How to Set Up a Vesting Scheme for Your Startup?
Finances are often stretched thin within startups and rewarding the hardworking team behind the business can be difficult. One of the ways to handle financing is to provide shares in the business for the team through a process called vesting.
This guide will look to explain 1) what vesting is all about and 2) how a startup can set up a successful vesting scheme. The aim is to help your business reward and motivate the team behind it without stretching company finances too much.
WHAT IS VESTING?
Before you venture into setting up a vesting scheme, you must fully understand what it means. Vesting is essentially a process by which the parties in the startup accrue non-forfeitable rights over the stock ownership of the business. It is a schedule, which defines when and how the shares of the company, which have been promised for the founder or employee, will be distributed. For instance, as you setup the business, founders get their package of stocks at once, with the company receiving the right to purchase a percentage of the equity back, if the founder decides to leave the company.
A vesting scheme provides employees and members of the business a right to benefit from the success of the business, while also protecting the business from people simply walking away. The process always involves a specific vesting schedule, which determines when the employee has full ownership of the specific asset or how much of the stock the business can acquire back in case the person leaves.
While the premise of a vesting scheme is always the same, there are different ways to set up the scheme. The different vesting scheme models will be discussed in more detail in the next section, but below is an example of a typical vesting scheme.
An example of vesting
A typical vesting scheme in a startup would follow the following model:
Founder A and Founder B both own 45% of the company, with angel investors owning the rest 10%. The startup has a vesting scheme, which uses a one-year ‘cliff’ clause. This means if any of the parties decide to walk away within the first year of the business, they don’t receive the equity they owned. On the other hand, if they leave after two years, they might retain 50% of what they owned.
If founder B leaves after two years, he or she will retain 22.5%. Founder B can walk away with the share, or founder A can purchase the 22.5% back for a reasonable price. The rest of the shares will be forfeited. If the founder leaves after four years, he or she will retain the full 45%.
The benefits of setting up a vesting scheme
Vesting is essentially a scheme to protect the business. Consider a business starts without a vesting scheme. Founder A and founder B both have 50% of the business and work hard in order for the business to succeed. But one day, founder B announces he will leave. Founder B can walk away with 50% ownership of the company, while founder A has to try to salvage the situation. If the business succeeds, founder B will get to enjoy the fruits of A’s labor.
But as the example vesting scheme showed, founder B wouldn’t be able to walk out with everything until the vesting scheme is completed. Therefore, the vesting scheme can act as an incentive for employees. The longer they work with the business and help it to succeed, the more they will gain. While the vesting scheme can protect the business from personnel walking out, it naturally also provides benefits for the members of the vesting scheme. Instead of simply being part of the payroll, the members of the scheme can reap the benefits of the business succeeding through the shares.
It might seem counterintuitive to protect yourself from people turning their backs on your business. Setting up a startup always has its risks and the ability to trust your team is essential for success. But there are multitudes of reasons people might have to quit the business and most of the reasons aren’t sinister. Perhaps the founder’s family situation changes dramatically due to an accident or an illness. Therefore, protecting the business’ financial situation is important and a vesting scheme can provide an extra layer of security against common startup risks.
Furthermore, startups aren’t typically covered in money and schemes that can boost fundraising opportunities are always welcomed. Investors tend to prefer vesting schedules because of the above reassurances. If a business has a vesting scheme in place, founders are unlikely going to walk out, which could mean investors won’t get their investment back.
Vesting schemes can even add value in terms of company acquisitions. Companies looking to acquire startups find vesting provisions beneficial, as they provide the incentives for founders to continue working for the business even after an acquisition.
Finally, the benefits of a vesting scheme even involve tax incentives. The equity provided for each member of the scheme is not taxed at the time of the vesting agreement. It also won’t be taxed, in most instances, when the person exercises their option and purchases these shares. In most countries, the tax is levied once the shares are sold and this can provide a monetary benefit for members of the scheme.
There are naturally different approaches to the taxation depending on the country where the startup operates. But in many instances, the vesting schemes have a favorable tax outcome.
THE ESSENTIALS OF A VESTING SCHEME FOR STARTUPS
With the above benefits in mind, the success of vesting schemes isn’t a surprise. As mentioned earlier, there are different ways a startup can organize its vesting scheme. When you are selecting a vesting scheme model, you should cover the following points.
Picking the right vesting scheme
The best model for your startup can depend on the type of business you are running, as well as the number of people involved, for instance. You should always consider the benefits and disadvantages of each scheme for your business. While certain common models might work well for other startups, your business might benefit from a more unconventional model.
The vesting scheme doesn’t have to be the same for all parties involved with the business. Your startup likely has people such as the founders, employees and board members working for it. In order to provide incentives for all of them, you can use different vesting models for each group.
The typical schemes include:
- Vesting scheme for employees. The norm for employee options typically involves vesting with a monthly rate. The vesting period runs for around four years. This would mean the shares are divided into 48 portions. Every month, the employee receives 1/48 of the shares, becoming fully vested after 48 months or four years.
New employees can also be offered shares through a vesting scheme. These shares are often subject to a ‘cliff’ period. This is typically one year, meaning the shares are not issued during the first year of employment.
- Vesting scheme for consultants. Many startups are also offering vesting schemes for consultants. These schemes are offered for consultants, which work with the company at least for a year. The scheme would offer an option that vests rateably monthly over the consultation period. On the other hand, if the consultation lasts for an unknown period, the startup could offer a vesting scheme based on achievement of milestones.
For example, the consultant could receive 10% of his shares after a specific milestone, such as helping the company sign a new contract.
- Vesting scheme for directors. Directors’ vesting scheme generally follows a similar model to employees. The main difference is the vesting period, as directors could potentially be provided a shorter vesting scheme. This is mainly down to the import role they can play in adding prestige to a startup.
