One of the most common themes in early stage startup incorporation is founder vesting. But what exactly is vesting?
A. Vesting Schedules: The main idea is that instead of the founders getting all of their stock immediately at the incorporation phase, the founders will get their stock over time according to a vesting schedule.
i. Four Year with One Year Cliff. The standard vesting schedule for startup companies is four years with a one year “cliff” and monthly or quarterly vesting thereafter. This means that all of the shares will be fully vested after a total period of four years. The one year cliff means that no shares will be vested, with regards to any common stock, until the startup completes its first anniversary. On the date of the company’s first anniversary, twenty-five percent (25%) of each of the founders shares of their common stock will become vested, representing the first quarter of the total four year vesting period. Thereafter, the remaining unvested shares will vest every month at an amount equal to 1/48th of the total unvested shares, such that at the end of the remaining 48 months (or three years) all of the shares will be fully vested. Some companies use quarterly vesting, in which case the total remaining unvested shares after the one-year cliff are divided into 12 remaining portions vesting each quarter.
ii. Consequences. This vesting schedule means that if a founder leaves the company or is terminated by the company before the founder’s shares are vested, the founder will only be entitled to those shares that have already vested under the schedule. For example, if the founder leaves before the startup’s first anniversary, the founder will not be entitled to any common stock as the one-year cliff has not yet triggered. If a founder leaves after 15 months, the founder will have 31.25% of his common stock vested (25% after the first year, plus the 2.083% vesting each month for 3 months). Thus, the founder leaves the company with much less shares than if the founder’s stock had been vested immediately upon incorporation. Vesting restrictions are usually addressed in a restricted stock purchase agreement, which each founder is required to sign and which would grant the company the right to repurchase any unvested shares (at the initial purchase price) if a founder decides to leave the company or if the founder’s employment with the company is terminated by the company.
iii. Retroactive Start Date. Another available option is to vest a portion of the stock immediately by setting a retroactive start date. Since the provisions of the Founders Restricted Stock Purchase Agreement allow for a vesting start date to be a date that is prior to the actual incorporation date, founders are free to agree upon such date and set vesting to start upon such date, thus effectively vesting stock immediately upon execution of the incorporation documents. For example, if the incorporation is on October 1, 2015, the founders could agree to set the vesting start date on October 1, 2014, perhaps the date preparations began toward forming the company, meaning that upon the incorporation date one year of the vesting period has passed and the first 25% of the shares are immediately vested. This means that one or more founders would receive a certain percentage immediately, usually as a result of their contributions to the venture prior to the issuance of the stock or the date of incorporation. The most common use for a retroactive vesting start date is when the founders of a startup start to work on their new venture a long while before they actually incorporate. Since the founders actually began working on their venture long before it was legally incorporated, it would not be fair if the founders will start vesting only upon the date of incorporation.
B. Why Vesting? Why would a founder choose to have a vesting schedule when they could receive their stock immediately? The reason is financing. A vesting schedule is usually be required by investors in connection with a Series A financing, Series Seed financing or a convertible loan deal. This is because investors want to see that founders are committed to staying with the company and are incentivized to grow the company during the vesting period. Accordingly, it is prudent for a company to impose a reasonable vesting schedule upon each of its founders during incorporation. A company should impose reasonable vesting restrictions upon incorporation to address this customary requirement by investors but also to address any issues between or among founders. In most cases, stock has been issued to founders not only for existing services or intellectual property relating to the conception of the venture, but also (and sometimes mainly) for the founder’s continuing commitment and efforts. Vesting is designed to avoid an unfair situation where one of the founders quits the venture after a few weeks or months, but still is permitted to keep all of his/her stock. Therefore, even if you do not have investors lined up yet, setting an appropriate vesting schedule is highly recommended when you incorporate.