August 17, 2006

The importance of vesting schedule in start-up equity

Not sure how "vesting" applies in the Indian context, but Andrew Fife's recommendations - based on the experience of having to close down his start-up - makes a lots of sense to me.
Equity is used to attract capital and is a major part of employee compensation packages. Thus, it is very important that startups are as efficient with their equity distribution as they are with their capital. Stocked owned by anyone who isn’t contributing to the companies success represents dead weight, which means there is less in the pot to attract new investors and team members.

No matter how close of friends, how much you trust each other or how good your intentions are money comes between people and everyone over estimates their own contributions. Furthermore, founders become highly emotional about their companies. Thus, the process of negotiating taking back stock from founders is not rational and inherently very difficult. However, vesting schedules reduce the difficult negotiation to simply and mechanically exercising the companies pre-agreed right to repurchase stock at the price it was issued. I foolishly let myself fall into the “it won’t happen to me” trap but no startup gets it right on the first try and theses hiccups often lead to changes in the team. Believing that any startup won’t have to deal with stock vesting issues is totally unrealistic.

Typical startup vesting schedules last 36-48 months and include a 12 month cliff. The cliff represents the period of time which the person must work for the company in order to leave with any ownership and the vesting schedule represents what percentage of stock the company can buy back at the time of departure. For example on a 48 month vesting schedule with a 12 month cliff, if an employee is offered 1000 shares but leaves in the first 12 months they don’t keep any equity. However, if they leave after 26 months they get to keep 26/48 of the equity promised or 542 or the 1000 shares. Key team members leaving will always be difficult but using a vesting schedule can make one acrimonious aspect of their departure much easier.

The second key lesson is that boards are most effective when they have 3 or 5 voting members and include at least one objective outsider to break any deadlocks. Early-stage startups are probably better suited with 3 directors than 5 so that the entrepreneur(s) can focus on building their company without getting bogged down managing their boards. My experience suggests that 3 is a good number even for bootstrapped companies that haven’t yet raised capital. Upon raising capital the investor will likely want a board seat so one of the board members needs to be ready to resign.

Arun Natarajan is the Founder of Venture Intelligence India, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of Venture Intelligence India newsletters and reports.