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Starting a company is tough, and figuring out how to pay your team with stock can feel overwhelming. This guide is here to help you with unvested shares, a special kind of stock option for startups.
Unlike regular stock (where people own it immediately), unvested shares have a waiting period. Founders don't get full ownership until they meet certain goals or stick around for a set time. This can be tricky, but it has advantages!
Unvested shares can be a great way to keep your best people on board. They're like a reward for sticking with the company and helping it grow. Plus, they help protect the company's stock from ending up with people who leave early.
The bottom line is; understanding unvested shares can help you make smart choices about your team and the future of your startup. Keep reading to learn more.
What are Unvested Shares?
Unvested shares refer to the portion of shares that an employee, founder, or advisor has been granted but has not yet earned the full rights to own.
These shares are usually part of a vesting schedule, which dictates the timeline over which the recipient earns ownership of the granted shares.
Vested Shares vs. Unvested Shares
Vested shares are shares the recipient has fully earned the right to own. Once shares are vested, they remain with the recipient regardless of their continued employment or association with the company.
Unvested shares, on the other hand, are still in the process of being earned according to the vesting schedule. If the recipient leaves the company before these shares vest, they forfeit their rights to these shares.
The table below provides a clear comparison of vested and unvested shares so that you can understand the differences and implications of each type of share:
Why is Unvested Shares Repurchase Important?
Imagine you're building a rocket ship, and stock options are like fuel for your crew. Unvested shares are like fuel that hasn't been fully "earned" yet. They come with a waiting period to ensure everyone is on board for the long haul.
But what happens if someone decides to leave the rocket ship early? Unvested share repurchase lets you, the captain, buy back that unused fuel.
Here's why it's important:
It Protects Your Company's Equity Pool
When a team member leaves the company before their shares have fully vested, your company can repurchase the unvested portion. This prevents dilution of the equity pool, ensuring that the shares can be reallocated to new employees or investors.
The company can better manage its equity distribution and maintain sufficient equity reserves to attract and retain top talent by retaining control over these shares.
It Aligns Team Members' Interests with the Company's Success
Since shares vest over time, employees and founders are incentivized to stay with the company and contribute to its growth and success. If an individual leaves prematurely, they forfeit their unvested shares, which can then be repurchased by the company.
This arrangement encourages commitment and loyalty among team members, encouraging a stable and dedicated workforce that is important for the growth of a startup.
It Offers Flexibility in Managing Equity for New Hires
Having a repurchase option for unvested shares provides startups with the flexibility to manage their equity distribution more effectively. When an employee or founder leaves, the repurchased unvested shares can be reallocated to new hires.
This flexibility is valuable for startups that need to attract new talent with competitive equity packages. Recycling unvested shares allows startups to offer meaningful ownership stakes to new employees without excessively diluting existing shareholders.
It Reduces Potential Legal and Financial Risks
Without unvested shares repurchase provisions, a company could face legal and financial challenges.
For instance, if a founder leaves early but retains a significant portion of their unvested shares, it could lead to disputes over ownership and control. In addition, the company might end up with less equity available to incentivize new hires or attract investors.
Implementing clear repurchase tackles these risks by ensuring that unvested shares are managed predictably and fairly.
How Unvested Shares Affect Founders' Equity
For founders, equity not only reflects their contribution and stake in the company but also serves as a motivating factor for driving the startup’s success.
Here’s the impact unvested shares have on founders’ ownership:
Initial Allocation vs. Actual Ownership
When founders are issued shares at the company's inception, they often receive a significant portion of the total equity. However, if these shares are subject to vesting, the founders don't have immediate access to the full amount.
Over time, as the vesting schedule progresses, founders earn their shares incrementally. Until shares are fully vested, the founders' ownership percentage in the company is lower than the initial allocation.
Motivation and Retention
Vesting schedules are designed to keep founders committed to the company's long-term success. The promise of future equity incentivizes founders to stay with the company through its critical early years.
This mechanism aligns the founders’ interests with the company’s growth, ensuring they are motivated to increase the company's value, which increases the value of their vested shares.
