A startup’s success is closely tied to its founders’ contribution, especially at early stage, and such contribution will have a significant impact on the valuation of the company. Consequently, it is essential for the growth and the success of the company that its founders remain involved in the company for a certain period of time. Stock restriction agreements provide an efficient mechanism to ensure founders’ commitment to the company.
A. WHAT IS A STOCK RESTRICTION AGREEMENT?
A Stock Restriction Agreement (“SRA”) is an agreement between the company and a founder which sets forth the allotment of the founder’s shares, the restrictions applicable to such shares and the company’s right to purchase such shares upon the occurrence of certain events. Under the SRA, all the founder’s shares become restricted (unvested), meaning that although they have been issued, the founder does not have exclusive ownership of them. The SRA provides a vesting schedule under which the founder’s shares shall become free of contractual restrictions. If the founder leaves the company before the end of the vesting period, the unvested shares shall be forfeited and the founder shall retain ownership of the vested shares.
B. WHY DO YOU NEED A STOCK RESTRICTION AGREEMENT?
A SRA is usually signed by the founders following the issuance of shares, or at the request of investors during a financing process.
The main purpose of a SRA is to ensure the founders’ commitment to the company for a certain period of time. It serves to guarantee that such founders will continue to contribute to the company, particularly during its early stage. Let us take the example of 3 founders who start a company. Since cash is usually rare commodity at early stage, one of the founders gets fed up with the hardship and decides to leave the company. The other two founders continue working hard and eventually, the company is worth millions of dollars. The SRA is there to ensure that the departing founder’s unvested shares are repurchased by the company (usually at their original subscription price) when he leaves, so that he does not profit from the work and effort of the remaining founders.
C. INVESTORS
Early investors typically condition their investment upon the signature by the founders of SRAs in a form approved by such investors. If the founders have already signed SRAs, the investors will review them to determine if they are satisfactory. The investors may insist on the founders signing new SRAs if too many shares have already vested (if, for example, more than one year has passed since the original SRAs were signed), or if the terms of the existing SRAs are not satisfactory.
Let’s have a look at the SRA terms which shall be reviewed by the investors.
D. TYPICAL TERMS
Vesting Schedule
The vesting schedule in the SRA sets forth the timeline upon which the founders’ shares shall cease to be unvested shares. A standard SRA typically has a 4-year vesting schedule with a one-year cliff. This means that after one year, 25% of the shares become vested and are thus free from the contractual restrictions set forth in the SRA. Each month thereafter, typically 1/48th of the founder’s total shares become vested during a 36-month period, meaning that all the founder’s shares become vested at the end of the 4-year vesting period. A monthly vesting schedule provides incentive to the founders to continue their involvement in the company for the full vesting period.
Accelerated vesting
A SRA will also provide the conditions upon which there shall be accelerated vesting, meaning that all or some of the founder’s unvested shares shall become fully vested upon the occurrence of certain events such as liquidation event (event which triggers a payout to investors and founders such as the sale of the company). For example, a SRA can provide that upon the liquidation event, all the founder’s shares shall automatically become vested.
Repurchase Rights
As stated above, the purpose of a SRA is to ensure the founders’ commitment to the company. Founders usually sign employment or service agreements with the company under which they agree to contribute to the growth of the company. A SRA typically provides a triggering event upon which the company shall be allowed to repurchase a founder’s unvested shares. Such event is usually defined as the termination of the employment or contractual relationship between the founder and the company. When the founder leaves, his unvested shares are repurchased at their original subscription price.
Keep in mind that although the vested shares are free from the SRA restrictions, they remain subject to the terms and conditions set forth in the shareholders’ agreement between the founders and the investors, if any. Some shareholders’ agreements provide that upon the termination of the employment or service relationship between the founder and the company, the founder’s vested shares shall be sold to the remaining shareholders or the company at their fair market value.
E. CONCLUSION
A SRA is an important tool to guarantee the founders’ commitment to the company during its early stage. Investors are willing to put their funds into a company in part because of its founders. Both founders and investors want to ensure a certain stability in the company during its crucial formative stage. Endlex Legal can help both founders and investors draft an adequate SRA to protect the company’s interests.
Information provided in this article is intended as general introductory information only. The information provided in this article is not legal advice. It should not be construed as legal advice and should not be relied upon as such. Should you want legal advice regarding the information provided in this article, please contact one of our lawyers.
