Carlos Trénor Löwenstein February 1 2023 Value of vesting and cliff clauses for start-ups López-Ibor Abogados | Corporate Finance/M&A - International Carlos Trénor Löwenstein Corporate Finance/M&A IntroductionExampleFor future investorsIntroductionIt is common for an investment agreement in a start-up to contain vesting clauses, cliff clauses or lock-up periods. These types of clauses are also included in partnership agreements between the founders of a company in the form of phantom shares (for further details, see "What are phantom shares and how can they help start-ups to retain talent?") or stock options for employees."Vesting clauses" regulate the period of time during which the beneficiary of the vesting gradually acquires rights over a percentage of company shares before acquiring full rights over them. "Cliff clauses" establish a minimum initial period of time prior to vesting required for the beneficiary (one of the founding partners or an employee) to start consolidating those rights through vesting.ExampleTo better understand the concept, an example using common terms in the market is provided using:a one-year-old cliff;the vesting of shares with quarterly maturities over three years from the beginning of year two to the end of year four; andpartner X, who owns 30% of a company's shares, and leaves the company at the end of year two.In this case, the full period of the cliff will have elapsed, and its consolidation rights from the beginning of year two until the end of the year will begin to accrue, so that it will have fully consolidated its rights over a third of its shares, equivalent to 10% of the capital of the company.At that time, it will be necessary to comply with what has been regulated in the vesting clause to determine the consequences. In particular, if the company (or the rest of the partners) has the right to repurchase their shares, it will be necessary to determine the conditions under which that partner left (also known as a "leave clause", common in senior management contracts or with key employees). If they have left by a simple majority decision of the rest of the partners, without having breached their obligations or due to circumstances that are not attributable to them (eg, death, disability or retirement) they are known as a "good leaver", and a reasonable price will be paid for their shares under market conditions or the terms that have been established. If they leave voluntarily or due to a breach of their obligations, they are known as a "bad leaver" (often comparable to what in labour terms would be a "fair dismissal"), and they will not be paid anything or, at most, a nominal contribution.For future investorsAn investor, when investing in a company, is likely to have a keen interest in keeping committed and reliable partners involved in their investment. An investor therefore requires, through the inclusion of this type of clauses in the investment contract, that the founding or essential partners remain in the company for a period of three to five years. The founding partners, even if they have regulated something similar in their original partner agreement, will see that they will have to reset their counters to zero again to consolidate their rights from the investor's entry.Depending on the negotiating strength of each case – either due to the number of potential investors that the start-up has due to the terms that are handled or the urgency to dispose of the investor's money – it may be considered whether part of the shares of the founders are already vested, as well as implementing longer cliff and vesting terms. However, it is common practice in the market to establish cliff periods of six months to a year, and vesting of between three and five years, with monthly or quarterly maturities.In any case, if the founders understand the reason for these stipulations, they will be more willing to agree to them. In addition, they will be able to see that this is not about pitting two sides against each other (ie, founders versus investors), but rather it means protection of the company's value that benefits everyone involved. Also, when put into practice in an exit situation, it usually puts investors in agreement with the majority of the founders, compared to the outgoing partners.For further information on this topic please contact Carlos Trénor Löwenstein at López-Ibor Abogados by telephone (+34 915 21 78 18) or email ([email protected]). The López-Ibor Abogados website can be accessed at www.lopez-iborabogados.com.