When supporting startups in their early stages, investors seek to reduce the risk created by the uncertain future they face. They place their bets on entrepreneurs, whose skills and capabilities are the only certainty investors can have. Most investors place their bets on founders they believe will build successful startups.
The first stages in a startup’s life cycle are full of decisions and situations that can complicate the relationship between members of a company. One of the most common reasons startups fail is not because bigger companies copy their idea, it is because founding teams end up fighting among themselves. A huge part of the startup’s success or failure is in the hands of the founders, who in many instances are not aware of the mechanisms they have to protect their share, to secure trust in first employees or other key positions, or even to instill trust in investors on their long-term commitment. The tool I am referring to is vesting.
If your company is co-founded by various people, you will definitely want to make sure that you and your co-founders stay for the long haul and put in the work needed. In that case, you can agree to “earn” your shares over a period of time which is a practice known as vesting. It also recommended that you and your co-founders make your stock grants subject to it as well. Otherwise, co-founders can leave the company (for another job, to go back to school, or whatever it may be) and still possess a large portion of the company’s shares, even though they are no longer working full-time or contributing in the way that had originally been agreed on.
Vesting is not just for the founders’ protection, it is also a general mechanism used by investment funds for raising capital and a way to ensure permanence in talent that is essential to the company’s growth. A deeper understanding of vesting will reveal the many ways in which startups can benefit from this mechanism.
What is vesting?
Vesting is a legal mechanism that guarantees the permanence of founding partners, employees, and shareholders of the company. It gives them an incentive to stay with the company for a certain period of time or until they meet the agreed objectives. In other words, it is the period of time every founder or employee has to work to obtain 100% of their shares.
The general recommendation is a period of 4 years to release the total value of shares, annually dividing the percentage. This means that holders will receive 25% of the total value per year. If it sounds a bit confusing, it might be easier to illustrate with the following example.
Example:
Equity= 30% of the total shares of a company
Vesting= 4 years
Anually= 7.5% (30 / 4)
However, the vesting period depends on the vision and the stage of each startup, meaning that a longer commitment might be needed. It is highly unlikely that a vesting period will last less than four years, since a shorter period is unrealistic considering the objectives and efforts that a startup demands in order to grow.
What about the cliff?
Vesting is usually accompanied by a cliff which is another clause for ensuring the protection of a company’s shares in exchange for a commitment from founders. The first few years of a startup can be the most difficult, and at least during the first year, leaving the company means losing the right to being a creditor. The logic behind this is that a period of time that is less than a year does not account for much in the long-term results and it would be unfair for someone who lasted less than a year to have life-long shares in the company.
Cliff is the period in which no partner or employee receives shares. Generally speaking, this period lasts from one to two years before the vesting period. If a founding partner expecting to receive 50% of the company after four years of vesting with one year of cliff abandons the project on the 11th month, he or she would not be allotted shares. Only after completing the 12th month would the company start delivering shares on a monthly or yearly basis.
Therefore, a cliff is simply a date that marks the moment in which a person subject to vesting can be assigned shares. If a potential creditor ends their work relationship any time before the accorded cliff date, he or she would lose their right to shares. However, once the cliff date is reached, then all of the shares that would have been acquired if there had been no cliff, would be assigned immediately (in other words, in the case of the 4-year vesting period, 25% of the total allocated capital would be granted at the end of the cliff period, which is typically one year).
Example:
A company with 4 partners that agree on 25% of shares each:
Equity= 25% of shares
Vesting= 4 years
Cliff= 1 year
If one of the partners decides to leave the company on the 11th month, he or she no longer has a right to the shares.
Types and Uses of Vesting
Incorporating vesting clauses in agreements is a common practice among Silicon Valley startups when raising capital or hiring, and many other places are following suit. The most well-known application of vesting is in the Founder Agreement, but there are many others that are as useful for startups.
Founder Agreement
As previously mentioned, vesting in the Founder Agreement is a great protection tool for guaranteeing the permanence of the founding partners of a company. Vesting can be the key to building the right team in a startup’s early stages, in which case, could require a longer cliff period (2 years).
Founders usually carry out a variety of tasks, therefore having a fixed set of activities for them to complete is not ideal. As opposed to other types of vesting where the Founder Agreement can contain a fixed schedule for activities, the common practice is simply a vesting clause sometimes accompanied by a stock allotment schedule with the overall goals to be met, which provides clarity to when and how many shares correspond to each founder.
Employee vesting
As for employees, managers, or collaborators in a company, vesting is common and works in very similar ways. In these cases, vesting can be carried out through stock options, which encourage employees and managers to become part of a startup’s evolution.
This type of incentive can be a good complement to the traditional economic retributions used to dissuade an employee from leaving the company. In addition to giving these benefits, it is important to establish when they can exercise these stock options (whether it is at the end of the marked time period or gradually within the period), and what objectives should be fulfilled in order to acquire those shares that will turn them into shareholders. If they fail to fulfill those requirements, they will not be able to keep that shareholding.
The de facto standard for the allocation of shares to employees is to reward them with monthly or annual equity during a period of 4 years starting from the employee’s entry date at the company. It is also common to set a cliff for one year. The incentives at play for the employees justify this “4:1” standard; shares motivate employees to stay longer and work harder to create value for the business.
However, given the time and resources needed for a company to incorporate and train their employees, it makes sense that if an employee’s time at a company ends too early he or she will also lose the opportunity of gaining equity. The company needs the capital that had been reserved for the leaving employee to provide the appropriate equity incentives for the replacement of that employee. In that sense, it is better to adopt longer terms to ensure that the benefit for the company and the employee is mutual.
The four-year period is generally accepted as a reasonable prospect for employment retention. A shorter period would mean the company would have to start budgeting sooner for additional incentives to retain that employee once the shares are completely vested. The longer the period, the more likely that the role of the employee has materially changed and/or there has been a significant change in the company.
Daniel Kurt explains in Investopedia that the most important considerations regarding stock options are “the ability to buy shares in the future at a fixed price, even if the market value is higher than that amount when you make your purchase. Your ability to exercise your options is determined by a vesting schedule, which lists the number of shares an employee can purchase on specific dates thereafter.”
Advisor vesting
The norms for the allotment of shares for mentors and advisors are very different from the allotment of shares in the Founder Agreement. Advisor vesting tends to be shorter and acts as a compensation to the advisor for the experience and knowledge that he or she adds to the company. Advisors frequently receive special shares and are not subject to a cliff, since they generally expect to be compensated as soon as they start to offer their services. Usually, these experts help the company plot a strategic course for growth, revenue, and a potential exit. Ideally, this type of vesting is reserved for the growth stages of a startup.
This article is not meant to provide legal advice. It should be understood as a simplified overview for readers to consult with their legal advisors as every situation is unique.