Case Scenario: Vesting Ownership in Company Stock: A Sound Strategy for Start-Ups

If you're not familiar with vesting, the idea is that when a firm is launched, instead of issuing stock outright to the founders, the stock is distributed over a period of time, typically three to four years, as the founder or founders "earn" the stock. The same goes for employees who join the firm later and receive company stock. Instead of giving someone stock all at once, the stock is distributed over a period of time. The reason vesting is a smart move is that although everyone is normally healthy and on the same page when launching an entrepreneurial venture, you never know what might happen. You want everyone involved with the firm to stay engaged. You also want a way of determining the price of a departing employee's stock, if the firm has a "buyback" clause in its corporate bylaws and wants to repurchase a departing employee's shares. vesting provides a mechanism for accomplishing both of these objectives. A typical start-up's vesting schedule lasts 36 to 48 months and includes a 12-month cliff. The cliff represents the period of time that the person must work for the company in order to leave with any ownership interest.

Thus, if a company has a 48-month vesting schedule and offers 1,000 shares of stock to an employee, if the employee leaves after 10 months, the employee keeps no equity. If the employee leaves after 28 months, the employee gets to keep 28/48 of the equity promised, or 583 of the 1,000 shares. The shares will be issued at a specific price. If an employee leaves and the company is entitled to buy back the employee's shares, normally the buyback clause will stipulate that the shares can be repurchased at the price at which they were issued. vesting avoids three problems. First, it helps keep employees motivated and engaged. If the employee in the example mentioned in the previous paragraph received his or her entire allotment of 1,000 shares on day one, the employee could walk away from the firm at any point and keep all the shares. Second, if an employee's departure is acrimonious, there isn't any squabbling about how many shares the employee will leave with-the answer to this question is spelled out in the vesting schedule. In addition, if a buyback clause is in place and it stipulates the formula for determining the value of the departing employee's stock, the company can repurchase the shares without an argument. It's never a good thing to have a former employee, particularly one that left under less than ideal conditions, remain a partial owner of the firm. Finally, investors are generally reluctant to invest in a firm if a block of stock is owned by a former employee. It just spells trouble, which investors are eager to avoid.

Questions for Critical Thinking

1. Investors are often criticized for insisting that a vesting schedule be put in place for stock that's issued to employees. After reading this feature, do you think this criticism is justified? If a company anticipated that it will never take money from an investor, is it still a good idea to establish a vesting schedule? explain your answer.

2. Why do you think start-ups launch and distribute stock to founders and others members of their new-venture team without vesting schedules?

3. Is it typically necessary to hire an attorney to set up a vesting schedule for a firm, or can the firm do it on its own?

4. If a company started with a single founder and no employees, is it necessary to set up a vesting schedule for the founder?