A company may issue employees and other key persons (i.e. directors who provide services to the company) with vesting shares. The idea behind vesting shares is that they promote loyalty towards the company. The prospect of receiving shares in the company encourages employees to remain long-term until their shares have fully vested.
Vesting Shares are particularly common in start-ups. Start-ups generally want to keep their original team in place in the early stages of development to best facilitate aggressive growth. They may be able to pay their employees and key persons a lower salary if they offer vesting shares in the company.
How do Vesting Shares Work?
Generally, employers issue vesting shares to employees up front. There should be a vesting schedule contained in either the Shareholders’ Agreement or a Share Vesting Agreement. This Agreement outlines when or how the vesting shares will vest with the employee or key person. For example, the shares may vest once the employee has met particular key performance indicators. Alternatively, they may vest at a given point in time.
A common provision in a vesting schedule is where shares vest over a four-year period with a one year cliff. This means that when the employee or key person has worked for the company for one year, 25 percent of its shares will vest. After two years of service to the company, 50 percent of the employee’s shares will vest. After three years of service, 75 percent of the employee’s shares will vest. And after four years, 100 percent of the employees shares will vest.
What Happens if an Employee or Key Person Leaves the Company Before its Shares have Vested?
If an employee leaves the company before any or all of its shares has vested, it will have to sell any shares that have not vested back to the company. Usually, they will be sold for their issue price. This means that it would be as if the employer never issued the employee with those shares.
What Happens if an Employee or Key Person Leaves the Company After its Shares have Vested?
After an employee’s shares have vested, that employee can generally retain the shares unconditionally. There is no obligation to sell the shares back to the company, even if the employee ceases to provide their services to the company. This is because the employee is seen as having earned those shares, usually by having accepted a lower salary during the vesting period.
Vesting shares can be a good way of encouraging loyalty among employees and key persons who you want to retain until they have met certain goals or until a certain period has passed. They can also be an effective way for start-ups to recruit quality staff without having to pay a large salary.
If you would like any additional information or assistance about vesting shares or drafting a Shareholders’ Agreement and/or Share Vesting Agreement, please do not hesitate to contact LegalVision today. One of our business structuring experts would be delighted to assist.