Vesting Explained in Simple Terms…
Vesting of shares means that the stockholder has to earn those shares over time by providing services to the corporation. If a stockholder ceases to provide services to the corporation and owns unvested shares, then the corporation will have an option to repurchase the unvested shares at their original issue price, which is often times the par value of the stock, a very low number. The company’s option to repurchase shares lapses over time. This is how the shares “vest.” If the shares issued to a stockholder will have vesting provisions, the stock is called “restricted stock,”meaning stock issued with a vesting schedule.
Stock options are also frequently subject to a vesting schedule, meaning that the “optionee” (the person receiving the option) may only exercise the option and purchase shares that have “vested”—shares that have been earned by providing services.
Vesting is very important to protect the initial stockholders of the corporation, called the “founders,” from each other. When a stockholder quits working for a startup company and takes a large chunk of equity with him or her, it can be very demoralizing for the remaining stockholders who continue to work for the corporation in order to build stockholder equity. Vesting is the mechanism that guards against that happening.
Vesting is preferred over a traditional “Buy/Sell Agreement” for startup companies. In a typical Buy/Sell Agreement, if a founder stops providing services to the company, the corporation and/or other stockholders have a right to buy out the departing stockholder at a purchase price equal to the fair market value of the departing stockholder’s stock. There are two problems with this approach. First, the determination of the fair market value is often the subject of dispute, and second, in a startup the corporation and/or other founders simply don’t have the money to buy out the departing stockholder. Buy/Sell Agreements lead to no one being happy. Vesting is a cleaner approach.
A vesting “cliff” means that there is a period of time of no vesting, but when the specified time (the “cliff”) is hit, the benefit becomes fully vested. For example, in a 48 month vesting schedule with a 12 month “cliff,” no vesting occurs for the first 12 months, but at the 12-month point the stockholder receives full credit for 12 months of vesting. After the “cliff” is met, vesting would continue thereafter on a monthly basis. A “cliff” is often used with new employees. It acts as a probationary period during which the new employee has to prove him or herself.
The vesting provisions in our Restricted Stock Purchase Agreements contain a clause that all unvested shares will vest in full on an accelerated basis upon a sale of the corporation.
When you get a Restricted Stock Purchase Agreement or a Vesting Agreement from Venturedocs, the total vesting period for any unvested shares is measured from the date of the applicable legal document going forward. With new employees, it is customary to see a 48-month vesting period.
For LLCs issuing “units” instead of shares, the same concepts of vesting above apply.