Furthermore, director vesting schemes provide either a proportion or all of the shares in case the business changes ownership. This means the shares become fully vested in an instance of an acquisition, for example. This is called accelerated vesting and you can read more about it in the next section.
New directors typically have a ‘cliff’ period added to the vesting scheme.
- Vesting scheme for advisors. Advisors’ schemes typically follow a similar pattern to directors. The vesting schedule can range from a short two-year period to the more common four- to five-year period. There’s tendency to offer advisors vesting schemes, which accelerate towards the end. For example, during the final year, instead of a monthly 1/48 share portion, the portion grows to 3/48.
- Vesting scheme for founders. The founder’s vesting scheme vests rateably monthly over a specific period of time. The vesting scheme period tends to be around four years.
The difference to the other schemes is how portion of the shares is vested up front. Instead of having to wait, the founders might receive 20% of the shares immediately at the time of signing the agreement. This option is usually offered for founders, who provide valuable intellectual property to the company. For example, they might be behind the patent of the product.
Founders’ vesting schemes generally don’t feature a ‘cliff’ period, although it isn’t uncommon. Startups, which have more than one founder and where the partners have no previous working history, a ‘cliff’ period can add an extra layer of protection.
Finally, founders’ vesting schemes tend to use the acceleration option as well.
Deciding on the vesting schedule
Startups must decide whom they offer the vesting schemes and they must pick the vesting schedule for each scheme. A vesting schedule dictates the timeline for exercising the stock options, in addition to the restrictions on the stock. The schedule is time-based and as mentioned above, often uses a monthly schedule over four years.
The schedule is important part of setting up the scheme, as it can help ensure the company has enough protection. In addition, it also defines the attractiveness of the scheme. If the vesting schedule is too long, employees might not be incentives to sign to it. On the other hand, if the schedule is too short, the startup might not benefit in terms of protection.
There are three different options when it comes to picking the vesting schedule.
- Immediate vesting. As the name suggests, immediate vesting provides 100% ownership of the shares immediately from signing the contract. This is therefore, relatively uncommon.
- Cliff vesting. We’ve briefly mentioned the cliff period. A vesting cliff simply refers to a type of cool off period before the vesting scheme starts. In the case of startups, this is typically a one-year period.
For example, the vesting scheme might have a one-year cliff period, with the vesting providing 1/16 of the shares quarterly over a four-year period. The person could be offered 20% shares in the company. In the first 12 months, the person wouldn’t receive anything, after which he or she would receive 1/16 of the 20% every quarter over the next four years.
While a year is a common cliff period for vesting schemes, startups can pick a specific period for their business.
- Graded vesting. Finally, graded vesting is the most common option to use and the examples in the guide have mainly used the graded vesting schedule. It essentially means that the ownership is provided over a certain period, often through equal portions. For example, the above example used the graded vesting schedule, as the person gained his or her 20% share ownership over a period of time.
In graded vesting scheme, the person will only receive the shares they’ve ‘gained’ in case they walk out from the scheme and the company before the end.
When the business is picking the vesting schedule, incentivizing is a key part of the equation, together with protecting the company. Protection of the company doesn’t involve only the aspect of maintaining the workforce and its input. Finding the right schedule is also crucial in terms of business finances.
If the vesting schedule is too rapid, the company might find it difficult to support it financially. If the company loses a large chunk of the ownership at once and has to provide most of the profits to shareholders, it can hit its ability to finance growth. Therefore, a startup with a number of vesting schemes has to carefully devise the timeline to ensure it can financially afford it.
Finally, the vesting schedule can accelerate upon a specific instance. The instance that typically involves acceleration involves company acquisition. There are essentially two different accelerating scenarios in this case:
- Single trigger acceleration–An event triggers the acceleration of vesting, meaning the equity owner will receive the full or partial value of the stock. For example, if the business were acquired, the founder or employee with a single trigger acceleration scheme would receive the full equity.
- Double trigger acceleration – Two events are required to trigger the acceleration of vesting, resulting the equity owner to receive the full or partial value of the stock. For example, the company is acquired (event one) and the founder or employee’s contract with the company will determinate (event two).
The ‘standard’ model
While the above shows how there are a number of ways to set up a vesting scheme, startups tend to go with a so-called standard vesting schedule. The standard model has been found by many to be a viable option, but it is by any means a model you should automatically subscribe to.
The standard vesting model looks something like this:
- Founders: 25% of shares immediately and the rest monthly over a three to four years period.
- Employees: 25% of shares after the first year and the rest monthly over a three to four years period.
In both of these instances, the company would also have to decide whether or not to use accelerating schedule. As mentioned earlier, acceleration is often used in the case of founders, but skipped with employees.
Let’s consider the above vesting models use acceleration with founders, but not with employees. Under this model:
- The founders would receive 25% of their total shares upfront. From then on, they could receive 2% of the remaining shares every month over a three-year period. If they had single trigger acceleration scheme, in the case of acquisition they might receive the full amount of shares at once, whether or not the vesting scheme has completed.
- On the other hand, the employees would receive their 25% of total shares after one year. Afterwards, they might receive 2/10 of the shares each month over a three-year period. In the case of acquisition, the vesting schedule wouldn’t change.
THE BOTTOM LINE
Vesting can be a crucial tool to manage business finances and reward the people who help ensure the startup succeeds. Setting up a vesting scheme should be considered and carefully planned to maximize its benefits. For many startups the most important questions to answer involve the groups of people, they want to include to the vesting scheme and the timeline for vesting.
There are as many options to schedule your vesting than there are startups. Therefore, you shouldn’t simply copy what other businesses have done, but look carefully your individual situation. You need to pick an investing schedule and scheme that supports the right personnel in a manner that is reasonable for your business’ finances.