Share Vesting Arrangements and Why You Should Adopt Them.
What does Vesting mean?
Vesting is a method that enables an individual to obtain stock that would normally be unavailable until a time period has passed. By share vesting, an employee,investor, or co-founder is rewarded with shares or stock options but receives the full rights to them over a set period of time. While we may refer to this process as ‘vesting’, it’s important to note that the individual does not actually have a physical claim to the stock until a certain time or milestone has been hit.
What is a Vesting Schedule?
Vesting schedules are used in private and public equity as well as in some forms of venture capital. A vesting schedule sets forth a specific schedule and method for determining the amount of shares or other rights that a participant will receive, based on such factors as services rendered to the company and the passage of time (for example, one-fifth of the shares vest after each complete year of service).
It is a table of periods and percentages. It indicates the percentage of value that a participant will receive as described in a vesting agreement. It is not only a single agreement for each employee’s equity, but also the future of how a business will manage and treat its employees and other stakeholders.
Types of Vesting Schedules?
Graded Vesting: Graded vesting is a type of vesting in which employees receive a certain percentage of their shares after each year of service. This increases the number of company shares they will own after completing a specified period of service. Graded vesting is a system in which the stock becomes vested through a set schedule. For example, let’s say a company wanted 100% of an employee’s stock to vest after three years. The employee should get 1/3rd of their share every year for each year they work at the company or business. year 1 = 33%, year 2 = 66%, and year 3 = 100%.
Cliff Vesting: Cliff vesting is a form of vesting that gives employees either nothing or everything they've earned. The company sets a specific amount of time for the employee to earn those benefits, after which they may keep their full compensation. Employees become fully vested and benefit from the employer’s contribution only after a predetermined time period, typically 3, 4 or 5 years.
Performance-based Vesting: Performance-Based vesting is an incentive mechanism that ties executive compensation to performance. Performance-based vesting of options gives options holders the incentive to work hard and ensure that the company achieves its objectives. If the goals are met, all options vest immediately. If not, no options vest, which encourages workers to put in as much effort as possible in ensuring that those objectives are met.
Benefits of Share Vesting
First, stock or share options act as a long-term promise promising employees and co-founders that if they stay with the company, they will be rewarded. Employees and co-founders have a fiscal incentive to stay loyal to the company and provide work that contributes to the success of the company.
Also, for founders, issuing share vesting schedules helps to communicate the founder’s commitment to creating and growing the business. Since the founders have equity in the company, they are willing to make sacrifices on their behalf. By developing a share vesting schedule, the founder demonstrates commitment to the long-term vision of the company. In contrast to conventional compensation methods, offering equity can fully align the interests of the employee with those of the company.
Furthermore, share vesting protects startups by acting as an insurance policy against uncertainty. It acts as a form of insurance for startup founders in case they are forced to let someone go who doesn’t turn out to be a good fit for the business.
