Vesting is a hack

Posted: April 6th, 2012 | Author: | Filed under: Startups | 32 Comments »

Vesting in general (and founder vesting in particular) is an oft-misunderstood tool that has a tendency to really screw up young companies.  There are some deep misconceptions at work here that often cause founders all sorts of grief.  Most of it comes from the simple fact that stock grants are, at their heart, a crude hack to avoid taxes.  Vesting is a hack to the hack – and one almost every founder needs.

Let me explain with a hypothetical.

Imagine AcmeCorp, a new startup.  Jack and Jill are the founders.  They incorporate and give themselves each a million shares – in other words, splitting the company fifty-fifty.

The next day, Jack has a change of heart.  Startups are a lot of work!  He quits AcmeCorp and takes a cushy executive gig at a fortune-500 tech firm.  Jill’s left solo.

Years pass.  Jill first works without salary, then pays herself a pittance.  She bootstraps the company, starting with consulting and moving on the develop a highly successful web service.  As she brings on staff, she issues stock to new employees, ultimately handing out a half-million shares of the company.  Eventually she’s the CEO of a 50-person firm, pulling down a respectable $200k per year as the CEO; nearly as much as Jack’s pulling down at his gig (not including his benefits and bonuses).

When the company is finally sold, it’s a great success – $100mm exit.  And here’s what happens.

For her million shares, Jill gets $40mm.
The employees’ half-million shares net them $20mm.
And Jack?  He gets a call one afternoon that, for sitting on his duff for the past five years, he’s worth a cool $40mm, same as Jill.

Obviously something’s wrong with this picture.  The crux of it is that, with stock grants, value is awarded in a big block at the beginning, even though the contribution is (or isn’t) provided over a long period of time.  It would be like if you paid someone four years worth of salary in a lump sum on their hire date.  The obvious solution, of course, is to not issue all the stock at once.  Instead, treat stock like salary – give it out in small chunks over time.

Unfortunately this is a terrible idea.  As time goes on, the stock gets progressively more valuable, and the tax impact to the founders gets worse and worse, plus the strike price (if they’re options) gets higher and higher.

As I’m sure you’ve gathered by now, the solution is – vesting!  The founders get their stock at the beginning in a big whack, but the company has the right to take it back for a negligible amount of money (the “repurchase agreement”).  As time goes on, that right erodes.  So the net is the same – the founders’ stake grows over time – while still letting the founder keep ownership of the stock from a legal standpoint as it appreciates, allowing long-term capital gains treatment, favorable initial tax treatment, voting rights, and all that jazz.

“But wait!” the novice founder cries out.  “If I build lots of value and sell the company, I get the shaft! My stock may not be vested, and I’ll lose out!”  Yes you will, young padawan, unless you include acceleration in your vesting schedule.  Acceleration is the final hack to the hack, which brings the force back in to balance.

Acceleration comes in two flavors.  Acceleration on change of control (aka single-trigger acceleration) means that if the company is sold, some or all your stock vests.  Yay! Double-trigger acceleration means that if the company is sold AND you’re fired, then some or all of your stock vests.  Sort of yay!

The former is obviously better for the acceleratee, but keep in mind that a deal may be hard to get done if the acquirer knows that all the stock incentives to stick around disappear when the deal closes.  Double-trigger, or a mix of single- and double-, is often a nice compromise to keep the company marketable (a few years down the road) while rewarding people for their hard work.  This is often more of an issue for employees (who join later, and will still be vesting when a transaction happens, and who can’t leave en-masse if the transaction is to go through).  For reasons of company lifecycle timing, founders are usually fully vested already by the time a deal happens.

Regardless, the important thing is this: founder vesting is founder friendly, the exact opposite of what most people think.  You want it.  Don’t fight it.  In fact, don’t wait for an investor to tell you that you need it – get it done when you incorporate.  Just remember to pair it with acceleration on change of control!

And now, some suggestions for vesting schedules.

