Why Do Startup Companies Use Vesting Schedules for Founders?
As a startup founder, you’ve probably heard that your startup’s shares should be subject to a vesting schedule. You may not know why a vesting schedule is important when issuing startup founders’ shares. Today’s post highlights some of the major reasons why a vesting schedule makes sense for most startup companies, including why investors prefer investing in companies that use vesting schedules when issuing stock to the founders.
An example of why startup companies use vesting schedules for founders
Suppose ABC Company was founded by John and Jane. ABC has created a new crowdfunding portal where investors can invest in businesses online. ABC raised a small friends and family round of investment to help launch the company. John and Jane have been working for 18 months on the business, including creating a unique process for completing the investment online. Two days before the company launches, John decides to quit the company and go his separate way. John’s stock in the company was not subject to a vesting schedule, and John’s technical skills were incredibly valuable to the company. John’s exit leaves the company scrambling to launch and unable to immediately support ongoing obligations. John’s stock was fully vested, and he holds 30 percent of the company’s stock. Because his stock is fully vested, he may be able to come back to collect on this equity once the company grows into a profitable business, even if he quits at such an inopportune time. And the company may never succeed because future investors may not want to invest in a company with even 30% controlled by a non-participating member.
How vesting provisions help protect you, the company, and its investors
To protect the company and its founders and investors from this scenario, founders’ stock is usually subject to a vesting schedule. Generally, the founders’ stock will vest over a two to four year period. During that time, the rights in the stock are only obtained as the founder continues to work for the company. Many startups include various milestones upon which the founders’ stock will vest. Buy-back provisions also provide that if the founder leaves before his or her shares are fully vested, the company may repurchase the stock from the founder on terms that are favorable to the company. These protections are important to ensure the company’s viability, especially when the business will need or plans to seek outside investment to be successful.
Why investors prefer vesting schedules
Investors understand that the key to a successful startup is not only the product or service that the company sells, but the team behind the product or service. After all, we’ve all read the stories about companies tanking after key employees and executives leave the company. Therefore, investors want to be assured that founders and other key employees will not leave the company after the investor puts in money. Vesting schedules offer investors comfort that the founders will either stay with the company or be forced to sell back their shares if they exit early.
Who else benefits from vesting provisions?
Founders also benefit from vesting provisions. First, these provisions protect founders from uncommitted co-founders–at the very least it incentives founders not to drop out at the first sign of weariness. Second, founders benefit because vesting provisions can make their company more valuable to people and companies looking to acquire the company. Often acquirers will want to be assured that founders will stick around after the acquisition, and vesting provisions are often a powerful incentive for the founders to remain with the company after it is acquired. Likewise, other shareholders (investors, key employees, etc.) benefit from the value added to acquirers, as they will benefit financially from an increased acquisition price.
If you’re a startup founder whose stock is restricted by a vesting schedule (or any other individual or entity receiving restricted stock), it’s important to consider and file (if appropriate) your 83(b) election with the IRS. Filing an 83(b) election allows you to recognize the full amount of your restricted stock upfront rather than recognizing the value of the stock as you vest. Stock in a startup company generally carries its lowest value when the company is first formed, so it generally makes sense to recognize the full fair market value of the stock on day one rather than when the stock vests (assuming the company gains value over time and its shares increase in value). Check out this post to learn more about the benefits of filing an 83(b) election.
To learn more about vesting provisions and some common vesting details, check out our Key Term Sheet Provisions series.