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Optimum Share and Option Vesting
I believe vesting is the most important element of corporate structure. It is essential to ensuring that both entrepreneurs and investors are treated fairly and equitably. Vesting has incredibly powerful effects on the group psychology, culture and corporate performance. I have seen many companies literally fail due to flaws in their vesting.
Widespread employee ownership is still a relatively new concept. Even as recently as the 1980s, there was still debate on the degree to which employee equity ownership affected corporate performance.
Today, it is widely accepted in North America that companies with broad employee ownership create larger increases in shareholder value.
After a couple of decades of experience and a few good analytical studies, there is now a broad consensus on the range of equity that is reasonable for a new CEO, or other senior employee, to expect when joining a company.
Agreement on Magnitudes But Not Vesting Formula
Even though there is now reasonable agreement on the ideal magnitudes of equity ownership, there is still discussion on the optimum vesting formula.
In the mid-1980s, ten year linear vesting was common. As the technology industry matured during the later 1980s, vesting periods shortened.
As tech gathered momentum through the 1990s, it became more difficult to hire and retain. Vesting periods got shorter and shorter. In Silicon Valley, in the mid and later 1990s, vesting periods were often as short as 18 months.
Anyone who has built a company knows this doesn't make sense. It takes much longer than 18 months to get a return on the cost of recruiting and training a new employee. Many employees have not even reached their maximum level of productivity in a new job for the better part of a year.
Interestingly, even though those short vesting periods did not make fundamental sense, they were widespread because the market for human resources is so efficient. Companies quickly realized if they did not offer short vesting periods, they would not be successful in recruiting new employees.
Along with the equity markets, the pendulum swung back in the 2000s. As an example, recent vesting at Microsoft was over 4.5 years. Common ranges for vesting periods today are 4 to 6 years.
Psychological Vesting
One of the challenges in discovering the optimum vesting formula is 'psychological vesting'. Veteran serial entrepreneurs and investors usually agree that when someone is two-thirds vested, they reach a psychological turning point where the vesting of the balance of their equity is much less meaningful to them.
This means that six year vesting is really only effective as a retention mechanism for about four years.
New Appreciation of the 'Contract' with Investors
Experienced early-stage investors have also come to believe that one term in the fundamental 'contract' between the entrepreneurs and investors is that the employees will both increase the value of the investors' shares and ensure that at some point they also execute an exit.
Investors in companies with large founders positions have often found themselves in situations where the founders have successfully increased the value of the shares but have either no motivation to create an exit or have left the company to pursue some new venture, leaving who ever comes next with the responsibility to create liquidity. Investors familiar with this phenomenon often describe themselves as 'stuckholders'.
Up to Half the Value Can Be Created During The Exit
There is also increasing agreement that up to half the value that an investor or entrepreneur realizes on an investment can be created during the last few months -- during the exit transaction. If an employee leaves before the exit, it does not seem fair that they participate in that final increase in value.
The Optimum Vesting Formula
The optimum vesting formula is the one that is most fair and equitable to both the entrepreneurs and the investors. I believe the best formula has to incorporate the implicit contract to execute an exit and realize on the 50% value increase that is often created at the exit.
This means that the most fair and equitable structure, and the one that maximizes the alignment between the founders and the investors, is to vest:
- 50% of the shares daily over a three year period; and
- the other 50% when there is a sale of the Company.
- All vesting for senior employees accelerates on a sale of the Company.
A sale of the company is an event where everyone in the company has an opportunity to exchange their shares for cash or shares with effectively immediate liquidity (for example, a stock with enough liquidity so everyone who wanted to could sell their shares). In this context an IPO is not a sale of the company. Neither is a conversion into restricted stock.
In these situations, the board should develop a new formula to recognize the incremental or delayed liquidity created by this type of transaction.
This vesting formula is built into the "one page term sheet". I've used this formula in virtually all of my angel investments for over 20 years. During that period, I've had a chance to watch how this vesting formula has affected the group psychology and increased the probabilities of success in over thirty companies. I am convinced this is as close as we can get to optimum.
