 |
Best Practices for Angel |
Sign up for the Email Newsletter |
Subscribe to the RSS Feed |
 |
Share and Option Vesting
Widespread employee ownership is still a relatively new concept. Even as recently as the 1980's, there was still debate on the degree to which employee equity ownership affected share price.
Today, it is widely accepted in North America that companies with broad employee ownership create larger, and more rapid, 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.
Even though there is reasonable agreement on the optimum magnitudes of equity ownership, there is still discussion on the optimum vesting formula.
In mid-1980's, ten year share vesting was common.
As the tech equity mania gathered momentum in the last decade, and it became more difficult to hire, vesting periods got shorter and shorter. In Silicon Valley, in the mid to later 1990's, vesting periods were often as short as 18 months.
Anyone who has built a few companies knows this doesn't make sense. It takes much longer than 18 months to build a company. 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 still widespread because the market for talent is relatively efficient. Companies soon realized that if they did not offer short vesting periods, they would not be successful in recruiting new employees.
Along with the equity markets, the pendulum has started to swing back. Today, at opinion leading companies like Microsoft, vesting is over 4.5 years. Common ranges for vesting periods are 4 to 6 years.
One of the challenges in discovering the optimum vesting formula is something called 'psychological vesting'. Veteran serial entrepreneurs believe 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.
Experienced early-stage investors have also come to believe that the fundamental 'contract' between the company founders and the investors is that the founders will both increase the value of the investors shares and ensure that at some point they are also liquid.
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 a liquidity event 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 phenomena often describe themselves as 'stuckholders'.
There is also increasing agreement that roughly half the value that an investor realizes on their investment is created during the last few months of an investments lifecycle, during the exit.
As a result, today many experienced serial entrepreneurs and investors believe the most fair and equitable vesting formula is one that captures this implicit contract to create liquidity and this 50% value increase created at the time of 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 those situations, the board should develop a new formula to recognize the incremental or delayed liquidity created by this type of transaction.
