If you're a startup founder, there's a good chance you've heard of vesting. But what is it, and why do you need to know about it? In short, vesting is a way to ensure that founders and employees don't walk away with all the company's shares when they leave. By requiring that shares be vested over time, everyone has an incentive to stay on board and help the company grow. In this post, we'll explain everything you need to know about vesting, including how it works and the different types of vesting schedules. We'll also discuss some of the pros and cons of vesting, so you can decide if it's right for your business. Founders who understand share vesting can use it to their advantage, and we hope this post will give you the information you need to make the best decision for your company.
What is share vesting?
Vesting is the process by which employees or founders earn the right to own shares in a company over time. There are two main types of vesting: cliff vesting and graded vesting.
Cliff-vesting: This type of vesting agreement means that the employee will only vest their shares after a certain time period has passed (the “cliff”). For example, if the cliff is two years, the employee will only vest their shares after they have been with the company for two years.
Graded-vesting: This type of vesting agreement means that the employee will vest a portion of their shares each year over a set period of time. For example, in a four-year vesting period, an employee may vest 25% of their shares each year over 4 years.
What are vested shares?
Vested shares are shares that an employee or founder has earned the right to own, typically through a vesting agreement. They may be subject to certain conditions, such as continued employment or the achievement of certain milestones.
Why would someone want these shares? They protect the shareholder if the company is sold, as they are more likely to receive a payout. It also gives the shareholder more control over the company and its direction.
Why do companies use vesting?
Vesting is a way to ensure that employees and founders are invested in the long-term success of the company. By requiring that shares be vested over time, everyone has an incentive to stay on board and help the company grow. This can be especially important for startup companies, which often require employees to make significant sacrifices in the early stages of growth.
What are the benefits of vesting?
Vesting is the process by which you earn your assets, like stock options over time. Making use of vesting within your company has multiple benefits:
1. Preserving your cash flow
When you are starting as a founder, you want to keep your expenses low. Therefore, optimizing your cash flow is always something you are working on. When using a vesting schedule or equity compensation plans, you can use equity instead of cash. This is one of the top benefits of using vesting as you can ensure obligations in the long term without having to use cash.
You might have heard the story of the artist who painted a mural in the headquarters of Facebook in 2007, David Choe. Until today, this is one of the most famous stories on whether to choose equity or cash. By the time, Facebook was just a small company, and because Choe charged a high quote for his work, he was offered to get paid cash or in Facebook stocks. Choe chose the latter, and when Facebook went public in 2012, Choe's shares were valued at around $200 million. It's safe to say that his bet paid off...
This example shows how using equity instead of cash allows you to leverage your company's potential by paying with equity. By making use of vesting, you leverage your equity for long-term relationships.
2. Retaining top talent
Vesting schedules are often used in job contracts as a way of keeping new hires with the company for a set period. The theory is that if someone has to wait a while to get their equity compensation to be fully vested, they're less likely to leave before then, thus increasing employee retention.
This can be a great retention tool for top talent, as you can keep them with the company for a set period (often four years) until they vest and give them a form of employee compensation.
Not only does this give you more time to train them and get them up to speed, but it also helps to create a sense of loyalty. After all, if someone has put in the work to vest their shares, they're more likely to stick around for the long haul.
3. Aligning interests
Another benefit of vesting is that it can help to align the interests of shareholder management and employees. This is because these schedules often have cliff vesting, which means that vesting only occurs after a certain period (usually three to four years).
This means that employees have an incentive to stay with the company for the long term, as they won't vest their shares until then. This aligns their interests with those of the shareholders, as both parties want to see the company succeed in the long term.
4. Tax benefits
Another benefit of vesting is that it can provide tax benefits for the company. This is because vesting can be used to defer income tax. For example, if you have a four-year vesting schedule, you can spread the vesting over that period and only pay tax on the shares when they vest. This can be a great way to save on taxes, as you can defer the tax liability to a later date.
5. Creating a sense of ownership
Finally, vesting can help to create a sense of ownership among employees. This is because stock options give employees a stake in the company, like partial ownership, which can make them feel more loyal to the company and its success. Studies have shown that employees who feel connected with the company have a higher productivity rate and a lower turnover rate. It also gives a sense of security and stability, knowing that they will eventually have full ownership of the asset.
What Founders Need to Know About Vesting
The main thing founders need to know about vesting is that it's important to align the interests of employees with those of the company. This can be done by setting up a vesting schedule that incentivizes employees to perform well and stay with the company.
This alignment of interests is important because it ensures that employees are motivated to help the company succeed. When employees have a vested interest in the success of the company, they are more likely to put forth their best effort and contribute to its long-term success.
Founders need to be aware of these things when creating a vesting schedule for their company's shares. By doing so, they can create an incentive for employees that will help the company succeed in the long run. Do you need any help with setting up your vesting schedule? Or not sure if your current vesting schedule is fully aligned with the company's vision? The WE.VESTR team is happy to help you out with whatever question you might have.
What is a vesting agreement?
