‘Vesting’ is one of those legal terms you’ll end up hearing a lot if you hang out in the “startup scene”; the point of this post is to explain what vesting is, and more importantly, why it matters.
What is vesting?
It’s probably easiest to think of ‘vesting’ as analogous to ‘earning’; if a person’s RSPA (restricted stock purchase agreement — basically the contract you sign when you are being issued equity) specifies a four year vesting schedule this means that this person must earn his shares over a four year period, by working for the company in whatever capacity has been agreed upon, rather than receiving all of his issued shares immediately after signing the RSPA. In other words, if I give you one million shares with a four year vesting schedule, and you end up leaving the company after two years, you are legally only entitled to five hundred thousand shares, since you only earned 2/4 or 50% of your shares.
A very typical vesting schedule (at least when I was working at a law firm in Silicon Valley) is four years with a “one year cliff”. I’ve already discussed what a four year vesting schedule means; the ‘cliff’ is the point at which the shares begin to be issued.
Allow me illustrate by example. Suppose I issue you one million shares, and your RSPA specifies a four year vesting schedule with a one year cliff. The four year vesting schedule, as we discussed, means that you earn your one million shares over a four year period (earning 250,000 shares per year). The one year cliff means that you do not earn ANY shares until the one year mark has passed, at which point you are issued 25% of the shares (250,000 shares in this example). After the one year cliff has passed, you will continue earning your shares, typically on a monthly basis so that if you work for the company for two and a half years, you will earn that proportional number of shares (i.e. 500,000 for the first two years plus 125,000 shares for the first six months of the third year). But the one year cliff matters insofar as a person who works for 11 months and then either quits or is terminated earns NOTHING.
A four year vesting schedule with a one year cliff is not the only kind of vesting schedule; a cliff is optional and you may choose however long of a vesting schedule as you’d like. In rare cases we have, at Sportaneous, issued vesting schedules as short as a few months, for people that preferred equity to cash but who were only willing or able to contribute for a short period of time.
Why is vesting important?
Vesting is one of those things that almost everybody with legal or startup experience agreesis a hugely important clauses to have in all of your RSPAs, and which you will probably get advice about. I remember constantly getting the advice to ‘make sure you include a vesting schedule in your RSPAs’ and although I somewhat blindly took this advice initially, I came to realize the importance of a vesting schedule as time went on.
In my view, vesting is so important because the reality is that a startup is not the right career for most people, and even though it sounds sexy and exciting at the beginning (which makes it relatively easy to recruit good people), there are bound to be huge hurdles you face down the road. At this later stage, it takes a certain kind of personality to stick with it and keep working despite considerable uncertainty about the future, severely limited resources, and considerable stress including the looming prospect of failure.
I’ve come to realize that almost every startup ends up losing people at these difficult junctures, and it is at this point that the vesting schedule becomes your best friend as a CEO. Without a vesting schedule, a key shareholder leaving the company prematurely may mean the death of the company, since you now have a big chunk of equity that is basically doing nothing for the company, and that equity cannot be reissued to people who may create value. In contrast, if every shareholder understands and consents to a vesting schedule in his RSPA, this allows any of the shareholders to leave the company in a way that allows you as CEO to re-issue those shares to another person who is still adding value.
Although four years may seem like a long time for a vesting schedule, the reality is that most startups take that long to really move from an idea to a profitable business, and you want to make sure that people you give equity to are in it for the long haul. What’s great about a vesting schedule is that even if you (or they) are not sure if they are in it for the long haul, they can always leave early; they just won’t earn as much equity if they do that.