Vesting Shares: A Complete Guide for Entrepreneurs

3rd July 2023
If you’re an entrepreneur, you’ve probably heard of ‘vesting’ and ‘vesting shares’. But what exactly does it mean, and how can it benefit your startup?

In this article, we’ll explain the concept of vesting in detail and explore how entrepreneurs can use it to attract and retain top talent.

Jump to the following sections:

What are vesting shares? A definition

Vesting shares are equity compensation that has become increasingly popular in recent years. Essentially, they are company shares granted to an employee but only wholly owned by the employee once certain conditions are met.

These conditions are typically related to the employee’s continued employment with the company and may include a certain length of service, meeting performance goals, or other criteria.

Vesting shares are an essential tool for both employees and employers, as they help to align the interests of both parties and create a sense of shared ownership in the company. In this article, we’ll explore how vesting shares work, the benefits they offer for employees and employers, and the risks and considerations that should be considered when negotiating a vesting agreement.

Related:What Are Preferential Shares? A Startup’s Guide

Vesting shares: the concept explained

At its core, vesting is a way of structuring equity compensation so that employees become entitled to their shares over time. This means that instead of receiving all of their shares upfront, employees must work for a certain period or achieve specific performance goals to earn their shares.

The idea behind vesting is to incentivise employees to stay with the company and work toward specific goals. By offering equity compensation that vests over time, employers can encourage employees to work harder and achieve better results, which can be especially important in the early stages of a startup when every employee’s contributions can make a big difference in the company’s success.

Vesting schedules

One common way of structuring vesting is to use a vesting schedule. A vesting schedule outlines the conditions under which employees become entitled to their shares. For example, a vesting schedule might specify that an employee becomes entitled to 25% of their shares after one year of employment, with the remaining 75% vesting over the following three years.

How do vesting shares work

At its core, the concept of vesting is relatively simple. When an employee is granted vesting shares, they are given the right to purchase or receive a certain number of shares of the company’s stock at a set price, typically called the grant price.

However, the employee only fully owns these shares once certain conditions are met. These conditions are spelt out in the vesting agreement, a legal document that outlines the terms of the arrangement.

Time-based or graded vesting

The most common type of vesting schedule is time-based vesting. This means that the shares vest over a period of time, such as four years. During this time, the employee gradually gains ownership of the shares, typically on a monthly or quarterly basis. For example, if an employee is granted 1,000 shares that vest over four years, they might gain ownership of 250 shares after one year, 500 shares after two years, and so on.

Performance-based or milestone-based vesting

Another type of vesting schedule is performance-based vesting, which means that the shares vest based on achieving specific performance goals. For example, an employee might be granted 1,000 shares that vest only if the company meets a particular revenue target or reaches a certain level of profitability. This type of vesting can be more complex to set up and administer, but it can be a powerful tool for aligning employee and company goals.

Cliff vesting

This means that the shares vest all at once after a certain period. For example, an employee might be granted 1,000 shares that vest in full after three years of service. This type of vesting can be riskier for employees, as they may only receive ownership in the company once the vesting cliff is reached.

What are vesting shares used for?

As a founder, using vesting shares can be a smart move to attract and retain top talent, incentivise employees, and align company and employee goals.

Here’s a more detailed explanation of how and why a founder might use vesting shares:

Attracting and retaining top talent

One of the biggest challenges that many startup founders face is attracting and retaining top talent. This is especially true in highly competitive industries where there is a need for more skilled workers.

Offering vesting shares as part of a compensation package can be an effective way to attract and retain top talent. By offering a stake in the company’s success, founders can provide employees with a sense of ownership and motivate them to work harder to achieve the company’s goals.

Incentivising employees

Vesting shares can also be used to incentivise employees to stay with the company and work toward specific goals. For example, a founder might structure a vesting schedule so that employees become entitled to more shares as they reach certain milestones or achieve particular performance goals.

By doing so, the founder can incentivise employees to work harder and achieve better results. This can be especially important in the early stages of a startup, when every employee’s contributions can make a big difference in the company’s success.

Aligning company and employee goals

Another benefit of vesting shares is that they can help align company and employee goals. When employees have a stake in the company’s success, they are likelier to work toward the same goals as the founder and other stakeholders.

