Equity holdings in a company have long had an attraction for entrepreneurs and employees alike. While the primary underlying factor is wealth creation, there are other factors at play, such as the desire of employees to have an ownership interest in their creations and inventions. The attraction of ownership in companies has been fueled by the emergence of the Tech sector from the early 1990s and the overall stellar performance of stock markets from around the same time. Over the past 30 years, the development of these two factors has essentially been symbiotic. In this article we discuss sweat equity vesting over a period of time and the different ways of doing that whilst not endangering the interests of the company.
So, what is Sweat Equity?
In its simplest form, Sweat Equity is the exchange of non-monetary items for a monetary gain. The items for exchange could include a person’s time, labour, skills and knowledge, a landlord could supply space, suppliers could provide goods and services.
Within the context of a Start-up, sweat equity vesting relates to the issue of shares or grant of share options as part of the compensation packages of Founders and Co-Founders of the Start-ups (“Founders”) and employees. By offering time, skill and knowledge, Founders and employees can have an ownership interest in their Start-up which they could not otherwise have.
A Start-up can issue shares and options for its shares at a discount based on certain pre-agreed milestones being achieved such as turnover, net profit, return on equity and earnings per share (“Milestones”) within agreed time periods or at certain times (“Timepoints”). Various conditions may also be attached such as cliff periods and vesting periods. From the perspective of the Start-up, the objectives are primarily threefold:
to preserve cash resources without the need to take on debt;
to compensate Founders for the low compensation being paid; and
to retain the services of Founders for the longer term.
What is Given and Received
At inception, Start-ups tend to have limited resources to fund operations and limited scope to generate cashflow from operations. If the Start-up can issue shares or grant options in exchange for goods and services, its ability to fund its operations would be significantly improved.
Founders offer their time, skills, knowledge and creativity to the Start-up for significantly lower compensation than they could command at an established company. To partially compensate for this, most Start-ups offer Founders shares or options. For Founders, the benefit is an equity stake in the Start-up and the prospect of a huge increase in the value of the shares or the options if their hard work and creativity pays off. A win-win situation for all involved if the plan works out.
The danger for the Start-up is that once the shares /options are issued, the Founders could leave, or the Founders may not perform their duties at all or not to the required standard. As mentioned earlier, the Start-up can protect itself by adding restrictions on when shares or options vest and by having claw back features if defined Milestones and Timepoints are not met.
Vesting means the time at which the ownership of something passes from one party to another. In terms of shares or options, vesting is the time at which ownership of the shares or options passes to the other party. The vesting can take place with or without restrictions attached. At such time, Founders are said to have a vested interest in the shares or options. Until vesting takes place, the shares or options are said to be unvested. There is no ownership interest in them.
Restrictions on vesting taking place are time or event based or a combination of the two. For example, vesting may be dependent on the Start-up achieving sales of £500,000 per annum. Alternatively, vesting may be purely time based, taking place over a period of time or at a defined time.
Where unvested shares are issued or options granted, they are usually accompanied by a vesting schedule setting out a timeline according to which vesting will take place (“Vesting Schedule”). The unvested shares or options will vest at each specified Timepoint and the vesting may also be conditional on specified Milestones being achieved at those times. There are numerous Vesting Schedule variants as follows:
Standard Vesting Schedule
The most common Vesting Schedule usually uses a 4 or 5 year Vesting Period with vesting taking place on a linear basis. On a purely time based vesting situation, the unvested shares or options would vest in equal annual instalments over the 4 or 5 year period provided the Founders are still with the Start-up and specified Milestones achieved, if any. The instalments can be on a monthly, quarterly, bi-annual or annual basis depending on negotiations and the by-laws of the Start-up (for shareholders’ agreements click here). By the end of the Vesting Period, all the unvested shares and options will have vested in the Founders.
The time requirement is quite often accompanied by event conditions which must also be met. These can range for Start-up wide targets such as revenue and profit targets to specific targets for the Founders to achieve such as Milestones for the development of software.
It is quite common for the Vesting Period to be preceded by a Cliff Period. This is essentially a period during which the Founders will not be able to earn any vested shares or options. The Cliff Period most commonly ranges from 1 to 3 years from the date the unvested shares or options are issued or granted.
Reverse Vesting Schedule
In some situations, it may be more suitable if fully vested shares are issued to Founders with the proviso that the Start-up would be entitled to buy back the shares from the Founders should they leave the Start-up prior to an agreed date. Like the Standard Vesting Schedule, Timepoints and Milestones can be attached. On the achievement of each of these, the number of shares that the Start-up can buy back will decline. Essentially, this is a clawback provision if certain conditions are not met. This will protect the Start-up from an early departure of Founders.
The shares issued to Founders under a Reverse Vesting Schedule are referred to as restricted shares and may be held by the Start-up in escrow. During the Reverse Vesting Period, the Founders will benefit from almost full shareholder rights including the right to vote and entitlement to dividends and other distributions. However, in some respects their right would be limited; for example, the shares cannot be sold, and they may not be able to pledge or charge the shares for loans as they do not have unrestricted ownership interest in the shares.
The price at which the Start-up buys back the shares is usually the price the Founders would have paid for the original purchase. Alternatively, a sliding scale could be used with the price increasing as Timepoints and Milestones are achieved.
Early Vesting Events
While not a Vesting Schedule as such, the parties can reach agreement that certain events could result in the Founders’ shares becoming fully vested as certain Timepoints and Milestones are achieved. Examples of this would be acquisition of the Start-up by a third party for an amount above a specified target or an IPO of the Start-up above a stated valuation. The vesting of the shares or options in such instances would allow the Founders to fully participate in the transactions.
Another form of vesting, and again not strictly a Vesting Schedule, is Cliff Vesting. Here, the Founders are issued or granted unvested shares or options. The shares or the options will remain unvested until an agreed Timepoint at which time all the shares or options will vest in the Founders. Milestone can also be attached if desired. If the Founders leave the Start-up before the Timepoint, the unvested shares or options will be cancelled, and the Founders would receive no value.
While the interests and objectives of the Start-up and the Founders may be fully aligned in the initial launch period, at some point they will begin to diverge for a wide range of reasons. The issuing of shares or granting of options to Founders by a Start-up can contribute significantly to the retention of Founders for the long term and perhaps on long term profitability. To derive full benefit from such tools, their use must be carefully planned and targeted. Poorly designed share issues and share option schemes can cause great harm, unnecessarily dilute ownership interests and be counterproductive. It is thus key to have the proper sweat equity vesting arrangements in place.
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