Key Term Sheet Provisions: Vesting
Why Vesting is Necessary
Imagine this: three founders form a company, and three months into their venture they complete a round of financing with two major angel investors. The three founders each own 25% of the company’s issued stock, and the two investors each own 12.5% of the issued stock. In month four one of the three founders decides to quit working for the company. If there were no vesting provisions, that founder would walk away from the company with the same stock rights as the founders that continue to work for the company. The investors would also lose a key part of their investment. And the founder walking away could still prosper significantly if the company takes off.
How Vesting Works
To protect from such a scenario, founders’ stock is usually subject to vesting or buy-back provisions. Commonly stock will vest over a four year period, where rights in the stock are only obtained as the founder (or other key employee) continues to work for the company. Buy-back provisions provide that if the founder leaves prematurely, the company may repurchase the stock from the founder on terms that are favorable to the company.
Common Vesting Details
Often no stock vests until the founder/employee has remained with the company for a year. Upon the one year anniversary a substantial amount of stock vests. This is commonly referred to as a one-year cliff. If the founder doesn’t stay with the company for at least a year, he or she leaves without stock. After the one-year cliff, stock vests in smaller monthly increments for the remaining vesting period.
Sometimes, where a founder has dedicated substantial time and resources to an enterprise prior to the allocation of stock, that founder receives one quarter of his stock immediately, with the remainder vesting in monthly increments over a three year period.
A key part of vesting negotiations revolves around what happens upon a merger or acquisition. Sometimes the unvested stock, or a portion of it, vests automatically through a vesting acceleration trigger. A “single trigger” provision provides that stock automatically vests upon a change of control such as merger or acquisition. Whereas a “double trigger” provision provides that stock automatically vests only if there is a change of control and the founder/employee is subsequently fired. A standard accelerated vesting provision may provide for a double trigger with one year of accelerated vesting.
Who Benefits From a Vesting Provision?
Founders benefit from vesting provisions in two ways. First, these provisions protect founders from uncommitted co-founders (as in the example in the first paragraph above). Second, founders benefit because vesting provisions can make their company more valuable to acquirers. Often acquirers will want to be assured that founders will stick around after the acquisition. Vesting provisions provide a powerful incentive for the founders to remain with the company after acquisition. Likewise investors benefit from vesting provisions because the provisions protect an important part of their investment: the key personnel of the company. They also benefit from the value added to acquirers, as they will benefit financially from an increased acquisition price.