Por Mauro Rebelo

Vesting agreement and other things


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When, at a meeting of entrepreneurship teachers, my colleague Edison mentioned the title of the book ‘Founder’s Dilemmas’, I knew I had to read it. But the book was much better than I imagined. An extensive historical survey of startups and entrepreneurs showed me that my dramas weren’t just mine: they were common and there were even statistics and best practices (since, as the name implies, they are dilemmas and don’t necessarily have a right answer) for them.

“For Ockham’s co-founder and CEO, Jim Triandiflou, not receiving a salary was the badge of honor of an entrepreneur: ‘April 19 was the first day of Ockham because it was the first day we didn’t receive a salary. If you’re not getting paid, then you’re now an entrepreneur'”.

It’s a beautiful definition that I take from the book. It’s what Nassin Taleb calls ‘risking your own skin’. People do incredible things when they have a lot to lose. And they get complacent when they don’t. That’s why you can’t completely trust or follow the advice of someone who has nothing to lose from the consequences of their actions. An entrepreneur has to risk his own skin or the market (and the company) won’t see the value in him.

Here’s another example from the book:

“According to agency theory, executives [de uma empresa] are ‘agents’ who act in their own interests, as opposed to the interests of the company; company owners therefore need to structure remuneration (and monitor the behavior of their agents) in order to link an executive’s self-interest as closely as possible to the organization’s objectives. […] On the other hand, founders (especially founder-CEOs) tend to act more like the directors or “administrators” of management theory – people who identify closely with their organizations and therefore derive greater satisfaction from promoting organizational interests than from purely selfish behavior.”

That’s why I don’t want executives in my company: I want partners.

But having partners isn’t easy. In fact, it’s so difficult that I’ve spent most of my time as an entrepreneur resolving corporate conflicts. If I had read Founder’s Dilemmas beforehand, I might have spent more time choosing my partners and perhaps had fewer conflicts as a result.

It was in this book that I learned about vesting agreements and what kind of situation we should anticipate in these contracts. I’m going to list some passages from the book that have educated me and I believe can educate others.

“Inspired by a famous quote from former US Secretary of Defense Donald Rumsfeld, my colleague Deepak Malhotra has developed a general way of categorizing the different types of uncertainty involved in contracts as ‘knowns’ (whose outcomes are already known or are guaranteed), ‘known unknowns’ (scenarios where one can anticipate the occurrence but not the outcome) and ‘unknown unknowns’ (any complete surprises that the future holds). These three types of uncertainty can be addressed by terms, contingencies and confidence, respectively. […] The distribution of shares among the founders involves known elements, such as how much capital each founder has contributed or who owns the patents, which can be dealt with using standard contractual terms. […] The known unknowns can be dealt with using contingent provisions that describe how the equity split should change for various worst-case, expected and best-case scenarios. […]”

He cites a few cases

“The agreement specifically mentioned the possibility that Ken would not be working for the startup: “In the event that Burows is not a full-time employee of the Company by April 19, 2000, the remaining Founding Shareholders shall have the right to (…) purchase fifty percent (50%) of the Shares owned by Burows.”

This agreement can be made through a call option to be executed under a specific condition (in the case above, Burrows not being a full-time employee of the Company by a certain date) and a power of attorney to remove his name from the articles of association without needing his signature. The condition for executing a call option can be linked to performance, which makes the terrain more dangerous the less objective the targets are. It’s a powerful way of implementing meritocracy.

The author continues:

“But in the high-uncertainty world of startups, a lot can fall into the category of unknown-unknowns. The first step in dealing with them is to work hard to identify as many as possible and discuss how things should change if that event occurs; that is, turn the unknown unknowns into known unknowns. […] Teams that are willing to surface and discuss such scenarios will be able to turn some unknown unknowns into known unknowns and work out contingent arrangements for dealing with them. [… But] No matter how hard teams try to turn unknown unknowns into known unknowns, there will still be surprises and upsets. At such times, the team must rely on the trust that has been developed between the members.”

The author goes a little deeper and specifies that it’s not just any trust, but trust that the partners will be able to put the company’s interests above their own.

“This trust, if it has a chance to grow strong before tension problems arise, allows co-founders to act outside their immediate self-interest – above and beyond the call of duty – confident that, in the long run, they will reap what they have sown. Although it’s easy for the co-founders to assume that they will always trust each other, the attempt to found a startup often burns out a team instead of forging a stronger one. For this reason, the members of a founding team need to constantly look after their mutual trust; at any moment, it could be the rope that prevents them from going over the cliff together. Even if a founder is trying to take steps to increase the startup’s success, his co-founders may see it as a violation of mutual trust.”

The attempt to share equity between the founders could be a good gauge of the future of this relationship:

“The tense and lucrative share split negotiation is in itself a double-edged sword, an experience that can make the team wiser, stronger and more unified, or it can undermine trust within the team. In particular, some founders forget that the share split negotiation is one of a series of negotiations that will determine the founders’ individual and collective success. A founder who goes to great lengths for every last percentage point of equity can leave the other founders feeling that they’d better watch their backs, which will make it harder for the team to deal with the inevitable unknown-unknowns.”

He gives an example of such a negotiation:

“Phuc Truong, for example, earned $200,000 a year from software development consultancy contracts and was convinced that UpDown would compensate him for most of this lost income if he joined full-time. He wanted a salary of $110,000, and his lower limit was $70,000, but for every $10,000 below $110,000, he wanted an additional 0.25% of equity.”Much of my hassle could have been avoided if I had known about the vesting agreement:

“Vesting is the common type of dynamic equity contract. Vesting terms require founders to earn their equity stakes over a specified period or when they achieve specific goals, rather than owning shares from the start, as is the case with static divisions. Founders who leave a startup before their equity is fully invested must relinquish the uninvested portion to the startup or its co-founders, transferring it to co-founders who will continue to build the startup’s value or allowing it to be reallocated to someone who will replace the departing founder. Vesting terms help serve as “golden handcuffs” that give financial incentives to each founder to continue contributing to the startup, rather than giving up while retaining full ownership, or help protect the remaining founders when a founder leaves.”

A vesting agreement is the fairest way to implement meritocracy and won’t work without a clear target plan. But there is a great risk in trying to set rigid (and therefore clear and objective) goals in a startup:

“In companies that change rapidly, adopting rigid frameworks can be dangerous and must be done carefully. In the future, necessary changes in the startup’s strategy may render obsolete a milestone on which part of a founder’s equity depends, requiring another round of tension-filled negotiations over shareholdings and milestones, or else leaving that particular founder feeling cheated or creating destructive rigidity while he or she continues to pursue an obsolete milestone. […] As with all high power incentivesA vesting agreement should be designed with these unintended consequences in mind. Boards and founders should ‘stress test’ their experimental milestones in a variety of scenarios, assessing whether each milestone would work well in all scenarios and adjusting milestones that, in some scenarios, may cause misalignment.”

An example of how this agreement can be made:

“The founders agreed that if the co-founder wanted to reduce her time to 80% or 60%, her investment would adjust to that rate. They also agreed that working less than 60% of the time would be equivalent to leaving the company or would require a more extensive discussion about what to do then. At Ockham Technologies, the founders designed a buy-back system whereby, if Ken, the ideal person, cut back to half time, his equity would be reduced accordingly and, if he hadn’t joined by the end of the first year, his equity could be completely bought back”

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