Understand Term Sheets  -  Part 3: Vesting and its Implications on Acquisition Offers

In this series, we are discussing the often less understood terms that define the economics and control of a venture deal.

• In Part 1, we discussed how the proceeds may be shared disproportionately among founders and investors when the startup is acquired.
• In Part 2, we learned how to build protections for a down round in the future.
• In this Part 3, we will introduce the concept of vesting and discuss how it can have profound and unexpected implications during an acquisition.

Introduction

When an employee is granted a stock options, they are not awarded in one go. Instead startups usually follow time-based vesting, i.e. the allocation of options is dependent on time.

An industry standard is a linear 4-year time-based vesting with a 1-year cliff. Let’s look at what these terminologies stand for with this specific vesting schedule as an example.

In other words, the stock options are awarded as per the orange line in the graph below for a linear 4-year time-based vesting with a 1-year cliff.

Note that the stock options awarded to founders also follow a vesting schedule.

My options have vested. Do I own the stock now?

Once the stock options are vested, the option holder gets promised number of shares when they are exercised. The option gives its holder the right to buy a certain number of shares by paying a previously determined price per share. For example, exercising an option for 1,000 shares of stock at $10 per share means the option holder can own 1,000 shares of stock by paying $10,000 to the company when the options are vested.

If the option holder leaves the company before or after the completion of the vesting period, a time limit is imposed on this exercise, which is referred to as ‘exercise period’.

What happens to my stock options if I leave the company?

Scenario 1: Founder/employee leaves the company before completing the full vesting period

Note:

• They get a percentage of stock option per the vesting formula. For example, if the options are vested monthly (1-year cliff, 4-year vesting) and an employee leaves after 18 months, they receive 25% + (25/2)% = 37.5% of stock options.

• The unvested equity or the vested but unexercised equity of employees goes back to the option pool to be reissued to future employees .

• However, the founder’s equity gets redistributed among shareholders resulting in their proportionate increase in ownership.

  
  

Scenario 2: Founder/employee leaves the company after completing the full vesting period

Note:

• The departing founder or employee is liable to 100% of their equity.
• Exercise period related restrictions still apply.

Scenario 3: Founder/employee stays with the company after completing the full vesting period

There is usually no restriction on when the options need to be exercised. The exercise period is applicable only on the departing founder or employee.

Can vesting be accelerated?

There are two provisions for accelerated vesting:

1. Single-trigger acceleration: only 1 event (e.g. an acquisition) is needed for automatic accelerated vesting.

2. Double-trigger acceleration: 2 events (e.g. an acquisition and layoff from the acquiring company) are needed for automatic accelerated vesting.

   
   

For example, imagine a scenario where a founder’s stock options are to be vested in 4 years and the startup gets an acquisition offer at the end of its 2nd year. If the founder’s stock has single-trigger acceleration, 50% of the unvested stock option is immediately awarded.

Effect of vesting on acquisition

Vesting schedules of founders have one of the most significant implications when the startup receives an acquisition offer.

Different objectives of different parties

There are three key parties on the negotiation table —  all with slightly different financial objectives.

This is where accelerated vesting comes into play. We are continuing with our previous example of a startup receiving an acquisition offer when the founder’s 50% of stock options are vested.

Scenario 1: Founder’s options with single-trigger acceleration

Founder’s remaining 50% stock options will be vested immediately once the acquisition is complete. Now they have the option to either exit the company or stay with a renewed financial incentive.

The acquirer would prefer to add a management incentive in the deal structure to make the stay attractive for the founder. So if the deal package was worth $100 million, $10 million might be set aside as management incentive and $90 million as the amount to be distributed among shareholders.

However, the investor gets reduced proceeds for the same deal value.

In this scenario, the objectives of the acquirer and the founder are met.

Scenario 2: Founder’s options with double-trigger acceleration

With double-trigger acceleration in place, the 50% options stay unvested. As a result, the founder has to wait for 2 years for the stock award while working under a new management that they might not be fully aligned with. Hence, their objectives have not been met.

The acquirer has no need to add a management incentive as there is already a stock-induced restriction on the founder.

The investor now has a higher exit for the same deal package.

In this scenario, the objectives of the acquirer and the investor are met.

To summarize, founders prefer single-trigger vesting acceleration for their stock options while investors prefer double-trigger acceleration for founder’s options.

Closing Thoughts

In this article, we covered the following topics:

• Introduction to cliff and vesting provisions
• The journey from vested stock options to stock ownership
• Stock ownership in the event of an exit before and after the vesting is completed
• Accelerated vesting and its implication on an acquisition offer

References:

Feld, Brad and Mendelson, Jason. Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist. Wiley, 2019.

Acknowledgments:

Thanks to Shyam Swaroop for his valuable comments on the early drafts.