What is vesting?
Vesting, by law, is defined as the moment when a party’s right to an asset cannot be taken away by a third party. In the context of stock, it refers to the process by which restricted stock ownership changes in status from conditional and restricted to unconditional and unrestricted.
What that means is that when you purchase restricted stock, you own it, but someone else might have the right to repurchase it if certain conditions are not met.
In the context of entrepreneurs and startups, vesting usually comes up as a means by which founders prevent significant stock ownership from falling outside the hands of parties not actively participating in the company.
It is customary and wise for startups to issue stock to founders based on a vesting schedule. This vesting schedule provides a timetable by which a founder’s conditional ownership in stock of a company transfers to unconditional ownership in a company. There is no absolute, hard and fast rule as to what the timetable should be to transfer stock into the hands of a founder. That all depends on what a company’s expectations of founders are and the timetable for exit. The standard timetable for stock vesting is “four years with a one year cliff.” That just means that no vesting occurs in the first year, after which 25% would vest. Another 1/48th would then vest every month for the next four years.
If a founder leaves before the stock has fully vested, the company typically has the right to repurchase the stock at a given price, which can be determined by the language of the contract.
Why is vesting important?
Founder disputes are more common than not. Yet, because most founders do not start in a position where they are sitting on a mountain of cash, most founders work for equity in the startup. Vesting is the means by which founders can be rewarded with equity for working with a startup without hamstringing the company if they leave because of dispute or difference of opinion.
There are many ways a departed founder can hamstring a company. For one, a shareholder with a significant percentage of stock also may have significant voting influence that could impact the startup ability’s to make important decisions. Also, a departed founder might slow down or derail negotiations with an investor because they aren’t willing to dilute their ownership percentage to accommodate an investor. Perhaps more significantly, since startups usually value their stock at a low price initially, if you don’t have a schedule for vesting stock, you might be forced to hand over part of your company to someone who might not have earned it!
A vesting schedule is a critical vehicle for rewarding those who work to make a startup great while keeping significant possession out of the hands of those who depart early in the process. It’s a must-have for founders who want to protect the future of their company.