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by • February 16, 2013 • Founders, Funding & investmentComments (22)1351

Equity basics: vesting, cliffs, acceleration, and exits

As a cheatsheet, the “normal” equity structure is:

  • Founder terms: 4 year vesting, 1 year cliff, for everyone, including you
  • Advisor terms (0.5–2.0%): 4 (or 2) year vesting, optional cliff, full acceleration on exit

Getting equity structures right

When it comes to equity terms, there are only 3 things to understand: vesting, cliffs, and acceleration. For these examples, let’s say that I’ve got a co-founder and we’re splitting the company 50/50.

The problem we want to avoid is if one of us decides to quit early on, taking half the company’s stock with us. In that case, the other founder is then totally screwed, because they don’t have enough equity left to incentivize new team members. And even if they succeed, it’s super unfair that the guy who left still has half the company.

Cliffs & vesting

Vesting is how we fix that. Everyone who has equity should really, really be vested.

Vesting means that instead of each getting our 50% immediately, it gets given to us regularly over some period — usually 4 years. So if we quit after 6 months, we’d have earned 1/8th of our total 50%, or 6.25%. If we quit after 3 years, we’d get 3/4 of our total 50%, so we’d keep 37.5%.

A problem this can lead to is that you can end up with loads of people who each own a tiny percentage of the company. That makes future legal work more painful, and it’s what cliffs are designed to solve.

Cliffs basically allow you to “trial” a hire or partnership without an immediate equity committment. You agree on the equity amount and vesting period immediately, but if you part ways (via either quitting or firing) during the cliff period, then the leaving party gets no equity. Apart from that, it acts like normal vesting.

Remember our 50/50 split, 4 year vesting? Now let’s add a 1 year cliff.

With those terms, if I quit after 6 months, I’d actually have nothing. But then at 1 year in (as soon as my cliff is over) I immediately get a full quarter of what I’m entitled to (since I’ve made it through 1 of the 4 years of vesting). And after that, I get my remaining equity dripped to me smoothly as time passes.

Once I stay for the full vesting period (in this case 4 years), I’ve paid my dues to the company, and can choose to either stay or leave. The equity I’ve earned is mine in either case.

Advisors, acceleration, and triggers

Advisors get an extra term which is “full acceleration on exit”. That basically means that if you sell the company (or IPO), they immediately get 100% of the equity you promised them, even if the full vesting period hasn’t finished yet.

This one is standard and makes good sense. They did a great job advising you, you built a successful company, they get what they were promised, and their job is done. Hooray.

However, you can also get too complicated with equity triggers. For example, a hired-gun tech team might get their equity based on product deliverables instead of time passing. Or sales guys might have triggers from hitting revenue targets.

I’d would strongly advise against getting fancy, at least for now. When you add too many rules to your equity system, folks find wacky workarounds. Plus, if you’re new at this, you don’t have to justify yourself and don’t risk getting out-negotiated when you stick with the standard format.

Exits, investors, and re-vesting

It’s tempting as a founder to give yourself a “better” deal by picking a shorter vesting period, like 1 or 2 years. It seems good (“more equity faster!”), but typically leads to disaster since it allows someone to walk away with too much of the company.

And even if it doesn’t kill the company, it doesn’t actually help you. If you have an overly generous vesting structure, investors will only fund you if you “fix” it back to a normal 4 year period. And when you sell the company, the acquirer will usually “re-vest” you over another 4 years.

So speeding up your vesting now doesn’t actually help you cash out faster later. It’s all downside (co-founder problems) with no upside.

How the legals work in the UK

In the US, vesting is standard enough that it’s taken for granted. In the UK (and probably other places), it’s less well-known. For example, I’ve met British startup lawyers who are so recklessly incompetent that they recommend against vesting, citing it as an over-complication. It’s super necessary, and also easy, so no reason not to[1].

In the US, vesting is a thing which legally exists, the terms of which are right there on your boilerplate docs, waiting to be filled in.

In the UK on the other hand, you just sort of write it into your shareholder’s agreement. Vesting isn’t a well-known legal thing, so you just do your best to explain what’s meant to happen. Consult a lawyer on that to be safe (I am not one), but that’s been my experience.

Edit: Andy did a much better job of explaining how this actually works in the comments. The following is in his words. Thanks Andy!

With founders, you allocate all the shares up front (when they’re worth next to zero) to avoid getting hit on tax if you were to issue yourself shares later (when they’d be – hopefully – worth a lot more, and you’d have to pay tax on the difference if you obtained them without paying the company the full market value in cash).