  • Use a four-year vesting cycle for founders, the same as you eventually will for employees.
  • Put founder vesting in place before you start to raise money.  Investors will be impressed that you know what you’re doing.  If your vesting terms are reasonable, they’ll be accepted without argument.  And when you’re negotiating terms, it’s better to have fewer things that matter to you on the table.
  • If there’s a “trial period”, for example people working part-time for a few months, then consider a cliff that expires after the trial.  That means the first vesting doesn’t occur until the trial period is over (and then you vest a lump of however much you would have received anyway).  Stock is best used for people who are totally committed, so the stock accumulation shouldn’t kick in until the commitment does.  The obvious exceptions to this are strategic advisers who will only ever be partially committed, but where that level of commitment is all the company wants and needs.
  • If there’s a meaningful commitment of resources in advance of the vesting agreement, it’s reasonable to “fast forward” the agreement by an appropriate amount.  For example, if you’ve been working full time for a year before vesting is in place, it’s not unreasonable to start with 1/4 of your stock vested already and put the rest on a 3-year schedule.
  • Stock that’s in payment for resources doesn’t need to vest.  For example, if the company is split 50/50, but then one founder puts in $100k in exchange for 10%, then the 10% that they get should not vest.  Since the value is delivered up front, the stock should be too. (Obvious corollary: investor stock has no vesting terms)
  • For founders, accelerate 50% of the remaining unvested stock on change of control (single-trigger), and 100% of the rest double-trigger. This is totally reasonable and fair, and makes it very unlikely that you’ll leave much value on the table.
  • It is generous, but not unreasonable, to consider double-trigger acceleration for some or all of your employees.  However, you may cause yourself problems during M&A down the road – check with your lawyer first.
  • Try to avoid single-trigger acceleration for non-founders whenever possible.  Not only is it sure to cause issues during M&A (the acquirer will be worried that everyone vests & leaves after the transaction), but an acquirer may make changing these terms a condition of a deal, which just leads to ugly.
  • Get the legal paperwork for your stock agreements sooner rather than later, to start the capital gains clock ticking.  This can easily be a seven digit difference if you happen to have an early exit (ask me how I know).
  • Edit: File your 83(b) elections the day your incorporation goes through. You have 30 days to do it, and then you’re screwed forever.  If you’re not sure if this applies to you, ask your lawyer.  If they’re not sure, fire them and hire someone else.  This is one of the most common, avoidable, and expensive mistakes founders make (thanks for the reminders about this in the comments!).
  • One last thing: the founder vesting arguments assume multiple founders.  If you’re a solo founder, you might skip founder vesting, and hope no one notices…

Founder vesting may sound terrible , but when paired with reasonable acceleration, it’s a good thing for everyone.

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  • Dan, good points on vesting and acceleration. I think a key point to highlight is that everything is typically negotiable on M&A, meaning that even if the founders are vested at the time of an acquisition, the acquiring company may try to rewind the vesting as a term for the deal.

  • Dan, so how do you know about the 7-digit difference upon early sale? :)

  • Thank you, Dan for bringing clarity. Appreciate it.

  • The paragraph that starts with “””As I’m sure you’ve gathered by now, the solution is – vesting!””” should be clarified a bit.
    As far as the IRS is concerned to the Individual Taxpayer, there is little difference between reverse vesting (repurchases) and forward vesting (grants or options).  The IRS considers the value of the stock taxable when there are no restrictions on the stock — which would be when your reverse vesting period ends, not begins… or when you’re able to exercise an option or receive the grants.  ( options get tricker with paperwork because you have non-qualified and incentive which are treated differently ).In order to get all the gains you’re talking about with reverse vesting , you need to file an IRS form 83B within 30 days of receiving the stock.  The 83B election lets you pay taxes on the current fair-market-value of the stock – which could be as little as $10 total for the founding team.  Years later, you’re then able to treat the sale price of stock as capital gains.  If you don’t file the 83b, then you’re taxable on the sale price of stock (or whatever the price is when the stock vests).Years ago my lawyers and accountants said that it’s technically possible to use a ‘forward vesting’ grant and be safe with taxable events, but they recommended against it because reverse vesting has a lot simpler paperwork — the lawyers/cap tables are only involved on a repurchase event (which rarely happens) and you can construct the bylaws of the company to allow shareholder rights on the restricted stock.

  • Joe Griffin

    Many start-ups are LLC’s. Most of this article applies to LLC’s as well – like single and double-trigger. It would be great to here more advice on the protocol for the LLC business owner.

