Startup Equity 101 – Why You Need to Vest and How it Works

You and your friend come up with an idea. It’s something you believe is going to be the next big thing. You agree to work as co-founders and make it happen. Both of you work hard for the first year. For whatever reason, your partner decides to walk away. You really believe in this idea and you keep working hard for the next few years. Eureka! You finally sell your company for a whopping 100 million dollars.

You’re about to pop the champagne but wait… your phone rings. It’s your old partner. Right after congratulating you, she asks for her $50 million because of the 50% you had agreed when both of you founded the company. Wait! What just happened?

A painful lesson a lot of entrepreneurs learn is that an exit does not only mean to sell your company, it is also the sign hanging on top of the door through which your partners can walk away with your equity. This is why vesting is so important.

This is Ali. He’s a fictional character that lost 50% of his equity because he did have a vesting schedule. Don’t be Ali.

But wait….What is vesting?

Vesting is the process of accumulating a full right that cannot be taken away by a third party. In the context of the founders’ equity, a startup initially grants a package of stock to each founder.

The co-founder (and a shareholder) will not be entitled to the full ownership of securities until the vesting terms have been met. Typically the shareholder will be entitled to vote the shares but cannot trade them. In the event that the vesting conditions are not met, the shares are purchased back by the corporation without contributing effort. Over a period of time called a vesting schedule, a founder acquires a full ownership that cannot be forfeited by the company.

How does vesting work?

The vesting schedule may be agreed upon when the founders’ stock is issued. It can vary for different agreements. That being said, the most common founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis.

However, it may be appropriate (depending upon the founders’ respective contributions and relationship), to:

i) Impose a one-year “cliff” (in which case all stock would vest at a specific time); and/or

ii) Vest a portion of the stock up front

This means that a co-founder will fully have all shares after four years or whatever time period the co-founders agree upon. If the founder walks away before then, he or she will not be entitled to any shares. During the four-year period, the company can forfeit the shares or buy back at the initial purchase price, if a founder leaves the company. Also, the right to transfer stock is limited during the vesting period.

Why vesting is important for startups:

You should impose reasonable vesting restrictions on the equity issues for multiple reasons.

First, it makes good business sense since the equity will presumably be issued not only for the founders’ services or property relating to the conception of the venture, but also for their continuing commitment and efforts. Now, if you intend to seek funding, a vesting schedule probably be required by the investors. If a reasonable schedule is already established, it is more likely that the investors will simply keep it in place.

A vesting schedule will usually be required by the investors in connection with a Series A financing. Accordingly, it is important for the founders to impose a reasonable vesting schedule upon incorporation for another reason: If a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place.

If the founders have not established a vesting schedule or a large percentage of the founders’ stock has already vested (due to either the lapse of time or the unreasonableness of the schedule), the investors will impose their own vesting schedule. This means, in effect, that founders will be forced to “earn” stock they think they already own. This may be a difficult pill for the founders to swallow. However, from the investors perspective, this is a significant issue – they believe they paying for the founders’ long-term commitment and “sweat”— and thus will rarely give it up.

Main Takeaway:

If there are two more or more founders, you should impose reasonable vesting restrictions on the stock issued to them at the time of incorporation. In most cases, the stock has been issued not only for their services or property (e.g., technology) relating to the conception of the venture, also for their continuing commitment and efforts. As you can see from our little story, it would be inherently unfair for one of the founders to quite the venture after a few weeks, but still be permitted to keep al l of his stock.

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This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. This blog should not be used as a substitute for competent legal advice from a licensed lawyer.