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In early phases of a startup, finances are often stretched thin. Vesting shares can protect your startup by only granting equity to those who earn it.
Startups typically have lots of optimism and not very much money. One way in which startups often handle financing is to pay founders, advisors and employees in the early stages in the form of shares (or potential shares) of the company's stock. In most cases, this equity consists of "stock options," or the right to buy future shares at a fixed, discounted price. This fixed price is called the "strike price." Like any investment, the possible level of return on these shares is high because the risk involved is also very high. Overall, startups have a 75% to 90% percent chance of failure, in which case shares have no worth at all.Bill Harris, who helped engineer the startup of PayPal and now coaches young entrepreneurs, points out that "the people you want to attract to your business are the people who want equity." He goes on to say, "you need people who are willing to take risks. And then you need to reward them." One famous example of someone who took this gamble and won in a big way is artist David Choe. He painted murals on the walls of the original Facebook office in Palo Alto, California. Facebook, a one-year-old startup at that time, offered him a choice between a payment of several thousand dollars or some shares of Facebook stock that had the same value (at that time). Even though Choe had little faith in Facebook's future, he took the shares instead of the cash, and held onto them. In 2012, on the eve of Facebook's initial public offering (IPO), his shares were valued at about $200 million.
What is "Vesting" and How Does it Work?
"Vesting" is a word for the schedule of actually distributing the shares of stock that are promised to people who are involved with the startup. It rarely happens that a founder or early employee is simply given the full amount of equity that is promised to them, all at once. After all, if they were, they could simply take their shares, cut loose from doing any work to make the company succeed, and just sit back and wait to see whether they would get rich. Instead, it's usual to "vest" someone's shares over a space of several years, based on their staying with the company for that entire period. If the vesting period is four years, which is fairly typical, the person might receive one-quarter of their promised equity at the end of each year, or they might get a fractional amount at the end of each month. This process incentivizes the employee to truly invest their full effort into the success of the business.
What is a "Cliff?"
In many cases, there is a delay (often one year long) before the vesting process begins. This delay period is called a "cliff" and it's considered to be a way of building in a trial period for a new hire. If there is a four-year vesting period with a one-year cliff, for example, and a new employee doesn't work out after the first six months, they leave the company with no equity. However, if they are still there after one year, then they get the first 25% of their vested equity.
Pros and Cons of Different Vesting Schedules
If a person's shares don't vest right away, the expectation is that he or she will remain tightly connected to the company because of the future promise of gain. This is usually positive; however, some experts suggest that the vesting intervals be made monthly or quarterly, so as to avoid the potential problem of employees just hanging on because they have a big vesting event coming up.
Tax Benefit of Stock Options in Startups
Since equity is mostly given in the form of stock options, it is not taxed at the time the vesting agreement is made, and it's also not taxed at the point when the employee exercises their option and purchases the shares. Tax is only levied at the time that the shares are sold. Furthermore, if the stock is held for at least a year before being sold, and for at least two years after the original equity agreement is made, then any profit that's earned on the stock price is taxed as capital gains, which is usually a much lower tax rate than income. Further tax complexities come into play when the amount of shares sold exceeds $100,000, but in general the method of paying with stock options has very a favorable tax outcome.