Stock Vesting Agreement
This document is the basis of credibility and transparency in the vesting process, which would reduce any employer-employee conflicts.
When founders come together to form a startup, one of the basic things they agree on is vesting for their company stock. A fair term of equity is a great motivation to stay invested in the company and work together to reach new heights. Similarly in established companies, once an employee qualifies for equity, terms of vesting have to be discussed.
As stock vesting is subject to time, eventually the company will define the terms of the stock vesting and draft a stock vesting agreement. This document is the basis of credibility and transparency in the vesting process, which would reduce any employer-employee conflicts.
When a company offers equity to employees, it is always conditional. It is uncommon to grant 100% of the shares upfront. Thus, a restriction on share ownership is a must to protect the business, and some rules are put into place. Let us discuss this in detail.
What are vested shares?
The first step in offering company equity to an employee is to issue shares. The next step is to set up conditions on complete ownership of these shares. This process of restricting share ownership based on certain regulations (years of service in the company or performance milestones) is known as vesting. The terms of vesting are laid out in a vesting agreement. Those allocated shares, which have reached a point of maturity where the employee has complete ownership over them, are known as vested shares. A shareholder, in this case an employee, can act on vested shares (sell them).
Shares ‘vest’ based on a timeline known as a vesting schedule. This determines how many shares will vest and when. Usually, most common vesting schedules span over 4 years including a one-year cliff period, which is the time an employee has to work in the company before becoming eligible for shares. Then on, a certain percentage of shares ‘vest’ monthly in an incremental fashion. In some cases, shares may vest immediately. Details of a stock issue and credit to an employee are defined in the vesting agreement terms.
For example, ABC Inc. issues 100 shares to its new product designer Mark in June 2020. Mark signs a vesting agreement, which among other things lays out a vesting schedule of 4 years with a one-year cliff. Mark will receive the first 25 shares only in June 2021. The next 25 shares will be credited in June 2022. At this point, Mark has 50 vested shares in his name. Though he was issued 100 shares, he will have complete ownership over all 100 shares only in June 2024.
What are the benefits of offering Vesting?
Vesting is used by startups and established publicly traded companies alike. Startups use vesting as an alternative to cash compensation for recruiting key talent and retaining them in the business, while large companies use vesting as part of their overall employee compensation packages and retirement benefits. Either way, only well thought out vesting agreement terms will make vesting for employees profitable in the long run. The three basic reasons why companies opt for vesting are:
- Vesting encourages loyalty – Be it employees, consultants or investors, vesting agreement terms ensure that the stakeholder contributes some quality time in the company before reaping a share in its profits. Vesting keeps them invested in the growth of the business, which will only happen over time. Vesting is strategic in retaining key talent.
- Vesting reduces cost – Startups typically struggle with cash flow. In this situation, offering equity to employees via vesting reduces the burden of cash compensation. If the business grows as estimated, vested shares will be far more profitable than limited salary compensations in cash. Even in case of retirement plans, companies tend to offer multiple rounds of vesting to an employee during their service period. Using vesting agreements to offer company shares in these benefit packages reduces the company’s massive burden of cash incentives.
- Vesting promotes confidence among investors – One of the basic things startup founders discuss is share vesting. Vesting agreement terms bind co-founders to stay committed to the business. The stability of co-founders is precisely what investor look for in startups. It builds faith in investors that their money is in good hands and the business has the potential to go big in the future. Thus vesting benefits the company and the employee.
Offering as well as holding equity of a company is a risky affair at many levels. The value of shares depends not only on the performance of the business but on many other market forces as well. High share values call for celebrations while plummeting share values is a bitter pill to swallow. Hence to ensure transparency and accountability between the share issuer and the shareholder, in this case between the company and the employee, (or in the case of a Startup, between Co-Founders) it is safe to agree upon vesting agreement terms at the very early stages of engagement.
What is a Vesting Agreement?
This is a document based on which a company sells its shares to a stakeholder. Terms of a vesting agreement enables the company to apply vesting conditions on the issued shares. Vesting agreements are designed when the company has decided to issue shares to a stakeholder (an employee or consultant or investor) and vesting conditions have to be applied.
Why do you need a Vesting Agreement?
Vesting agreements are crucial for startups. They are used by co-founders to agree upon vesting terms with utmost transparency. As discussed earlier, vesting agreements protect the interests of all parties contributing to the company’s growth. They ensure that share ownership is sufficiently restricted and is earned by fair means only in par with the stakeholder’s contribution to the business. The terms are stringent enough to ensure that the business does not suffer due to the incompetency or lack of commitment of one contributor. All parties involved should be clear about their liabilities in case of an early exit.
What does a share vesting agreement cover?
All terms of a share vesting agreement must be negotiated upfront. There should not be any room for confusion and all parties must be transparent about their deliverables. Since vesting schedules are subject to elaborate timelines, terms of vesting agreements must be declared and agreed upon at the very beginning so that the entire process is automated. There is nothing worse than having to re-negotiate terms of stock credit mid-way through the process. In most cases, it might not be possible as well. Some basic terms that must be included in the vesting agreement are:
- Details of the shareholder
- Number of shares
- Type of shares
- Vesting criteria
- Vesting schedule
- Company buy-back options
- Terms of confidentiality
- Definitions and interpretations
- Exit terms
As you can see, multiple aspects are covered in the vesting agreement. Each one is governed by a set of rules and strategies of implementation. Assuring the stakeholder about optimum transparency is the basis of vesting. Hence a person handling vesting must be well versed with vesting agreement terms. In the next section, we will discuss some of the key terms one must know while working with vesting agreements.
