How Does Share Vesting Work
Companies, particularly start-ups, frequently include share vesting schemes as part of an employee’s payment package. They are a good way to reward loyalty and commitment from employees and reduce the immediate outlay of pay a company needs to make to the employee.
What are shares?
Shares are intangible assets that represent units of ownership of a company. So if you own 30% of a company’s shares, you own 30% of the company. Vested shares are shares that the owner can act upon fully, including receiving dividends, voting in company meetings and selling them. Share options are rights to shares that cannot be immediately acted upon, because you don’t actually own the shares yet, rather you only have an option to buy them (or be allocated them) in the future.
What is a share vesting scheme?
The basic idea is that when an employee commences employment, they are allocated a certain number of share options. However they cannot access these shares straight away. The shares vest, i.e. become available to the employee to use and sell, over a certain period of time.
A common vesting period is monthly over 4 years with a 12-month cliff. What’s a ‘cliff’ go to do with anything? Think of it this way, you are down on a beach. In front of the beach is a cliff. You have to climb the cliff that is in front of you before you can get to greener pastures (i.e. your shares).
So back to our example of a 4 year vesting period and a 1 year cliff, what this means is that each month, 1/48th of the employee’s share options will vest. However no shares start to vest until the initial ‘cliff’ has been passed, in this case a period of 1 year.
Using this example if an employee was to leave before the anniversary of their first year of employment, they won’t be entitled to any of their shares.
This helps to prevent the company losing money to employees who only stay for a short while. After four years of employment, all of the employee’s share options will vest so the employee is able to act on (for instance if the shares have voting rights) or sell the shares.
There is no reason why you can’t have your own predetermined vesting period and cliffs. For instance a 3 year vesting period with a 2 year cliff, or a 5 year vesting period with a 3 year cliff. At the end of the day it’s a balancing act, trying to balance the interests of the company (a longer cliff so that shares do not have to be allocated in the short term and a longer vesting period) with the interests of the employee (who would prefer no cliff and their shares to vest as soon as possible
Share vesting for company founders
There is a good reason why start up founders should use share vesting as well. What? As if !
Some founders don’t like the idea. You might be thinking, why shouldn’t I be entitled to immediate ownership rights of shares in a company that I have started?
Look at this the other way, it’s not about you, but rather about your other co-founders. Starting a company requires a mammoth amount of work. What happens if one or more of your co-founders have a change in circumstances or you can’t agree on the direction of the company? If they want to leave relatively early on, you want to make sure they can’t take a substantial portion of the company’s shares with them. Or think about it this way, if there are 4 co-founders and each of you are given 25% when you start the company, what happens if one co-founder leaves after 3 months. Should they be entitled to 25% of the company for ever and a day?
You should also be aware that venture capital investors generally require that co-founders sign onto a share vesting scheme as a condition of the investment. However they usually take into account the time and work you have put into the company before receiving investment. So if you have been planning and working on your idea for 18 months, and the vesting period is monthly over four years, 18/48 or 3/8th of your shares will immediately vest.
A share vesting agreement is one of the first agreements you should be making with your co-founders and investors when you start a company. If you need assistance drafting or reviewing a share vesting agreement, please get in touch.