Vesting Agreements

Startups often utilize equity (such as issuing shares or options to purchase shares) as a form of compensation to attract and retain employees, contractors and others. The potential issue is that, once an employee is issued shares or exercises an option to purchase shares, the employee can quit - the employee will have their shares, while you will be without your employee. The solution to this issue is the use of vesting.

When equity compensation vests, it has been earned by the recipient and the recipient now has an entitlement to it. For example, (a) when share compensation "vests", it is issued to the recipient; and (b) when stock options vest, they can be purchased (exercised) by the holder. Vesting arrangements are used to ensure that the equity compensation occurs over a period of time or based on the achievement of specified milestones.

Stock Option Vesting

Stock options can be used to slowly permit employees to purchase shares over time (at a price which could be below fair market value). The stock option agreement will set out the vesting schedule. For example, the options can vest over 4 years, annually, with a 1-year cliff. No shares can be purchased during the first year (the "cliff"). Upon the completion of each year, 25% of the shares are available to be purchased.

Using stock options, if the employee resigns or is terminated after 2 years, only 50% of the shares will have been available for purchase. The stock option plan or a shareholder agreement can include additional provisions which describe what happens once an employee who has been issued shares resigns or is terminated.

Reverse Vesting

Reverse vesting is another way to ensure a person, often a founder, earns their shares over time. In a reverse vesting arrangement, all of the shares are issued to the recipient at once. However, a person (typically the corporation) will have the right to repurchase the shares for their purchase price (often a nominal amount) in decreasing amounts over a period of time. These repurchase rights would often be found in a reverse vesting agreement or shareholder agreement.

For example, let's say a founder purchases 100 shares for $1 per share and enters into a reverse vesting agreement with a vesting period of 4 years, annually, with a 1 year cliff. If the founder terminates or resigns within the first year, all of their shares can be repurchased by the corporation for $1 per share (the amount they paid for each shares). If the founder resigns after year 1, but before the year 2, the corporation can repurchase 75 shares for $75. If the founder resigns after year 2, but before year 3, the corporation can repurchase 50 shares for $50. After year 4, the founder's shares can no longer be repurchased by the corporation.