Slicing the Pie: Allocating Equity and Vesting
Allocation of Equity
When a corporation is formed, its founders have to establish how the equity or value of the corporation’s holdings will be allocated. To this end, founders generally take into account:
- the respective percentage each founder ought to receive
- an approximation of the percentage to be held by founders, as opposed to employees and consultants
- the possibility of a reserve of shares in the event that the startup enters an accelerator program (i.e. Y Combinator) or increasing the number of founders at a later date.
In the event that a corporation elects the standard 10,000,000 authorized shares, the following represents a common breakdown of allocation:
- 8M shares divided amongst the founders
- 1M shares for stock offerings to employees and consultants
- 1M shares set aside for future opportunities
Although the number of authorized shares designated in the certificate of incorporation can be adjusted at any time, it represents an undesirable, and arguably unnecessary expense. As such, it is worth getting this one right the first time.
Stock issued to founders is almost always subjected to vesting. This means that even though the founder owns shares, the corporation is able to purchase back (buy out) a founder if he or she is no longer providing services to the company. The number of shares that can be bought back is governed by the number of shares that have not yet vested.
If common stock is subject to vesting, it is called restricted stock. Restricted stock usually vests over a predetermined period of time, referred to as a vesting schedule. This process begins on an established date known as the vesting commencement date.
The “four year vesting with a one year cliff” is far and away the most popular vesting schedule among startups. According to this plan, 25% of one’s holdings vest on the one year anniversary. From that point forward, just over two percent vests each month, so that the total holdings will be vested at the conclusion of the fourth year.
Following this in terms of popularity is the “four year straight line” model. This is essentially the same as above, except that there is no one year waiting period. 1/48th of one’s holdings are vested each month, such that 100% will be vested in four years.
The vesting commencement date is generally the date that shares are issued to founders, but it may be post-dated to credit certain founders for their contributions prior to incorporation. This is referred to as vesting credit.
Vesting is meant to protect the sweat equity of startups. It provides a means by which there is a common financial motivator for the company to maintain focus and to stay intact.
For Solo Founder
Vesting is also common among solo founders. This is generally a preventative measure, in that a future angel investor may require that the founder’s stock is vested before contributing to the startup. In the event that a solo founder didn’t subject his holdings to vesting, there is no guarantee that the investor will offer vesting credit for his or her time spent.