What is vesting?

This is a form of reward that an employee is eligible for only after he or she has met the terms of the vestment. It can come in the form of a stock option or pension. Whatever it is, the receiver can only lay claim to the asset in the future after the conditions are met. But vesting is not only applicable to employees, founders can also be vested. In this article, I will talk about the pros and cons of vesting, why it is being done, and the different types of vesting. 

Types of vesting models

There are three types of vesting models, there are; Time-based vesting, Milestone vesting, and Hybrid vesting. 

Time-based vesting

In time-based vesting, the beneficiary is eligible to receive the vested asset (either a stock option, a 401K, or some other monetary compensation) over time. This type of vesting is usually done using a schedule or a Cliff period. In scheduled time-based vesting, the beneficiary is given a percentage of the vested asset in a monthly or quarterly increment over the specified period of time. In the cliff method, the beneficiary will have to spend a fixed amount of time (known as a cliff) working for the company before they are eligible to start receiving a percentage of the vested asset. 

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Milestone vesting

In this model, the beneficiary has to be employed with the company until the specific milestone is achieved before exercising their vested option. These could be a task or sets of objectives. In a situation where a hybrid model is used, the employee has to fulfill both the time duration and also achieve the specific milestone. The milestone vesting model can be applied in sales. In this case, an employee would be eligible for a certain percentage of the vested asset when they achieve or unlock specific sales milestones.

Hybrid vesting

When you combine both time-based vesting and milestone vesting, you get hybrid vesting. In essence, the beneficiary of a vested asset would be bound by both time schedule and a set of objectives or tasks to be accomplished. If this sounds complicated, that’s because it is. Hybrid vesting is rare but still being practiced. 

Founders vesting

In their early days, startups are usually strapped for cash. So the best way to compensate its founders is through equity. By having a share of the company to their name, founders are guaranteed a percentage of the company’s profit should it become profitable in the future. But what happens if the founders decide to pack up and leave? Well, that's where vesting comes in. The vesting clause as it applies to the founder’s share means that a founder can only leave with 100% of his or her shares only after a specific time period or milestone has been accomplished. 

Time-based vesting is usually for a period of 3 to 4 years. If a founder should choose to leave before this time, then the company will claim back the percentage of shares not earned based on the vesting clause. That is to say if the vesting clause applies for 4 years and a founder chooses to leave after spending just 2 years with the company. Then they are entitled to 50% of their original shares. The remaining 50% will be reclaimed by the company. 

Employee vesting

This is similar to the founder vesting except in this case it could either be a stock option or cash (pension or retirement benefit). Either way, the company stipulates a specific time for which an employee must remain employed with the company in order to be eligible for 100% of the vested asset. Founders use employee vesting as an incentive to avoid employee turnover. Should an employee decide to leave the company for a new one, he or she may want to exercise vested options before doing so. 

What is the importance of Vesting?

Vesting can be used as an incentive to boost employee morale by encouraging them to work towards a set target. Apart from this, vesting can also be used in retaining employees. In a startup, employee compensation may not be comparable to the work being done. In such a case, founders can compensate their employees and gain their loyalty by offering them vested share options commonly known as employee stock options (ESOs). 

Vesting also guarantees investors that the founder would not bail out on them after they have invested in the company. As such, it is not uncommon to see a vested schedule in contracts drafted out by Venture capitalists as part of an investment agreement. This might seem outrageous at first but here is quick math showing why this is important. 

Example;

Let’s say startup A has two co-founders who both hold 40% of the company. Now, they can both decide to sell the remaining 20% of the company shares to investors in order to raise capital. But having shareholders also means that the cofounders aren’t making decisions all on their own. The investors now have a say and sometimes, there are disagreements that could lead to one of the co-founders leaving the company.

Assuming his stocks aren’t vested, that means the cofounder (who is leaving) will take with him 40% of the company stocks. This will leave the investors and remaining cofounder short-handed and they would have to sell their stocks to finance the startup. But if the stocks are vested, then the cofounder will have to remain with the company for the duration of the vesting or lose their stocks. In summary, a founder's vesting affords the investors some security similar to how employee vesting affords the employer some security.