Published in · 4 min read · Mar 12, 2014
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As a founder, you’ve probably heard that your startup company’s shares should be subject to a vesting schedule. You may not know why a vesting schedule is important when issuing shares to founders and other key employees. Today’s post highlights some of the major reasons why a vesting schedule makes sense for most startup companies, and why investors prefer investing in companies that use vesting schedules for founder and other key employees.
Example of why startup companies use vesting schedules for founders
Suppose ABC Co was founded by John and Jane. ABC has created a new crowdfunding portal where investors can invest in businesses online. ABC raised a small friends and family round of investment to help launch the company. John and Jane have been working on this idea for 18 months, and have created a unique process for completing the investment process online. Two days before the company launches, John decides to quit the company and go his separate way. John’s stock in the company was not subject to a vesting schedule, and John’s technical skills were incredibly valuable to the company. John’s exit leaves Jane (and the rest of the company) scrambling to launch and unable to immediately support ongoing obligations. John holds 30 percent of the company’s stock (all fully vested). Because his stock is fully vested, he may be able to come back to collect on this equity once the company grows into a profitable business, even if he quits at such an inopportune time. And the company may have trouble securing future investors may not want to invest in a company with even 30% controlled by a non-participating shareholder.
How vesting provisions help protect you, the company, and its investors
To protect the company, founders, and investors from the scenario above, founder stock is usually subject to a vesting schedule. Generally, the founder stock will vest over a two to four year period, with an initial vesting of 25% or so on signing or after one year. During that time, the company has a repurchase right to buy back the founder’s stock if they leave the company at a company-friendly price. As time passes, that repurchase right will go away and a portion of the shares will become “vested,” or no longer subject to that repurchase option. If the founder continues to work for the company, the shares continue to vest. If they leave during the vesting period, the company can buy back all unvested shares. These protections are important to ensure the company’s viability, especially when the business will need or plans to seek outside investment to be successful.
Why investors prefer vesting schedules
Investors understand that the key to a successful startup is not only the product or service that the company sells, but the team behind the product or service. After all, we’ve all read the stories about companies tanking after key employees and executives leave the company. Therefore, investors want to be assured that founders and other key employees will not leave the company after the investor puts in money, or that they are at least incentivized to stay with the company during the early days. Vesting schedules offer investors comfort that the founders will either stay with the company or be forced to sell back their shares if they exit early.
Founders also benefit from vesting provisions
First, these provisions protect founders from uncommitted co-founders. At the very least it incentives founders not to drop out at the first sign of weariness. Second, founders benefit because vesting provisions can make their company more valuable to people and companies looking to acquire the company. Often acquirers will want to be assured that founders will stick around after the acquisition, and vesting provisions can be a powerful incentive for the founders to remain with the company after it is acquired. Likewise, other shareholders (investors, key employees, directors, advisors) benefit from the value added to acquirers, as they will benefit financially from an increased acquisition price.
If you’re a startup founder whose stock is restricted by a vesting schedule (or any other individual or entity receiving restricted stock), it’s important to consider filing (if appropriate) an 83(b) election with the IRS. Filing an 83(b) election allows you to recognize the full amount of your restricted stock upfront rather than recognizing the value of the stock as it vests. Stock in a startup company generally carries its lowest value when the company is first formed, so it usually makes sense to recognize the full value of the stock on day one rather than when the stock vests (assuming the company gains value over time and its shares increase in value).
Photo: see you, future | Flickr