A vesting agreement is a contract between an employer and employee that sets out the terms and conditions of the vesting schedule. The agreement will specify the number of shares that will vest and when they will vest. It may also include provisions for what happens if the employee leaves the company before the end of the vesting schedule. Usually, a vesting agreement is part of the employee stock ownership plan of the company.
A vesting agreement has many benefits for both employers and employees. For employers, it protects them from employees leaving the company early and taking their shares with them. For employees, it gives them certainty about their rights and interests in the company.
Are there different types of vesting agreements?
There is a great variety of vesting agreements that companies utilize. Below we've gathered 4 types that are used very often: time-based vesting, performance-based vesting, milestone-based vesting, and cliff vesting.
The most common type of vesting is time-based vesting. This is where shares become fully vested over time, usually three to four years. The length of this period will depend on the company and the position of the employee. Time-based vesting is often seen in companies with a cap table that use employee stock purchase plans.
Another type of vesting is performance-based vesting. This is where stock options are only vested if the employee meets certain performance targets. These targets could be based on financial measures such as profitability or shareholder value, or they could be based on non-financial measures such as customer satisfaction levels.
Another common type is milestone-based vesting, which means that the shares will vest when the employee reaches certain milestones. For example, the shares may vest when the company reaches a certain milestone, such as profitability or IPO. Milestone-based vesting is great for companies working with big projects, sales targets, or other tangible milestones. As startups regularly change their model in search of the perfect product-market fit, and these things can take a long time, some companies in this stage prefer milestone-based vesting over time-based vesting.
Cliff vesting is a type of vesting where the employee only receives the shares after a certain period of time, usually three to five years. The main advantage of cliff vesting is that it motivates employees to stay with the company for the long term.
Finally, there are also vesting agreements that combine time-based and performance-based vesting. This means that the shares will vest over time, but they will only b vested if the employee meets certain performance goals.
As you can see, there is a big variety in vesting agreements. Looking for a tailored solution for your company? Make sure to contact the team at WE.VESTR.
What are the drawbacks of having a vesting agreement?
There are also some drawbacks to having a vesting agreement in place:
The difficulty of changing vesting agreements once they have been signed
This can be a problem if the company needs to make changes to the vesting schedule in response to changes in the business environment.
It can also create an incentive for employees to stay with the company even if it is not doing well. This is because they may fear that they will lose their vested shares if they leave.
Pre-mature company leaves may forfeit unvested shares
If an employee leaves the company before they have fully vested their shares, they may forfeit their unvested shares. This can be a problem for employees who need to leave the company for personal reasons, such as illness or family commitments. It can also create tension between employees and management if employees feel that they are not being given enough time to vest their shares.
Finally, vesting agreements can be complex and time-consuming to set up. This is especially true for milestone-based or performance-based vesting agreements.
What is a vesting period?
A vesting period is the length of time that an employee must work for a company before they vest their shares. These periods are typically set at 1-4 years. It is designed to incentivize employees to remain with a company for a certain period and add them to an equity compensation plan.
What are vesting schedules?
Vesting schedules are affected by vesting criteria and dictate when employees can take advantage of their stock options. For example, when you receive stock options on your grant date, you can't exercise those options until they fully vest. The typical vesting schedule is set up so that employees will vest a portion of their shares each year over a set of time. For example, with time-based vesting, an employee may vest 25% of their shares each year over 4 years.
What are vesting cliffs?
A vesting cliff is a vesting schedule that requires employees to wait a certain period before vesting any shares. For example, with a four-year vesting timeframe, an employee may vest 0% of their shares after 1 year, 25% after 2 years, 50% after 3 years, and 100% after 4 years. Vesting cliffs are designed to incentivize employees to stay with a company for a longer period in order to receive their full portion of stock options.
How does stock vesting work?
The process of stock vesting is designed to incentivize employees to remain with a company for a certain period. Vesting schedules are typically set up so that employees will vest a portion of their stock options each year over a period of time. Their compensation package is part of the employee stock ownership plan that more and more companies are offering these days.
As an example, let's take a four-year vesting schedule, an employee may vest 25% of their stock options each year over 4 years. This type of arrangement gives employees a sense of security and stability, knowing that they will eventually have full ownership of their shares. It also aligns the interests of the employees with those of the company, as both parties want the company to succeed.
What are the tax implications of stock vesting?
The tax implications of stock vesting will depend on the type of (employee) stock options that are being vested. For example, if employees vest stock options, they will not be taxed until they exercise their options and buy the underlying shares. If an employee is vesting restricted stock units (RSUs), they will be taxed when the units vest. The amount of taxes owed will depend on the fair market value of the stock options (stock price) at the time it vests. Please note that these implications vary per country and may affect your income tax rate, make sure to contact your tax lawyer for the most accurate information.
So, what do you need to know about vesting? First and foremost, it's a way to ensure that founders and employees don't walk away with all the company's shares when they leave. By requiring that shares be vested over time, everyone has an incentive to stay on board and help the company grow. Second, there are different types of vesting schedules, so you'll want to choose one that fits your company's needs. Finally, if you're not sure how vesting works or which schedule is right for you, we can help. Contact us today for more information or a demo of our software. The team at WE.VESTR is excited to help you take your startup to the next level!