You then have written into the shareholders agreement a “buy-back” clause, detailing how the company has the right to buy back your shares at nominal value if you leave. Over time, the company has the right to buy back fewer shares, until zero when you are fully vested – this is known as “reverse vesting”.

For employees, and particularly once you’ve done an investment round giving your shares a significant value, the employee does not get the shares up front, but instead has the right to buy more and more shares over time in accordance with their vesting. In the UK, the company can register an EMI-approved share option scheme with HMRC which means the employee can get their shares in the future without paying the full market price and still not be hit with the tax.

 

[1] The non-vesting way to handle co-founder disputes in the UK is a disaster. It works on the basis that we each have our 50% from day one, but the company gets progressively more valuable over time. That means that when I walk, you can just buy back my 50% for whatever it’s currently worth, on the basis that soon it will be worth even more. It’s trouble for tech startups because you tend not to have much cash on hand and because valuations are impossible to agree on without the market pressure of having multiple investors bidding against each other.

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22 Responses to Equity basics: vesting, cliffs, acceleration, and exits

  1. Kees van Nunen says:

    In the Netherlands vesting also does not exist legally, according to our lawyer. How we solved it in our shareholder agreement is that you have to sell the non-vested portion of your shares at an early exit for 1 euro back to the other founders & you can keep your vested shares or sell them at a real market value.

    • robfitz says:

      Sounds like a similar sort of workaround to what we have in the UK. It’s a bit spooky to be using something so unstructured, but I still think (as you evidently did too) that it’s much safer than doing nothing.

  2. Ogaba says:

    Thank you for making this super super easy to understand. Ginormous thumbs up!!

  3. Eze Vidra says:

    Great clear read! thanks for sharing Rob. The young Paul Graham!

  4. Ben Hall says:

    What’s the best way to allocate shares when it comes to companies house? On day zero would there be no share holders? Or do you agree to give back unvested shares if someone leaves?

    • robfitz says:

      I’m not totally sure on this one in the UK, but I believe you allocate the shares up front, and then put something in the shareholder’s agreement which specifies how much the person “gives back” when they depart.

      Doing it the other way (giving the right number of shares as people leave) gets them hit with taxes, since they’re getting something that’s worth more now.

      Again though, definitely check that with a lawyer or at least find a bit of boilerplate to use. I think Seedcamp open sourced their UK legal docs and those may include something like this.

      • AndyY says:

        Yes, this is exactly right – for founder equity/vesting.

        With founders, you allocate all the shares up front (when they’re worth next to zero) to avoid getting hit on tax if you were to issue yourself shares later (when they’d be – hopefully – worth a lot more, and you’d have to pay tax on the difference if you obtained them without paying the company the full market value in cash).

        You then have written into the shareholders agreement a “buy-back” clause, detailing how the company has the right to buy back your shares at nominal value if you leave. Over time, the company has the right to buy back fewer shares, until zero when you are fully vested – this is known as “reverse vesting”.

        For employees, and particularly once you’ve done an investment round giving your shares a significant value, the employee does not get the shares up front, but instead has the right to buy more and more shares over time in accordance with their vesting. In the UK, the company can register an EMI-approved share option scheme with HMRC which means the employee can get their shares in the future without paying the full market price and still not be hit with the tax.

        Apart from that, great post Rob!

  5. Brendan Gill says:

    Great article Rob.

    I think having a standard 4 yr vesting period might be a bit long though – 2 yr advisor vesting is probably more common. I think its likely to be a little harder to attract a potential advisor with a 4 yr vesting period and in reality the advisory needs of a startup in years 1-2 could be quite different in years 3-4. Perhaps early on the startup wants some experienced entrepreneurs who can help with company inception and getting seed inception, but perhaps later on you want an industry advisor that can help you navigate the world of enterprise sales.

    More importantly, if you simply offer half the equity to vest over 2 yrs instead then you have the flexibility to renew that contract after year 2. Its worth noting that the Founder Institute, who open sourced useful (US) legal docs for signing up advisors default to a 2 yr advisor vesting period (http://fi.co/contents/fast).

  6. Andy Whyte says:

    I was expecting this to be much more complicated..! Very well explained, thanks Rob.

  7. Tom Psillas says:

    You guys and gals are making me dizzy. For http://www.weezoo.com, I am using Revenue Royalty financing; the kind Kevin Oleary on the Shark Tank loves.
    He gives you $1 Million. You give him a 25% return per year (ROI) on the $1 Million. You pay him back 5-10% of your revenue until he gets back his principal, plus total ROI. If it takes you 3 years to pay him back, he gets $1.75 Million total.
    Sometimes, you got to give up some equity, as a kicker, in addition to above, but I try to avoid it, if I can.
    Investors like it too, because no exit strategy is needed. You blow less money that way, as well. It works well for cheapskates, like myself.

