After you have formed your new startup, one of the first things you should be thinking about is the vesting schedule. This is crucial especially if you have formed a company with more than one founder. It is crucial to have a vesting schedule in place so that everyone’s interests are aligned and committed in the company.
An overview of ‘vesting’ for startups
“Vesting” is a corporate exercise in a company upon which equity interest held by a person (eg, founder, key talent or even an advisor) in a company is no longer subject to forfeiture or ‘clawback’ by the company.
The ‘vesting’ will be dealt in accordance with a pre-agreed timeline usually known as the vesting schedule (or vesting period).
“Vested shares” means shares that you own, which will be yours even if you’re fired or you decide to quit the company.
“Unvested shares” means shares that have not yet vested or are subject to a right of forfeiture or ‘clawback’ by the company.
A “vesting schedule” sets out the equity interest that a person can receive on an aggregate basis (eg, 10,000 shares in total to be ‘vested’ over a period of time).
The ‘unvested shares’ in a vesting schedule can be uplifted or unrestricted based on two criteria, namely:
- On a prescribed timeline (eg, usually between 1 to 4 years period). The plain vanilla Silicon Valley’s vesting period is 4 year inclusive of 1 year ‘cliff’ period.
- The unvested shares can be uplifted upon achievement of certain key milestones (eg, KPIs or deliverables) by such person.
Now let’s take a look at Malaysia’s context when it comes to structuring a vesting schedule for a startup.
What is a ‘standard’ vesting schedule for a startup?
For employees or even founders shares in a startup, the usual Silicon Valley vesting schedule for equity awards (also known as shares options) is 4 years with a 1 year ‘cliff’.
The ‘cliff’ essentially means the minimum time (usually at least 1 year) that a person needs to be attached to a startup before he or she can earn any of the shares.
When it comes to the vesting schedule, the remaining ‘unvested shares’ can vest in 36 equal instalments each month throughout the end of the 4 year period. For instance, if an employee leaves before the end of the vesting schedule, then all the ‘unvested shares’ are forfeited without additional compensation or payment.
Just take note that these are the market norms as anywhere else like in Silicon Valley. So if you want to vary the vesting schedule you may of course do so. Unless you have a strong justification for waiving the vesting schedule like rewarding an adviser or a consultant as sweat equity in exchange for mentoring time, it can be tricky if you need to explain to investors in the future why the vesting schedule has been varied.
What are the usual ways vesting schedules can be implemented in Malaysia?
In Malaysia, vesting can be implemented in two ways, either as upfront shares issuance (or “reverse vesting” scheme) or as a ‘shares option’.
1. Upfront shares issuance (or “reverse vesting” scheme)
When a group of founders come together and form a legal entity to run a company ,the shares are usually issued upfront based on the agreed percentages.
We won’t delve into the details on how to split the equity pie among cofounders in this post, but assuming that you’ve decided on a fixed percentages, the next step will be to get the shares issued accordingly based on the agreed percentages.
At this stage, it is crucial to get a founders agreement or vesting agreement in place! I’ve seen too many times startups can’t continue their next funding round because they can’t get rid of one founder that refuses to transfer his shares back to the remaining shareholders. Even worse, a founder that you got into the business failed to deliver to your expectations or even refuse to deliver work!
Running a startup isn’t easy. Stuff happens in life. A founder may get into a life changing situation and may reluctantly decide to leave the company and pursue a more stable income like getting a day job.
Unlike Silicon Valley startups, startups in Malaysia and even in Singapore are restricted from buying back shares. The recent changes to the companies law in Malaysia has allowed some flexibility for shares buy back for private companies.
But the current shares buyback requirements that need to be satisfied are quite onerous. It may not be practical for a startup. To illustrate, a startup that wants to do a shares buyback needs to get the board members to sign a solvency statement to declare that the startup will remain solvent after the shares buyback and obtain at least 75% special majority in a shareholders approval.
On a side note, an upfront shares issuance to a shareholder may reduce any income tax exposure so long as the shares received by the shareholder have been duly paid at the issuance date (even if the shares value may have appreciated in value in the future).
The usual challenge is when it comes to a ‘clawback’ or ‘repurchase’ scenario.
Assuming that the startup’s share price has appreciated over time, the ‘clawback’ can only be done by a shares transfer. The remaining shareholder receiving the shares from the outgoing founder will need to pay the stamp duty on the assessment value (usually, calculated based on the latest audited accounts).
If you don’t have a vesting schedule in place, how are you going to ‘clawback’ the shares if the other person decides to go missing!
To illustrate, here’s an example of a typical “reverse vesting” scenario:
- Let’s say everyone in a startup decided to issue 10,000 shares to a co-founder on 1 June 2021 which comes with a ‘reverse vesting’ provisions. For this illustration, let’s stick to the usual standard Silicon Valley’s vesting schedule (which is for the entire 10,000 shares to be vested over a 4 year period and inclusive of 1 year cliff).
