What to do with equity if co-founder / early employee quits?

I founded a company on my own a couple of years back. Got a couple of small clients on board and started making money (not a lot!).

Worked for 1 year on it alone and decided to get an excellent creative guy onboard for a below market rate salary, but with 25% equity, which is to vest over 4 years.

We've no legal paperwork in place (I know, we totally suck) and we're having a theoretical discussion (I hope it's theoretical!) about what should happen if he is to leave (quit!) after the vesting period?
Options: 1. Lose all equity (his choice to leave)?

2. Have to sell all / some equity back to company / me at fair market value?

3. He keeps his shares but loses any shareholders rights (voting etc.)?

4. Nothing, he hangs on to all his shares?

Any experience out there? What would you want in my position? What would you think was fair in his position?

If he leaves after the vesting period that's it, he's vested, he owns his stock.

Normally you put a shareholders' agreement in place precisely to determine what to do in this situation.

In most shareholders' agreements, you can't force him to sell his shares back to you if he leaves. He will still have voting rights, but the bylaws of the company are usually structured in a way that this doesn't matter (for example, typically, all important decisions are made by the board of directors, and the shareholders agree to vote for a particular board of directors, so their voting rights are pretty meaningless).

You do have to go get shareholder's agreements and legal paperwork in place immediately. When you say "We've no legal paperwork in place -- we totally suck" you need to understand that this is not like "We smoke and don't floss our teeth -- we totally suck." This is "We send our children to play with rocket propelled grenades in the highway instead of sending them to school -- we totally suck."

In other words, it's common not to have legal paperwork, but it's not common in a ha ha funny way, it's common in a self-destructive, you-honestly-deserve-whatever-horrible-thing-happens-to-you kind of way (and horrible things will happen).

If your partner is agreeable to being bought out at a fair price you can live with, that's definitely the way to go, assuming he is genuinely vested to some degree. It makes no sense to continue paying distributions to someone who's gone, or giving up equity forever. That would make it much harder to attract additional shareholders/investors/etc. down the road.

I was in your partner's place (exiting fully vested, but with the business continuing) in a previous business (long story) and we did exactly this. We settled on a price and my partner bought out my shares. Not all break ups wrap up so nicely, and lucky for my partner I just wanted to be done and not be a jerk about it. Many founders are not so lucky -- if your partner is similarly agreeable, jump on it before he changes his mind.

After the vesting period - barring any other requirements you haven't shared - he owns it.

One additional point to consider is "right of first refusal" for the equity. Basically, it means that if he wants to sell the shares to someone else, you have the opportunity to match the deal.. and you win any ties. If you can't/won't match the offer, then it can proceed.

Many pre-IPO companies put these into their documents to prevent shares from getting out into the wild without their knowledge/approval.

Please follow Joel's advice and get these agreements in place asap.