Vested Equity Startup - Funding Startups, Stock & Vesting

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Startup Equity & Vesting: Paying Employees without Money

The period of time immediately after a company’s inception, may not be the most profitable. And whatever funds generated would need to be reinvested to grow the business. So how are startup founders and key employees to be paid?

That’s where the term vested equity startup may start floating around.

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Compensating employees and founding partners, during the startup phase for any business, can be a sticky situation. That’s where a company equity grant or some stock units can be used to keep the founding team members and startup employees satisfied in the short term. All while keeping them committed to the long term goals of the establishment.

These terms may be a bit confusing and the process itself may be complex. So let’s discuss and simplify.

Common Terms Used in Vesting Agreements

In order to fully understand the details associated with cashless compensation and vested equity startups, lets break down all the terms:

What is Equity in Business?

Equity is the level of ownership a party (person or firm) has in a particular company. It’s basically the amount of money that would be obtained, by a shareholder, if all company assets were sold off and debts settled.

What is Stock?

Stock is a representation of a fraction of ownership in a particular company. Owning company stock essentially means that you possess an ownership certificate for a piece of that company.

What are Shares?

Even though the term stocks and shares are used interchangeably during casual conversations, there is a difference. “Stock” is the actual asset that you have under your name, representing your degree of ownership in a company. “Shares” is the unit of measurement used to describe company stock.

For example, a startup founder may receive an equity grant of 100 stock units. Or 100 shares of company stock in other words. In turn they’d describe their level of ownership as being 100 shares, not 100 stocks.

What is a Shareholder?

A shareholder is an organization, or an individual person, that has invested money into a company by purchasing a fraction of the ownership. Ownership of a portion or “share” of an organization, translates to being a shareholder.

Different Types of Stock

Even though all types of stock represent ownership of a fraction of a company, there are a few differences in exactly what they represent and how they work.

1. Common Stock

Common stock or ordinary stock is the most basic form of equity ownership in a company. Owning common shares gives shareholders voting rights.

Owners of common stock are allowed to vote at shareholder meetings and they are entitled to receive dividends, in some companies.

Payouts to common stockholders are prioritized after owners of “preferred stock.” This means that dividend payments are not guaranteed to common stock owners. As a matter of fact, some companies opt to never pay dividends to owners of common stock.

Also, in the event the company’s assets are liquidated, common stockholders are last in line to receive payments after creditors, bondholders and preferred stockholders.

2. Preferred Stock

Preferred stock owners are not allowed to vote at shareholder meetings. However, their payments are prioritized over owners of common stock, in the case of dividends or liquidation of company assets.

3. Convertible Preferred Stock

Convertible preferred stock are preferred stock units that have an option to convert into a certain number of common stock. The option to convert becomes active beyond a stipulated date.

Additional Types of Stock

Common and preferred stock can also be classified into the following categories:

1. Restricted Stock

Restricted stocks are company shares, that have restrictions tied to them. They can be common or preferred but there are rules and restrictions associated with its transfer or sale.

2. Founder’s Stock

Founder’s stock is the general term used to describe the shares given to startup founders of the company. These can also be common or preferred.

3. Income Stock

Income stocks are those that generate dividends on a routine basis. Investors value them for their constant income generating benefits.

More often than not, they would be preferred shares. However, they could also be common shares in certain companies, that pay dividends to common shareholders.

Shares from a well seasoned, profitable, non-government owned utility company, that has been around for years, are a good example of income stock.

4. Growth Stock

Growth stocks are relatively long term investments, where buyers purchase them for their appreciation potential. These stocks tend to grow in value faster than the market average at the time of purchase.

Stock of startup companies are often viewed as growth stock. Investors are lured in with the potential the company offers, and buy in with the hope of aggressive capital growth. Earning stock dividends are unlikely in these instances.

5. Value Stock

Value stock are stocks that are offered as a good deal. The technical rationale is that they have a low price to earnings (PE) ratio. They are priced low and have good income earning potential.

Value stock could be classified under the categories of income stock or growth stock, depending on how money is earned by investors.

Usually, value stocks are created when an industry-wide shift in investment strategies cause certain company stocks to lose popularity. Some investors pounce on this with the hopes of a comeback.

6. Blue chip Stock

Blue chip stocks are established, proven stocks, that have stood the test of time. They are shares in reputable, solid companies, that have been around for several years and have a successful business history.

What are Dividends?

Dividends are a portion of a company’s profits that are distributed to its shareholders under the discretion of the company’s board of directors. It may be paid annually, or quarterly, in the form of cash or additional stock known as stock dividends.

