Founders Own Their Equity

[Disclaimer: I wrote this post long ago – and actually forgot about it.  I just dusted it off and am now posting – because I think it’s an important concept.  This is in no way a commentary on any dynamics with any of my partners or portfolio cos.]

I recently overheard a VC (and friend) express resentment for a founder that left a company with a big slug of equity.  While the founder was asked to leave the company (he/she was fired without doing anything malicious), the implication was that the founder didn’t deserve or hadn’t earned his/her share of the pie.

I disagree with this perspective and wanted pipe up on this subject for the benefit of the community.

Some background:

Employees of companies vest their options over time.  They receive options (the right to buy shares), not actual shares, because options have tax advantages.  What’s important for this argument is that this vesting mechanism grants employees the right to more equity compensation as they EARN it over a period of time.  They start the job with no equity and as part of their monthly or annual compensation they accumulate a pile of options – the right to buy stock.

In spirit, employees are being compensated with equity for their time.  More time equals more equity.  It’s one of the carrots that is designed to keep employees around and show them the appreciation they deserve for their hard work.

Founders have a similar structure that replicates a vesting schedule called a buyback mechanism.  Since founders already own their shares outright when they form the company, investors will typically subject founders to a buyback mechanism to incentivize them to stick around after an investment.  Buybacks replicate a vesting schedule by allowing companies to purchase shares from founders at a really low price (often $0) if they leave early.  The amount of shares that the company can buyback shrinks over time making it look a lot like a vesting schedule.  If a founder voluntarily leaves before the agreed upon “vesting period” is up he or she will not leave with all of his/her shares.

Options vesting and buybacks schedules can look very similar.  If both a founder and an employee of the company had 100% of their equity subject to a buyback and option vesting schedule, respectively, and both quit their jobs voluntarily 50% of the way through their “vesting period”, both would typically be entitled to 50% of their equity compensation.  There’s no surprise here since buyback mechanisms are designed to replicate vesting schedules.

From my vantage point I don’t believe that founders “earn” shares in a company as their buyback expires.  Founders already own their shares, they don’t need to “earn” them.  They earned them by founding the company.   Rather buybacks exist to serve as a penalty for early departure.  If employee vesting is a carrot, founder buyback is a stick and there is an important spiritual difference therein.

The spiritual divide is illuminated in how a vesting schedule and a buyback differ.  The biggest difference exists in how employees and founders are treated if fired without cause (meaning being “fired” without doing something illegal or really evil).  Typically if an employee is fired they’re not entitled to their unvested options – their vesting stops.  In contrast, if a founder is terminated without cause they often leave with all of their shares – the buyback right disappears and founders keep their equity.  There’s good reason for this:  the shares already belong to the founder.

My point:  The perception that terminated founders are taking something away from investors, employees or other shareholders if terminated (without cause) seems inconsistent with the spirit of the arrangement.  Resenting a founder or any other party for benefitting from a commonplace legal arrangement seems silly.  If you don’t like how the deal is structured, don’t sign the contract.