Offering too much too early has landed many startup founders in a pickle.
They want to demonstrate projected company success and recruit the best participants to help them achieve major benchmarks. However, offering big rewards too early causes more problems than solutions.
Individuals may end up walking away with a big slice of the pie before contributing their fair share, and can leave the remaining startup founding team with too little pie to keep them sustained. This is why offering assets that vest can present big rewards, but not before a participant has contributed their fair share.
Here’s what founders need to know about vesting, why assets vest, and how to manage these assets to incentivize participant longevity while protecting your startup’s interests.
How Vesting Helps Maintain Startup Interest
Early stages of startups are exciting times. Ideas are numerous, plans are being formulated, and involved parties bring a lot of energy to the table. Founders like to think this positivity will continue throughout the life of the company. Nonetheless, team members could change their minds – willingly or due to uncontrolled circumstances – and walk away early.
Vesting periods help ensure invested parties maintain an interest in the company. Rather than being considered a negative tool or a punishment of sorts, vesting periods ensure founders and integral team members earn their equity compensation over time instead of all at once. The vesting structure incentivises involved parties by rewarding those who continue to show up, contribute, and continue building and refining the startup.
What is the Ideal Vesting Timeline?
Vesting timelines involve a cliff period, which is a window of time where no stock is earned. Typical vesting timelines span four years for founding teams and employees, including a one-year cliff period, though longer vesting timelines can be structured. While some could argue vesting schedules could vary depending on the team member’s role, maintaining standard vesting schedules across the company ensures alignment and prevents complications down the road.
Nothing vests during the cliff period. If someone walks away during this time, they forfeit their assets. At the first year mark, 25% of their stock vests at one time. After the cliff period is over, the remaining assets vest in equal increments throughout the remaining three-year period. While monthly vesting is normal, frequency can be scheduled in whichever way best suits the company and its cap table projections.
What Vesting Triggers Should Be Outlined?
While vesting structures have frequently been associated with timelines, some founders are increasingly using business milestones as vesting triggers. This strategy incorporates the notion that startups can find success at varying timelines, and helps to encourage company dedication through various business cycles rather than strictly by timeline.
Mergers and acquisitions typically lead to single-trigger or double-trigger acceleration. When founders begin drafting formation documents and determining equity distributions, the team must decide how to outline vesting acceleration triggers should a merger or acquisition occur.
If single-trigger acceleration is chosen, all unvested shares would vest immediately upon acquisition. If double-trigger acceleration is selected, the founder or employee must be terminated without cause by the acquiring company. This protects the startup because the new owner is not required to distribute a significant portion of equity right away, and at the same time protects founders from losing their unvested assets if they are forced to leave.
Should I File an 83(b) Election?
Founders, team members, or investors who receive vesting stock should probably file an 83(b) election, and do it quickly. This tax-saving strategy must be filed within 30 days of receiving shares. Otherwise, the IRS views gained equity as income, and shareholders will have to pay accordingly.
To avoid overpaying in taxes as equity increases, the 83(b) election allows recipients to pay taxes upfront, based on the value of the shares at the time of distribution. If and when stocks are sold at a later date, shareholders are only responsible for paying a capital gains tax.
If the 83(b) election is not filed, the IRS will require shareholders to pay income tax on the increased share value, which could be quite significant and much more than the total of the capital gains tax owed if the election was filed appropriately. A startup attorney can advise if this is an ideal strategy depending on the startup’s circumstances.
How Do I Structure Qualified Small Business Stock?
Combined with an 83(b) election, the IRS’ Qualified Small Business Stock exclusion could be the most favorable tax positioning for founders holding vesting stock. There are eligibility restrictions — only C-corporations with less than $50 million in assets when stock was issued are eligible. In addition, stock must be original issuance and founders must hold their shares for a minimum of five years.
This setup may qualify shareholders to exclude all capital gains from their taxable income when stock is eventually sold. There is a limit: up to $10 million or 10 times their initial investment, whichever is greater.
What is Reverse Dilution?
Reverse dilution occurs when a founding team member or early employee leaves the startup before their shares vest. The unvested shares are not redistributed; they disappear. The total number of outstanding shares decreases; therefore, the ratio of each team member’s shares to total shares increases proportionately across the company.
For employees, granted stock options that have not been used are returned to the option pool. Founders can redistribute those options, or hold onto them for future hiring incentives.
Are There Vested Assets Other Than Stock?
In addition to restricted stock shares, several types of business incentives vest over time. This is fairly standard across the startup ecosystem, and is a tool that illustrates the long-term commitment of participants.
Retention Bonuses
Rather than paying a lump sum as a hiring incentive, founders may choose to implement a vesting retention bonus to compel new hires to remain with the company over time. Payout architectures can vary depending on the position, project, or mission, or can be paid when specific company milestones are reached.
401(k) Employer Match
Employee contributions to their 401(k) accounts will always be theirs. However, employer matching dollars can vest over time. This not only boosts recruitment incentives, but also encourages employee longevity.
Token Allocations
Ownership allocation increasingly involves tokenization. These digital assets can turn physical, real-world assets into digital assets that incentivize participant longevity when a vesting structure is applied.
Safeguard Your Startup’s Assets with HJF Law
Expert startup attorneys at HJF Law can help you structure vesting schedules, documents, and contracts to protect the interests of your early-stage company. Whether ensuring transparency and alignment among a founding team or ensuring assets are protected throughout various growth stages, our team is here to support you.
It’s never too early to hire a lawyer! No matter the stage of your startup, having an attorney at your side helps keep your business protected. Reach out to our team here or call us at (917) 726-8184 to schedule a free consultation and learn more about how we can help your business.