Startups are a business model that very often relies on the knowledge of qualified staff. However, it does not always have enough capital immediately to be able to offer key employees attractive remuneration. One mechanism to motivate professionals to work harder and commit to the business is share vesting. What does this solution consist of?
What is share vesting?
Vesting can involve both shares and stocks, depending on the organisational and legal form in which the company that is the vehicle for the business idea operates. A vesting clause can be found in the company’s articles of association (or statutes) and consists in the employee gradually acquiring rights to purchase shares at a predetermined price over certain periods of time.
Through the vesting mechanism, you can increase the involvement of key team members – e.g. managers, board members, sales specialists, developers – as they begin to participate in the company’s activities in real terms and have a say in what happens to the company. In this way, the risk of key employees leaving the company can also be reduced.
Of course, the shares or stocks acquired through vesting are not ‘virtual’. In order to be able to share them, the company must first issue them which means that it needs sufficient capital to do so. It is less common to vest through the sale of existing shares or stocks.
Vesting of shares is one of the elementary parts of ESOPs (Employee Stock Option Plan).
Vesting of shares by example
The easiest way to illustrate the principle of vesting is to use an example. Let’s assume that a startup operating under the name Alfa S.A. currently has four shareholders, each holding 50 shares. The company then hires a manager who is responsible for implementing sales plans. The company’s articles of association stipulate that a maximum of 30 shares can be allocated for vesting. To increase the motivational effect of vesting, however, the manager does not receive the entire pool of newly issued shares at once, but will acquire them gradually according to the following scheme:
- 10 shares after working the first year;
- 10 shares after working the second year;
- 10 shares after working the third year.
By resigning from his position, the manager loses the opportunity to acquire further shares. Moreover, failure to perform his or her duties reliably may lead to sanctions in the form of loss of shares already acquired. This example of vesting is as simplistic as possible, but it illustrates well what motivating employees is all about.
What to bear in mind when building a vesting clause in a company?
In most cases, the vesting clause is quite elaborate. This is justified, however, as the maximum precise provisions that must clearly define who acquires the right to shares, when, for how much and in what proportion.
Above all, it must be specified which of the company’s employees will have access to the issued assets, as well as the duration of the clause itself. In practice, the acquisition of shares or stocks is spread over a period of 2 to 5 years. As regards the personal scope of the vesting, it usually concerns persons who have a real influence on the company’s financial performance.
The conditions that must be met in order for an employee to receive shares or stocks can then be defined. This can be the mere fact of working a certain amount of time in the company, but also making the benefit conditional on certain economic criteria, such as:
- increasing the productivity of the department by a minimum of 10%;
- acquiring three new customers for the company during a quarter;
- an increase in the company’s profit by a minimum of 5% expressed as EBITDA.
Simple and staged vesting
The next stage is to create a timetable for the acquisition of shares or stocks. The simplest solution assumes that the employee acquires a certain pool after a period of time indicated in the company’s articles of association or agreement. This is, so to speak, ‘upfront’ and in good faith, as it assumes that the employee receiving, say, 50 shares in the company at once will want to work with the company for a longer period of time. Another solution is the introduction of the so-called Cliff Period, i.e. successive stages after which the possibility of acquiring shares appears. The periods for acquiring such holdings result from a structured schedule.
What is reverse vesting?
A variation of ordinary vesting is so-called reverse vesting. It consists in awarding to an entitled employee the entire pool of shares due to him or her “in advance”, with the provision that in the event of non-fulfilment of the criteria indicated in the agreement or the articles of association, these shares will be cancelled (gradually or in one go). In this way, the company creates an incentive tool, as the person who has received the benefit of the issued shares must try to work efficiently enough to keep them.
In the case of reverse vesting, it is very important to precisely describe the conditional or compulsory redemption mechanism.
How can the company’s interests be protected when introducing vesting?
In order to protect the company against unplanned changes in the composition of the workforce, it is necessary to introduce protective clauses into the agreement or articles of association. One such solution is a shareholder’s priority right to acquire shares that the vesting employee does not wish to acquire or plans to sell. In this way, the shareholder protects the company against the entry of a third party into the company. In order to preserve the existing balance of power, the priority right is often combined with a so-called anti-dilusion clause. This stipulates that new shares may only be obtained in proportion to the number or value of the shares already held.
Another solution is the so-called lock-up, i.e. the introduction of a restriction in the agreement or articles of association, according to which the acquired shares cannot be sold before a certain period of time, e.g. three years, has elapsed. This allows the remaining shareholders to raise capital to repurchase the shares offered by the person who previously benefited from the vesting.
A frequently used alternative is also to extend the procedure for the company to consent to the disposal of shares. Although the provisions of the Code of Commercial Companies do not allow for the exclusion of the possibility of selling shares, it is possible to introduce, for example, the necessity of obtaining consent from the supervisory board or the meeting of shareholders (general meeting of stockholders).
Vesting may prove to be an excellent way to motivate key employees and bind them to the company. However, the construction of such a clause needs to be well thought out, taking into account not only the applicable regulations, but also the specifics of the business. Linke Kulicki Law Firm specialises in providing legal services to startups and supports its clients in developing ESOPs tailored to the needs of a specific business. Our lawyers will take care of the preparation of the necessary documentation and provide training to management on how to use vesting effectively.