Vesting is an important concept for many businesses in their infancy. It can be particularly important when (1) two or more partners are building the company with their sweat (e.g., bootstrapped company or (2) when one partner is contributing his/her “sweat”, services, time and/or labor and the other partner is contributing cash or valuable property.
In the first instance, the partners typically divide up the company amongst themselves (e.g., 3 equal partners at ⅓ of the company each). But, whenever I ask the partners “If Partner A stopped showing up to work tomorrow, would it still be your intention that he/she owns ⅓ of the company?” Almost invariably, the answer is no. The reason, of course, is that there is still much to do until that particular partner has “earned” his/her share of the Company. Vesting is a great solution to help keep the “carrot” out in front of the partner to get them to continue to provide their valuable services and “sweat”. It also provides the Company with a “stick” in case the Partner ceases to provide those services (or otherwise doesn’t live up to the agreed upon expectations). In such an event, the defaulting Partner forfeits the unvested portion of his/her interest.
In the second instance, again, the partner contributing cash or valuable property has done his/her part to get the interest. But, the “sweat” partner has not. Thus, vesting can be a good solution to protect the partner who contributed cash or valuable property from the “sweat” partner from failing to live up to the agreed upon expectation.
In the context of venture capital, you can be nearly certain that any investor in an early stage round is going to want to see that the founders still have the “carrot” and the “stick” to keep them providing their valuable services.
Common Vesting Schedules
As the entrepreneur puts work into the company, they will earn a certain percentage ownership of the business. This process is called vesting. A common vesting schedule in early stage startup companies is called a “4-year cliff”. This is where the entrepreneur will earn 25% of their total agreed upon ownership after one year, and then the additional 75% spread out monthly over the course of the next three years. At the end of the four-year period, the partner will have earned the agreed upon ownership of the business.
Of course, the vesting schedule can be customized significantly; but, it should be carefully thought through to match the Company’s real objectives and expectations.
There are situations where waiting four years (or whatever the agreed upon amount of time is) doesn’t make sense. For example, if the company is doing very well after two years, and the company has a liquidity event (e.g., it sells to an acquirer). When the business is sold, often times, the parties will agree that such a circumstance warrants an “acceleration” of their unvested shares so that the partner’s full value is realized..
Drafting a Contract and Planning for Taxes
Whenever making a financing deal with vesting, it is important to ensure your contract is comprehensive to cover whatever the future holds. In addition, this sort of an arrangement can trigger tax issues that need to be planned for. Contact Doida Law Group to discuss your situation and get the legal help you need.