by Kamal Hassan
Many people, including me, suggest that entrepreneurs always ‘vest’ their shares. What does this mean, and why is vesting needed?
Vesting is a way of solving a prediction problem about the future. Shares typically have close to zero value when a company is founded. As the company starts to raise money over time from financial investors, the shares will then start to gain in value. For instance, shares may be worth $0.001 when the company is founded, and then be worth $0.15 cents within a year or so. If you own 1,000,000 shares these will be worth $1,000 at the moment of founding, and worth $150,000 just a year later.
If you are given these 1,000,000 shares one year after the company is founded, you will receive the equivalent of $150,000 in cash: money on which you owe tax. If you buy these 1,000,000 shares at the moment of founding, you will (i) be buying the shares for cash so owe no tax, and (ii) be doing a $1,000 transaction not a $150,000 transaction so the tax impact is minimal. It’s the same 1,000,000 shares, though!!
To benefit from the tax ‘exemption’ around founder’s shares, you need to guess how many shares to give each founder based on what you expect their contributions to be in the future. How do you take care of the fact that people’s contributions may not turn out to be as you expect? You do this through a ‘vesting’ agreement. Typically, the language in a vesting agreement says: (a) if a person leaves the company for any reason, then (b) the company has the right to buy back a certain number of founder’s shares at the price paid for them.
The first condition is important: if you leave for any reason. You may be fired or you may choose to resign. This typically doesn’t matter for vesting. Of course if you leave you should lose shares. How about being fired? The point is that if you are adding so little value to the company that you can be fired, then you don’t deserve to keep shares after that point.
The actual transaction involves the company buying back the founder’s shares at the price paid for them. It doesn’t matter if the company keeps these shares ‘in treasury’, as it is called, or cancels the shares: the result is the same. If you own 10% of the the shares in a company, and the company owns 50% of the shares in itself, you effectively own 20% of the company.
A standard vesting timeline is four years for full-time work. If you work full-time in the company for two years and then leave, you keep 50% of your founder’s shares. A standard vesting timeline for 20 hours/week work should be around 10 years. Why so long? Well, first, if you are working 20 hours vs. 40 hours per week it should take twice as long to vest … so it should be 8 years at least. Secondly, no full-time entrepreneur really works a 40 hour week: most work a 50-60 hour week. So 20 hours/week should be compared to 50 hours/week for 4 years … meaning 10 years of vesting for a 20 hour/week part time person. Yes, vesting schedules encourage and reward people for working full time. This is intentional.
You may also have an option grant for someone part time that vests over 4 years, because that person got fewer shares to begin with because you knew all along that they would only work part time. This works OK if you know that the person will NEVER work full-time. Remember, if they do start working full-time, you can’t magically give them more shares … without also giving them a huge tax bill.
A last clause which is common is to say that vesting ‘accelerates on change in control’. In other words, if the company is sold to new owners you should be paid based on the founder’s shares you were granted, not the shares you have vested. The company may no longer even exist after it is sold, so why should you keep vesting hypothetical shares in a company that doesn’t exist any more.
If you have any further questions on vesting, please feel to put them in the questions below.