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.
Standard vesting
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.
Let me know what you think in the comments or on Twitter @simeons.
As you are probably aware, there is at least one top tier venture fund in town that appears to insist on five year vesting and others that may not insist but do use it from time to time. Five year vesting is like four years in that there is a cliff after the first year and then the remaining options vest ratably over four years. The argument, as I have heard it, is that five years brings the vesting for early employees more in line with the expected time to exit. Needless to say, we resist five year vesting on behalf of our entrepreneur clients.
Dave, have you heard of entrepreneurs choosing other investors because of the five year vesting?
I have not. I think most entrepreneurs are happy to take funding where they can find it. I have observed (can’t say I have been lucky enough to represent) a couple of early stage entrepreneurs with concepts so compelling that they have had several name brand VCs vying for the investment. I suspect that these folks many have length of vesting as an important consideration.
Outstanding post, Simeon. Vesting is an incredibly important topic and this is a very good description of the pros and cons. A few points: my objective in the 50% on exit is more to protect the founders than the investors. I have seen many companies fail due to the ‘ReallyNewCo’ syndrome. (Company failure also has a really negative effect on investor returns :-). Yes, my vesting formula works better for angels than traditional VCs. I was a VC and I believe the reason the VCs don’t use my formula is because they do not assume the founders will still be there at the exit (especially the CEO who they replace about 75% of the time.)
Basil, thanks for clarifying the 50% on exit point. I’m not sure I understand how withholding 50% of vesting until the exit protects founders, though…
Simeon, it’s the group psychology of the founders and something I call the “ReallyNewCo” syndrome. Its a heartbreaking failure mode. I hope this makes it clear, and protects your readers, http://www.angelblog.net/Corporate_Structure.html
Basil, I think I’m starting to understand your premise. In order to prevent a group founder exodus from a company you want to create an incentive structure that severely penalizes anyone from leaving before exit.
Why is this a fair treatment of a founder who leaves after adding a lot of value and doesn’t create a group exodus or a founding CEO who leaves in three years after hiring the perfect replacement CEO? What if it takes five or more years to exit?
I understand the end you are trying to achieve. However, I cannot imagine this ReallyNewCo syndrome to be more likely than the combination of various other scenarios of one or more founders leaving for very legitimate reasons. To me, this is a case where the end does not justify the means.
Hi Simeon – Wow, I need to improve my writing skills. No, I did NOT want to suggest that anyone be ‘severely’ penalized. I am only concerned that everyone is treated “Fairly and Equitably”. That is the only way the company will succeed.
Your question about what is fair is precisely the formula I suggest. The CEO who starts but exits in 3 years has EARNED only half of the stock that they would have fairly earned if they stayed all the way through. The 50:50 formula is the most fair and gives the company the best chance for success. (I SO wish I could show a math proof or do a double blind study.)
The ReallyNewCo syndrome is extremely common. I estimate that it seriously affects about half of companies with more than one founder.
Great dialog!
Basil, unless you can show some data as opposed to “estimates” to prove your point, it’s hard to believe your claim that the “50:50 formula is the most fair and gives the company the best chance for success.”
Smells like spin to me.
This is certainly interesting. I have to say anything that changes the status quo is good. There isn’t a founder alive that doesn’t dislike the idea that their vesting and post-exit career become negotiating points to the benefit of investors who have all their shares in hand.
Exits are a win by everyone and should be a win for everyone. If employees need to be locked in post exit that should either be something for the acquirer to factor in (or the post-IPO company to deal with) with new/additional options or whatever otehr incentive mechanisms are appropriate, or reflected in the exit price. This aligns interests.
I appreciate the deep knowledge you demonstrate – but I’m confused – I’ll give you the benefit of the doubt that the text may unintentionally make a false impression …but you appear to take no position on the ethics of various proposals.
The choice of vesting schedules has profound effects on real people. Kids get to go to college or not. People get to make down payments on homes or not. Have retirement savings or not. You appear to suggest “penalizing people who’ve worked for years at the company” as if this is OK? An acceptable neutral position?
IMO, this would be reprehensible in (almost) every set of circumstances. If each and every long-term employee had not been successful finding every way to build the company over the years, mgmnt should have terminated them long before. But if they built the company, it’s craven to short change them for “new friends” the CEO/mgmnt team has acquired towards the end before the sale (who may share zip code, alma mater, or social class or skin color).
It means the management team has had them (long-term employees) working in typical deprivation start-up conditions for years under false pretenses (that there was a fair reward at the end). Pulling the rug out from under them at the end also means that management was happy to benefit from their dedication while letting them live in a distorted reality (the thought of a fair disbursement of proceeds).
As might be obvious, I have lived through a start-up where contributions of the long-term employees were devalued when a global company acquired the firm, while the potential contributions of a new management team were wildly overvalued. It was a devastating betrayal of a team who built a medical device.
At least we live in a democracy and I was able to visit my local Congressman, write an OpEd and otherwise speak out about the
self-serving decisions made in boardrooms of private companies.
