If you’re the founder of a start-up, you’ll appreciate that your main driver is to grow the business. A company that’s increasing in value reflects the efforts you’re putting in, as well as the sacrifices you’ve made along the way.
Starting a new business is risky, and founders like you put their time, funds and sometimes even their homes on the line in the hope that they’ll be rewarded later as the company grows.
If a company is owned by one founder, the risks and rewards are theirs alone. However, if there are two or more founders, things can become more complicated. If you own a business 50/50 for example, you’re dependent on your partners to uphold their side of the bargain in terms of effort in, and value out. If they don’t deliver, their shares may grow in value, while the effort put is disproportionately yours.
One way of hedging against this risk is to put in place a vesting schedule so that company shares are awarded or ‘vested’ over time. That way, co-founders are encouraged to stay with the business throughout its growth trajectory. Co-founders’ rights to shares in the business are staggered, and dependent on their continuing investment and commitment to the company.
A vesting schedule also plays a part in signalling to future external investors that you’re serious about business growth.
Finally, if you’ve put in place an employee incentive scheme that gives key staff a right to shares, a vesting schedule can help you stop your precious founder shares becoming diluted by the automatic award of shares to individuals who don’t prove to be the right fit for your company.
Read on to find out more.
- What is vesting?
- What is a vesting schedule?
- Who is subject to vesting?
- What does a typical vesting schedule look like?
- What are the different types of vesting schedules?
- What is a reverse vesting schedule?
- Typical vesting schedules for start-ups & founders
- Why is it important to have a vesting schedule?
- Vesting for employees under incentive schemes
- What about exit based options?
What is vesting?
Vesting is a method of restricting someone’s access to company share ownership until certain milestones have been reached. Until that time, the person’s right to own shares is conditional or contingent. When the event occurs, the contingent right ‘crystallises’ and becomes able to be exercised by the individual who’s been granted that right.
Vesting can also be used to give a company the right to buy back someone’s shares under certain circumstances. This is sometimes referred to as ‘reverse vesting’.
What is a vesting schedule?
A vesting schedule is, in effect, a contract between the company and certain individuals who have the right to buy shares (or the obligation to sell back shares). It’s represented by a table (the vesting schedule) showing when those shares (or options) will vest (or de-vest). These individuals can be founders or employees.
The main benefits of a vesting schedule for a founder or founders are two-fold. Firstly, it protects them from giving away too many company shares (and diluting their own holding(s)) to those who don’t end up staying with the company, and secondly, it encourages individuals to remain with the business as long as possible.
Who is subject to vesting?
Anyone can be subject to vesting, although this is typically the company’s founders and future employees.
What does a typical vesting schedule look like?
A typical vesting schedule is linear and lasts for four years, with 25% of the shares or options being awarded each year. Sometimes there is a ‘cliff’ (a minimum length of time before which shares or options can’t be awarded) before the vesting kicks in. Thereafter, the vesting can be staggered monthly, quarterly or annually.
As an example of a vesting schedule, someone is given the option to purchase 100 shares of ordinary stock. The vesting schedule is four years, and a quarter (25 options) vest every year. On the one-year anniversary of the date of the vesting schedule, 25 options vest, and that person can purchase 25 ordinary shares in the company. On the second anniversary, another 25 vest and so on. After the end of four years, the person has access to all 100 options and can exercise as many as they like (or that are left unexercised).
What are the different types of vesting schedules?
Vesting schedules can be based on time, performance or some other milestone, or a combination of the two.
Time-based vesting schedules
Time-based vesting schedules generally feature a cliff date, before which no shares can be awarded. These are common in founder vesting schedules and employee incentive vesting schedules. In the case of founder vesting schedules, this is to keep the founders on board for a minimum period of time. In the case of employee vesting schedules, these are used to ensure that shares are not given away before an employee has had the chance to prove themselves. After the cliff, the shares are awarded over the remaining duration of the vesting period.
Milestone-based vesting schedules
Performance- or milestone-based vesting is common in employee incentive vesting schedules. An employee is entitled to their options or shares after they have achieved a certain target or after the occurrence of a certain event. Where these time- and performance-based features are combined, an employee is entitled to shares only if they’ve stayed with the company for a set period, plus achieved the required performance targets (or after a certain event has occurred).
Milestone-based vesting is less common in founder vesting schedules because it’s more difficult to define a milestone when a company is in its initial stages. However, if the founders agree that milestones or performance targets can be articulated and clearly described (for example, obtaining a certain number of users), milestone vesting is a good way to tie founders’ rights to the company’s growth and achievement of the milestones.
Until the milestones are reached, the founders will risk not having access to shares prior to achievement of the milestone, however much time and effort they’re putting in.
