The Importance of Vesting Schedules for the Foundersby Scott Edward Walker on December 14th, 2015
One of the biggest mistakes I see startups make is failing to set-up vesting schedules for the founders. Below is a short clip from my legal workshop “The 5 Biggest Legal Mistakes That Startups Make” and a few FAQ’s.
What Is a Vesting Schedule?
A vesting schedule is a mechanism by which the ownership of the stock issued to the founders is earned over time (typically four years, as discussed below), rather than owned outright immediately.
Why Do You Need Vesting Schedules?
You need vesting schedules to protect the company in the event a founder leaves, whether voluntarily or involuntarily. Indeed, it would be inherently unfair for a founder to quit the company after a few months (or weeks), but still be permitted to keep all of his stock. Moreover, it will be very difficult to raise money from investors if a departed co-founder holds a substantial percentage of the company’s equity.
What Is the Typical Vesting Schedule?
The typical founder schedule vests an equal percentage of stock (25%) every year for four years on a monthly basis. Sometimes, however, it may be appropriate to impose a one-year “cliff” — i.e., the founders would not get their first 25% unless they have remained with the company for 12 months. This is often used when the founders don’t know each other and/or don’t have a history of working together. Another possibility is to vest a portion of the stock “up front” — i.e., one or more founders would receive a certain percentage immediately (usually as a result of their work/contributions prior to the formation of the company).
Where Is the Vesting Schedule Addressed?
Vesting schedules are addressed in the Restricted Stock Purchase Agreements, which each founder executes in connection with the purchase of his stock and which would grant the company the right to automatically repurchase any unvested shares (at the initial purchase price) at the time of the founder’s departure. The Restricted Stock Purchase Agreement also addresses what happens if the company is sold prior to the expiration of the four-year vesting period and the issue of vesting acceleration (which is often heavily negotiated with investors).
Are There Any Other Important Issues Relating to Vesting Schedules?
Yes, it is very important that founders file with the IRS something called an “83-b election.” This prevents the founder from having to pay taxes for any subsequent appreciation of the stock at the time of the vesting. Instead, the founder buys all of his stock on day 1 (subject to the vesting schedule) and then solely pays capital gains tax upon its sale. The election is made by filing the appropriate IRS form within 30 days after the purchase date (no exceptions applicable).