equity

Equity Basics: How Vesting Provides Upside Potential for Team Members and Downside Protection for Your Startup

People make and break businesses. Adding a chief technology officer who turns a founder’s vision into a real product turns a great idea into a functioning business. Hiring a director of sales who secures key client relationships makes a business profitable. Harder to anticipate, however, are the people who might break a business. The star developer to whom the company granted 20 percent of its equity might leave without notice. Some employees don’t have malintent, but ultimately may turn a founder’s dream into a nightmare, as people decide to pursue new opportunities, or life events lead to geographic or career moves.

In short, *stuff* happens.

One tool and concept that helps in dealing with the unpredictability of team members when starting up is vesting.

What is vesting?

In technical terms, vesting refers to the process, time or conditions tied to an employee’s requirements to earn equity. To put it simply, vesting can be viewed as fulfilling requirements necessary to earn certain rights or benefits. For example, workers begin earning insurance benefits and matching 401K contributions after working for a certain amount of time.

For founders, it is always key to identify talent and often very important to save cash by incentivizing talented contributors with equity awards. Creating optimum vesting conditions is just as important for a startup as selecting the appropriate amount of equity to grant. The pathway should be crystal clear, both in the mind of the founder and in the written vesting provisions of the equity grant or separate vesting agreement.

Separate vesting agreements are referred to by a variety of names and titles, such as Stock Restriction Agreements, Share Restriction Agreements and Membership Interest Restriction Agreements. These are common titles, each noting the type of interest (share or membership interest) and purpose (placing a restriction of some kind on that interest).



What does it mean for shares to vest, and how do vesting provisions work?

In order for shares to vest, the process, time and any other conditions relevant to an equity grant must be satisfied with respect to those shares or a portion of those shares.

Vested shares are shares that the grant recipient has earned. Without provisions giving the company the right to repurchase those vested shares upon some event (the person leaving the company, for example), the person will own those shares and have the same rights as other shareholders.

Vesting agreement language should be crafted with care and reviewed with a fine-tooth comb to ensure that such language is straightforward and unambiguous.

The following elements should always be incorporated: (1) process, (2) time, and (3) any other conditions, which we will discuss more below.

Process

Will the vest be earned over time or upon the occurrence of certain events (i.e., achievement of certain milestones)? Vesting arrangements are often said to contain “time-based” vesting provisions, “milestone-based” vesting provisions, or a combination of both types.

What are the pros and cons of different vesting schedules? The biggest pro is flexibility. Companies can tailor vesting schedules to capture the value they hope to receive for granting their equity. Founders can even structure vesting arrangements amongst themselves to ensure that each founder fulfills his or her promises to the company and the other co-founders.

Time

Addressing time is straightforward, because the clock starts at the time agreed in the vesting language. That time may date back to formation for founders, or start on the agreement/acceptance date for employees or service providers.

With time-based vesting schedules, the vesting timeline is clear, but with milestone-based vesting schedules, the vesting timeline varies. Vesting will occur faster than anticipated if milestones prove easier to obtain than initially anticipated, or vesting will never occur if milestones prove too difficult to achieve.

For this reason, blended vesting schedules are often created. They provide time-based provisions for a portion of the equity and milestone-based provisions for the rest. In doing so, the company protects itself and provides a degree of certainty to the other party that some equity may be earned regardless of performance.

Conditions

Looking at conditions is often accomplished through defined terms and by way of reference to other agreements, such as governing documents, or those that govern all of the company’s equity awards. This is why it is crucial to ensure that such accompanying documentation is reviewed, up-to-date and clear.

For example, this could be time-based; working for the company for the specified period of time being the only requirement. If the recipient’s grant is for 100 shares, 25 shares (one fourth) will vest on the first anniversary of the award date.


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How early should startups draw up vesting agreements?

In any startup with more than one founder, drafting vesting or share restriction agreements right after forming the company is a great idea. Founders should use these agreements to make clear their expectations regarding how long each founder should stay actively engaged with the company, what each should contribute and what happens to one’s equity when leaving the company or reducing engagement.

Otherwise, founders face the risks of carrying deadweight, having awkward conversations to request a co-founder give up his or her equity stake, and answering questions from investors about why a person investors haven’t met holds a percentage of the company.

With respect to those that the startup plans to incentivize with equity grants (i.e. employees, consultants, investors), vesting provisions should always be incorporated into the equity grants and referenced in documents that mention the company’s agreement to utilize equity as partial or full consideration for employment, products or services. A good rule of thumb is as follows: if equity is functioning as an incentive (versus functioning as a capital raising tool), include vesting provisions in the equity grant.

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