Vesting: Everything You Need to KnowStartup Law ResourcesVenture Capital, Financing
Vesting is the process where an employee or founder earns shares over time. This means rather than having immediate equity in a company, you earn a percentage of shares on a monthly (or quarterly) basis over time.5 min read
2. Why Do Founders Need Vesting?
3. Exercising The Right to Shares
4. Common Vesting Schedules
5. Vesting Terms You Should Know
6. What You Should Know About Accelerated Vesting
7. Why Vesting is Important to Your Company
What is Vesting?
Vesting is the process where an employee or founder earns shares over time. This means rather than having immediate equity in a company, you earn a percentage of shares on a monthly (or quarterly) basis over time. Vesting protects a company from giving up too much equity to someone who spends only a short time with the company.
Why Do Founders Need Vesting?
In most cases, if you apply for venture capital, you will be required to have a vesting schedule for your stock. The good newsis in nearly all cases, you get credit for "time" that you've invested into the company. For example, if you have been working on the concept and idea for your company for two years, a venture capitalist would credit your agreed-upon vesting schedule for those two years.
Another reason vesting is important for founders is how they treat new hires when they are offering an equity position as partial compensation. It's easier to get a new hire to agree to a vesting schedule if you have one in place as founder.
Vesting also helps protect each partner in the business. The last thing you want to be concerned about is one partner walking out and having full access to half of the value of the company after only a brief period of participation.
Exercising The Right to Shares
It is important to note that when you have a vesting schedule, you are being granted the right to fully exercise (take) your shares.In nearly all cases, a company will require those who leave the company exercise that right within 90 days of leaving. When you remain with the company, you will likely be required to exercise your shares between your 7th and 10th year of employment.
Common Vesting Schedules
Silicon Valley is well-known for having vesting schedules. In most cases, they offer a forty-eight month vesting period with a one-year cliff. In effect, this means you will earn 1/48 of the rights to the shares you were granted. Each month this adds up until you have earned the full rights to the percentage of equity you were originally granted.
Vesting Terms You Should Know
Since we've discussed some of these terms it is important you understand what they are and what they mean for you and your business. Some of the terms involved in vesting are:
Cliff Vesting – Using the example above, if you leave during the first year (the cliff) you lose your rights to those shares. However, if you stay past the year (the cliff) you will have earned one-quarter of the stock and would continue to earn an additional 1/48th per month for the remainder of your tenure.
Accelerated Vesting – generally this is offered in the event a company is acquired. Let's assume you were two years into your vesting schedule and a company was acquired by another company and you were granted accelerated vesting. Instead of being entitled to only those shares that were vested, you may be entitled to additional shares. Most companies will offer six to 12 months additional vesting in the event a company is acquired and your role has significantly changed.
Follow on Grants – this comes into effect typically on additional shares. Let's assume you were given 10,000 options at the start of employment and after you were with the company five years you were given an additional grant of 5,000 options. Your "original" shares are fully vested and therefore you are granted the full 10,000 shares. However, additional shares are only paid proportionally to the length of time you stayed; in most cases, additional shares don't have a cliff
Pension Plans Cliff Schedule – this method is used by employers who offer pension plans that match funds. While the contributions by the employee are immediately vested, the employer often has a defined period of time before employer contributions are fully-vested. In some cases, this could be as many as three years. The IRS offers a full picture of this type of vesting schedule.
What You Should Know About Accelerated Vesting
Accelerated vesting could be a stumbling block when you are in the midst of discussions about a buyout of your company. Because accelerated vesting normally applies to upper levels of management. The reason it accelerated vesting is offered to executives and not more broadly is because during the buyout the new company has to purchase the vested shares. This typically means lower per-share price during the buyout.
Why Vesting is Important to Your Company
In addition to vesting being a requirement for most venture capital and angel financing deals, there are other reasons to ensure all founding members of a company have a vesting schedule in place. Let's take a look at some possible scenarios:
Founders Disagreements - you and two other friends start a company and each of you takes 25 percent equity in the company and saves 25 percent for investors and employees. One of the partners walks away after one year. In three years, you sell the company for $1,000,000. The partner who walked away after a year is entitled to one-quarter of the profits in spite of not having stuck with the business. A vesting schedule could have prevented this problem since they would only have earned equity based on the year they were there. This is important to you because otherwise you're losing out on a portion of equity that should have remained with the company either to be divided between the two remaining founders or to be used for investors and employees.
Employee Differences – let's assume you hire an employee for a specific role such as software development. To attract that employee you offer a 10 percent equity position. After six months, you've determined the employee simply isn't working out and you need a different specialist. Without a vesting schedule (with a cliff in this case) you would have to give up the 10 percent you offered in equity and wouldn't have that to offer a new employee.
Vesting can be complicated but it is a good idea to make sure you have an effective plan in place for company founders, management team hires and employees whom you've offered equity. Remember it will be important when you seek seed funding through both angel investors and venture capital firms to have a plan in place. Founders will generally have more preferential vesting schedules than hired management teams or employees and venture capital firms will typically grant you additional credit for the time you've been involved in developing your business.