The Founder’s Equity Dilemma: Vesting, Dead Equity, and Cap Table Health


July 29, 2025

By: Ricardo A. Barquero

Startups often begin as collaborative ventures between friends, classmates, or coworkers. The second article in Legal Basics for Startups: A Practical Series for Founders addresses getting early equity decisions right. Early equity decisions set the foundation for scalable success.

 

Founders tend to be people aligned around a shared vision or idea. In the excitement of getting started, equity is frequently split informally among these entrepreneurs. To divide initial equity, founders may rely on handshake agreements or assign equal shares based on little more than enthusiasm and early effort. While these equity arrangements may feel fair at the beginning, they often fail to reflect long-term contributions and commitment. Informal equity agreements can significantly hinder growth, fundraising, and governance down the line.

 

One of the most critical but misunderstood aspects of startup formation is how to issue founder equity efficiently. Consider:

  • The risks of dead equity
  • The value of vesting
  • The role of stock option pools
  • The expectations investors bring to the capitalization table

 

Dead Equity and Cofounder Disengagement

Dead equity refers to company ownership held by a founder who is no longer involved in the business. Dead equity often results from early equity splits that were not tied to long-term contributions. One founder may walk away after a few months and still retain 25 percent or more of the company’s equity. The remaining team must build the business with fewer resources and little or no leverage to recover that ownership.

 

Investors view dead equity as a serious liability. Dead equity:

  • Inflates the cap table
  • Limits the equity available for new hires
  • Signals that the team may have lacked foresight or legal guidance

 

Worse, dead equity can create internal tension if the remaining founders feel that someone who is no longer present is diluting their share.

 

Founders’ early equity decisions require the same discipline as later-stage financing. Equity should reflect ongoing value and commitment, not past enthusiasm. Without that alignment, startups may end up carrying unnecessary baggage into every future decision.

 

Equity Vesting and Clawbacks

To prevent dead equity, most startups implement an equity vesting schedule. The vesting schedule is a simple structure that ties ownership to continued participation.

 

While founders often refer to these arrangements as “vesting,” they are typically implemented by issuing restricted stock subject to a risk of forfeiture. These provisions can also be included in a buy-sell or founders’ agreement. A four-year equity vesting schedule with a one-year cliff is common for startups. This means founders earn no equity unless they stay at least a year. Then, founders earn monthly or quarterly portions until fully vested.

 

Vesting aligns ownership with commitment. It also protects the company if someone leaves early. An equity vesting schedule makes it easier to reassign unearned shares to new hires or future investors. Investors expect equity vesting schedules to be in place. They might demand one prior to investment and require a cap table restructuring.

 

In some cases, companies may include clawback provisions. A clawback allows the startup to reclaim vested shares under specific conditions, such as misconduct or breach of fiduciary duties. This clawback tool enhances security, promotes accountability, and safeguards the company from harmful conduct, even after equity has vested.

 

Clear vesting terms protect the company and founders who remain committed and continue to add value. They ensure everyone contributes to the shared vision.

 

Stock Option Pools and Managing Dilution

Most startups need to reserve equity for future hires. The stock option pool is a portion of the company’s shares set aside to compensate employees, advisors, and consultants with stock options. A company creates a stock option pool by adopting an equity incentive plan. Stock option pools typically range from 6 percent to 12 percent of the company’s fully diluted capitalization.

 

If not carefully planned, stock option pools can cause unexpected dilution. Investors often require the pool to be created (or increased) prior to investment. This reduces the company’s pre-money valuation. If founders fail to model the impact of a stock option pool, they may be surprised to find their ownership—and that of existing shareholders—significantly reduced after a financing round.

 

Stock option pool planning also intersects with equity vesting. Like founders, employees should earn their equity over time. A well-structured equity incentive plan includes:

  • Clear vesting schedules
  • Acceleration provisions
  • Board-approved grants aligned with market norms

 

Startups should regularly update the cap table to reflect stock option pool usage and future needs. Letting it drift can create misalignment and slow down funding or hiring.

 

Investor Expectations and Best Practices

Professional investors bring more than capital—they bring a sharp eye for cap table structure. Investors want to see that equity has been issued thoughtfully and responsibly. They want key contributors to be properly incentivized. They want to see flexibility for future hires and growth.

 

Investors will expect:

  • A clean, updated cap table
  • Equity vesting schedules
  • No dead equity or informal promises
  • A reasonable stock option pool allocated before a financing round

 

If things are out of alignment, investors may also request a re-capping process to readjust existing ownership as a condition of funding. This process is never easy, can derail relationships, and can delay deals.

 

Founders should follow these practices to signal responsible management:

  • Take a proactive, structured approach to equity from day one.
  • Formalize roles.
  • Establish vesting schedules.
  • Model dilution.
  • Keep clean records.

 

These practices make it easier to raise money.

 

Align Equity with Long-Term Goals

For a startup, equity is a powerful tool, but it can also become its Achilles’ heel. Founders who split shares too early, skip vesting, or delay formal agreements risk damaging their team’s motivation and undermining future funding efforts. Equity vesting, cliffs, and clawback provisions should be considered in every significant equity grant.

 

By approaching equity with clarity, discipline, and the long view in mind, founders build a foundation that investors can believe in. Nyemaster’s business attorneys are here to help startups structure equity in a way that supports growth, today and tomorrow.

 

Check out other articles in the series to explore specific legal issues for startups: 

 

This article outlines general best practices and is provided for informational purposes only. It does not constitute legal advice or create an attorney-client relationship. Readers should seek legal counsel before taking action relating to the subject matter of this article. For more information, please visit our Terms of Use.