If you are a business owner, you may have come across a term known as share vesting. Share vesting is a form of compensation that’s important for investors, co-founders, and management teams. An employee can be compensated through many financial instruments including cash, equity, stock options, and others. Traditionally, employees are paid a cash-based salary and potentially reward cash bonuses based on performance. However, in certain roles, you may be rewarded equity in the form of shares or stock options via a share vesting agreement. Read this Business Kitz post to find out more about share vesting.
Share vesting is when an employee is rewarded shares or stock options as compensation but receives the right to act on the assets once certain conditions are fulfilled. In many cases, this condition may be time-based, performance-based, or a mix of both. Once this condition is fulfilled, the shares will be fully ‘vested’ and may be acted upon (sold) by the owner. An unvested share cannot be acted upon, as the owner has not fulfilled their obligations. If the condition is broken, the shares will generally be repurchased by the company at their nominal value.
Businesses will often attach a time condition to the agreement so the employee is incentivized to extend their tenure at the firm. This may be structured in many different ways, depending on the company. The employer may arrange the schedule to suit the business objectives, arranging shares to vest at particular dates or milestones. For example, an employee is granted shares that are vested equally over 4-years:
Year 1 - 25%
Year 2 - 50%
Year 3 - 75%
Year 4 - 100%
The employee gains the rights over the vesting period and has full ownership in year 4. In the first year, the owner may exercise the right to sell 25% of their shares - while the rest remain unvested until other conditions are achieved. There may also be performance-based conditions attached, where shares remain unvested until certain KPI's are achieved.
Equity provides a long-term incentive for employees to act like owners, reducing the principal-agent problem. By aligning the incentives of owners and workers, they are both acting in their own self-interest in a positive and productive manner.
It allows the firm to provide compensation and compete for top-tier talent without having access to large amounts of cash. In order to compete with corporations that pay attractive salaries and cash bonuses, startups will offer equity ownership as a form of compensation to attract and retain talent without excessive cash outflows through wages. This allows the business to use capital efficiently, reinvesting the cash saved back into other areas of the business.
If the relationship doesn’t work out, the employer will repurchase the shares and retain the equity. This is a better outcome than the employee receiving cash or fully vested shares at the time of employment and can walk away with them at any time.
Investors are attracted to companies that have management with vested shares. It provides a sense of security, that they are committed to the business and growing the future value of the company through time-based vesting. If management is compensated by ownership, their interests are aligned with shareholders - to maximize shareholder value.
For employees, it provides a form of compensation that will pay exponentially if the business performs well in the future. Rather than a cash bonus, equity can compound over time and provide an exponential return.
The duration of the vesting schedule must be attractive enough for potential employees to accept, but beneficial enough for the employer to give up an equity stake in the business. The employees would like the vesting period to be as short as possible, while employers look for a longer-term commitment. Addressing this duration mismatch can prove difficult for businesses.
Although share vesting is an attractive form of compensation, employees will still need tangible short-term liquidity to fund their daily life. Therefore, companies must negotiate a base salary in order to fulfil this need.
Share vesting can prove valuable to certain businesses, however, may be dependent on the financial position, industry, size, or other variables that may impact the value of vesting. If you want to attract and retain talent, protect your capital, and incentivize employees to perform better, then share vesting might be right for you.
If you require assistance regarding whether share vesting is right for your business, we recommend speaking to a legal professional. Our sister company, Legal Kitz can assist in creating the perfect incentive scheme for your business. They offer a FREE 30-minute consultation to answer any questions or queries you may have. Book here now!
