When it comes to starting a business, one of the biggest mistakes owners make is giving away too much equity. This especially applies to people who were there at the start, but didn’t end up pulling their weight. This can also be an issue for employees who are present when shares are distributed but don’t end up sticking around. To avoid this, every startup should start investing in vesting. This sets a timeframe and criteria for shares to be handed to the recipient. In this article, we’ll discuss how vesting works and what investing in vesting means for the ownership of your company.
- Vesting simply means to earn equity over time
- It is a common feature of Employee Share Schemes (ESS)
- Vesting can be based on length of time or on performance of employees
- You can outline this all by using a Share Vesting Agreement
What is Vesting?
Vesting is the concept of earning equity as you go. As the employee works and helps build the business, their equity vests. Often, the equity will only start to accrue after 12 months. The equity will continue to accrue until the vesting period lapses (often 3 or 4 years). After this, the recipient can receive the full benefit of owning the shares.
Individuals contribute to a startup and are given equity in the business in exchange for their efforts. A vesting schedule outlines the percentage of shares to be vested according to a particular timeframe or target. The schedule gives the company the right to purchase a percentage of the founder’s equity in case they leave the company.
Why do you need a Vesting Schedule?
If you have a Vesting Schedule, in the event that your business partner walks away after a couple of months, they will not be able to claim their percentage. This is because the company purchased the equity when they left the company. In essence, vesting protects founders from each other. It also aligns incentives so everybody focuses on a common goal – building a successful company.
Cliffs are common in vesting and mark the point at which shares begin to vest. A one-year cliff would mean that if you, as a founder, left before the first year was up, you wouldn’t be entitled to any of your shares. At the one year anniversary, you will have 25% of your shares vested. After that, vesting usually occurs monthly.
Your vesting should accelerate upon a change in control of the company, such as a sale of the business. Such acceleration usually takes place either immediately upon the consummation of an ownership change (single trigger), or is conditional upon the executive’s termination within some specified time interval thereafter (double trigger). The Vesting Agreement must include a clause on acceleration to protect or at least compensate executives in the event of an acquisition.
A typical schedule (4 years, 1 cliff year)
Standard vesting clauses typically last four years and have a one year ‘cliff’. This means that if you had 50% equity and leave after two years you will only retain 25%. The longer you stay, the larger percentage of your equity will be vested until you become fully vested in the 48th month (four years). Each month that you actively work full time in your company, a 1/48th of your total equity package will vest. However, because you have a one year cliff, if one of the founders leaves the company before the 12th month, then he or she walks away with nothing; whereas staying until day 366 means you get one fourth of your stocks vested instantly. As an entrepreneur, investing in vesting simply means protecting your company and rewarding employees for the contribution they make to your business.