There is no such thing as the best or optimal vesting schedule in a startup. That doesn’t mean current vesting schedules are really good but it does mean that many of the so-called best alternatives are not much better.
No such thing as best
“Best” as a concept has natural appeal. It’s great to be best, to know you’ve done something in the best possible way, etc. It tickles our pride and makes is feel good about ourselves. In the process, we tend to forget that there are at least two ways to evaluate the quality of decisions: as determined by current information, given knowledge & experience, and as determined by hindsight.
Hindsight is the harshest and probably best judge. Even then, it’s hard to make accurate judgments since the decisions made earlier, especially if they were made years before, could have influenced outcomes and hence affect the accuracy of hindsight. Still, if we are to talk about “the best vesting schedule,” I can’t imagine anything better than a hindsight test. Did the vesting schedule in a startup help or hurt returns for various types of equity holders? Which is where we immediately get stuck on two issues about how we define “best”.
First is the notion of pareto optimality. A pareto optimal situation is one where we cannot make someone better off without making someone else worse off. Since vesting affects anyone who leaves before being fully vested negatively and everyone else on the cap table through the repurchase of unvested shares positively, almost any vesting schedule is pareto optimal. Therefore, we can’t talk about a best vesting schedule for everyone. We can only talk about a better vesting schedule for certain parties, which requires judgment as to some type of preference order. Do investors come before employees? Do execs come before individual contributors? Do founders count for more? Do you penalize people who’ve worked for years at the company and then leave and reward the ones who joined a year ago? I don’t know about you, but I don’t have set answers to these questions. A lot depends on culture and should be within the control of entrepreneurs, execs and investors. They can set it up however they think makes sense and then others can make decisions about whether to join as employees or investors later.
The second issue is simply that a company has to pick vesting schedules months and years before major events such as product launches and an eventual exit. We all know how uncertain things are with startups. To say that one can pick some type of “best” vesting schedule that positively impacts returns to more than one type of holder regardless of whether the company exits for $3M in 18mos when everyone on the founding team is still there or for $350M in five years after three different CEOs is, to say the least, improbable.
Just to get our bearings, the so-called “standard” vesting schedules many companies use are along the lines of:
- Founders: 25% up front and the rest monthly over 3-4 years.
- Employees: 25% after one year and the rest monthly over 3-4 years.
An example alternative vesting schedule
A comment to my VentureHacks article on building agile founding teams asked about an alternative vesting schedule proposed by Basil Peters, a successful super-angel. Basil’s proposal has three key points, reproduced here:
- 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.
My summary analysis is that this is an interesting vesting approach that is more investor-friendly than founder- or employee-friendly and that is likely to work better in the case of companies that have small exits in short periods of time and may actually hurt returns in the case of larger companies. Point by point:
- 50% daily vesting over three years
- The 50% is related to the next bullet, I’ll address it there.
- I don’t see a big difference between monthly & daily vesting. Daily is probably better. As rule, I like continuous functions–discontinuities and kinks sometimes influence decision-making in bad ways. That’s why I think quarterly vesting is a terrible idea–someone who’s ready to leave may stay on as dead weight for a couple more months to get that extra bit of vesting.
- Three years for 50% is a bit long but that actually depends on the size of the initial grant (is it above or below market?), which is something the proposal doesn’t discuss.
- No vesting cliff means there is a penalty to pay for people who don’t perform well or leave after a short period of time. I don’t have a problem with this–same argument as why I prefer daily or monthly vesting compared to vesting over longer periods of time. Perhaps it will make companies more careful about who they hire.
- No founder acceleration is unfair to the effort founders have put in prior to funding the company. If founders have a choice, they may prefer to raise money from a different investor whose ideas about vesting do include acceleration. Therefore, this clause may actually hurt an investor’s deal flow / win rate and, therefore, returns in the long run.
- 50% on exit
- The argument here is that up to 50% of the value is generated close to the time of exit and by running a great M&A process. This may be true for exits that are near rounding errors on the acquirers’ P&Ls. It’s certainly not true for larger startups most of the time. Analysis by M&A powerhouses such as Updata and Jeffries/Broadview suggests there is such a thing as a “market rate” for exits and it’s hard to get far outside the valuation curve of the day. Yes, there is such a thing as a strategic premium and I do agree with Basil that very few companies know how to make trade-offs between investments that grow their strategic premium and investments that just grow the business. The bigger the company, the more inertia there is and the harder it is to make changes that quickly impact the strategic premium. M&A execution also matters but I haven’t seen any data that suggests that M&A execution, independent of the company’s state, can influence exits on a regular basis by that much. If anyone has that data, I’d love to see it.
- Holding equity/option grant sizes constant, withholding 50% of vesting till exit seems grossly unfair to founders and employees. What if a company takes six years to exit? Why should an engineer who built + helped launch many versions of the early product and left after four years be penalized that the company hasn’t exited yet? Why should a founding CEO who hits her ceiling, brings on a successor CEO and leaves after three years be penalized for doing that?
- There is an additional macro industry impact. A provision like this restricts labor mobility perhaps in a bigger way than non-competes. Vesting shouldn’t be a tool to force founders and employees to stay with a company. It should be a tool to connect their equity stake to their continued contribution in building the business.
- Acceleration on exit
- The way I read this, it implies full (100%) vesting on exit. This may be OK in the case of small companies that are being acquired for their technology as opposed to the ability of their teams to create additional value. If an acquirer doesn’t care about the incoming team in an M&A situation, there is little impact to the acceleration. If, on the other hand, the acquirer wants the team then full acceleration on vesting can depress exit values to an extent. The acquirer will need to create a retention package, say $5M, for the team since there will be nothing transferring over through the acquisition that has retaining value. That retention package increases the total cost of the acquisition by $5M. If the acquirer was willing to pay $100M at most in total, they’d only be willing to pay $95M of that directly to the company.