Venture deals in IT: lock up, vesting

We continue the series of posts in which we familiarize you with the basic terms of venture deals in IT. In today's post we’ll descrive two tools - lock-up and vesting. 

I.    Lock-up

What is a lock-up?

Lock-up is a prohibition to alienate the shares in a startup (i.e. exit the business) within a certain period of time. Any kind of alienation is prohibited: selling, donation, pledging, etc. 

Lock-up ensures a stable composition of the startup's members, prevents the appearance of the third parties in the startup.

Who is the lock-up set up for?

Typically, in venture capital deals, lock-up protects the investor's.

Founders do not need to be afraid of the lock-up. It’s necessary to understand that venture deals are high risk for the investor. When investing in your business, the investor must be sure of your 100% commitment. It is the lock-up that guarantees the investor a stable team, thanks to which he may have entered the project and, as a result, greater involvement and interest of the founders in success of the business. 

Lock-up can be set up for all the founders, one or several founders, founders with a certain percentage in the startup (20%, 40%, etc.), other options are also possible depending on the agreements of the parties.

Rarely, lock-up can also be set for the investor. Therefore, if for some reason it is important for founders to set a mirror condition for the investor, they can enter into negotiations.

How long is a lock-up set for?

The average lock-up period for funders is 2-3 years. 

The term is also affected by the start point of the lock-up. For example, if it starts from the date of signing the termsheet, and the  binding documents will not be signed in the near future (for example, there are still many negotiations between the parties to reach agreement on all terms of the deal), then it is reasonable to set the lock-up for a longer period of time (e.g. 3 years). If the lock-up starts to operate from the date of signing of binding documents, the term may be shorter, for example, 2 years.
Note that the above examples are not a mandatory rule. The period of prohibition to exit the business depends on the agreements reached between the parties, the goals and plans of the startup. It is necessary to agree to a lock-up, but this does not mean that it is impossible to enter into negotiations and seek a balance.

II.    Vesting

What is vesting?

Vesting is a step by step receipt of the shares in a startup depending on the occurrence and fulfillment of certain conditions. Vesting can be set up for all or part of the shares (i.e. some of the shares are provided immediately and some are vested).
Vesting can be set for founders and other key persons in the startup ( CEO). Vesting, like lock-up, is aimed at protecting the investor's interests by preserving a certain composition of the startup's members. In addition, vesting is a motivation for the company's founders/key persons: they receive shares in the startup for good performance.

What types of vesting are there?

There is a distinction between ordinary and reverse  vesting:

  • ordinary vesting: shares do not initially belong to the founder, but are credited to him in stages depending on fulfillment of certain conditions 
  • reverse vesting: shares initially belong to the founder in full, but if he fails to fulfill certain conditions, a part of the shares will cease to belong to him.
What are the conditions under which a founder can receive shares?

Time-based vesting: the granting of shares to the investor depends on the period of time spent in the company. As a rule, vesting is set for 3-4 years with a cliff. Cliff is the period of time that must pass before you start receiving the shares. Typically, the cliff lasts for a  1 year. This means that you will not receive the shares for the first 12 months. 

Let's break it down using the reverse vesting example. You are a founder with a 60% share under a vesting condition (4 years, 1 year cliff). Your shares will be released, i.e. pass to your ownership as follows:

  • 1 year - 0% of shares will be released (this is the cliff period)
  • 2nd year - 20% of shares will be released
  • 3rd year - another 20% of shares are released (total 40%)
  • 4th year - another 20% of shares are released, i.e. after four years all 60% are released from vesting and transferred to you. 

It turns out that if a founder leaves the startup before a year, he gets nothing. If he leaves after 2 years, he gets only 20% of the shares.

Milestone-based vesting: granting shares when the founder meets certain KPIs. KPIs are usually determined by the investor based on the startup's business plan. Here are some examples of KPIs: achieving a certain level of profit by the startup, developing a product/part of it, attracting a set number of new customers. If the founder fulfills them, he gets a certain percentage of the shares in the company (all or part of them, if the KPI is set several times).

Finally, mixed vesting: in order to receive shares, the founders need both to be in the company for a certain period of time and to fulfill KPIs.

When investing in a startup, especially at its early stages, it is important for the investors to keep a stable team of professionals in the project for as long as possible.  Therefore, founders should not be afraid of either lock-up or vesting. By agreeing to use these tools, you demonstrate to the investor your seriousness and desire to develop the business.