Vesting is an extremely important concept that arises (or should) among the founders when a company is formed, when equity incentives are granted and when outside investors invest. Although some founders view vesting as yet another heavy-handed term imposed by investors, vesting can actually be good for the founders too. Vesting is typically different: (a) for founders and employees and (b) for stock (or other equity interests) and options.
What is Vesting?
Vesting is a mechanism for equity or option holders to “earn” their interest in a company over time based upon their continued active involvement in contributing to the company’s success. With grants of options or restricted stock to employees, this typically means that the interest is not 100% owned upfront but becomes owned according to a vesting schedule. For founders, it typically means that the equity interest is owned upfront but is subject to a repurchase option by the company at nominal value that is released over time according to the vesting schedule.
Vesting is often reset during a VC round and can be a major source of contention. At any stage, keep in mind its fundamental purpose.
Vesting is simply a mechanism for aligning the goals of the parties so that all stay committed and contributing to the success of the company, i.e., adding value. Vesting protects both investors and founders by enabling the company to get back stock from anyone who flakes out or does not work out as planned. If a startup company has three founders and one leaves after three months, is it fair for the departed founder to keep all his equity while the other founders continue to work night and day? Probably not. Vesting is the tool that gets stock back from those who do not stay in the game as long as expected. That is good for both investors and the founders who remain.
How Does Vesting Work?
Vesting Schedules: Options and employee stock typically vest monthly over a four-year period, with a one-year cliff. This means that the first 25% ownership does not vest until the end of the first year. Thereafter, the remaining 75% vests 1/36 monthly over three years. The cliff is a mechanism to protect the company in the event an employee doesn’t work out.
Founders are treated differently. Not only is there usually no cliff involved, but founders are often credited with a percentage upfront, based upon their efforts prior to the formation of the entity or the financing round. Founders often have 25% vesting upfront with the remainder vesting monthly over three years. Other vesting schemes can be employed. Value is not often created uniformly over time, so vesting can be tied to the achievement of certain milestones or the completion of certain deliverables, but be careful! The company’s future trajectory often changes along the way. Milestones agreed to on the front end might not match the future reality. This can result in putting the equity out of reach if the milestones turn out to be unattainable.
Acceleration: Vesting typically accelerates in certain situations. The most common are change of control (sale of the company) and termination without cause (you’re fired!). On change of control, there are two options: acceleration on the change of control event (“single trigger”) or acceleration only after a change of control plus the founder/employee is terminated by the new owners (“double trigger”). Investors will argue for double trigger acceleration only. However, it is often possible for a founder to negotiate a partial acceleration for the change of control event with full acceleration if the founder is terminated thereafter. A similar case can be made for acceleration if a founder is terminated without cause or resigns with good reason. You agreed to a vesting schedule to show your good faith commitment. The investors should do the same if they want you gone for no good reason.
83(b) Elections: Pay Attention to the Filing Timeline!
One more thing. The IRS will tax you on the value of your compensation, both cash and stock. If you receive stock and it vests (cannot be taken away), you will be taxed on the value of the stock at the time it vests. This can be a big problem if your stock vests two years from now and is way more valuable at that time. You will need to come up with the cash to pay the tax.
Fortunately, the IRS does allow you to take the stock into income on the front end at the current (lower) value even if it has not vested yet. You do that by filing an 83(b) election with the IRS. Whether this is the right thing or not depends on your specific situation, but most often it’s a good idea. An 83(b) election allows the holder to be taxed on the value of the stock at the time of grant (presumably next to nothing), at ordinary income tax rates, and then be taxed on the future appreciation at capital gains rates on sale. Without an 83(b) election, the holder is taxed on the value of the stock when it vests (presumably a higher value), at ordinary income tax rates, with the subsequent appreciation taxed as capital gains on sale.
Founders/employees should seek competent tax advice. The election must be filed, if at all, within 30 days after receiving the stock. There are no exceptions. That’s a tight timeline and failure to file can cause major headaches for the holder, the company, and future investors.