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Share Vesting Arrangements
Startup founders often protect themselves against ‘free-riders’ through share vesting arrangements that rewards contribution to the venture.
One of the biggest attractions of founding or working in a startup is the opportunity to benefit from the appreciation in the share price as the business develops and grows. The granting (or vesting) of shares in a startup needs to be carefully structured and managed to ensure shares are fairly and equitably distributed amongst founders, employees, advisers and other shareholders, and that no unintended consequences arise.
What is vesting?
Shares in startups are often granted on a “restricted” or conditional basis. While they are restricted they are not the property of the recipient, who does not benefit from the rights of ownership such as voting or receiving dividends.
Vesting of shares occurs when shares become the unconditional legal property of the recipient without restriction.
Shares are usually vested based on a range of factors – a vesting date, achievement of milestones, performance of an individual or the business and so on.
Why set up a vesting arrangement?
Vesting gives employees an incentive to “earn their keep” based on criteria set by the founders. At most times, this is simply serving a set number of years (usually 4) which helps to keep key talent on for the long term.
In a vesting arrangement, shares in startups are often granted on a “restricted” or conditional basis. While they are restricted, they are not the property of the recipient, who does not therefore benefit from the rights of ownership such as voting or receiving dividends until they vest.
Vesting of shares occurs when shares become the unconditional legal property of the recipient without restriction. Shares can be vested based on a range of factors – a vesting date, achievement of milestones, performance of an individual or the business and so on.
Fullstack Tip – Performance based vesting arrangements are the best in helping direct your employee’s efforts towards company goals & stretch targets. Time based vesting can still be lead to mediocre results from employees.
How much shares to grant
The percentage of shares granted to different parties, and the structure of associated vesting arrangements varies markedly. Structures are often arrived at through negotiation, and depend on factors such as;
- The importance and expected contribution of a role, position or function
- The stage of development and riskiness of the startup – Concept, MVP, Pre-revenue, Scaleup, etc.
- Whether the startup has cash resources and is funded
- The objectives and challenges facing the business
The market average ranges (collectively) of share grants are;
Founders – 85% to 90%
Co-founders – 20% to 30%
Employees – Up to 10%
Board members & advisers – Up to 5%
Fullstack Tip – An alternative to the above percentage approach is focusing on the number of shares given, rather than a given percentage. This allows for dilution to impact everyone equally, rather than just the founders.
Setting up vesting for founders
The founders of a startup are of course entitled to a majority of the shares in a company.
However, a problem for startups can arise when a co-founder leaves the company early (whether voluntarily or terminated). If that co-founder held a significant unrestricted shareholding, this leads to a situation where a person who is no longer associated with the business still has significant control or influence – the so-called “free rider” problem.
To address this, founders’ shares can be granted with a vesting schedule. A typical founder vesting schedule is for their shares to vest in equal quarterly instalments over say four years, with a 12 month “cliff”.
A cliff period refers to the time before vesting takes place – so a 12 month cliff means an employee must work for the company for one year before any of their equity vests.
For example, if a founder were to receive 100,000 shares which vest quarterly over 4 years with a 12 month cliff, they would receive;
Months 0 – 12 – NIL throughout, with 25,000 shares at the end
Months 13 – 48 – 6,250 at the end of each quarter until 100,000 shares have been vested.
In the case of a co-founder who leaves early, a vesting schedule helps to ensure they receive only the number of shares which reflect their contribution.
Including vesting shares as part of a salary package
Employees in startups are often remunerated via an employee share scheme (in exchange for a reduced cash salary package). A typical structure is for employees to be granted restricted shares, which are then vested based on length of service, satisfactory performance and/or the achievement of specific objectives.
The total number or percentage of shares available to an employee is based on the importance of the role and the stage of development of the startup – for example a pre-revenue, unproven startup is more risky to an employee so the number or percentage of shares will be greater than for an established revenue generating startup.
Vesting structures vary greatly. As an example however, for a key role (like a lead developer) 1% to 5% of the shares in the startup may be granted, which are vested with a 12-month cliff over a period of three years.
The total percentage of shares available to all employees is often capped at 10%.
Board members and advisers
Board members and advisers are also often remunerated partly or wholly with share grants. Board members and advisers usually receive an initial unrestricted grant of shares, with the remainder vested over typically 2 or 3 years.
Each Board member or adviser is usually granted 0.25% to 0.5% of total equity, with the amount depending on the skills and experience of the individual.
Shares issued to investors are not subject to vesting – they are issued on an unrestricted basis. It should be noted however that restrictions on shares held can be defined in a Shareholders Agreement or similar.
- There are a range of additional provisions which may be attached to share grants. These can include:
- Non-dilute provisions which provide for the automatic “topping up” of shares held to ensure their % ownership interest does not fall (i.e. is diluted) with successive share issues
- Drag-along and Tag-along rights which allow a shareholder to proportionately participate in subsequent share issues or disposals
These types of provisions are relatively uncommon but may be used in specific circumstances.
Startups who use share vesting arrangements can benefit from the incentivisation that they provide to stakeholders. Care is needed however to ensure share grants achieve their intent in practice. If you need help with share vesting reach out to the seasoned team at Fullstack whom can help with outsourced CFO services.
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Stuart Reynolds is the founder of Fullstack Advisory, an award-winning accounting firm for businesses leading the future. He is a 3rd generation accountant who specialises in tech companies, agencies and entrepreneurs.