We bet that you want your startup to have success in the long term. And we're here to talk about one essential step in that journey: a vesting schedule.
With a great vesting schedule, your startup will establish the best practices for founders' and employees' ownership. (Just between us: with the added benefit of saving you from a bunch of headaches in the future.)
But what is vesting, talking about the startup world? What is a vesting schedule? How do vesting schedules work? And finally, what are the best practices on vesting schedules for founders and employees?
Vesting means you have the right to receive or purchase shares of a startup. The ability to purchase is generally offered through an option grant, inside the startup's stock options plan (ESOP).
Vesting serves as an incentive to co-founders and employees: if the company's value goes up after some years, they can make a profit when selling their share of the pie.
But you're not giving a part of your hopes and dreams to everyone that joins your business on their first day of work, right? We sure hope you are not.
Starting a widely successful startup, selling it for millions of dollars, and making almost nothing from the sale yourself happens all too often to founders who don’t plan around equity dilution.
Yes, you should use vesting to compensate your best team members (especially if you can't offer stellar salaries right now). But you should also prevent people from holding equity that they did not help to build.
For everybody's protection, all the conditions for vesting should be detailed in a vesting agreement. When this contract is in place, stakeholders are subject to certain conditions before they can actually own shares of the company.
"This is one area where less creativity is better", says Dan Green, from the law firm Gunderson Dettmer, on an episode of the Latitud Podcast. Dan talks about how to structure your startup for international investments, what VCs look for during due diligence, and how to manage your vesting and cap table in the early stages.
Dan and we will get you used to the most common terms seen in a vesting agreement – starting with the vesting schedule.
To qualify for owning a share of your startup, all the founders and employees have to put in the time and effort (including you!). And what does that mean? That a vesting agreement works according to a vesting schedule.
A vesting schedule is a timeline for when a founder or employee will get the rights to receive or purchase shares. A vesting schedule can be time-based or milestone-based.
A vesting period means how long it would take for a founder or employee to increase their vested balance, all the way up to fully vested. Being fully vested means you have earned the right to buy the total amount of shares promised to you through the vesting agreement.
It's important to know that you'll probably not receive the option to buy shares from day zero. A vesting period generally starts with a cliff: the gap between when stocks are issued and when they start vesting.
After the cliff, each month the founder or employee will be able to receive or buy more and more stocks. That's also known as exercising your option.
The strike price is how much they'd have to pay for each stock. This strike price is defined by the fair market value (FMV) of the share when the employee joined the team.
If they joined as a founding member when the business was worth virtually nothing, the strike price would likely be close to $0. However, if they got in after some rounds, the valuation was probably a lot higher and so will be the strike price.
The vesting period, cliff, and strike price are all conditions meant to reward early members that stay long enough to build value and that take more risk by joining the company early on.
It's easier to understand with a real-world example. Silicon Valley's standard practice, which we also see as most common in Latin America, is a 4-year vesting period with a 1-year cliff.
What does that mean? First, it takes one year for a person to start earning rights to some of their shares. Second, it takes four years for them to be able to receive or buy all of them.
Past the one-year mark, 25% of the granted shares will vest immediately (which means they are available to be claimed). The other 75% will start vesting from then on, on a monthly basis over a three-year period.
The philosophy behind the 4-year vesting period is that four years "is a pretty good amount of time to know that this employee has created value for the company and will be able to monetize that equity at some point thereafter", says Dan.
A similar philosophy applies to the 1-year cliff. "In those first 12 months, still finding your groove and proving your value to the company. After that, you've shown that you're a well-valued member of the team. You're gonna vest thereafter in equal monthly installments."
Imagine your head of product left your company after only eight months. If you have a 1-year cliff, it's like the grant never existed. The shares would return to the equity pool. And if they left after their cliff, they'd have the option to buy only as many shares as they have vested at the termination date.
Vesting is different when talking about co-founders or employees. Co-founders already own the shares, while employees have the option to buy them at a set price. And that's why the best practices of vesting for founders and for employees are different.
Co-founders get the biggest piece of the pie, and that makes sense: they take on most of the risk in terms of money and time invested. So, special terms and conditions may apply to co-founders’ vesting agreements.
You don't have a cliff for founders generally, says Dan. The idea is that you're all demonstrating value from day one, so you don't need a trial period.
But you still have the need for vesting as founders. You, José, and Fernanda went to kindergarten together. You know each other through thick and thin. You've been through some tough times. That doesn't matter. You're still going to want to have vesting on your shares, to protect each of you and the startup as a whole.
Dan has seen the same situation over and over. The three founders don't create vesting on their shares (a.k.a. they own their shares outright). And then, nine months later, either something happens to one's health or somebody's life situation changes. They go off to the Himalayas to meditate and no longer create value for the company.
Without vesting, if their shares are fully vested, they've just walked away with all of their equity, which can be a significant amount for a founder.
Remember that talk we had about not giving a part of your hopes and dreams to everyone that joins your business on their first day of work? That gets more important as the number of shares you're giving grows.
There's something worse than an employee that keeps shares he didn't help to make more valuable: a co-founder that does the exact same thing.
Having a large chunk of your company with someone who's not that into it anymore can be a dealbreaker for investors, compromising your startup's future.
One thing that international VCs are looking for is a properly calibrated cap table. Not having it becomes a real handicap to even a great company that checks so many of the other boxes in terms of traction, team, and market, Dan says.
"If they have a cap table that isn’t aligned with what a VC is expecting, that can be fatal to the fundraising process. Why? Because these VCs are busy and getting tons of deal flow for the most part. They don't want to step in and clean up a cap table when there are dozens of other opportunities that don't have those issues that they can invest in."
That's why some special terms and conditions are meant to protect the startups from founders that give up on the business.
When a fellow co-founder leaves a company before their shares have fully vested, the startup has the right to buy back their unvested shares at FMV or lower.
Connected to that, the right of first refusal is often applied to co-founders’ shares. This allows the other founders or investors to stop a co-founder from selling their shares to a third-party, instead making it so that the only exit option is for the shares to be sold back to the company or to its founders.
These are last-resort measures. Dan says founders should think about their dedication from the beginning and divide equity accordingly.
There's a temptation to divide the pie equally between the co-founders (e.g. three founders and 33% for each of them). But you all need to be realists and admit that one or two might be contributing more value than the rest of the founding team.
"Generally speaking, the CEO has the highest equity stake because that person is leading all functions of a company. That person is the public face and usually leads fundraising. When a VC comes on board later, they're gonna expect the founding team to have done the hard conversations and the thought around making sure the equity’s aligned with what true value is going to be created", Dan says.
Dilution generally is continual throughout a company's lifespan: you're only gonna get more diluted as a founder. If you didn't think about fairly dividing shares from day one, there are opportunities to re-slice the pie and re-up the founder pool through a founder refresh.
"Keep it in the back of your mind. It's not always available but for well-performing companies, including in Latin America, I've seen it adopted in the last couple of years and it's very helpful."