What Does Vested Shares Mean And Is Vesting A Good Idea?
No, we are not talking about questionable fashion choices today–we are talking about finances! Vesting in this scenario is the process by which a shareholder earns shares or stock options over a period of time. This terms will be determined in a Shareholders’ Agreement, but it is usually either over a period of years or when a specific milestone is hit that one receives the equity.
So How Does This Work?
Let’s say your Shareholder’s Agreement has a four year vesting period for 2% equity. You will not receive the 2% equity upon signing the agreement. Instead, you will receive 0.5% equity for four consecutive years, totalling 2% over the four year vesting period.
What Is Reverse Vesting?
Reverse vesting works just how it sounds. A shareholder is given all shares up front but must give some shares back if he or she leaves early. Going back to our four year vesting period for 2% equity, in this case, the shareholder would receive 2% equity upon signing the Shareholders’ Agreement. If the shareholder leaves after one year, he or she must give back 1.5% of the equity, if the shareholder leaves after two years, he or she must give back 1% of the equity, and so on.
And What About A Cliff?
Your vesting period may come with a “cliff and vest” clause in your Shareholders’ Agreement. In this case, the cliff is seen almost as a probationary period. The cliff period is a time in which your shares are not accessible. So taking the same example as above, let’s add a one year cliff to the four year vesting period for 2% equity. In this scenario, your first year with the company you will receive no equity. After your first year, your vesting period will begin. In years 2-5, you will receive 0.5% equity each year, totalling 4% equity after five years with the company. A cliff ensures a shareholder’s commitment to the company before starting to receive vested equity.
Benefits Of Vesting
- Upon Exiting
When giving away shares, there is a risk that you will never get your shares back. With a vesting period, a shareholder only has the number of shares proportionate to the time involved in the company. If a shareholder chooses to exit, that initial risk is curbed by knowing that only committed shareholders will receive the full number of shares as specified by their Shareholders’ Agreements.
- Buying Out
When a shareholder leaves, there are terms which spell out the options for buying out shares. If a shareholder leaves before the vesting period is over, the remaining shareholders do not have to buy out the shares of the exiting shareholder, thereby alleviating pressure both on the parts of the exiting shareholder and the remaining shareholders.
In short, vesting is a great way to bring shareholders on board and make sure they are committed to the company before getting too far into the process. It is the best way to protect against the risk of losing shares to somebody who is no longer mentally and physically invested in a company. But, before thinking about vesting procedure, we recommend you to confirm your equity split with your co-founders. There are a number of factors to consider, like skills, past experience, added value to the business, and commitment level of each founder.
That’s why our legal team developed an algorithm that weighs the various considerations for how to split your equity fairly: Spliquity, the ultimate Startup Equity Calculator!
You can also download a detailed Equity Split Report in PDF for a more in-depth analysis of the breakdown for you and your investors.
It’s based on the experiences of thousands of startups and has been verified by our community of lawyers.