How do vesting agreements work?

You and your co-founder started a new business. It was all blue skies for a while: you hired your head of product, a few freelancers, and even got a couple of high-paying customers.

But eight months into the build, things start to change. You begin to disagree on 9 out of 10 topics, your ambitions aren't aligned anymore and, even though you're friends, they've been MIA for half of the week.

Eventually, they call you to tell you they've decided to take on a new opportunity.

"It's not you, it's me" – they say. It just wasn't working out.

At this point, you're both on the cap table and 40% is theirs. Depending on how you set things up, you're left with one of two possible scenarios moving forward:

a) a company with a ghost stakeholder that almost no investor will agree to bet on, or

b) the chance to start fresh.

Option B is for those who have a vesting agreement in place.

Okay, but what is vesting?

Vesting is good practice in startups to guarantee that every stakeholder that works for the company – like a co-founder, a key hire or even an advisor – adds as much value to the company as they own in equity.

When a vesting agreement is in place, these stakeholders are subject to a waiting period before they can actually own shares of the company, which is set up as a requirement in years of work.

To qualify for owning stock with the company, they have to put in the time and effort, which means a vesting agreement works according to a vesting schedule.

The vesting schedule

Silicon Valley's standard practice, which we also see as most common in Latin America, is a 4-year vesting period with a 1-year cliff.

The vesting period refers to how long it would take for stock to become fully vested, while a cliff is the gap between when stock/options are issued and when they start vesting.

That means that in this scenario, it takes one year for a person to start earning rights to some of their shares, and four years for them to be able to own all of them. Past the one-year mark, 25% of the granted shares will vest immediately, while the other 75% will start vesting from then on a monthly basis (1/48 each month) over a three-year period.

Let's go back to this article's introductory tale, in which your co-founder bailed after only 8 months. In this case, the cliff would be the reason why they walked out with nothing.

Without the cliff, considering their total was 40%, they'd have 6.6% of the company without contributing much to its growth. And if there was no vesting schedule at all, then you'd be in serious trouble.

Now, what if instead of your co-founder we were talking about your head of product, or your marketing lead? There are some technical differences there.

Co-founder vs. employee vesting

Not all vesting agreements are created equal. The schedule itself tends to be the same, but with one fundamental contrast:

Co-founders already own the shares but can have unvested shares bought by other co-founders.

On the other hand, with option grants (the most common form of employee stock compensation), the employees do not own the shares once they are vested, but instead have the option to buy them at a set price.

Vesting for employees

So to answer the question a few lines up: if the head of product left the company after 8 months, it's like the grant never existed, and the shares would return to the equity pool. If they left after their cliff year, however, then they'd have the option to buy as many shares as they have vested at the termination date.

Buying the stock, aka exercising the options, happens during their post-termination exercise period, established on their option grant. Most commonly, the window for post-termination exercise is 90 days after the termination date.

Then, the strike price determines how much they'd have to pay to exercise the options. The strike price is set by the fair market value (FMV) of a share (and of the company) when the employee joined the team.

If they joined as a founding member when the business was worth virtually nothing, the strike price would likely be close to $0. However, if they got in after Series A, valuation was probably a lot higher, and so will be the strike price.

These terms and conditions are meant to not only reward early employees for taking on more risk, but also those who stay long enough to build value.

If the company's value has gone up since an employee received their option grant, they will actually be buying stock at a lower price than that of the market currently, and will be able to sell for profit later. This is why being an early startup employee can pay off, and definitely a benefit you should make sure to communicate with your team.

Vesting for co-founders

You want to talk about risk? Co-founders eat risk for breakfast.

Well, sometimes risk eats them – but the point is, rewards should be proportional, especially if they stick around.

If they don't, the last thing you want is for them to hoard a big chunk of the equity while doing none of the work, because that drives investors away.

That's because the so-called "free riders" automatically dilute yours, your employees' and your investors' shares in the company. To avoid them, special terms and conditions may apply to co-founders vesting agreements.

The main one, as mentioned before, is that when a fellow co-founder leaves a company before their shares have fully vested, the company has the right to buy back their unvested shares at FMV or lower.

Connected to that, the right of first refusal is often applied to co-founders shares. This allows the other founders or investors to stop a co-founder from selling their shares to a third-party, instead making it so that the only exit option is for the shares to be sold back to the company or to its founders.

What makes a good vesting agreement?

Company equity is the onion that keeps on peeling, and rarely is any document concerning it this straightforward: with vesting agreements, there are many add-ons and clauses, and there are two you should have as top of mind: single trigger acceleration and double trigger Acceleration

Both types of accelerations are designed to protect the receiver of stock/options on a vesting agreement, with the goal of ensuring that they receive their promised equity even if there are unforeseen circumstances.

As the name implies, accelerations speed up the vesting process. The main two triggers established in these clauses are changes in control and terminations without cause.

• ‍A single trigger acceleration is typically attached to changes in control – think mergers and acquisitions, dissolution, new majority shareholder, etc. These aren't as common on their own, and even less so for employee vesting; they're mostly seen for advisors who have received equity incentive – this way a new CEO can't just replace them like they would change outfits before they have any vested interest.‍
• A double trigger acceleration requires both a change in control like the definition above AND an additional trigger criteria, which is commonly a termination without cause within the 12 subsequent months. It usually applies to C-Level talent and co-founders, but is not unheard of for general employees. Picture this: a company goes through an acquisition and the new owners decide to fire a co-founder after 6 months just because, but they had not yet vested all of their shares. It wouldn't be fair for them to leave at a loss, now would it? With double trigger acceleration in place under these criteria, the co-founder's stock will be instantly vested as a result.

Things to Remember

Vesting agreements are an essential part of any startup. As a founder, you should use them to fairly compensate your best employees and also to help prevent team members who are leaving to hold on to equity that they did not contribute towards building up.

You have worked too hard to build your company from scratch to have it come crumbling down because of a disillusioned co-founder. Vesting agreements are there for your own protection, so you may as well take full advantage of them.