When you start a company or offer equity rights at any time, it is oftentimes a wise choice to including a vesting requirement. The manner in which vesting occurs will depend on the specific circumstances, but generally speaking, it means that whomever is receiving the equity will be required to wait a period of time before gaining full control of it.
Vesting serves as a significant incentive to ensure that employees and business partners stay with the company for a worthwhile amount of time. For example, two people may decide to form a business together, each with a 50% stake in the company. If they elect to vest their equity in the company, neither will have unrestricted ownership to it until a pre-determined point in the future. Thus, each should be more committed to staying with the company at least until their equity has vested. Without proper vesting, one of those partners may leave the company prematurely, yet remain a 50% owner of the company. Vesting helps prevent that “windfall” from occurring.
Additionally, if you elect to hire a new employee and offer him or her equity in the company as a hiring bonus, you could include a vesting requirement to ensure that you aren’t immediately giving away ownership rights to your company to someone who isn’t going to work out to be a good employee. It also provides the employee an incentive to perform well so that they can stay with the company at least long enough for their equity rights to vest.
With the help of a skilled attorney, companies can choose to customize a vesting schedule that best suits their goals and needs. However, the schedule will usually take the form of either graded vesting or cliff vesting.
A vesting schedule that is “time vesting” links the vesting of ownership interest to time, an objective criteria. Thus, depending on how you structure the vesting, upon the passage of the stated time periods, the stated ownership interests will vest (and no longer be subject to forfeiture or nominal repurchase) in particular amounts.
A common method of time vesting is a “4-year vesting, with a 1-year cliff.” What this (generally) means is that ownership interest will be fully vested after 4 years. After 1 year, 25% (generally) of the ownership interest will vest (in one big chunk). Thereafter, the remaining amounts will vest (generally) in 1/36th increments each month until all of it has vested.
Under this vesting scheme, if a party who owns ownership interests that are subject to vesting quits or terminates the relationship with the Company prior to the 1 year mark, none of the ownership interest will have vested. If the relationship is terminated 1 year and 4 months after the grant, then the party would own 33.33% of the stock (i.e., 25% plus 4/36ths of the remaining 75%).
The increments of time and chunks of ownership can be customized to fit particular circumstances.
Milestone vesting links the vesting of ownership to the occurrence of specific events. Oftentimes, time may not be the factor that is most important to the owners, but rather the events (e.g., revenue, sales, accomplishing some task, etc.) and, in such cases, milestone vesting might be more appropriate.
In my opinion, milestone vesting can be a potentially problematic approach. Oftentimes, the events that parties specify aren’t as cut dry (or as objective) as they think they are. When an event is “blurry” as to whether or not it occurs, it can lead to disputes.
For example, if a Company were to tie vesting of ownership to the occurrence of, say, “the sale of [the Company’s product] to a major retailer,” disputes can arise as to whether a retailer is a “major retailer.” Thus, I often suggest that the vesting criteria are as objective as possible (i.e., they cannot be argued as to whether or not they have occurred). My experience has been that, in the real world, targets once thought to be relevant at the time of granting may shift, change, or otherwise become obsolete as the business pivots and moves through the market challenges it faces. So, without a crystal ball, the vesting might not be tied to the right milestones.