Developing a startup can be difficult, particularly with limited access to capital. And when it comes to compensating, hiring, and retaining talent – or finding potential investors – an early-stage startup may not have much to offer. In these types of situations, many startups turn to giving away equity as a tool to attract the right people.
However, giving away partial ownership of your company carries a lot of risk – without the right terms in place, someone could become a long-term owner without giving the startup a long-term benefit.
Share vesting is a potential solution to some of these problems facing a startup in its growth stages. In this four-part article series, we’ll tell you about share vesting, its advantages and disadvantages, and how you can use it to grow your company. This first article starts with the basics and discusses what share vesting actually is.
What is share vesting?
Share vesting is the process by which an employee, investor, or co-founder is rewarded with shares or stock options but receives the full rights to them over a set period of time or, in some cases, after a specific milestone is hit – usually one that’s established in an employment contract or a shareholders’ agreement.
For example, say you want to incentivise a new employee to join your company by giving them 2% equity in their employment contract. Using share vesting, instead of receiving rights to the full 2% upfront when signing the employment contract, the employee would receive rights to their equity little by little.
A common setup would be a four-year “vesting period”, where the employee in this example would receive 0.5% of their share rights for four consecutive years.
Why would a company use share vesting?
Broadly speaking, share vesting can help a company achieve three overarching goals:
(1) incentivising long-term commitment to the company,
(2) demonstrating a commitment to company growth, and
(3) protecting the company in case the relationship doesn’t work out.
First, the contractual promise of share or stock options incentivises employees or co-founders to stay loyal to the company. Only after having remained with the company through their vesting period does the co-founder or employee have the rights to the full number of shares to which they’re entitled. This encourages employees or co-founders to continue to serve the company until the end of the vesting period.
Second, share vesting can signal to investors that the founders are committed to growing the company, despite having limited access to capital to pay employees and founders in cash. Startups that are willing to use equity to attract and retain top-tier candidates as a better investment, as the value of the company is more likely to increase with sustained involvement from talented people.
Third, share vesting protects the startup by acting as an insurance policy against an employee or co-founder who ultimately isn’t a good fit for the company. Without share vesting, a co-founder or employee could walk away (or even be terminated) from their service commitment but remain a partial owner of the company – assuming that the startup doesn’t have much capital, the company may not be in a financial position to pay market value to buy their shares back.
Including share vesting in a shareholders’ agreement or an employment contract helps guarantee the buyback of shares won’t be too costly of an exercise. (We’ll expand upon buybacks in the next article.)
When you want to grow your startup, incentivise and retain your workforce, and protect your limited capital, share vesting is a very useful tool to consider. In the next part of this article series, we’ll look at what the specific advantages of share vesting are and how they can be used effectively.