A couple of founders get together to work on a new business idea. One of the first things they need to discuss is how equity will be divided among them.
They often hear their stock should be subject to vesting. Vesting is an important tool to ensure a startup’s long-term success, but it is often misunderstood, and often not implemented correctly.
In the following, we will discuss what vesting is, how it works, and why it is important for startup founders.
What is vesting?
Vesting is the process of accruing a full right that cannot be taken away by a third party. In the context of the founders’ equity, a startup initially grants a package of stock to each founder.
A founder owns all the stock granted to him, and has the right to vote or receive dividends on a total value of the stock, including the unvested portion.
However, a company retains the right to forfeit or buy back the unvested equity if the founder walks away without contributing effort. Over a period of time called a vesting schedule, a founder acquires a full ownership that cannot be forfeited by the company.
Stock subject to vesting is a type of restricted stock, and differs from stock options that are often granted to employees as incentives. While a stock option is a right to purchase shares in the future at a specific price, stocks subject to vesting are granted outright. A stock option holder needs to exercise the right, but a founder once given the stock does not have to do anything further to earn the full right.
How vesting works
The vesting schedule may be agreed upon when the founders’ stock is issued. It can vary for different agreements, but the standard vesting for startups lasts four years, with a one-year cliff.
This means that a founder will fully retain all shares after four years. With a one-year cliff, 25% of his shares will be vested after the first anniversary, but not before. If the founder walks away before then, he will not be entitled to any shares. After the first year, a percentage of equity will be vested either monthly or quarterly until it is fully vested after four years.
During the four-year period, the company can forfeit the shares or buy back at the initial purchase price, if a founder leaves the company. Also, the right to transfer stock is limited during the vesting period.
Why vesting is important for startups
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Vesting motivates founders to make long-term commitments.
Founders come and go. Not everyone is cut out for the startup life, which can be too stressful and demanding for many people who might find the dynamic nature of a startup unstable. Along the way, some might lose faith in the shared vision. For various reasons, many founders leave companies in the formative years.
Most startups begin with limited capital and rely on the founders’ efforts to build value. By offering equity ownership, which vests over several years, a startup can motivate founders to stay and continue their efforts to grow the business.
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Protection against departing founders.
As we discussed above, founders sometimes re-evaluate their commitments, and leave after a short period of time. Without vesting, a new company can jeopardize its future success.
Imagine you started a company with two other people, and each of you receives 33% of the equity. One founder decides to leave the company after a few months. Without vesting, he still owns 33% of the company. He still owns a 33% voting right with regards to management decisions, and might retain influence over how the company is run. He might also demand 33% of the proceeds when the company is sold a few years later.
Many companies that fail to vest the stock are compelled to buy out a departing partner for the market value of the stock.
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Professional investors prefer vesting.
After its initial startup period, a company might seek outside investment from venture capital firms or angel investors in order to accelerate the growth of the business. Investors will conduct due diligence of the company’s documents, and often request favorable terms in the company’s operating agreement or founders’ agreement before committing to their investment.
A stock vesting provision for founders and key employees is often demanded by investors, because it is a way to gauge the commitment of people involved in the company, and to protect equity from departing partners.
What happens to unvested stock when the company is acquired?
Many vesting agreements include a clause that accelerates vesting in the event of the sale of the company, in order to protect founders and key employees. There are two main types of acceleration.
Single-trigger acceleration: the shares are automatically vested with the sale of the company (a single-trigger event) and the company loses the right to buy back any shares. You will not be required to stay with the new company to earn the full equity under the original vesting schedule, and are able to cash out the equity you built.
Double-trigger acceleration: the shares are automatically vested with the sale of the company and the termination of a founder without cause. This acceleration clause protects the founders’ position in the new company, and ensures the new company will bring on board the people involved in the startup. If your vesting agreement has a double-trigger acceleration, you cannot cash out the equity unless you are terminated with the sale of the company.
Remember 83(b) election
If an individual founder does not file an 83(b) election with the IRS within 30 days of the grant of stocks, the shares are taxed as ordinary income on the date equity vests. That means a founder should pay taxes on vested equity as the market value increases, even if he was not paid any cash for it.
If the 83(b) election is timely made, a founder can be taxed on the equity value on the date the equity was granted, instead of the date of vesting. Assuming the value of the equity increases in the future, a founder can save on taxes by paying income tax on the small initial value of the equity.
Speak with a Startup Business Lawyer at Jiah Kim & Associates
If you are thinking about starting a company and would like to speak with an attorney, schedule an initial consultation at Jiah Kim & Associates. To speak with a startup business lawyer in confidence, call (646) 389-5065 or book an appointment online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.