This can be especially important when the company pursues a long-term strategy that requires a significant investment of time and resources. By aligning employee and company goals, founders can ensure that everyone is working toward the same objectives and that the company is moving in the right direction.

Reduce cash compensation costs

Using vesting shares as a compensation component can also help founders reduce cash compensation costs. By offering a stake in the company’s success, founders can offset lower salaries and other benefits.

This can be particularly attractive for cash-strapped startups trying to conserve their resources while still attracting and retaining top talent. By offering equity compensation, founders can provide employees with a financial incentive to work hard and help the company succeed without breaking the bank on cash compensation.

Protecting the company’s interests

Finally, understanding vesting shares is important because it can help entrepreneurs protect the company’s interests. By using vesting shares, entrepreneurs can ensure that employees who leave the company early forfeit their unvested shares, which can help prevent them from taking valuable equity with them when they depart.

Vesting shares: a tall tale

This short hypothetical story helps to illustrate how vesting shares might be used:

Alex is a startup founder. She needs help attracting and retaining top talent for her company. She knows that in order to succeed, she needs a team of dedicated and talented employees who are willing to work hard and help the company grow.

After some research, Alex learns about the benefits of using vesting shares as part of a compensation package. She realises that by offering employees a stake in the company’s success, she could give them a sense of ownership and motivate them to work harder.

Alex decides to offer vesting shares to her employees and structure a vesting schedule so that employees are entitled to more shares as they reach certain milestones or achieve specific performance goals. This incentivises her employees to work harder and achieve better results, which in turn, helps the company grow.

By offering equity compensation, Alex also reduces cash compensation costs (salary), which was particularly important for her startup, where every penny counts. This allows her to incentivise her employees without breaking the bank with cash compensation.

Ultimately, Alex’s use of vesting shares helps her attract and retain top talent, incentivise employees and align company and employee goals. Her startup grows and succeeds, and all the while, she knows that it wouldn’t have been possible without the hard work and dedication of her motivated and engaged team.

Examples of vesting shares in compensation packages

There are several ways that vesting shares can be used in compensation packages to incentivise and reward employees for their contributions to the company’s success.

Equity grants

One common way to use vesting shares in compensation packages is through equity grants. This involves granting employees a certain number of shares in the company that vest over time. For example, an employee might be granted 10,000 shares of stock that vest for four years, with 25% vesting after the first year and the remaining 75% vesting monthly over the following three years. This gives the employee a stake in the company and incentivises them to work hard and contribute to its success.

Stock options

Another way to use vesting shares in compensation packages is through stock options. This involves granting employees the option to purchase a certain number of shares of the company’s stock at a fixed price, known as the exercise price. The options typically vest over a period of time and can be exercised at any time after they vest. For example, an employee might be granted stock options to purchase 5,000 shares at an exercise price of $10 per share that vests for four years.

Restricted stock units

Restricted stock units (RSUs) are another type of equity compensation that can include vesting provisions. RSUs are similar to equity grants, but instead of receiving actual shares of stock, employees receive units that represent a promise to deliver a certain number of shares of stock at a later date. The units typically vest over a period of time and are settled in cash or shares of stock when they vest.

Performance-based vesting

In addition to time-based vesting, compensation packages can also include performance-based vesting provisions. This means that the vesting of shares is tied to specific performance metrics, such as achieving certain revenue or growth targets. For example, an employee might be granted 5,000 shares that vest based on achieving particular revenue targets over the next three years.

The specific type of equity compensation and vesting provisions will depend on the company’s goals, culture and financial situation.

Vesting shares: employee benefits

Vesting shares provide several benefits for employees, including ownership stake, financial rewards, alignment with company goals, retention and tax benefits.

Ownership stake

Vesting shares give employees a sense of ownership and stake in the company’s success. When employees have a vested interest in the company’s performance, they are more likely to work harder and stay with the company for more extended periods.

Financial rewards

As the company grows and becomes more valuable, the vested shares can appreciate in value, providing a financial reward for the employee’s hard work and dedication. This can also motivate employees to work harder and contribute to the company’s growth.

Alignment with company goals

By offering vesting shares, companies can align the interests of their employees with the company’s goals. When employees have a stake in the company’s success, they are more likely to work towards the same goals as the company, creating a more cohesive and productive team.

