Create a perfect vesting schedule for your startup
Vesting is one of the basic principles of a startup operation.
Vesting is one of the basic principles of a startup operation. Be it among founders or while recruiting employees, understanding how to use company shares to retain talent is the basis of a startup team. A well thought out vesting scheme will not only build a team of committed, loyal employees but also reduces a startup’s operating expense in cash.
Introduction to Vesting
Vesting is the process of granting non-forfeitable rights to a shareholder for company stocks. However, these rights are conditional and the allocation of shares does not directly translate into share ownership. A timeline that determines vesting is called a vesting schedule. An employee can exercise their rights only on those shares that are 100% vested in their account and not the entire allocated package.
These vesting schedules usually vary based on the type of company, their industry, and the size of operations. Also, each startup vesting schedule can be unique in a company.
Let us understand how vesting works specifically for startups.
Vesting for Startups
A startup is essentially a company of shared responsibilities. A couple of founders come together to scale-up a brilliant business idea. Founders contribute in cash, technical skills, industry expertise, and intellectual property each of which is a pillar in the formation of a company. Hence, it is only fair that all founders claim a share in the business profits based on their scale of contribution. Thus Founder Stock Vesting is one of the basic strategies discussed by startup founders. Creating vesting schedules is basic during the initial stages of a startup operation.
Why is vesting important for Startups?
Vesting ensures that stock ownership in the company is conditional. Though founders are the most reliable resources of a startup, it is safe to prepare for contingencies. Startup vesting schedules act as a safety net. Since vesting schedules prescribe a timeline for stock vesting, founders can protect themselves from giving away stocks to parties who are not actively contributing to the business. This way, only those resources (employees, investors alike) who have invested time and effort in the startup’s growth will earn the right over company stocks.
Benefits of creating a vesting scheme
Imagine Dory and Kate start a company with 50% stakes each, but without any vesting schemes. Within 6 months the business starts performing well and they manage to convince an angel investor to consider their startup for investment. At this point, Dory decides to quit, owing to a personal obligation. Dory leaves the company with her 50% shares with no scope of dilution. Kate is now left only with her 50%, an investor in tow, and the entire responsibility of running the company.
Creating vesting schedules is a shield against such messy circumstances. Vesting schemes are usually four years long with a one year cliff (qualifying period). The founder does not receive any shares during the cliff. After the cliff, shares vest monthly in a 1/48 incremental pattern for the next four years. If a founder exits during the cliff period, they forfeit the rights over all the allocated shares. If they quit in 2nd year, they will only leave with 24/48 shares, instead of the entire chunk. The company also reserves the right to buy back unvested shares. Thus some of the obvious benefits of vesting schemes are:
- Provides conditional stock incentives to employees contributing to the business.
- Shields the business in case of premature exits. Exiting employees leave with only the vested shares. Unvested shares are returned to the company.
- Protects the business from people who have not earned their claim to it by disallowing voting rights
- Adds value during acquisitions. Startup vesting schedules make provisions for the ‘acceleration’ of founder shares.
- Stable vesting schedules attract investors, as they insist on having these. A founding team bound by vesting schemes indicates a commitment to the business, so investors feel secure about their equity.
A startup environment can be stressful. A lot needs to be done with limited resources. Additionally, it takes time for the business to gain momentum and show tangible profits. Thus startup vesting schedules must have an optimum length. They are created to build loyalty among employees as well as to keep them motivated enough to achieve considerable milestones. Hence vesting schedules for startups must neither be too long nor too short. Here are the three patterns of vesting:
- Immediate vesting – As the name suggests, there is no ‘cliff’ in this pattern of vesting. 100% shares vest immediately on assignment. Startup vesting schedules assign immediate vesting to high-value resources, especially those who bring intellectual property to the company. Mostly founders and directors qualify for this category and a portion of their entire share package is granted as a sign-on bonus. These shares vest immediately.
- Cliff vesting – If a startup creates vesting schedules with a ‘cliff’, it means they are imposing a qualifying term before the shareholder can claim complete ownership over their allocated shares. Common vesting schedules span over 4 years with a one-year cliff. This means the shares start vesting only after the employee has worked in the company for one year. Cliff vesting acts as a testing period for the startup to measure up their hires. It protects the business from claims of undeserving candidates. No matter how many shares are allocated to an employee during recruitment, if they leave before completion of the cliff period, they will have to forfeit all the shares.
- Graded vesting – This is the most common type of vesting schedule. Shares vest on a graded pattern. If a shareholder is promised 24 shares over 2 years, as per graded vesting, shares will start vesting monthly in a 1/24 pattern. If the shareholder quits after one year, they will leave with 12/24 shares. This type of startup vesting schedule is mostly used for consultants or resources with short-term engagement prospects. However, for full-time employees who are expected to stay long, a cliff is imposed along with a graded vesting schedule spanning a maximum of 6 years.
