The importance of vesting

Image courtesy of FreeDigitalPhotos.netYou most likely heard about vesting. VCs often talk about it in their blog posts. Somehow startup founders still find it tricky to understand what vesting is about.

We’ll try to explain it here in the easiest way possible. It’s hard to overestimate the importance of vesting. If you are a founder you need to get used to this concept as early as possible in your entrepreneurial career.

Otherwise, you may find yourself in a situation Mark Zuckerberg talks about: He didn’t know what vesting was at the point when he started the company, and it cost him billions of dollars because of his co-founder Eduardo Severin.

The notion of vesting comes from a legal universe. Vesting is a common provision in equity schemes. Vesting means receiving the right (to the shares of equity).

To put it simply, if founders agreed to divide equity with a vesting condition, what they get at the beginning is unvested equity, which is just a promise. A promise that they will get their shares of equity as agreed only if they certain vesting conditions are met. The most common vesting condition is to stay with the company long enough for the equity to vest. Vesting conditions may include various milestones important for the company. An example would be getting 1 mln. of registered users – if this happens, founders may agree to have accelerated vesting of 25% of their shares of equity.

Vested shares are the shares the founders already earned. Founders can walk away with those shares if they decide to leave the company. That will be fair, as they received those shares for all their hard work.

Vesting is important even for teams with unequal equity splits. In fact, vesting has little to do with equal or unequal splitting. Imagine there are three of you, you split your startup equity 45%-35%-20% and get to work. In a month a founder with 35% looses interest in the project and leaves… taking 35% with him! The other two work hard, get VC money, become famous and in 6 long years launch an IPO. Of course, over those years 35% get diluted to, say, 7%, but that’s 7% of a billion dollar company – not bad for a month of work, heh?

That’s a made-up example, of course, but if there were a vesting provision in place the founder who left in a month would get no equity. And this would be fair to those who stayed and made their company a huge success.

Image courtesy of FreeDigitalPhotos.net

Five things you should know about founder equity (before you split it)

Founder equity (same as founder shares) is how much of the company (or soon-to-be company) belongs to its founders. We listed five most basic – and most useful – facts about founder equity to help you look at it in a new light before you split it with your co-founders.

1. It is an unlimited resource

Founder equity is not a limited resource. It’s an unlimited resource. It’s growing along with your company. Don’t be afraid to share equity with your co-founders, employees, advisers, investors. If you start working on an idea and own 100% of it – that’s 100% of nothing. It has no value yet. Value is created by people you’ll be able to attract and inspire by your idea. If at the end you have 10% of equity, that may be 10% of a billion dollar company. Isn’t it better than 100% of nothing?

2. Treat it as remuneration

At the very early stages of startup lifecycle founders are typically not paid salaries. Equity is then used as remuneration to the founders for the work they do. Similarly to remuneration, shares of equity should be aligned to founders’ performance, their contribution to the project, even the actual time spent working on the startup.

3. No payouts, at least in the short-term

In contrast to remuneration, however, equity is not “paid out”. It is a promise for founders that they will get the right on future company profits, if there are any. While the company is being built and has no real value, the founding team may want to regularly review their fair division of equity to make sure each founder gets a share corresponding to what he or she did relative to other startup co-founders.

4. Fix it when there is funding

The best time to get your division of founder equity fixed is when your startup is ready to raise funds or incorporate the company and use a real shareholder agreement. At that stage founders, if they take on executive roles in the company, usually start receiving salaries. From that moment on equity is a measure of how much control they have over the company and what is their share in the company profits.

5. Vesting is good for it

Founder equity may be subject to vesting. Vesting means that although founders already have certain shares of equity assigned to them, they still need to “earn” them by staying with the company long enough (standard vesting schedule spans over 3 to 4 years). Vesting prevents founders who lose interest in the project and leave from walking away with half of the company – which is good for those who stay and continue working hard to get things done!