One of the first topics that a start-up lawyer discusses with a company’s founding team is usually the ownership and vesting of the start-up’s initial shares of Common Stock.  At the start of the discussion, some members of the founding team often don’t understand what vesting is and why it’s important.  As described below, share vesting permits a start-up to reduce the ownership percentages of those founders who depart early in the start-up’s life, while rewarding those founders who stay with the start-up over the longer term by increasing their ownership percentages.

Shares in a start-up are usually issued for a low price, and everyone involved expects that those shares will become very valuable over time.  Full of optimism, the members of the founding team often earnestly assure the new company’s lawyer that stock vesting isn’t needed, because the members of the founding team have known each other “forever” (which sometimes turns out to mean “more than four weeks”), and everyone on the team is “fully committed” to the venture’s success (even though a member of the founding team may have not yet informed his or her employer that they are terminating their employment to join the start-up).

Unfortunately, as the start-up progresses and the team works together day and night, things change.  Sometimes the member of the team who expressed the greatest enthusiasm for the new company abruptly decides that another “opportunity” is too good to pass up, and departs.  Other times, members of the founding team come to the conclusion that an early team member doesn’t have the skills or temperament to contribute to the success of the new venture, and must be asked to depart.  In either case, if the departing team member’s shares are vested, then the departing founder will continue to fully share in the success of the venture through the ownership of all of his or her shares even though he or she has departed and is no longer contributing daily to the new venture’s success.

To prevent departed founders from enjoying such a “free ride,” founders’ shares (and stock options issued throughout the life of a company) are typically subject to vesting.  For founders’ shares, this means that the shares will vest over a period of time (often in monthly installments over about 48 months, after the passage of an initial 12 month “cliff” period), and if the founder’s service for the start-up ends for any reason, the start-up will have the option to repurchase the unvested shares for their original purchase price (which is usually very low), thereby reducing the number of shares held by the departed founder.  Similarly, options typically vest over time so that if an option holder’s service ends before the options are vested, only the vested options may be exercised.

By providing for the vesting of shares, a start-up rewards those founding team members who stay with the start-up over the long term.

The vesting of shares has important income tax implications, which we’ll address in a future blog post.