Owning shares in a company does not directly guarantee that dividends would be earned. Firstly, it depends on the type of stock owned and the benefits that comes with it for that specific company.

In some cases, company profits for a given year, or quarter, may be used to tackle losses incurred over previous periods. As for startups, profits would be reinvested so payouts of cash dividends are quite uncommon.

In order to reward investors without losing cash, the concepts of stock vesting and equity grants are utilized. As for a new company, that’s where the idea of a vested equity startup comes into play.

Time based vesting agreements and stock grants are used by the largest multinational corporations, all the way down to localized medium sized enterprises. It’s a strategy to safeguard company assets, while boosting investor morale, by celebrating the company’s success without spending cash upfront.

Stock Vesting and How Vested Equity Startups Work

Vesting, or stock vesting, is the process where an investor or recipient of a stock grant gains ownership of a quantity of shares over time. The equity ownership that comes with the assignment of stock units to their name, activates over a predetermined time period, known as a vesting period or vesting schedule.

Stock vesting works as a form of rewards program. Key employees receive incentive stock options, in the form of a stock based equity award, that materializes over time. This inspires them to stick along with the company and to continue their high performance on a long term basis.

In the case of newer establishments, startup founders of the company can be compensated similarly. These are vested equity startups!

Startup investors are rewarded with an equity grant in the form of company stock. According to the vesting schedule, all or some of the stock may become active, only after a certain amount of time has elapsed.

For example, the first 25% of stock may be vested after 1 year, with the subsequent shares being vested at that same rate afterwards. This means that if a grant of 100 shares are received today, based on a four year vesting schedule, it would take 4 years for all 100 shares become fully vested.

Even though the recipient would be happy to have received the award today, they wont be able to sell the first 25% of shares until a year has passed. They’d also have to wait 4 years before they can officially be able to liquidate all of them, if they wish to do so.

This is probably the most typical vesting schedule out there, but details can vary from one organization to the next.

What is a Cliff Period?

The time taken for the first batch of stock equity to be vested, or officially released to an employee or investor, is known as a cliff period. Most companies structure their vesting schedule around a one-year cliff. This means that recipients undergo a 1 year probationary period before they get their equity ownership.

In many cases, if an employee or founder leaves or parts ways with the company prior to that one year period, or one-year cliff, they receive nothing. If they go their separate ways with any unvested shares, still to be released to them, they forfeit this unvested equity. That is, unless an acceleration process is activated. We’d discuss this concept later on.

A vesting agreement or vesting scheme lays out the specifics of the vesting cliff period and other specific milestones. This can vary from one company to the next based on the incentive stock options that they provide.

Types of Vesting Schedules

There are several types of vesting schedules and equity agreements that may be offered to co-founders or as part of an employee stock option plan.

Immediate Vesting Schedules

For an immediate vesting schedule, all benefits are immediately active upon initial receipt. There is no waiting period for ownership equity.

Graded Vesting Schedules

A graded vesting schedule is where a fraction of equity is released ever so often. Full ownership of the asset occurs after a specified time period.

Cliff Vesting Schedules

A cliff vesting schedule is one of the most common types of vesting schedules. With this agreement, employees receive a lump sum after a stipulated time period or milestone and small portions are then vested incrementally. Eventually, 100% ownership of the asset would be granted.

The initial hurdle that needs to be conquered is the cliff. Cliff vesting can be:

Time-Based Vesting

Employees are granted their equity over time.

Performance-Based Vesting

Certain performance criteria need to be met and kept at a high standard in order for equity to be vested.

Milestone-Based Vesting

A project may need to be completed or business goals achieved prior to equity benefits being released.

Hybrid Vesting

Equity is received after a given time period has elapsed and business goals have been achieved.

Advantages of Vested Equity for an Early-Stage Startup

Offering incentive stock options and time-based vesting has several benefits when it comes to startup companies.

1. Compensates Co-Founders and Investors

Vesting ties co-founders and investors to the company for the long haul. It ensures that they receive compensation and a taste of ownership equity, while binding their interest towards the company. They would be forced to prioritize company growth for a few years to come.

2. Offers an Incentive to Key Employees

High performing employees can be rewarded with a number of shares for their dedication towards company growth. Since stock vests over several years, they would be inspired to stay on with the company.

3. Safeguards Company Assets

By offering vested equity and stock grants, instead of immediate cash payouts, company assets can be preserved over time. Cash can be reinvested and prioritized towards growing the business.

