The reverse vesting clause in Spain: basis, mechanics and key points for negotiation

Venture capital investors invest in ideas that solve problems and in teams capable of bringing them to fruition. One of the most important considerations when investing in a start-up is ensuring that a company’s key people, and in particular its founders, remain committed to the project for as long as it takes to bring the idea to fruition or, at the very least, until the project reaches a stage of maturity. In the eyes of investors, founders are a company’s main intangible asset in its early stages. 

Keeping key people aligned with the business helps to increase the company’s value and is therefore a necessary ingredient for the project’s success. For all these reasons, it is common for shareholders’ agreements in this type of company to include a reverse vesting clause, a mechanism designed to incentivise the founder to remain with the company and ensure their long-term alignment with the project.

What is reverse vesting: key elements

The clause takes the form of a call option in favour of the company, and, where applicable, the other shareholders, over the founder’s shares, exercisable should the founder leave the project before the end of the retention period agreed in the shareholders’ agreement.

Unlike certain incentive schemes such as "phantom" shares, where beneficiaries gradually acquire ownership of the shares, in reverse vesting the founder already owns their shares. The mechanism is not a process whereby the founder gradually "acquires" the shares: it works as a reverse process. As the agreed retention period elapses, the company progressively loses its right to repurchase those shares.

This process is known as consolidation or vesting. In practice, consolidating a shareholding means that the company’s option to purchase that shareholding is extinguished; consequently, as a general rule, once consolidated, the founder retains the shares, and the company cannot exercise its right to repurchase them. Shares that have completed this process are referred to as vested shares. However, certain shareholders’ agreements provide that, in the event of a "bad leaver", the company may exercise its right to repurchase all shares subject to the mechanism, including those that have already been vested.

Shares that have not yet completed this process are referred to as unvested sharesand remain subject to the call option. The parties may agree that all of the founder’s shares are subject to the reverse vesting mechanism or that only a portion of them is subject to it. The shares actually subject to the mechanism are referred to as vesting shares.

Cliff and vesting schedule 

The standard reverse vesting structure combines a total vesting period, of usually three or four years, with an initial period, known as the "cliff", which is typically one year. During the cliff, no shares vest. If the founder leaves the company before the end of this period, the company or the other shareholders or both may exercise their call option on all the shares subject to the mechanism.

Once the cliff period has passed, shares begin to vest progressively, for example, on a monthly basis, with the company’s call option being extinguished proportionally. In a three-year monthly reverse vesting mechanism with a one-year cliff period, one-third of the shares subject to the mechanism would vest on the first anniversary, and from that point onwards, the remainder would vest monthly over the remaining two years, in accordance with the timetable set out in the shareholders’ agreement.

Good leaver and bad leaver

One of the most important aspects of reverse vesting is determining what happens when a founder leaves the company before completing the agreed retention period. The issue is not limited to how many shares have vested, but also covers the circumstances of the departure and the price at which the company may exercise its call option on the unvested shares.

Shareholders’ agreements usually distinguish between two categories. A bad leaver is a founder who leaves under circumstances that are particularly detrimental to the company; for example, following a fair dismissal or a serious breach of their service contract. In such cases, it is common for unfavourable financial consequences to be agreed upon for the founder, and the parties may agree on various buy-back arrangements, covering both unvested shares and all vesting shares.

A good leaver covers situations where the founder’s departure is due to causes beyond their control or considered legitimate, such as unfair dismissal. The financial consequences tend to be more favourable to the founder, although the specific conditions – on the retention of vested shares and the buy-back price of unvested shares –  will depend on what the parties negotiate in the shareholders’ agreement.

In Spanish practice, it is also increasingly common to agree on intermediate or neutral leaver scenarios, with consequences falling between those of a bad leaverand a good leaver. Where the bad leaver regime is less punitive than usual – for example, because, in the case of a bad leaver, the employee does not lose all their shares, but only the unvested ones – a very bad leaverregime that is more onerous may be agreed in cases of particularly serious breaches, such as a breach of non-compete obligations or the commission of offences that may harm the company’s solvency or reputation.

Underperformance

The treatment of underperformance, in which a founder fails to meet the performance levels expected for their role, raises particular issues in the reverse vesting context.

In Spain, when a company dismisses a founder on grounds of underperformance, termination generally constitutes unfair dismissal, which in most cases leads to the founder being classified as a good leaver. In the United States, by contrast, underperformance is usually classified as "termination with cause", with unfavourable financial consequences for the founder. This divergence takes on particular significance when US venture capital funds invest in Spanish companies, since, recognising that underperformance leads, in most cases, to classification as a good leaver, many of these funds exert pressure to ensure that the buy-back conditions applicable to a good leaver are considerably more onerous than those usually negotiated by national or European funds.

Can a founder who fails to meet performance expectations be regarded as a bad leaver in Spain? We believe so, provided that the employment contract or service agreement clearly and objectively sets out reasonable performance targets for the employee in question (in the form of service levels or specific responsibilities). However, if the contract, as is often the case, does not clearly and objectively set out such performance targets, it will be difficult to justify a valid disciplinary dismissal or a unilateral termination on grounds of poor performance of a commercial contract for the provision of services.

Managing these expectations during the negotiation phase is particularly important when investors from different backgrounds and regulatory cultures are involved. A US investor may take certain matters for granted that are unlikely to be treated in the same way under Spanish law. Addressing these differences clearly and structuring enforceable and satisfactory remedies for the parties is an investment in legal certainty.

Osborne Clarke comment

Reverse vesting has established itself as one of the most significant mechanisms in venture capital practice for aligning the interests of founders who need capital to develop their project and professional investors who need certainty in order to deploy the funds they manage. Setting it up correctly requires taking multiple variables into account, with particular emphasis on the importance of precisely defining the circumstances that lead to classification as a good leaver or bad leaver – and, where applicable, an intermediate leaver or very bad leaver – and the financial consequences arising from each classification.

A poor definition of these scenarios can lead to situations of significant imbalance between the parties, either because the founder anticipates disproportionately favourable exit terms, creating a perverse incentive to abandon the project to the detriment of the company and the investors, or because excessively onerous consequences are imposed on them in circumstances that do not justify such severity. It is therefore essential that the parties pay particular attention to the negotiation of these clauses in the shareholders’ agreement, tailoring them to the specific circumstances of each transaction and the applicable legal framework.