This is the second post in my series on Startup Stock Options. This post applies to first-time founders as well as employees. Although the concepts are straightforward, I’ve seen both groups of people be surprised by some of these issues. The points discussed below are independent of whether you own ISOs or NSOs.
First off, Brad has a great write-up on vesting schedules as part of his term sheet series, that I’d highly recommend you read first. I’ll try to only duplicate the basics here, and then cover them from an entrepreneur/employee view.
Vesting schedules and option agreements go hand in hand for obvious reasons - they create financial incentive for employees (and founders) to stay and contribute to the growth of the startup.
If you are a founder seeking funding, expect to create a vesting schedule for you and your team (if you have a team and an entity, you should already have one). Although you’d likely own stock, not options, this would be structured similarly to an options vesting agreement - as an expiring right of the company to buy back your stock (ex: after four years the company no longer has any right to buy back your stock).
Some founders chafe at the idea of creating a vesting agreement for themselves. A vesting schedule for founders is a reasonable request from any shareholder (investor and employee alike) and frequently in the best interest of the founders for several reasons:
- No team is forever. We started Quova with 6 founders. At the end of four years, I was the only founder still full-time with the company. The other five left for voluntary and involuntary reasons and were replaced with seasoned management. This is not an infrequent experience. If inactive founders hold a disproportionate share of equity, managers and employees will not see the financial upside to their efforts and are more likely to leave.
- Cap tables are negotiable. I’ll go deeper into this in a separate post, but here is the gist: You own shares of stock (or options to buy shares of stock), not a percentage of the company. If an inactive founder holds a disproportionate share of equity, the company may issue more stock to active employees to give them an upside if they stay (thereby diluting your ownership). This is most commonly done with an investment round, but can also be done though board action. These actions are rarely taken, but if you aren’t active (and you hold significant equity incommensurate with your contribution), you’re more likely to have your ownership diluted.
- Triggers allow for protection in early liquidation scenarios. With a trigger agreement, your downside in an acquisition is protected. See Accelerated Vesting below for more.
- Vesting has no negative impact if you remain at the company. No reasonable shareholder will want to fire you if you continue to help grow the company.
The real message above is that you want to maximize the value of your equity, not maximize your equity.
I can understand why some entrepreneurs mistrust investors and why they believe that vesting schedules serve more nefarious purposes. I’d argue that if the trust isn’t there between investor and entrepreneur to support a vesting schedule (post-investment, you’re both on the same team), the entrepreneur should look elsewhere for money (and likewise the investor shouldn’t invest).
The typical vesting schedule is ratable over four years with a one year ‘cliff’. You would receive one fourth of your options after your first year at the company. Thereafter, vesting would continue at a monthly or quarterly rate until you own the full amount at the end of the fourth year. I’ve seen vesting schedules that are three and five years long, and heard of two-year initial cliffs and annual vesting cycles, but these tend to be rare. Opinions seem to vary on annual vs. monthly vesting cycles. I believe that an employee or founder waiting for a vesting event to occur before leaving is detrimental and more costly to the company, therefore cliffs should be kept to a minimum. If for some reason you’re presented with a vesting agreement greater than 4 yrs or an initial cliff longer than a year, I’d ask a lot of questions.
Many option agreements contain vesting acceleration clauses. These acceleration clauses are commonly called ‘triggers’, but just like the term ‘cliff’, you won’t see it used in an option agreement. Triggers either reward employees for an acquisition, or protect them in the event of an acquisition.
- Single Trigger (Reward). Vesting accelerates on a single event (typically an acquisition). Typically a six month or a one year acceleration of the vesting schedule. So, if you had two of four years vested, and you had a one-year single trigger acceleration clause, you’d have three years vested at the end of the acquisition. Depending on the circumstances, this reward may increase the cost of the acquisition to the purchaser since they’ll need to provide incentives to keep the employees (often a key asset that the purchaser is buying).
- Double Trigger (Protection). Two-events are required to accelerate vesting: Usually an acquisition and a termination without cause. This protects employees in case their role is obviated by the purchaser (they already have a sys admin), or if the purchaser just wants to reduce the cost of the acquisition (since unvested stock is returned to the company). The second trigger is frequently expanded to include other scenarios such as: requirement to relocate, lack of a position with similar responsibilities at the purchaser, etc.