Share ownership is important for both co-founders and investors. Startup co-founders typically agree to have their shares vest over a period. But how does share vesting work and what does its structure suggest to potential investors?
What is Share Vesting?
A startup can either have vested or unvested shares. A vested share is one that you can act on and sell. An unvested share is one that you can act on and sell after a period has passed, or an event occurs.
A typical arrangement is that shares will vest after a period (usually four years). The vesting period commences after a certain period (usually one year) from when the co-founders agree (known as the ‘cliff’). Practically, a co-founder will get nothing if they leave the company before the first year has passed. At the one year mark, 25% of the shares will vest and then, from that point onwards, they accrue at just over 2% per month until you reach 100% (assuming it accrues monthly).
|Period of Time||Shares Vested|
|Up to One Year||0%|
|At One Year||25%|
|At Two Years||50%|
|At Three Years||75%|
|At Four Years||100%|
You can structure your vesting period flexibly. For example, you may not require a cliff, or you may backdate to when you and your co-founder(s) first started working on the idea – even if you did not incorporate the company until later down the track.
Other Forms of Vesting
While less common than time-based arrangements, vesting can also occur when the business, or co-founder, achieve particular milestones. For example, revenue targets or particular key performance indicators.
Why is Share Vesting Important?
Broadly speaking, share vesting has three purposes:
- Incentivise the co-founder or employee to stay working in the business so that their shares vest;
- Protect the business if a co-founder or employee leaves; and
- Signals to investors the founder’s commitment to growing the startup.
If a co-founder or employee leaves, they will only receive the benefit of the shares that have vested, or receive no benefit at all if they leave before they reach the cliff period. This arrangement can potentially cost the co-founder or employee a significant amount of time and money when compared with remaining with the business.
Share vesting is also designed to protect the business in the event a co-founder exits while holding a large portion of shares. If there were no share vesting arrangement in place, the company, other co-founders or investors would need to buy back these shares. Having to buy back shares at a fair value can be a costly exercise out of reach for many startups.
Share vesting is also beneficial for your investors. A share vesting agreement can help mitigate risk, protect your startup and demonstrate to investors that you are committed to growing the company.
When is Share Vesting Relevant?
Running a startup is stressful. Juggling an often untested idea with access to limited capital in a dynamic market will often cause friction between co-founders who may have different ideas about how the company should operate. Unsurprisingly, this environment can lead to disputes – some of which may result in the relationship between co-founders breaking down.
A co-founder may need to leave the startup for other reasons. For example, unforeseeable poor health or family reasons. Share vesting is then a risk-mitigation tool.
Later stage investors such as venture capital firms are less likely to invest in a startup if the remaining co-founders only have a small portion of equity remaining. Investors view co-founders who only hold a small portion of equity as less incentivised to continue shouldering the stress of growing the business. If you secure funding, your investor may also require you re-vest your shares.
Share vesting is an increasingly common arrangement which benefits a startup’s co-founders and investors. If you have any questions or need assistance drafting a share vesting agreement, get in touch with our specialist startup lawyers on 1300 544 755.