vesting
Vesting is the term for the process whereby unexercisable employee equity agreements (like stock options) become exercisable. Before a stock option is "vested" it cannot be exercised by the employee. Though the stock option may be granted to the employee, the employee cannot exercise the option. Vesting usually proceeds according to a schedule, called the vesting schedule. Common vesting schedules for startup companies include 3-year or 4-year cliff vesting schedules. In these schedules the optionee receives no vesting until after the first full-year of employment, at that point 1/3rd of his or her options vest (for the 3-year plan) or 1/4th (for the 4 year plan) and regular, ratable monthly vesting begins for the remainder of the vesting period.
example: 4-year cliff vesting schedule
Optionee: Carol
Vesting at end of Year 1: 25%
Monthly vesting for each month thereafter: Add 0.208% / month (75% divided by 360 months--the remaining term of her vesting schedule)
Beneftis of vesting
While the benefits of vesting may not seem obvious, there are many reasons why vesting can be important and even critical. One of the major reasons for new business failure is that the founders have disputes or one founder leaves--see Starting a Business. Vesting helps to solve this problem by putting the interests of the company itself and its ongoing success ahead of the interests of any one individual founder or entrepreneur. Doing so will generally help the business to become more valuable over time benefitting all of the entrepreneurs. Because vesting stops when a founder leaves a company, vesting creates a number of positive incentives that help improve the chances of success for the business.
The specific benefits of vesting include the following:
- Incentive for founders to stick with a company even after they might otherwise give up
- Incentive for the founders to work hard to make a company more valuable
- The creation of an equitable means of dealing with a situation where one founder decides to no longer work, or work hard, for the success of the company
- Ability to properly incent a new replacement for a founder who has decided to leave
- Negation of the incentive for a departing founder to "free ride." This occurs when one founder leaves and the remaining founder(s) must work harder to pick up the extra slack without any additional equity reward, all while making the departing founder's equity more valuable.
Vesting