What Is a Vesting Schedule, And How Does It Help Startups?
We discussed venture capitalists, startup financing methods, exit strategies, Startup valuation methods, and marketing in previous articles. Now, we intend to discuss the Vesting Schedule, its features and its importance.
What is a Vesting Schedule?
A Vesting Schedule is a program in which stock ownership is transferred to individuals over time. This schedule is usually for shareholders and employees.
However, share transfer to individuals may also be scheduled by other factors, like business goals achievement. Still, in this article, we mainly discuss the timeline-based Vesting Schedule, in which the only criteria for transferring shares to individuals is the length of time they have been in the startup.
Simply put, a Vesting Schedule is a mechanism that allows founders and employees to acquire ownership of a company’s stock over time. If they leave the startup before the end of this period, a portion of the shares will be transferred to them based on the length they served in the startup. The rest of their claims will be redeemed by the company.
In other words, the part of the stock that has not been transferred evaporates. Management can use this part of the released stock to replace new people. If there is no new person, it will increase the share of other shareholders.
The main components of the Vesting Schedule, which we will discuss below, are the same for founders and employees. But given the fundamental role of founders in starting and running the startup, their Vesting Schedule is usually more simplistic. For example, part of the founders’ stock can be exempt from this plan in many cases. On the other hand, the minimum time required for them to exit the startup and receive their stock is shorter than for employees.
Main Components of Vesting Schedule
Vesting Schedule Period
The Vesting Schedule Period is the length of time a person must remain in a startup to own the entire stock allotted to him or her. This period is usually 3 to 5 years.
Stock Granting Periods
Ideally, it is better for a person to receive shares based on the number of days he has been in the startup. However, due to functional complexities, it is not possible to calculate the percentages on a daily basis. The Stock Granting Periods are usually one month or three.
Cliff is the minimum time that founders must stay in the startup to receive their first share of the stock. In the Vesting Schedule, the cliff is usually six months or one year. So if the cliff is set for one year and the founder leaves the startup earlier, he will not receive any share.
The founders can add the period they were working on the startup before developing a Vesting Schedule to determine their cliff. Consider a startup that has three co-founders. The first one has been working on the idea and value of the startup for about a year, while the second founder joined the team six months ago and the third one three months ago. In this case, each of the founders can receive credit in proportion to the length of time he or she has been in the startup before developing the Vesting Schedule, resulting in a reduction in his or her cliff.
Unvested Shares in Exiting Event
Another critical point to note in the Vesting Schedule is about unvested shares in events such as startup sales or layoffs. In such cases, an acceleration program is usually used. Founders must specify the duration of the acceleration period and the conditions for its implementation.
The Importance of Vesting Schedule in Founder Stocks
Founders may leave the startup shortly after raising it. This departure may be due to various reasons, including the dynamic nature of the startup. Given that they will have no role in building the startup’s future, it is not fair to own all the assigned shares initially. Thus, a Vesting Schedule is usually considered for the founder’s stocks. As discussed, this plan manages stock transfer to any individual based on the period they serve the startup.
“Due to the dynamic nature of startups, changing plans and responsibilities, as well as a high turnover of staff, one should consider the conditions such as the founders’ departure from the very first.
Also, having the absolute ownership of the shares by the founders increases the risk of investing in the startup. Venture capitalists can reduce the risk by using a Vesting Schedule for the founders’ stock.
Benefits of Vesting Schedule
Reducing the Risk of Investing for Venture Capitalists
The presence of founders in a startup, especially in the early stages, plays a vital role in its success. The absence of any of them increases the likelihood of startup failure. As mentioned in the previous section, the Vesting Schedule is an effective lever to keep founders in the startup.
Putting this clause in the founders’ shares assures investors that the founders will stay in the startup for a more extended period of time, thus reducing investment risk. The Vesting Schedule should be able to balance the goals of the venture capitalist and the founders of the startup.
Protecting Startups from Founder Leaving
The main reason for the founders to set up a Vesting Schedule is to protect the startup. Although a startup is initially based on mutual trust and long-term cooperation, one of the founders may decide to leave the startup early in the process. In such a situation, the probability of startup success decreases. Creating a Vesting Schedule can influence the founders’ decision to leave, at least to some extent.
Another important factor that shows the importance of this plan is shareholders’ voting rights and their controlling power. Suppose a startup’s technical manager, which owns a high percentage of the startup, decides to leave it. In this case, he can play a great role in startup decisions and influence the startup’s future with his evil and mischievous decisions.
Protecting the Founders against the Departure of other Co-Founders
The vesting clause not only protects the startup from the founders but also protects founders from other co-founders. This is the most significant reason for the authors to accept this clause. The founders themselves are interested in making a Vesting Schedule to prevent other co-founders from leaving or giving them too many shares (if they do exit).
Consider a startup that has three co-founders and no Vesting Schedule. One year after the founding, one of the founders leaves the startup. This person contributes disproportionately to the future success of the startup due to the stock he/she initially received without having a role in the future of the startup.
Creating and Maintaining the Proper Equity Structure and Increasing the Startup’s Chances of Raising Capital
Another critical factor is that the vesting plan helps founders build the proper equity structure. The share structure of the startup should be as transparent and logical as possible. Investors attach great importance to the stock structure. The disproportionate equity structure of a startup is one of the signs of the founders’ managerial weakness.
To better understand this, consider a startup that decides to raise capital. In its current equity structure, 60% belongs to the two current founders and 40% to one of the founders who has left the startup. This startup will definitely face difficulties in raising capital.
Without a vesting plan, existing founders would have to explain to the investor why a person who has been a part of the startup for a short time two years ago owns 40% of the startup. This is a meaningful sign that indicates the team probably has a low ability to manage and lead the startup.
On the other hand, using the Vesting Schedule, the person who left the startup probably either has no stake or a tiny percentage of shares. In this case, the startup founder can easily explain to the investor that, although the person is not currently in the startup, he owns part of the shares in proportion to the role he has played in the past. In this case, the investor ensures that the startup shares are distributed among them in balance with the role of individuals.
Encourage Employees to Stay in the Startup.
In the case of employees, setting the vesting plan in incentive stocks increases their motivation to continue operating in that startup. They know that the longer they stay in the startup, the more shares they get. This is especially important for startups that are growing.