‘Acceleration’ is a special feature for people in top management such as founders, directors, or advisors. In a startup’s growth curve, there might be a point when the company is acquired. In this situation there will be a change of control, and with a startup vesting schedule, acceleration is the clause that covers the treatment of unvested shares in such circumstances. It lays down transparent expectations regarding the unvested shares during such an event. One of two things could happen:
- Single trigger acceleration – In case of an ‘event’ where the company changes control due to an acquisition, all unvested shares of the employee vest at once irrespective of what their vesting schedule determines. The founder can immediately leave with 100% vested shares. Since this type of acceleration accommodates one move, it is called a single trigger.
- Double trigger acceleration – In case of control changing events in a startup, the existing management phases over into the new acquisition. All founders retain their positions in the company. This, on one hand, protects the interests of the founder and simultaneously helps the new company to ease into this transition. Meanwhile, all unvested shares of the founders will vest within 12 months from the time of acquisition. Since two moves happen here, this is called a double trigger.
Choosing Right Vesting Schedules for Startups
As we have seen, there is no rule of thumb for designing startup vesting schedules. It can be customized based on the industry, company size, and the employee’s position in the organization. Choosing the right vesting schedule keeping the employee’s needs in mind as well as protecting the business can be tough. Here are some common vesting schedules used in startups:
Vesting schedule for founders and directors in a startup
Founders are resources who provide valuable intellectual property in the startup. They are usually the ones with considerable expertise in their area of work, so they have to be incentivized to quit their existing role and choose a startup life. Hence it is only for founders that a special sign-on bonus is offered in stocks apart from an elaborate shareholding scheme that will vest throughout 4 – 5 years. The stocks offered upfront usually vest immediately.
Meanwhile, directors are treated as high-value employees but offered stock ownership with shorter vesting schedules. Their vesting schedule will be determined by the significance of their value-added to the company.
Vesting schedule for employees in a startup
Startups use vesting to compensate for cash deficits. Since most startups are cash-strapped, they offer company stocks to employees during recruitment. If the employee stays invested in the company, the stock prices of the company will grow and as a shareholder, the employee makes more profit in comparison to limited salary benefits in cash. Startup vesting schedules for employees are usually 4 years long with a one year cliff. Shares start vesting monthly in a 1/48 pattern only after completion of the cliff period. If the employee leaves during the cliff period, they will forfeit all allocated shares.
Employee stocks are mostly restricted stocks, and the restriction criteria is outlined in their vesting schedules. Restricted stocks could be in the form of Restricted Stock Awards (RSAs) or Restricted Stock Units (RSUs). RSA grants an employee the right to buy a limited amount of company stocks. They are granted these shares at fair market value or a discounted rate on a particular grant date. But they can exercise these options only after completion of the vesting period. While in a RSU, the employee does not need to buy any stock. The company grants a certain amount of stocks over a particular achievement and the employee simply has to wait through the vesting period to gain ownership over them. Read the difference between RSA and RSU here.
Vesting schedule for consultants and advisors in a startup
Consultants normally have a short-term engagement with the company. They are considered for vesting only after they have completed at least one year of service. After one year, shares vest monthly over their consultation term. In case their engagement extends into long-term, consultants might be considered for milestone vesting as well. Startup vesting schedules for consultants, in this case, will set performance milestones based on which shares will be allocated in packages.
On the contrary, vesting schedules for advisors are similar to those of directors. Their vesting period might be between 2 – 4 years. But as a special case, their shares might accelerate towards the end of their contractual period. For example, if an advisor shares are vesting at the rate of 1/48 for 4 years, towards the end it might accelerate to 3/48.
The Founder Institute’s FAST Agreement simplifies the process of offering equity to advisors. It is an easy to use template where all you need to do is check some boxes, sign the agreement and start working. This template aims at nurturing the startup market place by encouraging collaborations among experienced founders. The FAST Agreement does not promise any cash, but offers equity in the startup to experienced advisors in exchange for their mentorship.
Create the right vesting scheme using Eqvista
As you can see, vesting schemes are all about customization. It has to serve the needs of both the company and the employee. However, while a simple startup vesting schedule can be handled on an excel sheet, as the company grows and recruits employees on multiple levels of the company, keeping track of varied vesting schedules becomes cumbersome.
Eqvista’s state-of-the-art software provides the ease to create vesting plans for all employees on a single platform. Issuing and tracking company shares have never been easier! We provide options for time-based vesting, milestone vesting, and hybrid vesting.
Here is a basic example of a time-based vesting schedule created using Eqvista. This displays a 4 year vesting period. As you can see, 25% shares vest gradually over the time period. You can easily set the number of periods, frequency of vesting, schedule of vesting and the percentage of shares to be vested.
With Eqvista software, you can create customized vesting plans to suit your needs. For more information on company share allocation and distribution, check out these support articles or contact us today!