TL;DR
Vesting refers to the process by which an individual earns the right to keep company shares or stock options over time, typically tied to their length of service at the company.
Until the equity is fully vested, the company retains the right to repurchase or withhold the shares if the individual leaves the company.
For example, in startups, founders, employees, and advisors are often granted stock options or shares that vest over a set period. This means that they do not fully own all of their shares from day one but earn them gradually as they continue to contribute to the company.
Vesting schedules protect the company from situations where a key team member leaves early, while also ensuring that employees and founders stay motivated by giving them ownership over time.
How Does Vesting Work?
Vesting typically follows a schedule that specifies how much equity is earned at specific intervals, usually over several years.
During the vesting period, the individual earns a percentage of their total equity grant, and only after the vesting period is complete do they gain full ownership of all their shares or options.
A common vesting schedule is four years with a one-year cliff, meaning that the individual must stay with the company for at least one year before earning any equity. After the first year, a portion of the equity vests (usually 25%), and the remainder vests gradually over the next three years.
Example of a Vesting Schedule
Let’s say an employee is granted 100,000 stock options with a four-year vesting schedule and a one-year cliff. Here’s how it would work:
- Year 1 (Cliff Period): No options vest. If the employee leaves before completing one year, they forfeit all options.
- After Year 1: 25% of the options (25,000) vest.
- Monthly Vesting After Year 1: The remaining 75% vests monthly over the next three years, meaning the employee earns approximately 2,083 options per month.
By the end of the four years, the employee will have fully vested and earned the full 100,000 stock options.
Why Do Startups Use Vesting?
Vesting is used by startups for several key reasons, including incentivizing long-term commitment, protecting the company’s equity, and aligning the interests of employees, founders, and investors.
1. Incentivizing Long-Term Commitment
Vesting ensures that employees and founders stay committed to the company for a certain period. Without vesting, someone could leave the company shortly after joining and still walk away with a significant equity stake.
By tying equity to continued involvement, vesting motivates key stakeholders to stay engaged and contribute to the company’s growth.
2. Protecting the Company
Startups are often in a vulnerable position in their early stages, so it’s crucial to retain equity control.
Vesting helps protect the company from scenarios where a co-founder or key employee leaves early, ensuring that the departing individual doesn’t retain ownership of unearned shares.
This prevents the dilution of the remaining team’s ownership.
3. Aligning Interests with Investors
Investors expect the company’s leadership and key employees to be committed to the company for the long term.
It schedules help reassure investors that the founders and employees are incentivized to stay with the company, aligning the interests of both the team and the investors.
Types of Vesting Schedules
There are different types of vesting schedules depending on the nature of the equity grant and the agreement between the company and the recipient.
The two most common types of vesting are time-based vesting and milestone-based vesting.
1. Time-Based Vesting
This is the most common type of vesting in startups. Time-based vesting grants equity over a set period, with a specific percentage vesting at regular intervals, such as monthly, quarterly, or annually. A typical time-based vesting schedule is four years with a one-year cliff, as described above.
- Cliff Vesting: The first portion of equity vests only after a set period, often one year. This protects the company by ensuring that the recipient remains with the company for a minimum period before receiving any equity.
- Monthly or Quarterly Vesting: After the cliff period, the remaining equity vests in regular installments (monthly or quarterly) over the remaining vesting period.
2. Milestone-Based Vesting
Milestone-based vesting ties the vesting of equity to the achievement of specific goals or milestones, rather than the passage of time. This type of vesting is often used for advisors or consultants, where their contributions are tied to measurable outcomes.
- Example: A startup may grant equity to a product advisor that vests only when certain development milestones are achieved, such as launching a new product or reaching a certain number of users.
Vesting for Founders
Founder vesting is an important concept in early-stage startups. While founders are often the driving force behind a startup, vesting ensures that they, too, remain committed to the company for the long haul.
Investors typically require founders to have vesting schedules similar to employees, as this protects the company from a scenario where a founder leaves early but still retains a large portion of equity.
Founder vesting is typically structured as a four-year vesting schedule with a one-year cliff, just like for employees. This ensures that if a co-founder leaves the company early, the remaining co-founders can retain most of the equity.
Vesting for Employees and Stock Options
For employees, vesting is commonly applied to stock options, which give employees the right to purchase shares of the company at a predetermined price, known as the strike price.
These stock options vest over time, meaning that the employee earns the right to exercise a portion of their options each month or quarter.
If the company grows in value, the employee can purchase shares at the strike price and sell them at the market value after an IPO or acquisition, often resulting in a significant financial return.
Conclusion
Vesting is an essential mechanism in startup equity agreements, ensuring that founders, employees, and advisors earn their equity over time.
Interested in learning more VC related terms? Head over to our VC glossary!