Vesting: Think Before You Vest!
This is eighth 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.
In my last blog I alleged that no one understands vesting, and then proclaimed myself an expert. If you are still reading, I must have got it at least partially right. Or maybe not. In any event, last time I provided an introduction to what vesting is all about and sought to clear up the confusion of how vesting is different for shares versus stock options. In this article, we’ll focus on what vesting should look like and specifically whether there is one right way to do it (hint: the answer is no, there is not).
What are the Vesting Rules?
There are all kinds of vesting rules and there is no one rule which applies in all situations. Vesting should be applied in the context of the equity grant, and tailored to drive the desired behaviour of the recipient. It is kind of like training a dog. And not all dogs are the same, so apply vesting to drive the behaviour you want from Rover. Woof, woof.
One mistake I commonly see is confusing vesting with termination in the case of stock options. A stock option will have an expiry date, reflecting the period of time the option is exercisable for. Often between two to five years and as much as ten years. Vesting, on the other hand, relates to how much of the stock option the holder can exercise up to that expiry date. For example, an option for 300,000 shares vesting over three years might have a five-year term, meaning it expires five years from the time of granting. If the holder has vested half of that option, 150,000 shares, he or she can exercise those 150,000 shares at any time up to the end of that five-year term (unless other early termination provisions apply).
One Size Does NOT Fit All
An example of why one size does not fit all when it comes to vesting is in regards to how vested options should be treated for someone who leaves the company. This should depend on why they received the equity in the first place. Vesting of stock options in the hands of an employee who is otherwise being paid full salary should be a retention mechanism and structured accordingly – some or all of the option expiring shortly after they leave. Otherwise it defeats the retention objective.
By comparison, vesting of stock options for an employee in lieu of salary, or for a board member who is otherwise not being paid, is compensation for time served and not a retention device. In that case keeping what you have vested, even after departing the company, is no different than keeping the salary you would have been paid – you’re not required to refund the latter when you leave the company, so why should you lose options granted to you in lieu of salary? In the case of board members, you don’t want them hanging around on the board simply to keep their options alive. I’ve seen this happen many times. They should keep their vested options for the balance of their term.
Setting the Option Term
Similarly, the term of the option might be different in the two cases. Where the employee is being paid full or near full fare, the options might have a term of five years or less. That allows the company to turn over its option pool and grant new options to new recipients as time goes by and options expire.
But where the option was granted to the recipient in lieu of salary, or to a board member as their compensation, there is an argument that they should be given a longer period of time to exercise their options. Otherwise, it is like getting a gift certificate that expires if not used within a period of time. And using that analogy, since money does not expire a gift certificate bought with real money shouldn’t expire either. An option granted in lieu of salary or compensation is in effect a payment in lieu of real money and should continue as long as possible.
TIP FROM THE FRONT LINE
A mistake made by a lot of entrepreneurs is to want to lock down one vesting formula to apply in all situations. The examples above are just a couple that show why that will not work. However, it is still worthwhile to adopt a set of vesting provisions for the stock option plan which would apply by default where specific vesting is not needed.
A good starting point is vesting over three years, either daily or quarterly, with acceleration of vesting in certain situations (the latter topic to be covered in my next blog). And remember, a fed (vested) dog is a happy dog.
Next up – Vesting. More, Are You Kidding Me?
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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