What are vesting schedules and how do they work?
Marc Hoag via Midjourney
This is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.
Understanding the vesting schedule for shares and options is crucial for both founders and key team members. This guide aims to offer a comprehensive overview of what a vesting schedule is and why it matters.
1. What is a Vesting Schedule?
A vesting schedule outlines how and when company shares or options are distributed over time to employees or founders. It serves as a commitment mechanism, ensuring that key players are invested in the company's long-term success.
2. Types of Vesting Schedules
Cliff Vesting: No shares vest until after a specific period, commonly one year.
Graded Vesting: Shares vest gradually over time.
Accelerated Vesting: Shares vest faster under certain conditions, like an acquisition.
Reverse Vesting: Founders or key employees already own their shares but agree to "sell" them back to the company if they leave before a specified period.
3. Length of Vesting Schedule
The length of a vesting schedule is the period over which the shares are subject to vesting. A common duration is four years, although this can vary between three to five years. Sophisticated investors often expect a longer vesting period to secure their investment.
The vesting commencement date marks the start of the vesting schedule. For founders, this can sometimes be backdated to credit time already spent on the startup. For example, if founders began working on the startup on June 1, 2016, but didn't issue shares until January 1, 2017, the vesting could commence from June 1, 2016. All shares would then be vested by June 1, 2020.
4. Frequency of Vesting
Shares can vest either monthly or quarterly after any initial cliff period. For instance, on a four-year schedule with monthly vesting, 1/48 of the shares (around 2.08%) would vest each month. With quarterly vesting, 1/16 (or 6.25%) of the shares would vest every quarter.
Cliff: A period (often one year) must pass before any shares vest. Once reached, a significant portion vests at once.
Straight Line: Shares vest evenly and immediately from the vesting commencement date until the end of the vesting period.
5. Upfront Vesting
While uncommon, some shares can be vested upfront, especially to credit founders for time spent before the company was formally established.
Example: Assuming 5 million shares granted on January 1, 2018, with a commencement date of July 1, 2017:
Four-year, monthly, one-year cliff: No shares vest until July 1, 2018, when 1.25 million shares vest. The remaining 3.75 million shares vest monthly until July 1, 2021.
Four-year, monthly, straight line: Shares vest in 48 equal monthly installments, ending on July 1, 2021.
Five-year, quarterly, one-year cliff: No shares vest until July 1, 2018, when 1 million shares vest. The remaining 4 million shares vest quarterly until July 1, 2022.
Five-year, quarterly, 20% upfront: 1 million shares vest immediately, and the remaining 4 million shares vest quarterly until July 1, 2022.
💡When vesting restrictions are agreed to, it’s almost always to the founders’ benefit to file an 83(b) tax election. You can learn more about it here.
Understanding the intricacies of vesting schedules is essential for both startup founders and investors. It’s not merely a contractual obligation but a strategic tool to align interests and protect the company’s future.