Vesting for Start-Ups

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16 Nov 2022

For start-ups that highly depend on a small number of team members (say, a founder and co-founder) for success, vesting is an important way to protect the business and increase sustainability. By providing a time-based vesting schedule, team members can ensure loyalty and long-term security.
A cliff period also ensures that the team members are entitled to no compensation if they leave before the set period of time.
Example
Consider a tech start-up where Alexa (the chief technology officer) owns 40% of the shares, Siri (the chief executive officer) owns 40%, and the remaining 20% are owned by a venture capitalist. Collectively, Alexa and Siri set up a time-based vesting scheme with a one-year cliff period.
If either of them leaves before the one-year period, they will not receive any of the 40% of shares entitled to them. If they leave after two years, they will receive 50% of the shares (that is, if Siri leaves after two years, she will receive 20% of the shares out of the 40% that are entitled to him). If they choose to stay for four years and leave after four years, they receive the full 40% of shares that are allocated to them according to the schedule.

Advantages and Disadvantages for Employers

1. Availability of cash

Stock options and equity are a form of compensation for employees and are also substitutes for cash bonuses and rewards. They enable the company to maintain a higher share of cash, which can be used to pay off current liabilities and in cases of emergency.

2. Lower employee turnover rate

By providing employees with the incentive of stock options that are triggered by time-based milestones, companies can ensure loyalty and long-term futures with certain talented employees that they wish to retain.

3. Terms of vesting

Harsh vesting terms may lead to the resignation/rejection of many high-caliber employees. Therefore, there must be thought, caution, and investment in designing a vesting contract.

4. Complexity of vesting schedules

Designing and executing vesting schedules requires time and effort from employees, which may have a high opportunity cost, especially if the schedules are not successful in incentivizing employees to stay.