In a startup, failing to tie ownership of stock by founders and key employees to a vesting schedule can be very problematic. This was a lesson learned the hard way by co-founder of Zipcar, Robin Chase, who had a handshake deal with her co-founder Antje Danielson to split the equity 50/50. Antje never joined the company full-time, and kept her equity when she left, the story goes. The same was true for govWorks, whose co-founder Chieh left after five short months with the company. The other co-founders, Kaleil and Tom, ended up having to settle with Chieh for $700,000 for his equity stake in the company ($290,000 of which came from their own pockets). These stories are not uncommon - and it's important to get it right early.

At the beginning of a startup’s life, everyone is excited about building the next unicorn. But startup life carries with it significant risk. It is not uncommon for a founder or one of the first hires to leave after a year or even a few short months—whether because of personal reasons or lack of personality fit.

In this case, if the founder’s stock does not vest over time, he or she can walk away with a significant chunk of the company’s equity, and there is nothing the co-founders can do about it. The product is nowhere near complete, and the company doesn’t have enough equity left over to attract a new team member. Even if the company is able to continue on without the departing founder, the “dead weight” is certain to come up in conversations with investors.

Founders often hear that their stock and their employees’ stock should be subject to vesting. But confusion around what vesting is and why it is important leads many technology companies either to implement vesting without fully understanding why, which can lead to dissatisfaction and decreased morale in the company, or to forego vesting altogether, which can have more significant consequences. A better understanding of how vesting works and why it is important is critical to the long-term success of a startup.

What is Vesting?

Often times, vesting is referred to as a concept where a founder or employee will earn her shares over time. This is a somewhat limited definition that doesn’t capture the full picture.

In reality, the founder or employee will have rights to 100% of her stock once the shares are granted, even the unvested portion. However, when a founder or employee leaves the company, the company will have the option to buy back any unvested shares (this is called the “repurchase option”).

For example:

Assume a founder is issued 2 million shares on January 1. If there is a shareholder vote (for example, to authorize more shares or to elect directors) during the vesting period, the founder can vote all of her 2 million shares. Similarly, if the company were to issue dividends, the founder would receive dividends with respect to her full 2 million shares.

However, if the founder were to leave after 2 years of working with the company, the company can repurchase the 1 million shares that were unvested. The founder will keep the 1 million shares that have vested even after she leaves and can still vote those shares, receive any dividends, or sell the stock for a handsome gain at an acquisition or IPO.

What is the Typical Startup Vesting Structure?

It is common practice among startups to have founder and employee stock vest over a period of 4 years. Typically, none of the stock will vest until the founder or employee has been with the company for 1 year (this is called “the cliff”). Once the 1 year mark is reached, one-fourth of the stock becomes vested. After that, the remaining shares will vest over the next 3 years, either monthly or quarterly, in a linear fashion.

For example:

Assume the company’s first hire gets a 1% equity stake at 100,000 shares starting on January 1, 2016 with the standard "4 year, 1 year cliff" vesting schedule described above. If the employee leaves on December 31 of the same year (364 days later), she keeps nothing, and the company has the option to buy back all of the shares at the same price that she paid for them (typically, a nominal amount like $0.0001 per share). But if she leaves the next day, on January 1, 2017, she will keep one-fourth of her stock (or 25,000), and the company has the option to buy back the unvested 75,000 shares at the same price that the employee paid for them. And if she leaves six months later on July 1, 2017, she will keep 37,500, and the company can buy back the rest.

More information on how to structure a VC-appropriate startup can be found here.

What About Vesting Acceleration?

You may have heard of single-trigger or double-trigger acceleration. These mechanisms are typically put in place to protect founders and employees in the event that the company is acquired during the vesting period.

Single-Trigger Acceleration:

Under single-trigger acceleration, if there is a change in control in the company during the vesting period (for example, through an acquisition), the shares automatically vest and the company no longer has the option to repurchase any shares. Single-trigger acceleration is less common in Silicon Valley.

Double-Trigger Acceleration:

Under double-trigger acceleration, which is more common in Silicon Valley companies, if there is a change in control during the vesting period AND the founder or employee is terminated without cause, then the shares automatically vest. This approach makes more sense because many acquisitions are based on the value of bringing on the people involved with the selling company. If the founder or employee is hired by the acquiring company, they should continue vesting according to their previous schedule.

Why Vest Founder and Employee Stock Over Time?

Understanding why vesting is important is critical to the long-term success of a company. Founder that don’t appreciate the importance of vesting are not able to explain the benefits to employees, which results in lower morale. Or they may forgo vesting altogether, which can have significant consequences down the road with the founders or investors.

1. Commitment to Long-Term Success Among Founders and Employees

You often hear that people are a startup’s most important asset. Without the proper team in place to take the company from formation to maturity, the startup has little chance of success. A multi-year vesting schedule is a sign of commitment among team members, especially key employees, for at least the first few years of the startup’s growth.

It shows that the founders and employees will not pack up and leave as soon as things get difficult—which happens often in the lifecycle of a startup. Founders and employees need several incentives to keep them engaged and motivated, including meaningful work, ability to contribute, great training, and more. Equity ownership that vests over several years is one important incentive to prevent a brain drain.

2. Fairness When a Founder or Employee Leaves the Company

Founders come together with the hope that everyone is committed to the company in the long term. They understand that an exit may take years. And employees are usually hired with an eye towards a long-term relationship with the company. But the financial and family circumstances of founders and employees change. A founder or employee may not be able to bear the financial risk of working in a startup due to family or other reasons. So they may have to leave a month or two into their involvement with the company.

To maintain fairness, the founder who leaves after a few months should not get the same financial return as another founder who stays with the company for years. If equity is reflective of the value that a founder or employee adds to the company, it is important that the company should have the option to buy back unvested shares.

3. A Big Issue in Due Diligence Upon Investment

Investors often invest first and foremost in the people involved in a company. They look for founders that are both experienced and committed to the long-term success of the company. As explained above, vesting is one common and important way to gauge long-term commitment to the company. This is why investors often times demand it. If due diligence shows that founder and employee stock is not subject to vesting, they may be skeptical about the commitment of the people involved.

Conclusion

Any startup that wants to build a successful enterprise should vest its equity over time, particularly for founders and key employees. A carefully thought out and deliberate vesting schedule can prevent difficult conversations with investors or, worse, lost equity in the hands of departed team members.

If you have any personal stories about vesting or have any questions, please share those in the comments section below.