    VC’s are going to want to work with a c-corp entity, but many entrepreneurs and owners start with an LLC, and may look to setup stock options via an LLC – these are called membership interest warrants. There are similar rules to warrants, but also some major differences. Ultimately, the LLC might change to a c-corp, particularly at the request of the VC.

    Great article – a good follow up would be Stock Options Vs. Membership Interest Warrants.

  • The examples of properly applied acceleration were most helpful. Great post.

  • In a two man startup, couldn’t you avoid the need to vest by having an aggressive buy/sell agreement?

  • Xavier

    Well, of course if your partner is a rat there is not much that could be done. I was a cofounder, and the reason why the near shore operation worked but couldn’t work anymore with a sociopath so I left after 3 years and got royally screwed :) 

  •  Absolutely true.

  • For purposes of negotiation during acquisition, it seems it would be wise to have already vested. What acceleration techniques are available? What’s the best “hack” if somebody forgets 83b?

  • AFAIK, if you miss the 30 day window, you are well and truly screwed.  Do not pass go, do not collect $200, the bell cannot be unrung. 

    It’s nice negotiating leverage to be fully vested during a negotiation, but it’s all up for grabs anyway.  They can and will demand anything they want, including “unroll your last two years of vesting”, as deal terms. 

  • The only advice I have regarding LLCs is DON’T BE AN LLC.  All I know about them are the bellyaching I’ve heard from lawyers and entrepreneurs who are stuck trying to unroll them becomes someone unacquainted with startups did their incorporation paperwork. 

    Do it right from the start, which means a C-corp or an S-corp (which can be converted reasonably easy to a C).

  • That’s more or less what vesting is, when implemented as a repurchase agreement. Just bear in mind that if you personally are buying your founders’ shares, and the IRS decides you paid less than market value, you may have Significant Issues.

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  • Chris Stehlik

    Seeing that it’s all basically a tax dodge, I would say, it’d be simpler to just chuck it all and say ‘you’re getting $40mm frickin pay your taxes already’ instead of constructing a byzantine scheme to get out of it. 

  • eech1234

    Not really, Chris. Problem is that if you have stock in a private company, without the 83(b) you’re forced to pay taxes on something that may not actually hold that value out on the open market. So if you get a 100k shares grant for $1 total, then you get 25k vested after a year which point the company is worth $10/share — you’ll owe income tax on 250k income, even though you don’t see a cent unless the company gets purchased or goes public. If the company goes bankrupt the next year, you could claim that as a loss — but you’re not getting the tax payment back.

  • Sam

    A vesting arrangement among co-founders on the date of incorporation makes a lot of sense. For the solo founder, why not take an outright grant of shares and when a VC comes into the picture, agree to some sort of a repurchase agreement? Isn’t the 83(b) question avoided entirely in this situation? If so, it would seem co-founders who miss the 30-day window could take advantage of a repurchase structure to accomplish the same ends as vesting at any time during their relationship. I am not very familiar with the use of repurchase agreements rather than vesting so I may be missing something here.

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  • Thank you for your great article Dan. With startups becoming a
    global tendency, it becomes complicated to create one model that fits all.
    Any thoughts on adjusting vesting schedules, cliff periods
    and accelerations to ventures occurring in high-risk geographical areas?
    High-risk understood as high volatility & political unrest.

  • I wish I had some domain expertise to share, but I’m afraid I do not. In the abstract, I suspect that the prevailing tax and corporate law would be a bigger impact on vesting than political volitility.

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  • Another point is that these sorts of things vary country by country as well, so if you’re founding in Europe, half of everything that’s being done in the USA won’t even apply to you.

  • Dan, Great article, thanks for the summary. I had a comment on your last point –

    One last thing: the founder vesting arguments assume multiple founders. If you’re a solo founder, you might skip founder vesting, and hope no one notices…

    Now from an investor’s standpoint the number of founders shouldn’t matter. Whether you are a single founder or a team, the investor would still expect you to vest the shares correct?

    In this case would it make sense to skip vesting (and skip section 83(b)) and go in for a share repurchase agreement when an investor later invests into the firm?

  • Vesting vs. share repurchase agreement is just an implementation detail, as I understand. You use vesting for options and share repurchase agreement for shares. But yes, if an investor is coming on board and you’re a solo founder without a vesting/repurchase agreement, they will probably (and reasonably) want you to put one in place.

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  • James

    Great example Dan.. :)