If you’re a startup founder or an employee or other team member at a startup, you’ve likely heard of vesting and vesting agreement. But what exactly is vesting and why are vesting arrangements so important?
What is Vesting?
Startups and scaleups often offer shares or options (‘equity’) to team members as an alternative to or in addition to payment in cash. Vesting is the process by which the team member gains full ownership of the equity such that the company cannot take it away or make it worthless. From the company’s perspective, vesting is a mechanism for motivating team members and ensuring that team members who leave or under-perform or break agreements-with the company are not ‘overpaid’ in equity.
A Vesting agreement is the document that contains the terms of the vesting arrangement. Vesting terms can appear in a company’s articles of association, its shareholders agreement, investment agreements for funding rounds or in agreements for services with team members or in formal EMI or other share option schemes and option agreements issued by a company.
For professional help crafting the best vesting agreement for your business, start by booking a free introductory call with a JPP Law solicitor.
How Does Vesting Work?
Typically, vesting applies over a period of time, often called a ‘vesting period’, during which the team member or employee must work for the business in some capacity, whether as a provider or services or as an employee of the company to reach the point at which their equity is ‘vested’, meaning that the equity is no longer at risk because vesting can no longer be prevented or vested shares can no longer be taken away or made worthless by the company. A vesting period is often three to four years, with a portion of the equity vesting each year, quarter or month.
For example, if an employee has a four-year vesting period with a 25% annual vesting schedule, 25% of their equity will become vested at the end of the first year, 50% at the end of the second year, and so on until all the equity is fully vested after four years.
Vesting often involves a ‘cliff’. This is a period in which a portion of the equity remains at risk and then vests as a block. Vesting with a cliff often has a monthly or quarterly vesting schedule. For example, in a 48 month vesting period, the first 12 months may be a ‘cliff’, meaning that it is only after the end of month 12 that the first 12 months’ equity is vested even though for the remainder of the 48 months equity becomes vested at the end of each month.
Founders and Vesting
Some or all of a founder’s shares can be subject to vesting to protect the interests of the company and the other founders. The conditions of vesting sometimes appear in a Founders Agreement.
The purpose of a Founders Agreement is to ensure that the founders are committed to the long-term success of the company and that they are not able to retain all, or any, of their shares if they leave prematurely or do not contribute to the business as agreed. Vesting between founders provides a mechanism for the fair re-distribution of ownership of equity and helps protect the interests of all founders in the event of a dispute or departure and increases the chances that the business will succeed.
Even when founders are beyond the vesting period in their Founders Agreement or seed round Shareholders Agreement and their shares are vested, they cannot be certain that their shares will remain free of the risk of forfeiture. This is because incoming investors in funding rounds often insist on new vesting, good leaver and bad leaver arrangements as a condition to closing the funding round. These arrangements usually appear in new articles of association of the company or an investment agreement, and investors often insist on the founders’ entire shareholdings being at the risk of forfeiture.
The Advantages of Vesting Arrangements
Vesting arrangements can provide several benefits for a startup or scaleup company. Here are some key advantages:
Alignment of Interests
Vesting agreements can be used as a tool to retain key team members by fostering a sense of ownership and commitment . By making share ownership or, in the case of options, the possibility of share ownership subject to vesting, the company ensures that team members have a long-term commitment to the company’s success and are incentivised to deliver particular projects on time or meet agreed performance targets. This can be especially important for startups, as retaining talented team members can be crucial for growth and development of the business.
What Makes a Good Vesting Agreement?
A good vesting agreement should include several key components to protect both the company and the team member. Here are some considerations to keep in mind when creating a vesting agreement:
Vesting Schedule
The vesting schedule should clearly define the timeline and conditions under which the team member’s equity will vest. This includes any cliff and the remaining vesting period.
Accelerated Vesting
Vesting is often ‘accelerated’, meaning the vesting period ends early, in certain circumstances. The usual triggers are sale of the company or the shares in the company being listed on a stock exchange. These events are often called an ‘exit’. This ensures that team members are rewarded for their contributions even if the original vesting period has not been completed.
Forfeiture, Good Leaver and Bad Leaver
It is important to include provisions that are clear about the circumstances in which team members either lose the right to the vesting of equity or lose equity that has already vested (sometimes called ‘reverse-vesting’). There are a range of such circumstances, which are often labelled ‘good leaver’ or ‘bad leaver’ depending upon whether team members retain any vested equity or not and the payment, if any, they receive for any equity that is forfeited.
Tax Considerations
Taking into account the tax implications of vesting arrangements is vital for both for the company and team members . The stage of growth of the company, its value and the tax residence and status of team members will all affect how the vesting agreement will document the vesting arrangements. Consulting with a tax professional will help ensure that vesting is structured in a tax-efficient manner.
Who is Responsible for Creating a Vesting Agreement?
Typically, the responsibility for creating a vesting agreement falls on the company’s legal team. However, it is important for both the company and team members to have a clear understanding of the terms of the agreement and to seek legal advice to ensure all parties fully understand the terms.
Talk to JPP Law
Vesting arrangements and vesting agreements are an important for startups, scaleups and their founders and team members. Whether you’re a founder or a team member, it’s important to have a clear understanding of vesting arrangements and their implications. By seeking tax and legal advice you can create appropriate vesting agreements that benefit both the company and the recipients of equity that is subject to vesting..
Working with an experienced firm of commercial solicitors such as JPP Law means you get the advice and professional support to help your business now and in the future. For professional help crafting the best vesting agreement for your business, start by booking a free introductory call with a JPP Law solicitor.
