You’ve probably heard the term “vesting” before. It’s an important concept and one you need to understand to effectively manage your startup.
Vesting is the term used when shares already held by or awarded to someone in a company are earned by that person, typically over a certain period (referred to as a “vesting period”).
For example, 10,000 shares could be subject to a 4-year vesting period, where 625 shares would vest each quarter (this is the “vesting frequency” and can also be monthly or annually; though quarterly is more common) for 4 years until the full 10,000 shares become vested.
Clara Tip: Sometimes vesting isn’t just linked to time, but also to certain objectives or KPI’s. For example, achieving a certain sales target or onboarding a certain number of users.
Vesting vs. Reverse Vesting
If the shares are already held by the person, this is “reverse vesting”, which means the shares are fully owned by that person, but if the vesting period isn’t completed, they would have to transfer some of those shares back to the company. This is more typical for a founder who already holds all their shares in their startup.
If the shares are not yet held, but are being awarded to the person, this is simply called vesting, and the shares are issued to the person as per the vesting schedule (e.g., in our example the person would receive 625 shares every quarter).
So, what does a person have to do to keep their vesting schedule going? Usually, it’s not much more than continuing to be employed by the company. If they leave or are terminated, the vesting schedule stops, and any shares not yet vested at that point (“unvested shares”) will either be returned or will not be issued.
Clara Tip: You may hear the term “cliff period” used. This refers to an initial period during the vesting period where no shares vest. Cliff periods are used as a sort of probationary period to make sure the person is a good fit before having them become a shareholder.
The typical cliff period is 1 year in a 4-year vesting period. This means that during the first year, no shares would vest quarterly. Instead, at the end of that year a full quarter of the shares would vest.
In our example, that would mean no shares would vest for the first year and at the end of that year a full 2,500 shares would vest.
After the end of the cliff period vesting would continue as usual in accordance with the vesting frequency chosen (e.g., quarterly).
What does this mean for you as a founder?
Well, vesting (or reverse vesting) is a really important tool both in the context of fellow co-founders as well as employees, consultants or advisors that you are thinking of granting shares to.
Reverse vesting ensures each founder makes the contributions that were agreed to at the outset and stays with the startup for a minimum period. Without this, you may find yourself in a situation where a founder does not live up to expectations or decides to leave after a short period of time and keeps all their shares. This could be viewed by other founders as an unearned reward, causing resentment and depriving them of the share allocation they may need to give to a new co-founder.
For stakeholders, vesting ensures that they remain aligned and incentivised to stay with you and grow the business with share compensation awarded over time rather than all at once.
TL:DR, here are 3 key takeaways:
You should have vesting (for stakeholders) or reverse vesting (for the founders) in place to make sure rewards and contributions are fair and aligned.
Think about what vesting period you want to put in place (e.g. 4 years), whether there will be an initial cliff period (e.g. 1 year) and what the vesting frequency will be (e.g. quarterly).
Consider whether KPIs are suitable in addition to or instead of time-based conditions for vesting.