Investing In Vesting
Avoid giving away too much equity to undeserved parties by investing in a vesting schedule.
When it comes to starting a business or startup, one of the biggest mistakes owners make is giving away too much equity to people who were there at the start, but didn’t end up pulling their weight. To avoid that, every startup must establish a Vesting Schedule, which sets a timeframe and criteria for shares to be handed to the recipient.
What is Vesting
Vesting is the concept of earning equity as you go. As the founder or employee works and builds the business, their equity vests. Usually around the 3rd or 4th year the equity is vested.
The principle is simple enough: individuals contribute to a startup to build a product or service and are given equity in the business in exchange for their efforts. The vesting schedule gives the company the right to purchase a percentage of the founder’s equity in case he or she walks away.
Why do you need a Vesting Schedule?
If you have a Vesting Schedule then if your business partner walks away after a couple of months, he or she will not be able to claim his percentage because the company purchased his or her equity when they left the company. In essence, vesting protects founders from each other and aligns incentives so everybody focuses towards a common goal: building a successful company.
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 Vesting Schedule of 4 years with 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.
We highly recommend that entrepreneurs include vesting clauses when incorporating the company or raising a financing round.
Dominic is the CEO of Lawpath, dedicating his days to making legal easier, faster and more accessible to businesses. Dominic is a recognised thought-leader in Australian legal disruption, and was recognised as a winner of the 2015 Australian Legal Innovation Index.