Retention

Vesting shares can also help retain talented employees by making it more difficult for them to leave the company. If employees leave before their shares vest, they forfeit their unvested shares, which can deter them from considering leaving the company.

Tax benefits

In some cases, vesting shares can provide tax benefits for employees. For example, stock options can offer tax advantages if exercised when the stock price is higher than the exercise price.

By offering vesting shares, companies can attract and retain top talent, motivate employees to work harder and create a more cohesive and productive team that is aligned with the company’s goals.

Potential tax advantages of vesting shares

Vesting shares can offer potential tax advantages for employees and employers, depending on the type of shares granted.

For example:

Incentive Stock Options (ISOs)

ISOs are a type of vesting share that can offer tax advantages for employees. When an employee exercises an ISO, they do not owe any regular income tax on the spread between the exercise price and the stock’s fair market value at the time of exercise. If the employee holds the stock for at least two years from the grant date and one year from the exercise date, they will only owe long-term capital gains tax on any profit from selling the stock.

Restricted Stock Units (RSUs)

RSUs are another type of vesting share that can offer tax advantages for employers. When RSUs vest, the company can settle the shares in either cash or stock. If the company pays in stock, it can take a tax deduction equal to the fair market value of the shares at the time of settlement. This can help reduce the company’s tax liability.

Non-Qualified Stock Options (NQSOs)

NQSOs are a type of vesting share that do not offer the same tax advantages as ISOs. When an employee exercises an NQSO, they owe regular income tax on the spread between the exercise price and the stock’s fair market value at the time of exercise. However, if the employee holds the stock for at least one year from the exercise date, they will only owe long-term capital gains tax on any profit from selling the stock.

It’s important to note that the tax implications of vesting shares can be complex, and it’s recommended to consult a tax professional to fully understand the tax implications for both employees and employers.

Vesting shares: employer benefits

Employers can also benefit from offering vesting shares as part of their compensation packages.

Attract and retain top talent

By offering vesting shares, employers can attract and retain top talent who are motivated by the potential financial rewards and sense of ownership in the company. This can help the company build a strong team that is committed to the company’s success.

Motivate employees

When employees have a vested interest in the company’s success, they are more likely to be motivated to work harder and contribute to the company’s growth. This can lead to increased productivity and better business results.

Align employee interests with company goals

Vesting shares can align the interests of employees with the company’s goals, creating a more cohesive and productive team. When employees have a stake in the company’s success, they are more likely to work towards the same goals as the company.

Cost-effective

Compared to cash bonuses, offering vesting shares can be a more cost-effective way to incentivise employees. While cash bonuses are typically paid out immediately, vesting shares are granted over time, which can help manage cash flow and reduce the company’s expenses.

Long-term focus

Vesting shares encourage employees to take a long-term view of the company’s success. By tying the vesting of shares to specific performance metrics or time periods, employees are motivated to work towards long-term goals that can benefit the company over time.

Risks and considerations for employees

While vesting shares can offer potential financial rewards for employees, there are also some risks and considerations to keep in mind:

Risk of stock price decline

When employees receive vesting shares, they bet the company’s stock price will increase over time. However, there is always a risk that the stock price could decline, resulting in the shares being worth less than the employee initially anticipated.

Limited diversification

When employees receive vesting shares, they become heavily invested in the success of the company they work for. This can limit their diversification and expose them to more risk than if they had a more balanced investment portfolio.

Lock-up periods

Depending on the terms of the vesting agreement, employees may be subject to lock-up periods during which they cannot sell their shares. This can limit their ability to access the cash value of the shares when they need it.

Taxes

As mentioned earlier, the tax implications of vesting shares can be complex and depend on the specific type of shares being granted. Employees need to understand the tax implications of their shares and plan accordingly.

Employment status

Vesting shares are typically granted to employees as part of their compensation package, which means that if the employee leaves the company before the shares are fully vested, they may forfeit some or all of their shares.

Risks and considerations for employers

While vesting shares can be a valuable tool for employers to incentivise and retain employees, there are also some risks and considerations to keep in mind:

Dilution

When a company issues new shares as part of a vesting agreement, it can dilute existing shareholders’ ownership stake. This might concern some investors and may impact the company’s stock price.

