Welcome back to Legal Sollers startup Series designed to help startups and entrepreneurs receive basic information. Each week, we will answer most basic questions that founders often need answered.
So, what is vesting and why should a founder agree to vesting? Vesting of founder’s shares is often one of the most perceptive topics. Founders often argue as to why they should wait to receive benefits of shares of their own company. After all, they have earned their shares!
What is vesting?
Startups can either issue stock outright or with subject to vesting. Stock that is subject to vesting means that shares issued are exercisable over a period of time with certain conditions for the optionee to meet. The stock option becoming exercisable is referred to as “vesting.”
Let’s say for example, you have been issued 10,000 shares of common stock. However, initially not all of your stock is exercisable. Your stock becomes exercisable with 1000 shares every 4 months. That stock option is said to vest with respect to 1000 shares every 4 months.
FOUNDER SHARES & VESTING
When starting a company, founders often believe that they should receive the shares without any vesting because they own the company or are the ones working on the company. However, in most situations, having a vesting schedule in place for founder shares is in the best interests of founders for the following reasons:
a) When a company has more than one founder, there is a possibility of founders developing conflicts over a period of time. By having shares subject to vesting, if the other founder leaves before his/her shares have vested then the unvested shares can be purchased back by the company. If the shares are not subject to vesting, then the other founder will still own the shares he was issued.
b) Most VC’s or other investors would want to see founders be involved in the start-up, giving their 100 percent. Therefore the VC’s usually will not permit a situation where a founder can simply resign at any time and still retain all of the shares issued. Having vesting terms in place depicts to VC’s that the founders have a long term vision for the company.
c) If the founders wait to add vesting to their stock until they are in discussions with investors, the investors are more likely to dictate the vesting terms (e.g. longer vesting, fewer acceleration triggers).
What Vesting Schedule should be followed?
The length of a vesting scheduled as discussed is the period of time over which the shares will be subject to vesting. So, for example if you choose a two-year vesting schedule then your shares will vest over 2 years. However, the most common vesting schedule seen is a 4-year vesting schedule.
The frequency of your vesting is often expressed in terms of either a percentage or a fraction of total shares granted. So, for example, it can be that in your four-year vesting schedule with quarterly vesting i.e. 6.25% of your shares vest each quarter over 4-year period.
VESTING WITH A ONE YEAR CLIFF
Another important thing to remember is that vesting schedules can have vesting over a cliff or over a straight line.
Often your shares are subject to vesting schedules with one-year cliff. What this means is that the person must be at the company for at least a year before the shares vest. Whereas in a straight line, the shares will vest at regular intervals from the vesting date itself!
For example, 100,000 shares are being granted to a founder on December 1, 2019 with a vesting commencement date of January 1, 2020. In a four-year vesting schedule, monthly vesting with one year cliff, your shares will not start vesting until January 1, 2021. On January 1, 2021 25% of shares will vest immediately and thereafter the remaining shares will vest in monthly installments until January 1, 2024.
In the next blog post, we will talk about Acceleration provisions! Stay tuned!
DISCLAIMER: This post is for informational purposes only and not for the purpose of providing legal advice. You should not act or refrain from acting on the basis of any content included in this site without seeking legal or other professional advice. We disclaim all liability for actions you take or fail to take based on any content on this site.