Vesting: You Know Nothing, John Snow!
This is seventh 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.
No one understands vesting. Sorry, correction. I understand vesting, but no one else seems to. Ok, that is probably untrue. But it IS fair to say that a lot of people think they understand it, but don’t really. I know this because I have sat with experienced founders, board members, advisors, angels and VCs and watched them get it wrong, repeatedly. And they all speak like experts. As a result, lots of entrepreneurs don’t apply it correctly, or optimally. So at the risk of being called out for claiming to be the expert, I will humbly offer up my thoughts over my next series of blogs.
What is Vesting?
Vesting can be applied to shares or stock options, and to any person working with the company: founders, employees, consultants, board members and advisory board members. You can even vest the office dog (this is called biscuit vesting).
Vesting at its simplest is the concept that you earn your equity (or biscuits) over time, by either staying with the company and earning it by the lapse of time, or by hitting milestones on which vesting occurs. The period of time may vary widely, but is typically between two to four years. Any shorter length of time (other than where the engagement is short-term), is too short. Any longer is unrealistic as so much will change over that period of time. WHY you leave the company should not affect vesting – whether you quit, are fired or give it all up to make candles. You stop vesting when you leave. No more biscuits.
Vesting Shares vs. Vesting Options
Vesting can be applied to any equity granted or issued by the company, most commonly stock options and shares. A common mistake is to confuse how vesting works with shares in comparison to stock options.
In the case of stock options, it’s simple. All of the options are granted up front (which must be done in order to lock in valuation), but only the vested portion is exercisable by the option holder. For example, if you have a stock option for 300,000 shares vesting linearly over three years, then after one year you can exercise 100,000 of your options. You can only exercise the vested portion of your option.
In the case of shares, vesting does not mean the shares will be issued over time – this would be problematic for tax and valuation reasons. The shares need to be issued up front to give the recipient the benefit of the company’s current share price (which will hopefully go up). Since the shares have been issued to the recipient before the shares have vested, this is sometimes called “reverse vesting”.
Vesting Agreements – Why They Matter
For reverse vesting, the recipient must enter into a vesting agreement when the shares are issued whereby they agree to vest their shares over time. Vesting in this case means earning the right to keep some or all of the shares that have already been issued to you. It’s as if the shares were loaned to you and you don’t need to pay back the vested portion.
If an individual is issued 300,000 shares to vest over three years, what happens after one year if he or she leaves the company and stops vesting? When a stock option is only partially vested, it is easy to deal with the unvested portion. It is simply a book entry in your cap table to note what has vested and what has not. But what do you do with the unvested shares given that they have already been issued and reflected in the cap table? It’s not as if you can pretend they don’t exist.
In this case, the vesting agreement needs to provide that the unvested shares (200,000 in my example) are either cancelled or returned to the company to be redeployed. And while most companies remember to include vesting terms in their stock option agreements, many forget to draft a reverse vesting agreement for shares which are vesting.
A TIP FROM THE FRONT LINE
For shares that have been issued but not vested because the individual leaves the company, my preference is that they be returned to the company to be redeployed by direction of the board. This allows the board the discretion to either cancel the shares (reducing everyone’s dilution), or transfer them to someone they might have to bring in to replace the individual who has left.
It’s important to remember that these unvested shares are not being reissued when given to someone else – they are being transferred to that person because they are already-issued shares. This is an important distinction because it means they could be transferred to someone at less than the price the company has recently been issuing shares at. No different than if you decided today to sell me your shares of Apple for $1 instead of market price (btw, I am buying is anyone is offering).
This little bonus can help bridge the equity gap when recruiting a hot new team member in cases where the option pool does not have sufficient room to take care of them. Transfer that individual some unvested shares from a recently departed individual, and do so at a low price to incent them. A nice deal and a win-win scenario.
Next up – Think before you Vest!
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.Back to blog