Administrative complexity

Managing a vesting program can be administratively complex, especially as the number of participants grows. Employers may need to hire additional staff or engage a third-party administrator to handle the day-to-day management of the program.

Financial impact

Depending on the type of vesting shares being granted, the company’s balance sheet or income statement may have a financial impact. For example, if the shares are settled in stock rather than cash, the company may need to account for the fair market value of the shares as an expense.

Compliance

Depending on the jurisdiction and type of vesting shares being granted, legal and regulatory requirements may need to be met. Employers should ensure that they are compliant with all applicable laws and regulations to avoid any potential legal or financial penalties.

Retention risk

While vesting shares can be a powerful tool for retaining employees, there is always a risk that an employee may leave the company before their shares fully vest. This could result in the company losing the intended benefit of the vesting program.

Can vested shares be taken away?

Once fully vested shares, they cannot be taken from the employee. However, there are circumstances under which the vesting schedule may be modified or accelerated, resulting in earlier vesting of the shares.

For example, if an employee is terminated without cause, the employer may choose to accelerate the vesting of the employee’s shares as part of a severance package. Alternatively, if the company is acquired, the vesting of the employee’s shares may be accelerated as part of the acquisition agreement.

On the other hand, if an employee voluntarily leaves the company before their shares fully vest, they may forfeit any unvested shares. This is often called ‘cliff vesting’, where an employee must meet a certain length of service requirement before any shares begin to vest (read more about cliff vesting above). If the employee leaves before that time, they may lose their right to any unvested shares.

Can vested shares be sold?

Yes, once shares have vested, they can typically be sold or transferred by the employee. However, the specifics of selling vested shares may depend on the terms of the vesting agreement and the type of shares being traded.

  • If the shares are publicly traded, they can be sold on a stock exchange or through a broker. The employee would need to place an order to sell the shares and follow the standard procedures for selling publicly traded shares.
  • If the shares are privately held, selling them may be more complex. The employee may need to find a buyer, negotiate a price, and follow procedures required by the company’s bylaws or shareholders’ agreement. Additionally, the company may have a right of first refusal, which means they have the option to buy the shares before they can be sold to a third party.

It’s essential for employees to carefully review the terms of their vesting agreement and understand any restrictions on selling their vested shares. Employers should also clearly communicate these terms to employees to ensure clarity and understanding.

Our advice: Seek advice!

It is imperative to seek professional advice when negotiating vesting agreements for several reasons:

Complexity

Vesting agreements can be complex and involve legal, tax, and accounting considerations. Professional advisors, such as lawyers, accountants, or financial planners, can provide guidance on navigating these complexities.

Customisation

Vesting agreements can be customised to meet the unique needs of the employer and employee. Professional advisors can help ensure that the contract is tailored to meet both parties’ specific goals and objectives.

Legal compliance

Depending on the jurisdiction and type of vesting shares being granted, legal and regulatory requirements may need to be met. Professional advisors can help ensure the vesting agreement complies with all applicable laws and regulations.

Tax implications

The tax implications of vesting shares can be complex and depend on the type of shares granted. Professional advisors can provide guidance on the tax implications of the vesting agreement and help employees plan accordingly.

Negotiation leverage

Professional advisors can provide guidance on the negotiation process and help employees navigate any issues or concerns that may arise. This can help employees feel more confident in negotiating and improve their leverage.

Overall, seeking professional advice when negotiating vesting agreements can help ensure that the agreement is customised and compliant and maximises the benefits for both the employer and employee.

Find out if your business would catch an investor’s interest and money in less than 5 minutes. Our free PitchReady™ Scorecard is proven to work and is 100% tailored to your business. Try it now!

UP NEXT:

In a Startup, How Do Shares, Equity, and Dilution Really Work?

The Three Essential Personality Traits of an Investable Entrepreneur

Raising Investment: Three Mistakes Investable Entrepreneurs Must Avoid

Recent Posts

Keep up to date with what we’re up to via email



    Copyright ©Robot Mascot Ltd. All rights reserved.

    2024-05-02T12:18:53+00:00July 3rd, 2023|Categories: Pitching, Advice|

    Title