INTRODUCTION
Every new business starts with limited access to precious money that needs to use for maximum utilization. Simultaneously, every new business or startup needs a dependable and robust workforce for the business to succeed. One of the ways to reward your workforce, ensure that they remain dedicated to the new business, and save cash is through the process of vesting.
WHAT IS VESTING?
Vesting is a legal process through which a person in the startup ‘earns’ or
acquires a full right on the company’s stocks or stock option. No third party or company can take it away from that person.
BENEFITS OF A VESTING SCHEME
- Protection of your new business – Amongst many reasons for a startup to fail, founders or key employees leaving the company at its initial stage is one of the main reasons. Some people leave the startup because it is too stressful, risky, and challenging. Some lose faith in the company’s vision. Some face unexpected personal challenges such that they cannot continue working for the company. A vesting scheme protects the business from these departing members since they cannot take away the unvested equity. Example – Imagine two friends start a business together, and each receives 50% of the company’s equity. One of them leaves the company after a few months. Without any vesting scheme, the departing founder will still own his/her/it 50% of the shares, and the associated voting rights. If the business is successful or sold, the departed founder enjoys the profits. The departed founder might not take all 50% shares with a vesting scheme until the vesting scheme completes.
- Vesting schemes incentivize founders and employees to stay longer with the startup – because most of the vesting schemes vest the equity shares on a monthly or yearly basis, the scheme motivates the founders and employees to stay longer with the startup.
- Vesting schemes attract investors and add to the company’s value – Once the company is set up, the company is looking for investment for its growth. Most professional investors demand stock vesting provisions for the founders and employees because then the founders or employees are unlikely to leave. Such arrangements mean the company’s equity will be protected from departing members, which means that investors’ investment is safe. This stability provided by the vesting schemes also adds value to the startup when other companies acquire it.
VESTING SCHEDULE
Vesting is achieved through a vesting schedule that defines when and how much of the company’s stocks or stock options will be distributed to the parties in the startup. Vesting schedules that are too long are unattractive for the employees, and vesting schedules that too short jeopardize the startup’s protection. Generally, startup companies use –
- Cliff vesting – A cliff period refers to the period in which no stocks or stock options are granted to the employees or founder. It is a sort of a cool-off period before the vesting process starts. Generally, startups’ cliff period is one year. The idea is that one year period is too short for accounting for any long-term results from the employees’ services. Therefore, it would be unfair for an employee who lasted less than a year to have long-term ownership in the company. So, if a startup decides one year as the cliff and a partner or an employee leaves the startup in the 10th month, they will not receive any stocks or stock options.
- Graded vesting – An employee or founder will only receive the stock or stock options they have ‘earned’ or ‘gained’ in equal portions over a certain period. Suppose the vesting period is for four years without any cliff, with vesting on a monthly basis. Therefore, all the stocks or stock options are divided into 48 portions. In this case, the employee earns a percentage of shares every month that they work.
VESTING SCHEMES –
Apart from the salaries earned, there has been a recent trend of rewarding employees hard work through Stock Option Plans. The most common vesting process is where stocks or stock options are vested either on a monthly or annual basis for a period of four years with a one-year cliff period, starting from the employee’s entry date. Similar vesting schemes can be used for consultants, directors, and advisors of a startup. Again, the founder’s vesting scheme is similar to employees’ vesting scheme. However, unlike the employees’ vesting scheme, founders might receive specific percentages of the stocks upfront when signing the Founder Agreement. Furthermore, in the case of a company’s acquisition or merger, vesting is accelerated for the founders and sometimes for the key employees.
TAX CONSEQUENCES OF THE VESTING STOCKS –
For tax purposes, restricted stocks (stocks that are forfeitable) granted to an employee are considered as income when the vesting schedule is completed. The taxable income is determined by the fair market value on the date when stocks become fully vested, subtracted by the original purchase price of these stocks (which can be zero). However, such shareholders also have an option of Section 83(b) election. Under this option, instead of reporting the income on the day shares become vested, a recipient of the restricted stocks can choose to declare the fair market value of the restricted stocks on the day they are granted. This option is advantageous because stock prices are generally lower when granted compared to when they are vested. However, suppose the recipient leaves the employment before the stocks become fully vested, and therefore, loses all stocks’ rights. In that case, the recipient will be unable to recover the income tax paid on those stocks.
CONCLUSION
Setting up a vesting scheme can be crucial for a business’s success. However, there is no thumb rule for the best vesting schedule for a business. It depends on various considerations like the type of business, the number of people involved, and its end goal. Nevertheless, the underlying factors to consider are incentivizing the employees, protecting the company’s equity, and balancing business finances.
SOURCES –
https://jiahkimlaw.com/startup-planning/vesting-important-startup-founders/
https://www.cleverism.com/why-do-startups-fail/
https://www.investopedia.com/articles/tax/09/restricted-stock-tax.asp
https://latamlist.com/founders-agreement-first-steps-before-starting-a-business/
Photo Sources –
https://fi.co/insight/startup-equity-vesting-how-to-compensate-team-members-without-money
https://www.sec.gov/Archives/edgar/data/1037038/000095012305008114/y10404exv10w26.htm