In the third part of our series on “Introduction to shareholder’s agreement”, we present to you the clause on Vesting Shares.
A company may issue vesting shares to its key personnel as a remuneration for their services. So by design, vesting shares can be used to promote loyalty towards the company. The prospect of receiving shares in the company encourages employees to remain for the long haul until their shares have fully vested. This way the startup can retain its original team during the early stages of development to best facilitate aggressive growth.
The working of vesting shares
Vesting shares are issued upfront to the employees. The shareholder’s agreement contains a vesting schedule outlining the timing and trigger for vesting shares with the employees. So there could either be a key performance indicator or a point in time or both when the shares may vest
The employee has to resell to the Start Up the shares that haven’t vested, when leaving before any or all of its shares has vested. When the employee is leaving and all the shares have vested, there is no obligation to resell the shares to the Startup. The shares are considered earned as a compensation for services at a lower salary during the vesting period.
Shares issued to startup founders at formation are all initially subject to vesting – the shares are “unvested shares.
The stakeholders – co-founders, investors, employees, service partners – could view vesting on a Start up’s shares as an insurance. During the formative years, vesting of the shares assures the stakeholders of the founder’s motivation to establish a viable business. Thus, it offers a crystal clear and forthright understanding of the consequences when a founder stops participating in building and growing the startup.
The most common equity vesting structure is:
- Founder terms: four-year vesting, one-year cliff, for founders, co-founders, and employees
- Advisor Terms (0.5—2%): four or two-year vesting, optional cliff, full acceleration upon exit
Common stock vesting terms
A default vesting provision typically provides for:
- Share vesting over a four-year period: When the employee has worked for the company for a year, 25% of its shares will vest, after two years 50%, upon three years, it’s 75%. Upon completion of four years, all of the employees’ shares will vest. Vesting commences on the date the shares are issued.
- One year cliff: One year cliff defers vesting for a specified period of time, generally a year. Upon an exit prior to the vesting cliff date, the founder does not vest in any of the shares and the startup has the option to repurchase all of the shares from the founder.
- 100% double trigger vesting acceleration: A vesting acceleration provision is triggered when the founder’s employment is terminated inexplicably subsequent the start up’s acquisition. The provision cannot be modified for a year
- Credit to the founder’s time spent working full-time on the startup before issuance of the founder’s shares
Reportedly, 62% of startups fail due to disputes between co-founders and founders. Therefore it is crucial to seek legal counsel when drafting a Shareholders Agreement, particularly the Vesting provisions to help regulate relationship.