The Concept of Share Vesting

The agreement between the founders of a start-up defines the future of the company. Along with the Memorandum of Association and the Articles of Association, it is one of the foundational documents which can be used to judge the commitment, partnership and work ethic of the founders.

In light of this, share vesting or equity vesting is a clause that must be included in such agreements. This article outlines what exactly share vesting is along with its importance and the most commonly used schedule of vesting.

What Is Vesting?

Vesting is the process of accruing an absolute right on the equity owned by a founder, that cannot be taken away by a third party. This clause creates a timely schedule through which the founders of a company earn the right over the equity that has been granted to them.

For instance, a company has 2 founders who agree on an equal share division of 45% with the rest 10% being reserved for venture capitalists and angel investors. If the founders agree to vest, they are not granted the absolute ownership of their shares, rather they are subjected to a schedule by way of which their rights accrue gradually over some time.

So, if one of the founders leaves the company before the completion of the tenure of vesting, they leave only with the number of shares that have been vested till that date. The rest of the shares are forfeited by the company.

Why Is Vesting Important?

First and foremost, vesting is important for the stability of the company at its initial stage. If founders are allowed to leave the company with an absolute right over their equity and without contributing to its growth, it makes the company unstable and its decisions subject to the votes of shareholders who are not involved in the management directly.

Secondly, it is very important from the point of view of venture capitalists. When an investor invests in a company at the very initial stage of its business, they have to believe in the vision of the founders and not just in the capacity and the capability of the company.

If they feel that the founders are not committed to their vision or have an easy way out of the management, they will hesitate in investing. Vesting ensures that the founders stay in the company for at least a minimum agreed upon period, which ensures their commitment to the long-term success of the company.

Lastly, vesting also protects the other founders, investors and potential investors from share dilution. For instance, if a founder with 40% of the company’s shares is allowed to leave with an absolute right over his equity, more shares will be issued to the person who may then be appointed as their replacement. This leads to the dilution of shares of all equity holders, making it one of the reasons why potential investors always insist on having a vesting schedule for the founders.

The Ideal Vesting Schedule

Vesting is usually done at an early stage when equity is allotted to the founders. The most commonly recommended schedule is that of 4 years with a one-year cliff. This means that no shares are vested up front for 1 year after which there is a cliff during which a large number of shares vest together. After the cliff, the remaining shares continue to vest as per schedule.

The ideal period is of 4 years which is generally preferred by venture capitalists. Anything below 4 years may not be enough to convince them of the commitment of the founders. With a one year cliff, a period of maximum safety is created for the venture capitalists during the first year of the company’s operations.

Other than this, from the perspective of the founders, it is always beneficial to have monthly vesting of shares rather than quarterly, as some shares get vested every month rather than after a long period of time.

This article is authored by Ananya Vajpeyi, fourth-year law student at Jindal Global Law School and Board Member at LEC