Vesting shares can be a great way of getting skilled employees and other stakeholders to provide value to a business, without the need for paying them as much up-front. Here's how they work.
What is share vesting?
An employee, investor or co-founder is given full rights to shares over a specific period of time (the vesting period). This is usually set out in an employment contract or a shareholders' agreement (often known as vesting schedule).
For example, an employee may be incentivised with 4% equity of the business, but their employment contract may stipulate that they receive their equity little by little, rather than a lump sum at the start of their employment. The release of the equity could be over a period of years or upon hitting certain milestones.
This is great for employee retention.
What are vested shares?
When you've served enough time with your company to benefit from the equity you agreed at the start of your contract, you can start to profit from those shares.
You usually vest over four years, although the time it takes to vest may differ based on the company and the reason for the award.
Why are vesting rules important for startups?
Developing a new business is financially challenging, especially if you don't have access to capital. Paying staff, finding potential investors, and retaining early employees is made more difficult when you can't offer big cash incentives up-front.
Many businesses use equity as a means of attracting the appropriate people to join their team.
Without the right protection, giving away partial ownership of your business comes with a number of dangers.
Someone may acquire long-term ownership without providing the company with a long-term advantage.
This is where share vesting can be a solution to both of these issues during the early stages of growth.
Is vesting a good idea for businesses?
Share vesting has benefits to the company:
- The company is incentivising long-term commitment by paying employees to stick around.
- The employee is demonstrating a commitment to the company.
- It gives the company a great safety net should certain objectives not be met.
Shares are offered as a term of the contract to entice staff or co-founders to stay loyal to the business and continue to provide value.
The co-founder or employee will only have the rights to the full number of shares in their contract upon completion of certain milestones.
Because of this, employees or co-founders are likely to stay with the company until the end of the vesting period.
The opportunity for investors to earn returns on their investments, in addition to the value of a company's growth potential, is enhanced when employees and founders are not paid in cash.
Startups are willing to use equity as a recruitment and retention tool for top-tier talent, because the value of their business is more likely to grow with more experienced employees.
Vesting insulates the company from bad hires by providing a guarantee against an unsuitable employee or co-founder.
A co-founder or employee might leave (or even be fired) their service commitment, while retaining a portion of the firm's ownership if there is no vesting.
If the firm doesn't have much money, it may not be able to pay market price to acquire its shares back. Including share vesting in a shareholders' agreement or an employment contract helps guarantee that the repurchase of shares won't be overly expensive.
What is the vesting period?
The vesting period is the time it takes for an employee or co-founder to earn their full equity stake in the company. It is often over a four year vesting schedule, but it can be longer or shorter depending on the company.
Because time is not the only measure of performance, a company's shares may also be vested based on certain milestones, known as "milestone-based vesting".
What are vesting schedules?
Vesting schedules are timetables that specify when an employee or co-founder will earn their equity.
It's usually structured so that the employee or co-founder earns a certain percentage of their shares every year.
For example, an employee may be given 4% equity in the company, but their employment contract may stipulate that they receive 1% vesting per year.
This means that at the end of the first year, they would own 1% of the company.
When vesting schedules are completed, an employee may be "fully vested" which means they are entitled to ownership of their shares.
A vesting schedule is a document that outlines when and how an employee will earn their equity stake in the company. It usually stipulates that the employee will vest a certain percentage of their shares each year, but it can also be set up so that the employee vests a certain number of shares after hitting specific milestones.
Time-based vesting and milestone-based vesting are used together to create hybrid-vesting. Employees must stay with the company for a particular length of time and accomplish a specific aim or milestone to be eligible to benefit from their shares in this approach.
What happens if I leave before my shares are vested?
If you leave the company before your shares are vested, you will most likely forfeit your shares. This is often known as "cliff vesting."
Is cliff vesting a good thing?
Cliff vesting has its pros and cons. On the one hand, it encourages employees to stay with the company for longer in order to vest their shares. On the other hand, it may discourage employees from leaving even if they're unhappy with their job.
What happens to vested shares if a founder leaves?
If a founder leaves the company, their vested shares will usually be transferred to the remaining shareholders.
What is the difference between normal shares and vested shares?
A variety of shares are available to founders of startups. The two most common are ordinary shares and preference shares.
Find out more about preference shares vs ordinary shares
How can I set up a share vesting scheme?
You should seek professional legal advice before looking to vest company shares. The scheme may look different depending on whether you are dealing with a partner, employee or even a consultant. Each will have potentially different vesting periods or milestones as well as different stock options.
Can vested shares be taken away?
If an employee is fired or leaves the company before their shares are fully vested, they may forfeit their unvested shares. This is known as "cliff vesting."
The employment contract will determine the terms of the vested shares.
Do you get dividends on vested shares?
Dividends are typically paid out to shareholders on a pro-rata basis, meaning that each shareholder will receive a dividend based on the number of shares they own. However, the nature of the vesting schedule and shareholders agreements will determine if and how any dividends will be paid.
How else do businesses incentivise employees with shares?
UK employee share plans (also known as employee stock purchase plans) allow businesses to reward employees by allowing them to buy shares with significantly lower rates of tax than their normal income.
Shares vesting, what next?
We help businesses of all sizes throughout the UK with shareholder agreements and contracts relating to vested shares.
To help your business set up a vested shares scheme. Get in touch.