Vesting Is a Hack

4/9/12Follow @danshapiro

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 percent, then the 10 percent 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 percent of the remaining unvested stock on change of control (single-trigger), and 100 percent 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.

[Editor's Note: This post first appeared on Dan Shapiro's blog on entrepreneurship.]

Dan Shapiro is the CEO of Robot Turtles, a crowdfunded boardgame that teaches children programming. He previously worked at Google after it acquired his company, Sparkbuy. Follow @danshapiro

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  • peb4j

    Wow, I’m normally impressed with the guest posts on Xconomy but this one is extremely poor. How can you publish an article on founder stock vesting and leave out the single most important piece of advice – an 83(b) election?

    The rest of the post is full of semi-accurate information that is misleading in the context of the article and doesn’t get to the heart of the issue. One example is that putting in $100K for 10% of the company on day one can create additional tax consequences if it isn’t structured correctly. Xconomy should exercise some editorial control and remove the post.

  • http://www.danshapiro.com Dan Shapiro

    peb4j – you might have missed the 83(b) reference in the third to last paragraph. It’s not really the topic of the post, but it’s so important I added it to my personal blog when someone mentioned it there in the comments (and it’s been in the xconomy article since it was posted).

    I’m not quite sure what semi-accurate information you’re talking about. You’re quite correct that my example or any investment can create tax consequences if structured incorrectly, and should only be done with the help of a good lawyer. It would be great if you could be a bit more specific in your concerns, as I’d be happy to correct any material errors that you’ve found.

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  • http://www.linkedin.com/in/crnoble Chris Noble

    The title and first paragraph are somewhat confusing, but the premise is important: equity ownership should be earned over time and in proportion to ongoing contribution, by founders, employees, consultants and investors (beware “tranched” rounds with the latter). You should address stock vesting vs. options in a follow-up.

    Good article Dan, don’t mind peb4j’s hacks.

  • K L Vaughn

    Dan,

    Great article from a high-level point of view. I don’t think the point was to step in for an Entrepreneurs legal team but to offer recommendations/suggestions to consider prior to setting up the schedule.
    Sharing with my network now.

  • peb4j

    I agree that almost all high-tech startups looking to pursue external funding should implement founder stock vesting. I simply take issue with the way the concept was portrayed in this article (good idea, poor execution – at least in my opinion). The article starts out talking about how founder stock vesting is an oft-misunderstood tool that has a tendency to really screw up young companies. It’s actually the lack of founder stock vesting that screws up young companies.

    It goes on to describe stock grants as a hack to avoid taxes. It’s not the grants but the vesting that is designed to reduce taxes. You could certainly make that argument that vesting is designed to avoid taxes but your example highlights the reason most people use to justify founder stock vesting: you want to allocate the ownership at the outset while requiring the co-founders to earn their ownership overtime. I get it, the main reason you structure it this way is to avoid unfavorable tax consequences but there are other reasons (voting rights/control considerations, allocating the pie on day one so there’s certainty in the cap table as you raise additional capital, etc.).

    My fundamental complaint is that if you frame your justification of founder stock vesting as a hack to taxes you don’t want to write something that could lead someone to run into problems with taxes. If you frame the problem as ownership allocation and earning your equity overtime than it seems fair to gloss over the tax implications. To that end, the mention of 83(b) elections (one few things that can totally screw a founder and can’t be fixed) should be addressed as a major component of the post not an afterthought at the end of the post.

    Second, splitting the company 50/50 and then immediately selling 10% for $100k could easily create real tax problems for the founders and the company. Again, by framing the vesting issue around taxes it’s fair for a reader to think that the advice they’re getting has considered the tax consequences but this example clearly hasn’t. Finally, it occasionally intertwines options into the discussion without much guidance and they are very different animals especially when they can’t be exercised early.

    In the end, when I read this post it seemed like information that could get misconstrued by the founders you are looking to guide. The underlying message that founder stock vesting is important and founder friendly is extremely valuable. Clearly other people read the same article and saw value in the way you described vesting, I would just encourage you to frame the issue differently to avoid projecting a false sense of guidance on tax related issues.