Vesting Stock Agreement Key Terms You Should Know
The following are some basic terms seen in a vesting agreement. It is in the interest of the employee and the employer to have a broader understanding of these terms and their nuances before entering into a vesting agreement. Failing to have clarity about these terminologies will lead to misunderstandings in expectations between two parties. This is something no company can afford to risk. They include:
Vesting is a process by which companies offer contractual benefits to employees in the form of equity. By this process, the company provides conditional rights over their shares, which the employees earn over a period of time working for the company. Vesting is regulated by vesting schedules which is a timeline for stock vesting. Vesting is determined by a ‘cliff’(qualifying period), vesting period (time over which a company spreads out stock distribution), and expiration date (Last date by which employees have to sell their stocks before they lapse). A basic understanding of how vesting works forms the basis of vesting agreements.
The predetermined price at which a company issues shares to an employee is the strike price. This is usually lower than the market value of the shares. As a result, when the employee exercises their options, they gain from the difference between the strike price and the increased value of the share after the vesting period. For example, an employee is issued a share at a price ‘x’. After a four year vesting period, let us assume that the share value becomes 4x. On exercising this option, the employee thus makes quadruple profits on the initial pricing. The strike price has to be mentioned in the vesting agreement in case of employee options.
A cliff is a qualifying period in a company. Typically it is for one year. On employment and share allocation, an employee will not qualify for any stock credit unless they complete one year of service in the company. If they leave mid-way or are terminated by the company, despite being allocated shares as per their employment terms, they will have to forfeit all their shares.
This is one of the biggest advantages of having cliffs in the vesting agreements. It acts as a trial period to evaluate an employee’s performance instead of giving away shares upfront. However, in some cases such as hiring high-value resources such as the director of a company, a certain percentage of stock may be allocated as a sign-up incentive without any cliffs (to be vested immediately). The remaining shares will follow regular vesting rules.
The clause of ‘acceleration’ is an integral part of Founder vesting agreements. It determines the fate of founder shares, especially the unvested ones in face of an unprecedented event where the company’s management changes control. In such a scenario, primarily three things happen: the unvested shares vest immediately, the founders continue to work with the new company continuing with the existing vesting schedule, or they forfeit unvested shares to the new company and exit. The founder has to make a call on this and customize the vesting agreement terms accordingly.
ISO & NSO
ISOs are Incentive stock options and NSOs are Non-qualified stock options. These are basic patterns of stock vesting. Both in ISOs & NSOs, employees are expected to buy the shares from the company once fully vested at the pre-determined strike price. However, the difference is that tax breaks are given on ISO gains, whereas income tax has to be paid in full on NSO profits. Vesting agreement terms have to clarify which type of stock options are being offered by the company.
A liquidity event is a situation when a company is acquired by another. If the company has been performing well, a liquidity event is actually a profitable opportunity for all shareholders. They can cash-in their shares in such an event. However, the vesting agreement terms will determine the pecking order in case of a buy-out. Usually, employees are at the bottom of this pyramid.
A company offers equity to its permanent and contractual resources on varied terms. But the profits are paid to shareholders in a predetermined order called the preference stack. If you hold 0.5% of company shares, you would be wrong to assume that you are entitled to 0.5% of acquisition as well. This clause is included to protect the interest of investors. Usually vesting agreements place investors and high value employees on the topmost rungs of the preference stack.
Vesting agreements are a combination of these terms and many more which further exemplify the terms of vesting. A thorough understanding of the intricacies of these terms is important before signing up for vesting. It is advisable to seek expert assistance in case either of the parties are not confident about their understanding of these terms. Now let us see how each of these terms fit into a stock vesting agreement.
Stock vesting Agreement Template
By now we have a fair understanding of vested shares and on what terms they are credited to an employee. Here is a template of stock vesting agreement. This is an example of a simple agreement by the SEC covering some basic features of stock vesting.
Information about the actual grant, vesting, exit plans, change of control, conditions for share forfeiture, company’s buyback options, timing and method of delivery, and taxation rules are the building blocks of a vesting agreement, so be sure to reference these when creating your stock vesting agreement in your company.
It is natural for any company to expect a forward-looking approach to talent acquisition. In the case of startups, the founders do not get together to quit. Neither do investors bet their funds on a business that will not flourish in the future. All investments are done with an approach of growing together. But this should not restrict planning for contingencies. The reverse vesting clause in a vesting agreement is this contingency plan. Investors always insist on it.
What is Reverse Vesting?
Reverse vesting entitles a company to buy back shares from a shareholder at a nominal price. We have learned by now that vesting provides a shareholder non-forfeitable rights to their allocated shares. But reverse vesting is that clause which ensures that stock credit happens as long as all terms of the vesting agreement are fulfilled. In case of any lapse, the company will repurchase the unvested shares or in some severe cases of illegal activity, all the shares allocated to a shareholder.
What is the difference between reverse vesting and regular vesting?
Regular Vesting is typically done to retain employees in the company. It is a process of involving shareholders in the company profits, provided all conditions of vesting agreements are adhered to. Through regular vesting, employees have the right to buy company shares at a predetermined price, once their shares are fully vested. Reverse vesting is just the opposite. It is the process of eliminating a shareholder’s involvement in the company profits. Through reverse vesting, the company repurchases allocated shares from shareholders in cases of premature exits, voluntary retirement, or when an employee is asked to leave. Vesting agreements are composed of both regular and reverse vesting terms.
As we can see, transparency is key to the fine functioning of vesting plans. Vesting must not feel like an added assignment to the company or the employees, and working with an automated, user-friendly interface minimizes the founder’s burden of tracking and implementing stock vesting.
Eqvista’s sophisticated software provides just this support. Eqvista helps entrepreneurs record and manage their company stocks with the utmost ease. Read these carefully written support articles for more information on company stock related subjects. For further information contact us today!