- So what it means is that 2,500 shares will be vested every year for the next 4 years period so long as the co-founder remains with the startup.
- If the cofounder decides to leave the company within the 1st year (eg, let’s say on 1 September 2021 which is 3 months after joining the company!), the cofounder will still be within the 1 year ‘cliff’ period. So all the 100% shares (i.e. 10,000 shares) will be automatically forfeited. Typically, the remaining founder can get the 10,000 shares to be transferred back at a nominal value (usually RM1 in aggregate just for formalities).
- But if the cofounder leaves on 1 December 2022 (after the 1st year anniversary but before the 2nd year anniversary of the vesting period), the remaining founder can buy-back 75% of the shares (7,500 shares), and the departing founder can keep 25% of the shares (2,500 shares).
- Once 1 June 2025 has passed, the option period is over and the vesting is complete.
In practice, the vesting schedule can get more complicated when it comes to future funding rounds. For instance, a lot of venture capital funds in the U.S. will need the founders to ‘reset’ the vesting clock on their founder’s shares at the time that the funding deal closes, especially if you have vested more than 25% of your unvested shares. This can be a touchy topic especially when the founders have spent 2 or 3 years working on a project for the company.
On the flip side, the investor wants to reduce their downside risks and see your value as the key person in the company. So do take it as a compliment and the investor wants to make sure that you continue to run your company.
Don’t forget about the ‘good leaver’ and ‘bad leaver’ provisions
In the case of a founding team, the vesting schedule will be tied to the ‘good leaver’ and ‘bad leaver’ provisions. This clause can be found in a founders agreement or a shareholders agreement. We won’t delve into the specifics here but the idea is that the shares of the departing cofounder will be based on whether the cofounder is leaving as a ‘bad leaver’ or a ‘good leaver’. This helps in aligning the interests between the founders and also helps manage downside risks for angels or venture capitals (which is why this is now a standard and non negotiable clause in most investment term sheets).
2. Shares options (or employees shares option scheme (ESOS))
The next option is akin to an employees shares option scheme (ESOS) which is to grant shares options to the founder to buy or subscribe to shares of the company’s shares at a certain pre-agreed price (usually at a nominal value), and for the options to be vested based on the vesting schedule.
To give effect to the shares option, the option holder (eg, a founder or an employee) may not need to put up his own cash upfront to subscribe or buy shares and there is not requirement to fully paid up on the issued shares.
Just take note that unlike upfront shares issuance, unexercised shares options do not give the right as a normal shareholder (eg, voting rights, dividends rights, or other customary rights provided as a shareholder). Although this can be distressing for a founder, the founder’s rights and interests can be addressed with a shareholders agreement or changes to the constitution of the company.
The other challenge that you need to navigate is keeping track of the shares capitalisation table (or ‘cap table’) so that you know how the shareholding structure and ratios will look like when an option shares is exercised.
What are the other things to consider before setting up a vesting schedule for my startup?
Vesting schedules are contractual agreements between the shareholders including the founding team and investors. So you can forgo certain economic benefits to the issued shares to mimic the entitlement usually afforded to the shareholder.
Some of the usual commercial issues to be considered include:
- Can the founders get all the same rights and benefits that come with the issued shares. To illustrate, ordinary shares come with voting rights in a general meeting, dividends rights, distribution of and participation in capital upon liquidation) on the ‘unvested shares’. So contractually speaking, any of these rights can be waived or restricted so long as the parties are agreeable in the founders agreement.
- Can a founder transfer and dispose of ‘unvested shares’ to any person?
- What are the steps and procedures when it comes to a departing founder leaving the company due to a shares forfeiture (eg, ‘cliff’ event or ‘bad leaver’ scenario) upon which the founder’s shares (which have already legally issued to such founder) needs to be sold or transferred back? And whether the shares should be transferred back to all the shareholders on a pro-rata basis or only to the founding team? And at what purchase price value?
You should speak to your legal counsel on whether you should have these protections in place or it can be forgo these issues to make the founders agreement simplified.
What else to know about vesting schedules?
Once you understand the basics, crafting a good vesting schedule is pretty much straightforward work.
Unfortunately, some founders like to overcomplicate the vesting schedules by coming up with additional conditions or even unusual terms which makes implementing and may lead to unintended consequences in the future. My suggestion is to keep things simple and stick to the plain vanilla structure. implementation and consequences for each vesting can be challenging which needs to be carefully considered on each basis.
Instead, stick to the straightforward “reverse vesting” mechanism – upon which the shareholders (eg, founders or key talents) get the shares or right to purchase shares over time. The mechanism can be documented in the same shareholders agreement or founders agreement or a separate shares option agreement for this purpose.
So to recap, when you want to adopt a vesting schedule, please make sure you get a corporate lawyer with experience in dealing with startups to take a look so that it’ll work. If you need to use a template vesting agreement, please make sure that the mechanism is workable in Malaysia.