Now that everyone has agreed to apply vesting to their shares (see What is Vesting and Why is it Important for Founders?), you next need to decide the right vesting schedule for your shares. While there are countless permutations of vesting schedules, we’ve distilled the options down by focusing on the five most important considerations.
The length of a vesting schedule is the period of time over which the shares will be subject to vesting. So, if you choose a four-year vesting schedule, it will take four years for all the shares to vest. While the length of a vesting schedule can vary, three to five years is fairly standard, with a four-year vesting schedule being the most common.
While four years may seem like a long time to founders, sophisticated investors expect founders to have skin in the game for a long enough period to increase the likelihood of a successful return on their investment. Also, while some investors have been proposing five-year vesting schedules when no vesting has been applied, if shares are already subject to a four-year vesting schedule, investors will typically accept this and not require an amendment. By contrast, if only a one or two-year vesting schedule has been implemented, an investor may require amendments to these vesting schedules as a condition to a financing, since the investor may view this as too short of a period.
The vesting commencement date is the date from which the vesting schedule commences. For founders, this date can often be an earlier date than the date of grant, in order to capture any time that the founder has already spent working on the company. So for example, founders started working on the company on May 1st 2015, but didn’t formally incorporate and issue founder shares until December 1 2015, the vesting commencement date for the founder shares granted in December can be May 1, essentially giving the founders credit for the seven months they had already been working on the company. So if you granted founder shares on December 1 with a four-year vesting schedule and a vesting commencement date of May 1 2015, this would mean that all of the founder shares would be vested by May 1 2019.
Notably, if an earlier date is selected for the vesting commencement date, the date chosen must be a date that the founders can justify when investors ask. Typically investors will accept a vesting commencement date of up to one year prior to the date of grant, assuming the founders can demonstrate that they were in fact working on the company during that time frame.
The frequency of vesting describes how often the shares vest over the length of the vesting schedule starting on the vesting commencement date. The most common vesting frequencies, after any cliff vesting period, are monthly or quarterly. This means that a portion of the granted shares vest every month or every quarter. This frequency is often expressed as either a percentage or a fraction of the total shares granted.
For example, if you have a four-year vesting schedule with monthly vesting, this would mean that 1/48ths or 2.08333% of the initial shares granted vest each month over the 4-year period.
Whereas, if you have a four-year vesting schedule with quarterly vesting, this would mean that 1/16ths or 6.25% of the initial shares granted vest each quarter over the four-year period.
Another important feature to understanding vesting schedules is whether the vesting schedule has a “cliff” or vests over a “straight line.”
A cliff means that there is some time period from the vesting commencement date before the shares begin to vest, but then once that cliff is reached a large chunk becomes vested (essentially making up for the period in which the shares hadn’t vested). Visualize a mountain and until you reach the top cliff no shares vest, but once you reach the cliff, a large chunk vests and the remaining shares then vest at a regular frequency. The most common cliff is a 1-year cliff, which means that no shares vest until the first anniversary of the vesting commencement date, at which point one years’ worth of shares immediately become vested and the remaining shares vest over the period left in the vesting schedule.
By contrast, straight line vesting means that the shares begin vesting immediately from the vesting commencement date at the frequency selected. In a straight line schedule, the shares always vest at regular intervals (there is no cliff to reach before the vesting begins), in a straight line, until all the shares have vested at the end of the selected length of the vesting schedule.
In most cases, no shares will be described as being vested up front per se, but rather, the vesting commencement date is used as the way to compensate founders for any time already spent on the company prior to incorporation. However, in some rare cases, founders may provide that, even though little to no time has been spent prior to formation working on the company, a portion of the shares granted are immediately vested and the remainder vest over the selected time frame.
This is not a common practice because, typically, most sophisticated investors want to see that all of the founder shares are subject to some form of vesting on the grant date.
Common Vesting Schedules Based on #1-5. Now that you understand the five important considerations of vesting schedules, let’s put it all together to come up with a few vesting schedules for founder shares.
For each of the below, let’s assume 4 million shares are being granted to a founder on December 1, 2017, with a vesting commencement date of May 1, 2017:
- Four-year vesting schedule, monthly vesting with a one-year cliff and no shares vested up front (*Note: This is the most common vesting schedule)
- What it means: No shares vest until May 1, 2018, on which date 25% or 1 million shares vest immediately, and the remaining 3 million shares vest in equal monthly installments until May 1, 2021, at which point all 4 million shares will be vested.
- Four-year vesting schedule, monthly vesting over a straight line and no shares vested up front. (*Note: This is the 2nd most common vesting schedule)
- What it means: This means that the 4 million shares vest in 48 equal monthly installments starting one month from the vesting commencement date, with all shares vested as of May 1, 2021.
- Five-year vesting schedule, quarterly vesting with a one-year cliff and no shares vested up front.
- What it means: No shares vest until May 1, 2018, on which date 20% or 800,000 shares vest immediately, and the remaining 3.2 million shares vest in equal monthly installments until May 1, 2022, at which point all four million shares will be vested.
- Five-year vesting schedule, quarterly vesting over a straight line with 20% of the shares vested up front.
- What it means: 800,000 shares are immediately vested as of December 1, 2017, the remaining 3.2 million shares vest in equal quarterly installments until May 1, 2022, at which point all four million shares will be vested.