The Importance of Vesting

I just came across this article by Rebekah Campbell, on a topic of crucial importance to entrepreneurs — how to divvy up ownership interests in a startup. Campbell is an Australian entrepreneur, and is the founder and CEO of Posse, a mobile social network that connects customers and retailers. In the article, she talks about the rather cavalier approach she took to dividing equity among her startup team, and the problems she encountered as her team eventually drifted away. She ended up where she started, alone, but with far less equity in her company.

The proper approach, which she goes on to describe, is to incorporate a vesting plan at the outset. Her suggested vesting plan is 3-year vesting, which is shorter than the 4-year vesting that is commonplace in US tech startups. Before looking at how vesting works, let’s start with what happens without vesting. Say there are three co-founders of the company. One co-founder puts in money and is the person who had the initial product vision; she gets 40% of the equity. The other two co-founders are the chief software developer and the marketing guru; they each get 30% of the equity. After about a year of work, the chief software developer is offered a plum job at Google and leaves, taking his shares with him. The marketing guru gets burned out, and leaves too, taking her shares. Now the initial founder is left alone to do all the work, but only has 40% of the company. If she brings in new people, she has to reduce her equity stake further. Meanwhile, two people owning 60% of the company are roaming around on the outside, able to exert a significant amount of decision making power over a company they are no longer involved in. They could veto a crucial acquisition opportunity, for example, or threaten to do so as a means of extracting preferential treatment.

Now suppose there had been a vesting plan in effect. The standard vesting plan is often referred to as “four year vesting with a one year cliff.” This means that the vesting takes place over four years, and no shares are vested at all until the end of the first year. So if the chief software developer takes that job at Google in the 10th month, he forfeits all of his shares. They weren’t vested yet, and they return to the company’s equity pool. He’s not just out, he’s completely out. Before he left, the original founder had 40% of the company, now she has 57% of the company because the software developer’s forfeited shares are no longer in the mix. The marketing guru leaves after a year and a half. At the one year mark, 25% of her shares vested, and each month thereafter, another 1/48th of her shares vest. So, when she leaves, she does leave with some equity interest, but far less than if there were no vesting. She walks out with about 17% equity in the company, rather than her original 30%, or the 43% her equity interest got bumped up to when the other cofounder left. It’s fair to her, considering the time she put in, and it’s fair to the company and the remaining cofounder, who doesn’t have to worry about a significant equity holder who is not involved in the company. Meanwhile, the original founder now owns about 83% of the company due to the departure of the cofounders and the forfeiture of their unvested shares.

This kind of vesting arrangement can easily be incorporated into a shareholders agreement, which is the contract shareholders should sign when the company is formed and they acquire their equity. There’s one other component that Campbell didn’t touch on in her article, and that’s the buyout option. When one of these cofounders leaves the company with some vested shares, a buyout option gives the company (and sometimes the remaining shareholders) the option to purchase those vested shares back from the departing shareholder. It also gives the company a right of first refusal if a since-departed shareholder tries to sell her shares to someone else outside the company. The company may not have the money needed to exercise this buyout option, but the option at least gives the company the power to try to maintain control and limit ownership. While adding a shareholder agreement with vesting and buyout provisions can increase the overall startup costs for a venture, it will pay for itself many times over in saving headaches and preserving the rights of the ongoing founders.