Equity Dilution
As a startup raises capital, new shares are issued to investors, diluting the ownership percentage of existing shareholders, including founders.
If founders have a significant portion of their shares unvested, the impact of dilution is more pronounced. For example, if additional shares are issued to investors before the founders' shares are fully vested, the founders' percentage of ownership could be reduced more significantly.
Legal Terms and Clauses in Equity Agreements
When drafting equity agreements, there are some terms and clauses that you must include. These terms clearly outline the conditions under which unvested shares may be repurchased. These include:
Vesting Schedules
This details the timeline over which shares become vested. A typical schedule might be four years with a one-year cliff, meaning no shares vest until after the first year.
Cliff Periods
It specifies the initial period during which no shares are vested. If the employee leaves before this period ends, no shares are earned.
Accelerated Vesting
It allows for immediate vesting under certain conditions, like a company acquisition.
Repurchase Rights and Triggers
These clearly state the company’s right to repurchase unvested shares and the conditions that trigger this right, like the departure of an employee.
Legal Considerations for Unvested Shares Repurchase
It is important to understand the legal framework that governs repurchasing unvested shares in your startup. Here are the key legal considerations to keep in mind:
Compliance with Local Laws and Regulations
Ensure that the repurchase process adheres to local corporate laws, which can vary by jurisdiction. This includes understanding any requirements for shareholder approval or filings with regulatory bodies.
Fair Valuation
When repurchasing shares, the valuation must be fair and reflect the current market value. Misvaluation can lead to disputes or claims of unfair treatment, potentially resulting in legal action.
Tax Implications
Both the company and the individual may face tax consequences. For the individual, repurchasing shares can impact their income tax, especially if they are appreciated.
The company must also consider the tax implications of repurchasing and potentially redistributing these shares.
Employee Agreements
Ensure that all equity agreements with employees are clear about the terms of vesting and repurchase. Ambiguities can lead to disputes if an employee's departure triggers a repurchase.
Non-Compete and Non-Disclosure Agreements
Non-compete and non-disclosure agreements are often linked with equity agreements. They must be carefully drafted to ensure employees cannot unfairly compete or disclose sensitive information after repurchasing their shares.
5 Best Practices for Managing Unvested Shares
Effectively managing unvested shares is essential in ensuring long-term startup stability and alignment with employee interests. The tips below will help your startup manage unvested shares:
#1 Clear Communication of Vesting Schedules
Transparent and Early Communication
Provide a comprehensive overview of the vesting schedule to each employee upon the grant of equity. Explain key terms like "vesting periods," "cliffs," and any conditions under which acceleration may occur.
Conduct sessions or workshops to educate employees about how vesting works and its implications. Encourage questions to ensure understanding.
Documentation
Provide employees with written agreements outlining their vesting schedule and any applicable acceleration clauses. Include details about what happens to unvested shares in case of termination, resignation, or other scenarios.
Update employees regularly on their vesting progress. Use clear, accessible formats like employee portals or regular email updates.
#2 Regularly Review and Update Vesting Schedules and Repurchase Agreements
Annual Reviews
Conduct annual reviews of vesting schedules and repurchase agreements to ensure they remain fair, competitive, and aligned with company goals. Evaluate whether adjustments are needed based on company performance, changes in ownership structure, or market conditions.
Employee Feedback
Establish mechanisms for employees to provide feedback on the vesting schedule and repurchase agreements. Act on feedback where appropriate to maintain morale and fairness in equity distribution.
#3 Establish a Standardized Process for Repurchasing Unvested Shares
Create Clear Policies
Develop and document a standardized process for repurchasing unvested shares upon an employee’s departure. Clearly define the roles and responsibilities of HR, legal, and finance teams in executing the repurchase process.
Board Approvals
Ensure that the process includes obtaining necessary approvals from the board of directors or relevant stakeholders before executing share repurchases. Maintain detailed records of board approvals and decisions related to equity repurchases.
Timely Execution
Act promptly to repurchase unvested shares when an employee leaves the company. Delays can lead to legal and moral issues. Ensure that all repurchase actions comply with legal requirements and company policies.
