my earlier post on an overview of vesting schedules that I’ve written last month.
In contrast, reverse vesting applies to the block of existing shares owned by the shareholders (eg, co-founders. the shareholder who is subject to a reverse vesting will have to sell their shares in the event of his or her departure from the company before a specific time (aka vesting period). In life, people may have to leave a venture for all sorts of reasons (like permanent disability or even death). The key component here is what amounts to an acceptable departure, hence the phrases “good leaver” and “bad leaver” (more on this below).
Reverse vesting: How does it work in Malaysia?
Reverse vesting is a scenario when a company’s co-founder gets his or shares upfront (usually upon entity formation). The shares issuance is subject to the vesting similar to employees shares option (aka ESOS).
This is where it gets tricky. Like what I’ve mentioned before, unlike a typical Silicon Valley company, the companies’ law in Malaysia is strict when it comes to shares buyback or repurchase. For instance, the shares buyback by a company is subject to solvency test and other compliance requirements. For example, in a solvency test, the company’s directors needs to demonstrate that it is able to pay off the company’s debts within the next six months from the date of buyback. It may be hard for a bootstrapped startup to fulfil these requirements in addition to other paperwork and filing to both the Companies Commission of Malaysia and the Inland Revenue Board respectively. In other words, it may not be practical to structure a shares buyback clause by the company.
To avoid dealing with the complexities of the law, I usually suggest co-founders to agree that if one of the co-founders leaves the company, the remaining co-founders will be entitled to acquire an agreed number of shares held by such departing co-founder (for example, on a pro-rata basis) so that the remaining founding team can source for a new replacement or substitute.
When should you set up a reverse vesting?
You can structure the reverse vesting as soon as you decide to form a new entity for your company. But if the company was formed by a single founder, then at the time of joining of the other co-founders. In my experience, too many founders use “gentleman’s agreement” without having any written agreement in place.
If your co-founder decides to leave the company and joins another company, you will be in a bind if the co-founder refuses to transfer back the shares to you (especially if the co-founder just decided to just leave suddenly and ignoring you). As a result, you’ll be stuck in a company with half of the shares held by a “phantom” shareholder. The business may get destroyed or stopped. In practice, the departure may even result in the company becoming “uninvestable” for most investors (and no investor wants to inherit your legal problems). You may end up having to form a new company just to start the company all over again. I strongly encourage you to get a startup lawyer to structure a vesting agreement (the terms can be signed in a standalone contract or even included inside a founders’ agreement or shareholders agreement) to ensure that all the founding team are aligned with the company’s long term goals