Share vesting is the process where you are given equity but do not acquire the full rights for the same as soon as you sign the contract. The investor is rewarded with shares over a set period of time or after a specific milestone is hit as explicitly mentioned in the shareholder’s agreement. Share vesting plan consists of the rules of how and when the shares will be vested.
For example, to incentivize a new employee a company provides 2% equity in his employment contract. Using share vesting he will not acquire the 2% upfront but little by little. Suppose there is 4 years vesting period, then the employee would acquire 0.5% of the share rights for four consecutive years.
Share vesting is a significant method to ensure that the interests of the company are properly safeguarded. Share vesting is regarded as one of the best ways to retain or reward employees by offering them shares as compensation.
ADVANTAGES OF SHARE VESTING
- Availability of cash – Share vesting is always beneficial for the company. As it does not involve cash, there is no outflow of cash shown in the company books. It simply reflects that the company is offering employee stock ownership.
- Employee incentivization – when the stock options are triggered by time-based milestones, companies earn loyalty and long-term future with certain talented employees. In start-ups the salaries are generally low, by offering shares, employees get additional benefits, apart from their pay. They have an inherent incentive to perform well.
- Protection of the company – Share vesting acts as an insurance policy against the employee if he doesn’t turn out to be a good fit for the company. Without share vesting, the co-founder or investor could walk away from their service and still remain a partial owner of the company. It then becomes difficult especially for a start-up to buy the shares back at market value.
DISADVANTAGES OF SHARE VESTING
- Tax consequences – the tax liability changes depending upon the types of shares vested. If the company chooses to vest shares as stock awards the income provided as stock-based compensation is liable to be taxed.
- Long time period – the benefits of share vesting is generally accrued after 3 to 5 years by the employees. Long term basis of share vesting acts as an undesirable option for the employees.
- Terms of vesting – harsh vesting terms and complex vesting schedules may lead to rejection or resignation from high-caliber employees. Therefore, much thought, caution, and consideration should be given in designing the vesting clause.
- Sometimes undesirable – when the employee chooses to leave the company due to any personal reason or gets fired before the vesting period ends, he is not able to reap the benefits of share vesting. This is the reason some of the employees avoid agreeing to this clause.
TYPES OF VESTING
Generally, there are three types of share vesting –
- Time-based vesting – This is the most common type of stock vesting. This means that the equity rights will vest over time. For example, if your company has rewarded you with equity, in the case of share vesting for the first year or a fixed period of time you will not be able to exercise any equity that has been granted to you. After the end of this fixed period that is cliff vesting, you are able to acquire full rights of shares. Generally, the equity is vested cumulatively in fixed intervals after the vesting cliff. For example, you might be able to exercise 25% of your equity shares after the first year, 50% after the second, 75% after the third, and 100% after the fourth year of business.
- Milestone-based vesting – this type of vesting refers to the method whereby the company grants the stock options and/or benefits only after the completion of a specific task or a certain kind of achievement set by the company. This type of vesting is not bound by time but rather an achievement or value-creating task completed by the employee, which would trigger the shares to vest. For example – the company pre-agrees that the employee will be granted 10% of the equity once he hit a certain KPI or once the company hits a certain revenue target.
From the employee’s point of view, this acts as a motivational drive to perform better in order to acquire a certain share of equity in the company. However, sometimes it becomes difficult to measure certain milestones or it takes a long period of time to materialize certain targets. Due to long wait and time consumption, the employee can actually lose interest and hope in claiming the value of their equity. This is why time-based vesting is considered a simpler solution than milestone vesting.
- Hybrid vesting – this type of method combines both the above types of vesting schedules. This means that you will acquire a certain amount of equity only after a fixed period of time and successful completion of a task. For example, the employee gets 25% of equity at the end of each year over a four years period provided that at the end of each he meets certain performance targets.
ELEMENTS TO INCLUDE IN A SHARE VESTING CLAUSE
Both the parties must be clear about each and every element of the clause. Here are a few ones that should always keep in mind-
- Clearly state the vesting criteria– Vesting is performed in several ways. A company can pursue time-based vesting in which shares are vested on a schedule. The vesting schedule is the term in the stock-based grant that outlines when the stock will be considered vested and the employee earns the right to purchase or own the stock. Alternatively in milestone-based vesting, shares are vested after the achievement of a particular target.
- Specify if there is any cliff – A cliff period is a time period where the employee’s shares cannot be vested. This is necessary if the company is pursuing time-based vesting.
- Clauses relating to acceleration– Acceleration refers to the manner in which shares are vested in case of a liquidity event. Without mentioning this clause, a dispute can arise between the employer and employee.
Share vesting is a good option for companies especially start-ups, who cannot afford to pay their employees large amounts of cash upfront. Share vesting is an important formula to ensure long-term commitment and company growth. It provides higher employee retention and motivation to work towards the goal of the company. For the company to it provides less hassle with hiring new employees as they stay for a long period of time to accrue the rewards of shares vested. A cliff period ensures that the employees are entitled to no compensation and rewards if they leave before the set period. An explicit and transparent share vesting clause in the agreement can aid in the growth and development of a company.