Many startups use share vesting to incentivise founders and key employees in their startup to stay committed to the business. Share vesting refers to the time period after which you ‘earn’ your shares. While you have unvested shares, you are unable to sell or do anything with them. Startups may introduce share vesting for shareholders in their shareholders agreement, or they may use it in employee share schemes for employees. This article will explain how share vesting works for startups.

What is Share Vesting?

Share vesting is a type of condition that a company attaches to the shares that you own. A vested share is one that is fully ‘yours’ and that you can act on and sell. An unvested share is one that you own, but can only act on and sell after a period has passed, or an event occurs. If you leave the company before the vesting condition has occurred, you will forfeit your unvested shares (and have to sell them back to the company for their nominal value).

By making shares subject to the passing of a period of time or the performance of milestones, a company can incentivise key business personnel to stay working in a startup and committed to its success. It also means that in the unfortunate event that someone leaves the business, they do not take a piece of the company with them that they have not yet earned.

Time-Based Vesting

The most common way that shares vest is through time-based vesting. This means that after a certain period of time, provided you are still working in the business, your shares will vest. The market standard is a vesting period of four years, with a one year cliff. The ‘cliff’ refers to the period of time that must pass before the first of the shares vest.

For example, it is common to have a one year cliff whereby you would get none of your shares if you leave the company within the first year. Assuming you are still working at the company, at the one year mark, 25% of the shares will vest. From that point onwards, you would accrue the remaining 75% over the next three years in monthly, quarterly or yearly instalments. So, if you leave at the end of year two, half of your shares would be forfeited, and the other half would be yours.

Milestone Based Vesting

Milestone based vesting means that your shares would vest once you have achieved certain milestones. This may be relevant to employees or contractors providing particular services (for example, software development). This is useful when the startup does not want the service provider to be able to keep all of their shares until they complete the promised services. Milestone based vesting incentives workers to complete the tasks they agreed to do.

Founder Share Vesting

Very commonly, startup founders will have their shares vest over a period of time. This is for two main reasons.

Investors

You want to signal to investors your commitment to growing the startup. Similarly, investors want to incentivise you to stay with the startup for a minimum period of time, particularly during critical growth stages.

Where an investor comes in and requires vesting for founders, sometimes founders are given retrospective vesting credit for work done before the company was incorporated. But more often, the four year vesting period will start from the date of the investment.

For example, Sally is the CEO and co-founder of a tech startup called Blitz Fish. Sally’s background is in project management and software development. She brings over 20 years of experience with her and has a lot of industry connections. Some investors are willing to invest $4 million in Blitz Fish. However, they are worried Sally might leave the startup once they have invested their money. They are afraid the startup will not be worth as much without Sally’s involvement.

The investors negotiate for Sally’s shares to vest for four years, with a one year cliff. This means she will earn 25% of her shares at the end of the first year, and the rest incrementally after that. Over the four years, Blitz Fish uses Sally’s experience and connections to grow into a very successful company. Sally stays committed to the business for the entire vesting period and now owns all her shares without restriction.

Co-Founders

You and your co-founder may find each other’s skill set particularly valuable to the startup. As a result, you want to encourage each other to work at the startup for a minimum period of time. Plus, if one of you was to leave early on, it may not be fair that they keep such a large percentage of the company.

Shareholders and Share Vesting Agreements

When founders shares vest, this will be set out in the shareholders agreement, or a separate share vesting agreement.

Shareholders Agreement

A shareholders agreement is a key company document that governs the relationship between shareholders and directors. The shareholders agreement will cover terms such as:

  • decision making;
  • exit provisions; and
  • the issue of new shares.

Most startups will include founder vesting in their shareholders agreement.

Vesting Agreement

A vesting agreement sets out the vesting conditions applicable to shareholders’ shares. You can draft a vesting agreement in addition to the shareholders agreement. This is useful if you do not want to amend an existing shareholders agreement to add in the vesting conditions. This is also a useful option if you do not want to put in place a shareholders agreement.

Employee Share Vesting

It is often the case that startups cannot remunerate their star employees as well other, more established business. To reward your employees and to attract the best talent, you could provide them with options or shares in your company through an Employee Share Scheme. Vesting is common practice when providing employees with shares or options. This is because you do not want employees to leave shortly after taking the share or options with them.

Similarly to founder shares, it is common to see time-based vesting. This is often again four years with a one year cliff. However, you can choose what time period or performance milestones you would like to use. Once an employee’s share or options have vested, they may have to sell them (for full market value) when they leave.

Key Takeaways

Share vesting is a common mechanism startups use to incentivise founders or employees to stay committed to a business. Investors often want a startup’s founder’s shares to vest, and founders often want their co-founder’s and employee’s shares or options to vest. This is a useful way to retain key talent in the business. The vesting conditions can be found in a startup’s shareholders agreement, a vesting agreement or employee share scheme document. If you have any questions about share vesting for your startup, get in touch with LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.

About LegalVision: LegalVision is a tech-driven, full-service commercial law firm that uses technology to deliver a faster, better quality and more cost-effective client experience.

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