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.