As a founder, it is understandable for you to want to control your company. Vesting is often perceived as taking away ownership or control from founders. But vesting is designed to encourage founders and employees (for example, as part of an employee share option plan) to continue working in the business rather than getting a “free ride” if they leave the business. We’ve written briefly about vesting in context of founders’ agreement in our article Do we need a Founders’ Agreement?. Here, we set out further detail on vesting and the issues you should consider when putting in place vesting arrangements, whether between co-founders or for your employees in an employee share option plan.
What is vesting?
When a company issues shares, those shares can be issued outright or subject to vesting. Shareholders receiving shares issued outright own those shares on the date of their issue: they can act on and sell those shares. A shareholder holding unvested shares can only act on and sell those shares after certain conditions are met.
Why should we use vesting arrangements?
Vesting arrangements are used to achieve the following purposes:
• Incentivising founders or employees to work in the business for a minimum period.
• Protecting the company if the founder or employee leaves (by returning the shares to the company, often at the same price as that paid by the founder or employee).
• Showing that the founders and employees are committed to growing the company.
• When a founder or employee leaves the business, they will only receive the benefit of those shares that have vested to them. If they leave before the cliff period is reached, the departing founder or employee will receive no benefit at all.
Vesting arrangements also protect the company because, if there was no vesting programme, the company or other founders or investors would need to buy back the shares from a departing founder or employee. This could be a costly exercise for many startups. If the company needs to replace the departing founder or employee and issue additional shares to the incoming replacement, the other shareholders will experience dilution of their ownership of the company.
What about investors?
VCs and other institutional investors are looking for companies where the founders and key employees have “skin in the game”. These investors are often looking to invest in you and your co-founders just as much as your idea, no matter how brilliant it is. They will not be interested in investing in a company where a founder can leave the business at any time and retain all their shares in the company. Putting vesting in place before the company seeks outside investors also allows founders the opportunity to put in place more favourable vesting terms for founders and key employees. Investors are less likely to request changes to existing terms provided there is a significant number of shares that remain subject to vesting arrangements and are on market terms.
What is time-based vesting?
This is the form of vesting we see most often: the shares will vest after a defined period (usually 3 – 4 years). After the end of the “cliff” period (usually 1 year), the vesting period will commence. So, if a founder or employee leaves the company before the end of the first year, they will get nothing for their shares. After the cliff period, a percentage of the shares will vest and, going forward, the shareholder will accrue shares each month until all the shares have vested to the shareholder.
The tables below set out sample vesting schedules over a 3- and 4-year period:
|Period of time||Shares vested|
|Up to 1 year||0%|
|At Year 1||33.33%|
|At Year 2||66.66%|
|At Year 3||100%|
Shares accrue at a rate of 2.78% per month from Year 1 onwards.
|Period of time||Shares vested|
|Up to 1 year||0%|
|At Year 1||25%|
|At Year 2||50%|
|At Year 3||75%|
|At Year 4||100%|
Shares accrue at a rate of 2% per month from Year 1 onwards.
What other forms of vesting could we use?
Vesting can also be used when various milestones for either the business or the founder/employee are achieved. Common examples include reaching revenue targets or other key performance indicators.
What else do I need to think about?
Consider the following when determining what vesting arrangements your company will adopt and whether they will be the same for each founder or each employee:
• Vesting commencement date: will this be a date prior to incorporation of the company to give founders credit for work on the startup before the company was incorporated? Has any founder invested significantly more time developing the startup prior to incorporation? If so, you must be able to support this earlier date to investors.
• Length of the vesting schedule: if a short vesting schedule is chosen, be aware that an investor may require amendments to it as a condition to investing in the company.
• Vesting frequency: how often will the shares vest over the length of the vesting schedule (i.e. the rate of accrual)? We typically see shares vesting every month or every quarter and this frequency is expressed as a percentage of shares (as indicated under each of the tables above).
• Cliff or straight line: will the shares begin to vest immediately (straight line) or only after a period of time after the vesting commencement date has elapsed (cliff)?
• Immediate vesting: will some of the shares vest immediately on the vesting commencement date to the founders or employees? This is relatively uncommon, particularly for founders’ shares, as investors will expect to see vesting arrangements in place.
• Contribution: has a founder or employee contributed a valuable item to the company’s intellectual property? Are all the founders working on the same basis (e.g. some are full-time and others are involved as a part-time side hustle while they have another job)? Are some of the founders unpaid and covering expenses of the business while others are being paid a regular salary or fee (however small)?