Thanks for another chance to let people know that employees are not powerless pawns in any inventor’s/investor’s/senior manager’s chess game.
P.L., there are two separate issues here. There is the issue of what’s to be considered ethical in vesting schedules and there is the issue of what I personally think about any particular vesting schedule.
On the former, it’s hard to say that a vesting schedule is unethical. A vesting schedule simply is. It cannot be retroactively changed. It’s out there for any employee to discover and make decisions on. Someone can make a decision as to whether they want to work at a company or not based on their vesting schedule. Having a “poor” vesting schedule, relative to what’s common in the market, is no different in principle than having below-market salaries at a company. If you don’t like it, don’t join the company.
I would consider it unethical if a company whose vesting schedule is substantially different from what’s prevailing in the market at any point in time does not disclose that to people who are about to be hired. I also do believe that everyone in a company should be more curious and better educated about the various documents they are signing and agreements they become parties to.
Perhaps you should read what I wrote again. I don’t suggest that penalizing people who’ve worked for years at the company is OK. I was simply describing what Basil’s proposed vesting structure would do in a number of cases. Some may think this is terrible. Some may think it’s OK because everyone who joined the company knew what the vesting schedule was.
As for my personal opinion on Basil’s vesting schedule, it’s simple: I don’t think it’s fair in most cases. It primarily makes sense in the case of build-to-flip companies where there is an agreement between investors and founders/employees that the team must stay together through exit. Even then, note that it is the founders and employees who bear the majority of the risk. To make the situation more fair in that case, they’d have to get above-market grants.
Last but not least, I’m not sure from your description how it was vesting schedules that caused the efforts of the long-time employees to be valued at less than the efforts of new management. Typically this happens with recaps + asymmetric option reloads or with acquisitions where the buyer pays a lower price for the company but gives above-market packages to key players.
Simeon,
You are doing some good writing here and this is a very important topic.
I was a little taken aback by your comment:
Basil, unless you can show some data as opposed to “estimates” to prove your point, it’s hard to believe your claim that the “50:50 formula is the most fair and gives the company the best chance for success.”
I sincerely believe this to be true. I have done my best to describe the group psychology of why this is the most fair formula on my blog (www.AngelBlog.net).
But of course there is no way to prove this – how could it be proved? If you can think of a way, I’d be very grateful.
Basil, if there is no way to prove it, don’t you think perhaps you should not say it is “the most fair” and that it gives “the best chance for success,” especially since under a broad range of possible outcomes the vesting schedule you propose results in meaningfully worse outcomes for some founders and employees than the prevailing vesting schedules?
Your vesting schedule is neither wrong nor inappropriate. It’s a thoughtful alternative. My issue is with the claims you make about its superiority and the superlatives you use to market it to entrepreneurs.
Simeon,
There are many times in the affairs of men when we can know something, but be unable to prove it. At times, most of us literally bet our lives on things we believe but cannot prove. For the class of high growth, tech companies I describe in my writing, I believe that is the most fair vesting formula and that it maximizes returns for both the entrepreneurs and investors. Best regards, Basil
@Simeon, great post and a provoking discussion!
@Basil,
As one recently joined a startup I may say that it would be tough to comprehend your idea. I agree with the ReallyNewCo syndrome premise but ain’t sure that 50/50 is an obvious solution, certainly not for hired employees (how do you explain that a fire/layoff is not due to a desire to safe but poor performance?) . For founders I’m missing how you protect a committed partner who after 3 years got ousted (CEO whose startup overgrew him) and if you don’t why his factual success (overgrown startup) leads to the penalties. If the only basis for the 50/50 split is to avoid the RNC syndrome then wouldn’t it be prudent to increase the founders’ cliff to 2 years? I’ve read your blog scrupulously and admit that the build-to-flip idea seems quite special to me so may be the 50/50 protection is only pertinent for that type of startups?
Thanks for the discussion!
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Dear all, besides the vesting, management has usually a lock-in period in case of a successful exit before they can take on new ventures. How long is this period usually and do you have examples? Many thanks!
In addition to the dead weight problem with discontinuities and kinks in the vesting schedule, there’s also the impossibility of terminating an employee without exposing the company to a lawsuit claiming the termination was to avoid an upcoming kink.
Good point, Frank. It highlights the importance of acting early as opposed to waiting to get closer to such a kink.
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Very interesting discussion. We are going through this very thing right now in our startup Business Texter Inc. I am worried about founders equity, vesting schedules and what preferred stock allocated to investors will mean 5 miles down the laser beam in a few years.
Thank you all for discussing this openly. 🙂
David – glad this was helpful. IMO vesting is one of the most critical elements in startup design.
Simeon, thanks for the discussion.
I have a question and would appreciate your thoughts.
How do you determine when a founder “leaves”? Many entrepreneurial founders are involved in more than one venture and may no be dedicated 100% to one activity; however where do you draw the line to determine whether the involvement of a founder is not enough? Thanks
Augusto, I think this has to be situation-specific. Just consider Jack Dorsey leading both Square and Twitter.
Can you give me some more details?
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