Stock vesting

Stock vesting is a burden on stock that declines over time or on certain events. The burden allows a startup to repurchase the unvested shares, in the case of restricted stock, or for the holder to exercise only the vested shares, in the case of stock options, if the holder ceases to provide services to the startup.

A startup could issue restricted stock or stock options over time and accomplish the same effect as vesting. There is a significant downside in doing so to the founder. As the price of the common stock increases, the stock purchases become more and more expensive because the purchase price must (actually, should) be equal to fair market value on the date of purchase. If the startups raises venture funding, the common stock is often priced at approximately 1/5 of the price of the latest preferred stock round, which is almost always much higher than the purchase price at formation of the startup. The holding period for tax purposes also starts typically when stock is purchased, so stock purchased at formation will have a longer holding period for recipients than stock that is purchased over time in tranches. The lowest capital gains rate is available only if a recipient holds stock for at least one year, and under current federal law, stock held for less than one year is taxed at ordinary income rates.

Many startups want to purchase their stock fully vested. Investors rarely agree to fully vested stock because the bargain among investors and founders is that founders are allowed to purchase their stock for close to zero while the investors pay much more, as long as the founders earn the stock over time through sweat equity. If this rule is violated, investors should pay less for their stock.

There is also another reason to vest stock issued to co-founders. Co-founders break up. Breakups happen in a majority of startups and it is not fair for the departing founders to walk away with all their ownership if the continuing founders have to earn their stock over time through sweat equity. Every founding team thinks they have the great team which won’t break up. Statistics tell a very different story.

Vesting for stock options is slightly different. With stock options, the holder is only able to exercise the stock options as they vest. In other words, the holder does not have control of the underlying stock initially (as in the case of restricted stock).The typical vesting schedule is four years with a one-year cliff. This means that 25% of the shares will vest after one year of service and the other 75% will vest in equal monthly installments over the subsequent three years. If a holder is terminated prior to the cliff, by contract he or she loses all of the stock. In practice, many times the board gives the holder some vesting to avoid claims of bad faith and unfair dealing and, frankly, lawsuits.

Stock also typically accelerates on a change of control, most commonly on a double trigger basis. This means that if the startup is sold and the founder is terminated within some period (12 months most common), some or all of the unvested share will accelerate on the termination. We recommend that the core founders have 100% acceleration on a double trigger basis, but the percentage could be 0% to 100%.

There also could be acceleration on a single trigger basis. This means that if the startup is sold, some or all of his or her unvested shares will accelerate on the closing of the sale. We do not recommend single trigger. Why? Investors hate it. And, why do they hate it? Because acquirers usually want part or all of the team and will pay less for a startup if they have to pay more to incent the team to stay. The incentive to stay is unvested stock. That is, acquirers are willing to pay a certain amount for startups. If they have to carve more of the consideration out for new incentives to the team, there will be less consideration paid to stockholders.