Vesting Shares and Options: Still More, Are You Kidding Me?!
This is ninth in a series of blogs on launching, growing and ultimately selling a technology company, with a corporate finance focus. Topics include cap structures, equity plans, financing, corporate partnering, board matters and how to achieve a successful exit.
Now we are going to talk about getting vesting right. Mistakes are made all the time and they can be costly. The first article introduced the differences between vesting shares and stock options, and the second made the point that vesting needs to be tailored to a particular situation. In this article I’ll cover time-based versus milestone-based vesting, and accelerated vesting.
Time or milestone-based?
It is intuitive to entrepreneurs to want to tie vesting to milestones. You earn when you produce – good concept. Yet, we see most companies tying vesting to time. The longer you are with the company, the more you have earned.
Why is that? Well, the simple reason is that early stage companies need to be agile and fluid. Milestones that were put in place six months ago may have already changed. Locked-in milestones to trigger vesting can quickly be off-plan — thus no longer achievable which can create a problem. Moreover, even if the plan doesn’t change that much, vesting tied to milestones may skew the day-to-day activities of the employees towards hitting those milestones even if there are other, higher priority, things that should be done. Smart people should not be punished for doing what needs to be done.
Where milestone-based vesting can work, however, is with sales staff. Similar to cash bonuses for sales targets achieved, option vesting can be an effective incentive to hit sales targets. Other than for sales staff, however, I have not had a good experience with milestone vesting.
Time-based vesting is a holistic approach to performance. If you are still here, it should be because you are performing and thus you should continue to vest. If you fail to perform and you either quit or are let go, then vesting stops. As noted in one of my previous blogs, to me it does not matter why you are no longer with the company — whether you quit, are fired for cause or not for cause, or decide to run off to the tropics. In each case, if you aren’t with the company, your vesting should stop.
Another vesting issue to get right is the concept of acceleration. Accelerated vesting means a situation where the options or shares vest immediately notwithstanding the fact that there is still a vesting period to run. For example, if the option was vesting over three years and halfway through that period the accelerating event occurs, then all of the options are considered fully vested.
The most common example of an acceleration trigger is the sale of the company. The idea of accelerated vesting is that the crystalizing event is good for the company so everyone should be aligned to see that it actually happens. Not accelerating vesting in the context of an offer to acquire the company might actually interfere with the deal – having those people whose options or shares do not accelerate vest be unsupportive, or even get in the way of, the deal. Not a good situation.
But hold on, there should be some brakes too
Having said that, some qualifiers should be put on acceleration. As an example, if a new employee is granted options that are supposed to vest over three years and then suddenly the company is acquired in the first six months of their employment (unusual to happen that fast, but not out of the question), it is unfair to other stakeholders to suffer the dilution of full vesting for that individual. And in the case of the individual, they have been given a windfall they neither expected nor earned.
This can be handled by providing that if a sale that triggers acceleration of vesting happens in the short term, some lesser portion of the option accelerates. An example would be if a sale happens within six months of joining the company, acceleration of vesting is only for the balance of the first year’s options.
Acceleration can be a great tool to reward everyone when a significant milestone is met, such as the sale of the company, or going public. When the company and its shareholders win, make sure you reward the troops that got you there.
Next up – Founders, your vested interests must vest. Surely you jest?
David practiced corporate finance law for 20 years representing numerous technology companies before retiring to co-found a venture capital fund where he was a partner and portfolio manager for ten years. He now provides corporate finance/M&A advice to a portfolio of early stage companies with a view to growing them to the point they are ready to exit, and then leading that process.
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