What is Vesting?
Picture this: Two people, maybe they're brothers, maybe they're best friends of ten years, have an idea to start a business together. They're extremely close, and they trust each other through and through. And they're thinking, "we're going to start this business 50-50", and it's going to be successful. And we're both going to get rich and live great lives.
As you are probably already aware, this is not usually how things work out when you're forming a new business. It's easy to be excited and pumped about starting a business when it's just an idea, but once the hard stuff starts to pop up, chances are, someone is going to lose a little steam.
Let's go back to our friends in business- they're both named Hal (what a coincidence). One Hal, Hal #1, is hard a work, putting in the time and labor to form the business, while the other Hal, Hal #2, is off talking up the new business. They're sharing a 50-50 split of their new venture, but that's not the way the work is being divided. Fast-forward: It's been a couple of years, and the company is taking off. But, Hal #2 is still slacking. And, that's where vesting comes in...
What Is Stock Vesting?
Most of us have either been Hal #1 or known a Hal #1. It's an easy trap to fall into when you're working with friends and family. Luckily, there's a way to protect yourself from all the Hal #2s out there, and it's called vesting. Sometimes, referred to as stock vesting, it's the preferred alternative to starting a business 50-50. Vesting is the practice of offering partial ownership to a company via the option to earn stock at a fixed price, at a later date.
In Hal #1's case, let's say that he retains 100% ownership of the business and puts Hal #2 on a 4 year stock vesting schedule. What's a vesting schedule you're wondering? I'm so glad you asked. Typically a vesting schedule allows you to earn stock on a monthly or quarterly basis over three or four years. However, in many cases, you'll see one or two-year cliffs, that prevent someone from buying stock until the outlined time period has passed.
And now, back to the Hals.
Hal #2 is on a 4 year stock vesting schedule with a one-year cliff, which means that he has to work (as in actually work) at the company for a year before he can exercise his stock options. Once his year cliff is up, the vesting begins. Over the next four years, Hal #2 will be able to earn his 50% of the company, as long as he has proven himself. The vesting schedule forced Hal #2 to do the work required of him, and put Hal #1 in a position to be successful, even if the other Hal wasn't up to snuff.
Vesting On An Equal Playing Field
The theoretical Hals are ideal for providing a clean and concise explanation, but the real world is neither clean nor concise. This type of vesting works best when a business owner is looking to bring in a partner. If you're starting a business out with an equal partner and have doubts, getting them to proactively agree to a stock vesting schedule is tricky at best. In this situation, you can protect both parties by forming a written agreement with a vesting schedule for both owners.
In the case of our favorite business partners, Hal #1 and Hal #2, let's take a look at a vesting agreement that protects both parties. ABC Holdings owns 100% of this business venture and BOTH of the Hals are put on a vesting schedule. And, much like in the first situation, if both Hals accomplish what is outlined by the agreement, they will each have the opportunity to earn their share of the holdings back from ABC. Vesting allows both partners to eventually retain equal ownership of the business, while protecting one if the other should fail to uphold their end of the bargain. This type of vesting agreement is much more suited to starting a business with two partners.
Forming A Vesting Agreement
The entire idea behind vesting is that you have to prove your worth. There is no upfront equity for you to take hold of... Instead, you'll have to demonstrate your dedication to the business. This is where you'll want to get an attorney involved to draw up the vesting agreement and outline a vesting schedule. The idea is to legally protect yourself from a lazy, lackluster, or otherwise unhelpful business partner. So, you'll want to make sure that if legal action is required, you're agreement will hold up in court.
That's all on vesting for now. In the meantime, you can hop over to our YouTube channel, where I discuss everything from the difference between an LLC and C corp to How to Protect Yourself as a Small Business Owner.