#4 Consider Acceleration Clauses and Their Impact
Define Acceleration Triggers
Clearly define events that trigger acceleration of vesting, such as change of control (acquisition) or IPO. Communicate these triggers clearly to employees to manage expectations and align interests.
Evaluate Financial Impact
Assess the financial implications of acceleration clauses on the company’s equity structure, including potential dilution and impact on valuations. Balance the benefits of attracting and retaining talent through acceleration with the long-term financial health and stability of the company.
#5 Legal and Financial Consultation
Seek Professional Advice
Engage with experienced legal advisors to ensure all equity management practices, including vesting schedules and repurchase agreements, comply with relevant laws and regulations.
Financial Advice
Consult with financial experts to understand the tax implications for the company and employees regarding unvested shares and equity transactions.
Wrapping Up
As a startup founder, it's important to understand how unvested shares work to keep your company on the right track.
Why? Because you want to make sure everyone's interests are aligned. Unvested shares give founders control over the company's ownership and also motivate employees to stick around and help the company grow.
Think of it like a reward program. The longer someone works for the company, the more ownership they earn. But there are rules. These are called vesting schedules and repurchase agreements. Understanding these keeps things fair and avoids any confusion down the line.
There are also some legal things to consider. Talking to a lawyer and financial advisor can help you set up a system that works best for your company and follows all the regulations. This might sound complicated, but don't worry! With a little planning, you can handle it.
In a nutshell, managing unvested shares is just part of being a founder. It takes some effort, but by learning the ropes, you can build a strong foundation for your startup's success. The more you and your team are on the same page about ownership, the smoother things will run.
FAQs
Can unvested shares be taken away?
Yes, unvested shares can be taken away by the company. Here are the reasons for this:
- Vesting is a condition of ownership: Unvested shares mean you don't fully own them yet. You're promised ownership after meeting certain requirements, typically staying with the company for a set period (vesting schedule).
- Company policy and agreements: Most stock grant agreements give the company the right to repurchase unvested shares if you leave before vesting or under certain circumstances outlined in the agreement. These circumstances could be poor performance or violations of company policy.
However, there are some exceptions:
- Vesting upon certain events: Some plans grant vesting rights upon certain events, like a company acquisition. In this case, even if you leave before your original vesting schedule is complete, the shares might still vest.
- Negotiation: Depending on your position and the company's culture, there might be room for negotiation, especially during termination without cause.
Can I sell my unvested stock?
No, you cannot sell your unvested stock. Since the stock is unvested, you don't have full ownership yet. Selling involves transferring ownership, which isn't possible until the vesting period is complete.
Here's a breakdown of why you can't sell unvested shares:
- Unvested stock lacks ownership rights: Until they vest, the shares are more like a promise of future ownership from the company. You can't sell something you don't fully own.
- Trading restrictions: There are limitations on trading unvested stock due to regulations from the Securities and Exchange Commission (SEC).
What happens to unvested shares when acquired?
This depends on the details of the acquisition agreement and your company's stock plan. Here are some of the things that could happen:
- Acceleration: In some cases, the acquisition can trigger acceleration, meaning your unvested shares immediately vest and become yours. This is often a benefit offered to retain key employees during the transition.
- Cashout: The acquiring company might decide to buy back your unvested shares and pay you cash based on a predetermined value.
- Cancellation: The acquiring company may simply cancel your unvested shares, meaning you lose the potential ownership entirely.
- New vesting schedule: The acquisition agreement could convert your unvested shares into shares of the acquiring company, subject to a new vesting schedule.
Do unvested shares count as ownership?
No, unvested shares don't count as full ownership for these reasons:
- Vesting is a condition: Unvested shares represent a promise of ownership that becomes reality only after you meet certain requirements, like staying with the company for a set period (vesting schedule). Until then, you don't have complete control.
- Limited rights: With unvested shares, you don’t have voting rights or rights to dividends (company profit distributions). These are some key ownership privileges.
- Company retains control: The company holds the legal title to the shares and can take them back if you leave before vesting or violate specific terms.
