Being a child of the 1980s and having grown up on Teenage Mutant Ninja Turtles, I quote the famous Casey Jones of TMNT fame: “You gotta know what a crumpet it to understand cricket.”
So before I explain vesting (i.e., cricket), let me take a moment to explain the difference between shares and options (i.e., crumpets). Shares represent an ownership interest in a company. Options are a right to acquire an ownership interest in a company.
Vesting is all about timing. It’s about the time at which someone can exercise a right. In the case of options, when an option has vested, the option holder can exercise their option and get shares in exchange for the option. This is a useful way to keep key personnel interested and involved in a company.
Shares issued to founders however are issued at the time of the organization of the company (usually right after it has been incorporated). So if the founders have already acquired their shares, how do you get them to “vest”? Well technically, you don’t. The workaround is called “reverse vesting”. Under this concept, 100% of the shares of the company are subject to a repurchase right at a nominal price in favour of the company (i.e., the company can buy back the shares for cancellation for pennies). The number of shares subject to this repurchase right is reduced over time.
If you take a look at the chart above, it shows you what a vesting schedule looks like over a 4 year period, with a 1 year cliff (i.e., 25% of the shares become “unrestricted” after one year). Each month thereafter, 2.083% of the shares held by the founder also become unrestricted shares, until 100% become unrestricted by the end of the 4 year period.
Given the high turnover in the initial stages of a startup, vesting or reverse vesting can be a useful tool in ensuring that those who are receiving equity early on stick with the business over the long term. And by the way, your investors will very likely demand it (and some may even reset vesting periods, depending on the timing and the size of the investment).
But be careful. There are not only corporate law considerations, but employment and tax issues that come up as well. Talk to your lawyer – this is important to get right.