  8. Roman says:

    Great post, I’ve been running a UK company for about two years now and would’ve approached the vesting setup like a simple contract, but @andyy’s input was very valuable here, especially his words on the reverse vesting concept, almost never considered the sudden ‘receiving shares’ tax spike aspect in later stages when the company has higher valuations – great point.

  9. Nick Jenkins says:

    Great article – the learning curve on everything in a startup is so big, we don’t need lawers and accountants making it harder. Not sure on the rules here in Australia for proprietary companies, but I suspect it boils down to the directors issuing a new class of shares with different rights. Will let you know when we get there!

  10. Thank you for the clarity in your article Rob. With startups gaining traction around the world, it is becoming harder and harder to “make a model that fits all”.

    A vesting period of 4-years might not be appropriate for ventures occurring in developing nations. It would be very hard to recruit talent for ventures operating abroad if both the vesting conditions and the cliff schedules don’t get adjusted for riskier settings. I appreciate your thoughts in this matter.

    Basically how do you adjust vesting/cliff schedule to geographical risk?

  11. Anonymous says:

    I wonder if anyone can advise. I took a job with a start up a year ago. Salaried plus small percentage of equity subject to a vesting agreement. One year on and despite prompting I’ve not received the agreement. This makes me frustrated and concerned. Presumably despite the percentage written into my contract (referencing the missing agreement) if I were to leave the company at any stage, I would not have any claim on any of the promised shares? Or would I? Could they just say the cliff was a period longer than that which I stayed working for the company? Thanks in advance to anyone that can advise.

  12. Nigel says:

    Does anyone know if this way of using shareholders agreements like in the UK works the same in Australia? A lot of our common law and company law is based on UK law for obvious reasons but I can’t seem to find anywhere and most lawyers I’ve spoken to to try understand this have no real clue.

    My understanding in Australian law though is that if we do the reverse vesting is that if 1 year into a start up we decide to move an equity partner out of the business and exercise the buy back of the shares, that even though the shareholders agreement says we can buy them back for $1 the tax office sees this completely differently and ensures taxes are based on ‘market value’, which could be huge!

    Anyone with any better clue than I and the lawyers I’ve spoken to!

    Thanks in advance and great blog!!

  13. Alan says:

    So let’s say 4 founders with equal equity are vested over 4 years, and the company is sold for $1,000,000 after 2 years where each founder is 50% vested. What does the payout look like?

    Do each receive $250k or $125k?

  14. Adrian Chaffey says:

    In defence of UK lawyers (and by way of a little insight into the way they think) when one says something is over-complicated, he or she is probably trying to steer you away from something because instinct built up over the years says it ain’t a good idea.

    They’re probably thinking any of a number of things: that, if things aren’t done this way here, there’s probably a reason for it; that there are almost certainly tax issues; that at best the tax issues would be difficult to navigate (and might rule out what is suggested); that sorting them out, even if it could be done, would take a lot of time (which the client won’t want to pay for); that it would require a lot of bespoke drafting and additional thought (which again the client won’t want to pay for); that all of this means the whole thing is rather risky; and that it is going to be better to look to achieve similar ends using more conventional UK methods.

    Don’t get me wrong, I understand the commercial reasons behind vesting, I just don’t think the US structure is likely to work here in the UK.

    Andy’s suggestion is rather different from (what I take to be) the US approach, but not that different from something that has been a staple of angel and VC deals for many years, and something your UK lawyer is going to be very familiar with. Andy is suggesting leavers get to keep some of their shares, but have to sell others for a nominal value. Any UK lawyer with any experience in this area will be familiar with leaving provisions with discounted prices for early leavers. Not quite the same, I grant you (and which is better could be debated), but not that different. Both provide the means by which leavers don’t get the full benefit of their shares.

    I’d add that unless the company has distributable profits (which won’t often be the case with startups), the company may not be able to buyback shares in the way Andy suggests anyway.

    Disclosure: okay yes, I am a UK corporate lawyer, and I do work with startups. Referred here by a client. Interesting post.

    • john bentham says:

      As an alternative to the buy-back scenario, you can just allow in the company’s articles of association for the ‘un-vested’ shares to automatically be converted into worthless deferred shares upon the founder leaving.

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