A Primer on Vesting
Fred Wilson recently wrote about the natural turnover on startup teams, with frequent references to the concept of “vesting.” “Vesting” refers to a startup’s right to repurchase an individual’s equity if that individual’s service to the startup terminates. This repurchase option lapses over time according to a “vesting schedule.” The following are some important points concerning vesting:
Industry standard is to implement a four-year vesting schedule, with a one year “cliff.” This means that the individual would need to work twelve months in order have the first 25% of his or her equity vest. After the one year “cliff,” the equity vests on a monthly basis for the remaining 3 years. The following is standard language implementing this vesting schedule from Orrick’s model Common Stock Purchase Agreement:
100% of the Shares shall initially be subject to the Repurchase Option. 25% of the total number of Shares shall be released from the Repurchase Option on the one year anniversary of the Effective Date, and an additional 1/48 of the total number of Shares shall be released from the Repurchase Option on the 15th day of each month thereafter, until all Shares are released from the Repurchase Option; provided, however, that such scheduled releases from the Repurchase Option shall immediately cease as of the Termination Date. Fractional shares shall be rounded to the nearest whole share.
The rationale behind the cliff is that there should be some minimal amount of service that each individual commits to a startup before they can walk away with any amount of equity. The cliff can be adjusted, especially in the case of a founder who has devoted significant time to a startup prior to implementing a vesting schedule. The rationale for equity vesting on a monthly basis after the cliff is to foster natural behavior from employees leaving the company when they desire to do so. It would be counterproductive to have an individual who no longer desires to work for a startup continue working merely to achieve a future significant vesting milestone.
Many people mistakenly assume that with a typical startup vesting arrangement an individual is acquiring equity as it vests. Actually, in the typical situation, an individual who owns restricted equity owns all of their equity. For unvested equity, however, the company has an option to repurchase that equity if the individual discontinues service for the startup before that equity vests. Typically, the startup can repurchase the equity at the same nominal price the individual paid for that equity. Contrast this with a buy-out of an individual’s vested equity, which will typically require a calculation or agreement upon the fair market value of that equity at the time of the buy-back.
To ease the mechanics of a startup exercising its repurchase option of unvested equity (which might take place after a falling out with the individual when the individual and company are not on speaking terms), it is common for both: (i) the startup to hold unvested equity in escrow, and (ii) for an individual, at the time of purchasing the restricted equity, to sign an assignment of unvested equity back to the company which the company will then sign if it executes its repurchase option at any time.
Triggering the Repurchase Option
It is important to think about what triggers a company’s right to repurchase an individual’s unvested equity. Typically, a company’s repurchase option kicks in when an individual’s “service” with the company terminates. Ideally, a company will have at-will relationships with all individuals and a clear governance structure such that an individual’s service can easily and clearly terminate.
Vesting is typically implemented through a Restricted Stock Purchase Agreement (for c-corps) or through a Restricted Unit Agreement (for LLC’s). Orrick provides a model Common Stock Purchase Agreement with industry standard vesting language.
Remember that a standard vesting arrangement (where the company can repurchase an individual’s equity at the purchase price) means the equity is subject to a substantial risk of forfeiture such that an 83(b) election should be filed. This prior post addresses 83(b) elections in detail.
As discussed previously on this blog, vesting is a critical part of setting up a healthy and productive environment for the startup team. The combination of vesting schedules and at-will relationships is what allows a startup to alter its equity allocation if the initial equity distribution does not align with the actual contributions made by each team member.