Vesting – Every Startup Founder and Partner Needs To Understand The Concept

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Vesting

Vesting means that at the very beginning each founder gets his or her full package of stocks at once, but the company has the right to purchase a percentage of the founder’s equity in case he or she walks away. it plainly means that instead of getting your full shareholding upfront, you get it regularly in portions over a set period.

Reports claims 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.

It is predicated on the notion that the founding and management teams must earn their equity ownership by contributing to value creation through so-called “sweat equity,” or hard work.

The range of credit that venture investors are willing to give a founder tends to fall somewhere between 10 to 25 percent, depending on the amount of sweat equity that a founder has already invested, the progress made in the business and the founder’s leverage in term sheet negotiations. It is also not unusual to see a shorter, three-year vesting horizon, particularly with companies that are likely to hit high-value milestones within a short time.

When it comes to equity terms, there are only 3 things to understand: vesting, cliffs, and acceleration. For these examples, let’s say that I’ve got a co-founder and we’re splitting the company 50/50.

The problem we want to avoid is if one of us decides to quit early on, taking half the company’s stock with us. In that case, the other founder is then totally screwed, because they don’t have enough equity left to incentivize new team members. And even if they succeed, it’s super unfair that the guy who left still has half the company.

Vesting means that instead of each getting our 50% immediately, it gets given to us regularly over some period — usually 4 years. So if we quit after 6 months, we’d have earned 1/8th of our total 50%, or 6.25%. If we quit after 3 years, we’d get 3/4 of our total 50%, so we’d keep 37.5%.

A problem this can lead to is that you can end up with loads of people who each own a tiny percentage of the company. That makes future legal work more painful, and it’s what cliffs are designed to solve.

Cliffs basically allow you to “trial” a hire or partnership without an immediate equity committment. You agree on the equity amount and vesting period immediately, but if you part ways (via either quitting or firing) during the cliff period, then the leaving party gets no equity. Apart from that, it acts like normal vesting.

Vesting is preferred over a traditional “Buy/Sell Agreement” for startup companies.  In a typical Buy/Sell Agreement, if a founder stops providing services to the company, the corporation and/or other stockholders have a right to buy out the departing stockholder at a purchase price equal to the fair market value of the departing stockholder’s stock. There are two problems with this approach. First, the determination of the fair market value is often the subject of dispute, and second, in a startup the corporation and/or other founders simply don’t have the money to buy out the departing stockholder. Buy/Sell Agreements lead to no one being happy. Vesting is a cleaner approach.

Advisors get an extra term which is “full acceleration on exit”. That basically means that if you sell the company (or IPO), they immediately get 100% of the equity you promised them, even if the full vesting period hasn’t finished yet.

This one is standard and makes good sense. They did a great job advising you, you built a successful company, they get what they were promised, and their job is done. Hooray.

However, you can also get too complicated with equity triggers. For example, a hired-gun tech team might get their equity based on product deliverables instead of time passing. Or sales guys might have triggers from hitting revenue targets.

I’d would strongly advise against getting fancy, at least for now. When you add too many rules to your equity system, folks find wacky workarounds. Plus, if you’re new at this, you don’t have to justify yourself and don’t risk getting out-negotiated when you stick with the standard format.

It’s tempting as a founder to give yourself a “better” deal by picking a shorter vesting period, like 1 or 2 years. It seems good (“more equity faster!”), but typically leads to disaster since it allows someone to walk away with too much of the company.

And even if it doesn’t kill the company, it doesn’t actually help you. If you have an overly generous vesting structure, investors will only fund you if you “fix” it back to a normal 4 year period. And when you sell the company, the acquirer will usually “re-vest” you over another 4 years.

So speeding up your vesting now doesn’t actually help you cash out faster later. It’s all downside (co-founder problems) with no upside.

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