Transfer of Share Rights | Promoter Lock-In | You Shall Not Pass! #SHA101

In the last blog, we introduced Transfer of Shares Rights with ROFR & ROFO. Let’s continue and talk about Promoter Lock-In in this blog.

Promoter Lock-in quite literally means locking-in the promoter from selling their shares to any third party. This clause in-fact precedes ROFO/ROFR that we discussed in the previous blog because any question of transfer by promoter arises only once the investor has consented to such a transfer.

What is Promoter Lock-In?

Promoter or Founder Lock-In is a standard clause in most Shareholder Agreements that prohibits the promoter/founder group to sell their shares to anyone without the prior written consent of the Investor.

Period of Promoter Lock-In

In most cases, the promoter lock-in is indefinite.

which means as long as the investor(s) are shareholders in the company and the particular SHA is valid (And mind you, SHAs of subsequent rounds tend to override these clauses and make earlier SHAs null and void!), the promoter lock-in clause would apply, and promoters/founders cannot sell their shares unilaterally.

However, in a few cases, investors do indicate a period for which the lock-in is applicable, typically say 4 or 5 years.

Which means, post 4 or 5 years of SHA, the lock-in clause will cease to apply. However, that is just the first hurdle, the other two hurdles (with respect to ‘Transfer of Shares’) — ROFO/ROFR and Tag/Drag rights would still apply.

Why do investors insist for a Promoter Lock-In?

• Retain Skin in the game (SITG): Promoters have the maximum stake/SITG in their company. Investors would want to keep it that way to keep their interest aligned. Any premature sale would send out the wrong signal to the market.
• Investors desire exit before promoters: It’s not surprising that investors, who put their LP-funded money just on the basis of founder’s vision, team and plan, would insist to enjoy the first pound of flesh whenever an opportunity to sell their shares arise! Hence Promoter Lock-in prevents the founders to sell first.

That said, in genuine cases, based on mutual consensus, investors do consent to founders selling shares. For example: Founder separation and settlement leading to transfer of shares, adjustment of shares within promoter group, partial liquidity for founders at a slightly later stage (say Series B round) etc.

Related Concept: Founder (Reverse) Vesting of Shares

A related concept to promoter lock-in is that of ‘Founder Vesting’. This is typically part of Co-Founder agreements and are also widely seen in SHAs. In many cases it is part of the larger ‘Transfer of Shares’ section within SHA, but you can also spot it under other heads such as ‘Promoter’s Commitment’ etc.

Well, you might ask:

When the founders already own the shares of their company, what does one mean by they still need to vest or earn their shares?

Well, you are absolutely fair and right to ask this.

On the other hand, the investor is also right in asking the founders to earn their shares by staying in the company for a definite period of time.

How can both be right?

Well, this is typically implemented with a concept of ‘reverse vesting’ which acts as a deterrent for founders to prematurely leave the company.

Think about it — an investor, especially in the early stages of a startup, is basically investing in the founder’s dream and ambition. And if one of the founders decides to leave the company prematurely, it is jeopardizing the interest of all shareholders including the investor. Also, it is unfair to the other founders who stand to lose out because of the exit. The departing founder would also takeaway their shares and in the event of the company doing well, enjoy the value appreciation for no contribution of theirs. To avoid such cases, founder vesting clauses are included in SHA.

Promoter or Founder Vesting Clauses indicate a vesting schedule for the promoters or founders to vest (earn) their shares over a vesting period by remaining in the company. If they fail to do so, they are forced to transfer their unvested shares as decided by the board/investors. This is called Reverse Vesting.

Typically, the transfer of unvested shares happens at a nominal value (let’s say the face value) to not give any upside to the selling promoter as they have not earned those shares. This is decided by either the board or the lead investor(s).

Things to Note:

Whom does the promoter sell the unvested shares to?

• ESOP Trust
• Other promoters or
• In some cases a set of investors or
• As decided by the board

In case of Termination with Cause: That is if the promoter is terminated over a disciplinary matter etc. one might have to forfeit their vested shares as well. This means the exiting promoter might not unlock any value from the company.

In case of Death or Disability: In certain SHAs, on compassionate grounds, in case the separation of the promoter is due to death or disability, the unvested shares can be vested on an accelerated basis to benefit the promoter or their nominees.

Mind the La(w)nguage

Promoter Lock-In Clauses are typically worded as below

On and from the First Closing Date and for a period of four (4) years thereafter (“Lock-in Period”), each Founder shall undertake that they shall not, without the prior written consent of the Investor, transfer to any other Party all or any part of the Shares held by them.

Founder Vesting Clauses are worded as below

The Shares held by Founders shall be released over a period of XX years from the First Closing, in YY equal tranches on an annual basis, as detailed in the vesting schedule in Schedule ZZ(“Vested Shares”).

There are further clauses detailing how the unvested/vested shares are handled on various cases of separation: termination (with or without cause), resignation, death, disability etc.

Founders should watch out for:

Long vesting schedules

Typical vesting schedules are either 4 or 5 years. Anything longer can be typically pushed back. Either way, these clauses will be re negotiated in the next round funding.

Back-loaded vesting

Investors could insist for higher proportion vesting towards the end periods of the schedule. Founders can insist for uniform vesting.

Indefinite vs. Specific Period

Promoters can request for a particular period for the lock-in, but typically this is based on investor’s standard template and founders might not have too much of a choice here.

In conclusion, like the meme on the banner:

Promoter Lock-in and Founder vesting act as ‘You Shall Not Pass’ pronouncements with conditions applied of course!

They act as the first level of hurdles to prevent promoters from selling their shares.

Once you have consciously decided to take the path through the Mines of Moria (Venture Capital), well, you better be prepared to be stopped at the gate.

PS: Hence, focus on building your ‘Fellowship’ right — one that would last and support you as you take the long journey to Mordor. Onward and Upwards 🚀