Equity Vesting: What is it and why is it important – Here’s all you need to know

February 19, 2021 9:55 AM

While equity vesting agreements can have deleterious effects, the benefits far outweigh the costs, thus making it a staple constituent of many agreements.

Without vesting, if one of the founders exits after a short period of time, a new company can jeopardize its future success.

While the concept of equity vesting has been in practice for long, it has gained much prominence with the maturing of the startup ecosystem in the country. While vesting acts as an especially important mechanism for ensuring a startup’s long-term success, it is often misunderstood and/or implemented incorrectly.

Let us understand briefly about vesting, its importance, and ways to implement it.

What is Equity Vesting?

Vesting is the process of accruing a full right that cannot be taken away by a third party. In the context of the founders’ equity, a startup initially grants a package of stock to each founder.

Equity vesting can be captured through the following example – When a start-up is incorporated with four founders with an equal shareholding of 25% each but, say, after 12 months one of the founders decides to quit, then under an equity vesting agreement, he will not be allowed to claim the entire 25% of the stock as he is leaving the journey in the initial stage and wouldn’t be contributing to the growth of the startup.

While, as founder/co-founder, they are the owner for the shareholding portion decided for themselves, the company still retains the right to forfeit or buy back the unvested equity, if any of them walk away without contributing the effort spread across a vesting schedule. Once the person has completed his tenure as per the vesting schedule, he rightfully gets the right to all of the shares and the company does not retain any right to buyback or forfeit in case one decides to move.

Why is Equity Vesting done?

Equity vesting is done to ensure that cofounders/critical talent stays for an extensive duration of time, typically required to stabilize the company, thus resulting in potential long-term success. Its benefit could broadly be summarized as below:

# Facilitates long-term commitment from founders:

The startup journey is full of ups and downs and some of the founders might lose faith in the shared vision during this journey. It is a known fact that many founders leave companies in their formative years. The startups have limited capital and remarkably high reliance on the founders’ efforts to work and stabilise the company and by vesting of equity ownership over several years, a startup can motivate founders to stay and continue their efforts to grow the business.

# Minimizing damages from existing founders:

Without vesting, if one of the founders exits after a short period of time, a new company can jeopardize its future success.

Imagine one started a company with three other people, with each receiving 25% of the equity. One founder decides to leave the company after a few months. Without vesting, he still owns 25% of the company, 25% voting right with regards to management decisions, and might retain influence over how the company is run. He might also demand 25% of the proceeds when the company is sold a few years later.

# Investors Protection:

It is a market practice for professional investors – venture capital firms or angel investors to demand stock vesting provision from founders and key employees before committing to their investment. It is a way to gauge the commitment of people involved in the company, and also to protect equity from departing partners.

When and How is Equity Vesting done

It is typically done in the early/earliest stage of the start-up’s founding as the start-up seeks to align the incentives of all the founders/critical talent with that of the start-up. Typically, equity vesting is done for 4 years using 1-year cliffs i.e., if one had 50% equity and he/she leaves in 2Y the company forfeits 25% of equity. Obviously, the greater the duration of stay, the more the equity will vest and, in this case, if one stays for complete tenure the entire equity vests, thus rewarding the concerned for staying for a long duration with the company.

STAKEHOLDER PERSPECTIVE

Investors:

From the perspective of the investors. their interests are protected as the founders/co-founders and other talents who are critical to the company’s growth have the financial incentive to not leave the company at an early stage.

From a start-up perspective, once investors know that all the key individuals are subject to a vesting agreement, they have sufficient peace of mind as they know that these critical resources cannot just walk away from the firm at no financial cost.

Founders:

In the Indian context, co-founders’ rift, as well as the attrition of critical masses ara some of the key reasons for the failure of startups. The vesting arrangement ensures alignment of interest over a period, thus helping in increasing loyalty as well as ensuring damage control in case of unlikely rift and departure. Also, it makes sense in cases where there is a separation of ownership and management, from the viewpoint of a start-up, a vesting agreement will allay the concerns of the founders that the CEO/CTO or other key professionals cannot walk away from the firm without having a detrimental impact on his financial fortunes. This will augment their confidence levels.

Advisors:

In India, advisors are given shares based on the vesting agreement. Advisors typically subsume advisors, mentors, and consultants. By subjecting them to a vesting agreement, they are accorded an incentive to participate in the firm’s success over the long run. Thus, from a start-up viewpoint, advisors who have been subject to equity vesting agreements have their incentives aligned with the long-run interests of the firm, thereby augmenting stakeholder confidence.

CONCLUSION

While equity vesting agreements can have deleterious effects (making a CEO continue when he/she does not want to do so) the benefits far outweigh the costs, thus making it a staple constituent of many agreements. Also, in case of any M&A or sale of the company, vesting agreements can include a clause for accelerated vesting which can protect the interest of founders and key employees.

(By Anurag Jhanwar, Co-founder and Partner, Fintrust Advisors)

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