Vesting Basics – What is vesting?

“Vesting” is a term of art that is often glossed over by new entrepreneurs as they grapple with other newer and scarier terms to which they are being introduced as they start their companies, like “pre-money valuation,” “fully-diluted capitalization” and “broad-based weighted average antidilution adjustments.”  However, I think it is good for entrepreneurs to have a thorough understanding of what vesting means.

Classic “Vesting.”  Most new entrepreneurs have previously encountered vesting in the context of stock options.  In this context, the stock option – or more precisely, the shares issuable upon exercise of the stock option – become exercisable over a period of time, conditioned upon the optionee continuing to render services to the company as an employee or contractor.  The stock option becoming exercisable is referred to as “vesting.”  By way of example, if an optionee receives a stock option to purchase 48,000 shares of common stock that is initially not exercisable for any of the option shares, and the stock option becomes exercisable with respect to 1,000 option shares per month, the stock option is said to vest with respect to 1,000 shares per month.

If the optionee exercises the vested portion of his or her stock option (i.e., purchases the vested option shares), he or she must pay the company the exercise price (i.e., the purchase price) of the vested option shares being purchased.  However, the optionee also had to render services to the company for the option shares to vest and become exercisable.  Consequentially, since the optionee had to work (and presumably break a sweat) to earn them, the option shares are sometimes referred to as “sweat equity.”

“Reverse Vesting.”  For reasons that I will discuss in another Founder Tip of the Week, it is sometimes beneficial for the optionee to be able to exercise the stock option immediately.  In this case, the optionee is granted an “immediately exercisable” stock option that can be exercised with respect to all of the option shares, but the company retains the right to repurchase the option shares that lapses over time, conditioned upon the optionee continuing to render services to the company as an employee or contractor.  The lapse of the company’s right to repurchase the option shares is referred to as “reverse vesting.”  By way of example, if an optionee receives a stock option to purchase 48,000 shares of common stock that is initially exercisable for all of the option shares, and the company’s right to repurchase lapses with respect to 1,000 option shares per month, the option shares are said to vest at a rate of 1,000 shares per month.

Reverse vesting can also be applied to stock issuances made other than through options. Founder shares are generally issued subject to reverse vesting.  As with option shares issued upon the exercise of stock options subject to classic vesting, even though the purchaser of the shares pays for the shares, the purchaser has to render services to the company for the shares to vest and cease to be subject to the company’s right of repurchase, so these shares are also often referred to as sweat equity.

Purchasers of shares subject to reverse vesting should consider whether to file an 83(b) election.  To learn more, view my prior Founder Tip of the Week on the topic of 83(b) elections.