Cliff vesting schedules
A cliff vesting schedule is one where no shares or options can be awarded before a certain date, known as the cliff date. After the cliff, rights to shares or options are awarded over time.
What is a reverse vesting schedule?
A reverse vesting schedule is one in which a person is given share ownership immediately, but subject to a time-based schedule. If that person leaves the company during the duration of the vesting schedule, the company will be entitled to buy back their un-vested shares (or a percentage of the shares) depending on the point at which they depart. The price that the company will pay for the shares on repurchase is usually the cost price for those shares.
Venture capitalist investors and co-founders often insist on reverse vesting schedules as these protect them against key individuals leaving before they have contributed to a growth in share value, thus incentivising them to stay for a minimum period.
During the vesting period, the founder or employee will be treated like any share owner with the right to vote and receive dividends for example.
Typical vesting schedules for start-ups & founders
In start-up situations, founder shares are typically awarded on a reverse vesting basis that forces them to re-sell their unvested shares to the company according to a pre-agreed vesting schedule. So, if a founder is awarded 100 shares on day one, with a four-year linear vesting schedule, on the first anniversary, 25 shares will be fully vested, on the second, 50 shares, and so on. If the founder leaves during the fourth year, then they will have to sell back 25 of their ordinary shares to the company.
An alternative vesting schedule is one that bases the vesting formula around certain milestones that typically occur in a start-up scenario. So, if a co-founder leaves before the company achieves a set valuation (during a funding round), that will trigger a percentage resale of their shares. Or, you can use other KPIs such as the company achieving certain revenue targets, customers or returning customers.
Some companies choose to accelerate vesting if the company is sold, or if a co-founder is asked to leave without good reason after a company sale. These clauses protect the founders who have invested time and effort in building company value.
Why is it important to have a vesting schedule?
You don’t have to have a vesting schedule to start a company. However, it’s a good idea for founders to put one in place early on because it stops their share ownership becoming diluted, and it also makes the company more likely to attract external investment.
Vesting acts as an incentive for each founder to remain dedicated to company growth. It’s also a signal to co-founders and later investors that those who are essential to help a company achieve its objectives work hard to ensure success. If that person leaves, for example, because they’ve found another job), the remaining founders can replace them and claim back the departing person’s shares.
When external investors come on board, they’re likely to insist on a vesting schedule because their decision to invest will be based on the talents of the founders. They’ll need to make sure that those individuals will stay on board long enough to grow the company (and reward the investors with an increase in the value of their own shares). A vesting schedule can also protect investors against share dilution as the departing founders’ shares can be bought back when they leave.
Introducing a vesting schedule when a company is formed, encourages co-founders to stay with the company long-term. Because start-ups can be stressful and working hours very long, some entrepreneurs may feel tempted to leave before the business has had a chance to achieve its full value. A vesting schedule encourages founders to make a long-term commitment to the business and ensures that they make their full contribution to company growth over time.
In addition, a vesting schedule protects the business against the departure of a key member of staff. Co-founders often have different, complementary skills, and make different contributions to the company. A vesting schedule can dissuade a co-founder from leaving early, and also encourages disputes to be resolved amicably as the cost of leaving is enhanced.
Vesting for employees under incentive schemes
In the case of employee incentive schemes, vesting schedules can be used as a tool to persuade your staff to stay with the business longer, as if someone leaves before their shares are fully vested, they can’t claim them.
In the case of share options, these permit staff to purchase shares at a given price, regardless of their true value. In the case of a public company, this value will be reflected in the stock market price for the shares. The expectation is that the employee will receive a benefit when they exercise the option to buy the shares, as the purchase price will be lower than the shares’ actual value.
As we’ve seen, there are a number of different types of vesting schedules for employees. In some cases, staff are given the right to a percentage of shares over time, or subject to certain conditions like achieving performance targets. In other cases, employees get the right to all of the shares on offer on the occurrence of a certain event, like the four-year anniversary of their joining date. This is known as a ‘cliff’ vesting plan.
What about exit based options?
Exit-based options allow shares or options to fully vest on the occurrence of a certain event such as a company sale, a change of control of the company, or some other major event like a management buyout, an IPO or merger that has the effect of changing the company substantially. With an exit-based scheme, shares will only be awarded after the passage of a certain amount of time, and in combination with the ‘exit’ event.
Exit-based schemes are most often used by companies whose business goal is to be bought out by another company or investor. The advantage of them is that no member of staff or founder will have full rights to shares unless a successful exit has taken place.
For more answers to commonly asked questions and advice on vesting schedules and start-ups, consult our corporate solicitors. Get in touch on 0800 689 1700, email us at firstname.lastname@example.org, or fill out the short form below with your enquiry.