4. Promotes Long Term Commitment to Company Growth

Founders, investors and employees can enjoy being rewarded and compensated for their efforts in the short term, while being motivated to work on expanding the company business, over the long haul.

Disadvantages of a Vested Equity Startup

1. Less Attractive to Angel Investors

Angel investors are private investors that provide financing to smaller scale business startups, with the intention of obtaining ownership equity in return.

Vested equity is usually less enticing to them, as they prefer to invest when they can receive their equity upfront and fully vested.

2. Complicated to Manage

The details associated with stock grants and vesting can be very time consuming and tough to manage. Many larger companies opt to outsource management to third party service providers such as Fidelity Investments.

The actual control of determining and announcing the unvested shares that are to be distributed to the employees, founders and investors still depends on the company’s local management team.

3. Poses Some Cost Associated Risks

The process can be costly for employers, if employees leave prematurely, with unvested stocks still in their portfolio.

4. Can Cause Inter-Employee Tension

Employees that receive stock grants may compare awards with each other. Since there is a direct monetary value assigned to each grant, some employees may feel undervalued or mistreated when compared to their peers. This may be counter productive and actually result in disgruntled employees.

Compensating Co-Founders in a Vested Equity Startup

Capturing certain details and entering the right co-founder agreement, when starting up a business, is vital! This safeguards the interests of all involved, including the actual company assets, founders, employees and potential investors.

Employees resign and sever ties with companies every day. The same applies to founding partners. A founder may decide to leave soon after a company gets going. If a founder decides to circle back to the company, years later, and make demands regarding compensation…this could be catastrophic. Lawsuits are not cheap!

Establish a co-founder agreement from day one!

What is a Co-Founder Agreement?

A co-founder agreement is a legal document that contains clauses regarding the compensation of co-founders under different conditions and time frames.

These agreements also include terms and conditions for the company to buy back shares from a co-founder in the case of a premature departure from the company. It also lays out additional benefits for founders, for their long term commitment to the organization.

Typically, for founder departure prior to being fully vested, they do receive the shares promised to them. The overall number of shares, that account for the company’s total equity, is then reduced, while the share value for each remaining share increases.

Company Acquisition and Co-Founder Compensation

An acquisition is the term given to the transaction when one organization purchases, or legally acquires (some or all of) another organization’s assets or shares.

If a company is acquired prior to co-founder shares being fully vested, the vesting period would undergo acceleration. Vesting period acceleration can be either single trigger acceleration or double trigger acceleration.

Single Trigger Acceleration

Single-trigger acceleration is a full or partial acceleration of vested equity in the case of a single triggering event. Examples of a triggering event include company sale (or acquisition) or involuntary employee termination.

Double Trigger Acceleration

Double-trigger acceleration is the acceleration of vested equity in the case of a two simultaneous triggering events. This can be company acquisition, paired with involuntary termination of an employee.

Double trigger acceleration is often used when companies are sold and the purchasing company desires a restructure to the acquired company’s board of directors and partners.

Compensating Employees in a Vested Equity Startup

For the most part, the same rules that govern co-founder compensation, also apply to employees when it comes to vested equity. Additional details may be tweaked and outlined in an employee agreement, as decided by the company’s board or directors.

Unvested equity or stock grants are often lost when employees are terminated.

Frequently Asked Questions for Vested Equity Startup

FAQ: What is the Most Common Vesting Schedule?

The most common vesting schedule is a four year period, with a one-year cliff. An employee must remain with the startup company for at least one year before receiving any equity.

After the first year, the first fraction vests and the remaining amount is fully vested by the end of the fourth year.

FAQ: What is Right of First Refusal?

Right of first refusal is the legal authorization for a person or company to conduct a business transaction with another party, before anyone else is allowed the opportunity to do so.

The ROFR holder is contractually allowed to refuse an offer or match an offer on an asset, before anyone else is allowed to.

FAQ: How does a Company Determine the Value of its Stock?

The fair market value of a company’s stock is determined by hiring a licensed, third party stock valuation company.

FAQ: What is Title Vesting?

Title vesting is more geared towards real estate, and is not to be confused with company stock and equity. Title vesting refers to the legal details associated with a property, such as the owner or owners, if/how/when it can be sold and who is responsible for covering the relevant taxes.

Final Thoughts on Startup Equity and Compensating Employees

Now you know exactly how vested equity works and how company personnel can be compensated without cash. The strategy is great for startup companies and established ones alike, as it safeguards company assets.

Do you have any other comments or advice on vesting, equity and employee compensation for startups? Share with us in the comments below. We’d love to hear from you!

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