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A Primer on Vesting

A "vesting schedule" does not refer to the days of the week when you must wear this.

A “vesting schedule” does not refer to the days of the week when you must wear this.

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:

Vesting Schedule

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.

Repurchase Option

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.

Documents

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.

83(b) Elections

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.

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Splitting the Pie

Photo Credit: DigiDi

Photo Credit: DigiDi

An early decision that can often trip up founders is how to divide the initial equity issued by the startup.  While there is no cookie cutter approach to this question, the following are some general principles founders should follow:
At formation, a startup is a long way from the finish line.

At formation, a startup is a long way from the finish line.
Photo Credit: Ben Shepherd

Future Effort– The vast majority of the equity awarded to founders should be based on the likely future effort needed to make the company a success.  Founders often over-value their contributions to the initial intellectual property upon which the founders are basing the company.  A general rule of thumb is that the founders’ equity granted in exchange for existing intellectual property being assigned into the company should be less than 10% (across all contributors), and often significantly less.

Aligning Interests & Properly Incentivizing – Don’t get too hung up on trying to precisely nail each founder’s value.  Instead, think about aligning each participant’s interests with those of the company.  To do this, you need to incentivize each participant to work their tails off to build a great company.  The right question is: how much equity is needed to properly incentivize exceptional effort from all involved?

Multi-stage Transaction – Founders should also recognize that taking a startup from concept to commercial success is a multi-stage transaction.  Investment rounds will often serve to correct any misalignments of interests between founders, the company, and investors.  For example, if a technical founder has 15% of the equity in a startup, but his or her role has become more important to the company than originally anticipated, investors will recognize the need for that founder to have a larger share of the company in order to be adequately incentivized.  The investors may require a reapportionment of the founders’ equity as a condition to investment.

Keep it Simple and Follow Established Models to Address Future Changes – Founders (especially student founders) are often concerned about the difficulty of allocating equity when the future time commitments of founders is up in the air.  Founders may be tempted to try to create an equity allocation that adjusts periodically based on the contributions of founders during that period of time.  This is unnecessary, can be unhealthy to team dynamics, and can cause tax complications.

Founders may be attempted to constantly adjust their equity to account for their changing contributions.

Founders may be attempted to constantly adjust their equity to account for their changing contributions.

Fortunately, there is an industry accepted model for aligning the interests of founders with the company and giving the company the flexibility to adjust its relationship with founders that are not living up to their end of the bargain.  This model includes:

  • establishing a “reverse vesting” schedule for each founder that grants the company a repurchase option in the founder’s unvested equity if the founder’s service to the company ends;
  • providing the company the ability to terminate a founder’s service at will (either through termination at will provisions in the employment offer letters or service contracts, or as a provision in the restricted equity agreement).

Accordingly, if a founder is not contributing the expected value to the startup, the startup can seek to adjust that founder’s equity split to something more appropriate.  If the founder acts unreasonably and is not willing to adjust his or her equity, the startup has the ability to terminate the founder’s service and stopping the founder’s stock from vesting.  This threat will either incentivize the founder to act reasonably and agree to an equity adjustment, or provides the company the ability to end its relationship with that founder without the founder leaving with equity that he or she did not truly earn.