What is vesting?
While the idea of instantaneous value may be exciting to founders (including yourself), if you have more than one employee, you will still want to have a vesting schedule firmly in place at the time you incorporate your company. Stock vesting is a common practice at most venture-backed startups.
You may have heard that not having a schedule may give you additional “leverage” over your investors, but this almost never the case—the lack of a schedule is apt to drive away VCs and angel investors, who will reasonably expect founders to have a vesting schedule in place.
Vesting, as a concept, essentially exists to ensure that essential employees, like founders, have the incentives to stay with a company through the initial lean years and for long enough to make the product a success. Most startups give employees, including founders, some form of equity compensation in the company’s equity, with a vesting agreement governing when the shareholder receives their equity.
In this article, we will cover how vesting works, standard vesting for founders & employees, repurchase rights.
The Vesting Period for Restricted Shares & Stock Options
If you’re already familiar with the concept of vesting for startup equity, feel free to skip ahead. An employee or founder’s stock options, equity grants, or other limited benefits are said to vest when they receive the non-forfeitable right to exercise those options. In almost all cases, this is governed by a pre-set vesting schedule, which determines at what time employees will be able to exercise their options and in what percentage.
A four-year vesting schedule is the norm for most stock options. In a typical 4 year schedule, the default assumption in Capbase, 25 percent of options will vest after the first year has passed since they joined the company—the so-called vesting cliff. This one year cliff, four year vesting period is standard for employee stock awards at venture backed startups.
After the one year cliff, the remainder of stock options may vest at any predetermined rate, but at the mass of companies, they vest monthly for employees and quarterly for other personnel, like advisors.
Under this schedule, the holder has gained access to the full portion of promised stock (or vested equity) after a four-year period—or the total vesting period. They are then said to be fully vested after this period of time has elapsed. Before this time, you are liable to lose the un-vested portion of your stocks or options if you are terminated or leave the company. Sometimes, when an employee is being laid off from a startup, the company may offer to accelerate the employee‘s share award, giving them a portion of their unvested shares in addition to any already vested shares.
One of the main reasons that startup founders have vesting schedules attached to their share award is to avoid a scenario where one founder leaves after only a few months with a huge stake in the company. This “dead equity” on the cap table, held by the departing founder, would jeopardize the company’s changes of raising funds from investors in the future.
Especially for founders, who have a special relationship with the company and have likely already devoted months—if not years—to the product, it helps to keep the option open to backdate their vesting schedule, adjusting it to begin at an earlier date to reflect the work they have already invested.
Co-founder equity is rarely the same. While the idea is romantic, it rarely happens that two (or more) founders of a startup bring equal portions of labor, intellectual property or material investment to the corporation. Each founder will bring something different to the company and likely has a different expectation of their time investment, and as such, the equity they receive will rarely be equal.
At the same time, most companies are served by splitting equity between founders in a balanced or equitable way, as in a 40/45 split rather than a heavily weighted 90/10 split. These issues are covered in expanded depth in the article How to Split Equity Among Co-Founders.
Vesting schedules are likely to be the same. Despite differences in equity, in most cases, companies will find it advantageous to maintain the same vesting schedule for all founders. This not only eliminates the appearance of inequality but may quell individual re-negotiations of terms by co-founders in the future. Founder equity awards may have double trigger acceleration attached to the grant, and, in more rare cases, single trigger acceleration, both of which accelerate when shares vest in case of acquisition..
Buying Your Founders’ Shares
In nearly all cases, the newly authorized founders shares are bought by founders at their par value at the time of incorporation and the founders are the majority shareholders in the company until raising substantial outside funding. Founders may choose to purchase their shares outright or in some cases trade a portion of their technological IP for some of the final value. Learn how a startup’s cap table changes as the company issues equity and raises funds.
The valuation of this IP is called consideration. We provide pre-filled forms for consideration handovers in Capbase. The importance of this particular process will be addressed in a future article.
Once you, or an employee have purchased or been given a stock grant, you will more than likely want to make a section 83(b) election with the IRS, which will allow you to obtain special tax treatment related to your stock option grant price. The buying process itself is a slightly more complicated affair, which is why we’ve automated and provided a sample timeline for it in Capbase.
How single and double triggers work with stock vesting schedules and startups. Learn what founders & employees need to know about acceleration triggers.
Written by Greg Miaskiewicz
Security expert, product designer & serial entrepreneur. Sold previous startup to Integral Ad Science in 2016, where he led a fraud R&D team leading up to a $850M+ purchase by Vista in 2018.
We cover all the important steps founders should take before incorporating their startup: choosing business entity, state of incorporation, name, board of directors, splitting equity between founders & more.
Vesting schedules play an important part in keeping a startup together. They’re a designed as a motivator not only for employees, but also for founders. If you have them, it sends a signal to investors, that you’re in it for the long haul.