I know what you’re thinking: ‘I’m running a business, not a private equity firm, so why do I need to know about vesting schedules and cliffs?’
Well, these can be important, even within a fairly small operation. As with most things, the entrepreneurial ecosystem has its own jargon, which can be confusing to the uninitiated among us. This is amplified when these terms are simply adopted from the American landscape and transposed onto a South African context.
A vesting schedule, as it relates to shareholding outlines how your equity interest in a company will vest over time, or there are ‘trigger events’.
The notion of ‘vesting’ is a legal concept that refers to the moment when your rights to exercise the entitlements and obligations attached to shareholding become absolute.
We often consult with founders who get swept up in the excitement of their new venture and the seemingly endless possibilities it offers for global domination. Sadly, it’s sometimes our duty as legal service providers to point out the realities and to ensure that your interests are safeguarded if things go sideways.
One of the mechanisms that we use to do this is to incorporate a vesting schedule, and apply a vesting cliff, which would be reflected in a customised memorandum of incorporation (MOI) detailing the mechanism through which the shares vest in a shareholder of the company.
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There are also situations where shareholders may want to part ways, and you need to ensure that this happens as seamlessly and fairly as possible.
A vesting schedule presents a good way to achieve this and ensures that all shareholders buy into the long-term vision of the company and agree to receive their agreed-upon allocation of shares on weekly/monthly vesting over a period of four years.
In other words, you don’t get all your shares until you have spent four years in the trenches with the company, fighting the good fight. This:
- Mitigates dead-weight equity
- Allows for transparency and certainty of the positions of all involved
- Provides clear guidelines for those who wish to exit the company at any stage of its evolution.
By way of example
Private Company A has two co-founders, each wishing to hold 50% equity in the business. Vesting dictates that instead of both co-founders receiving their 50% equity upfront, the equity is vested at regular intervals over a period of time. In other words, the founders would vest at a monthly rate of 1/48th of their total share allotment over 48 months.
Another alternative is that a predetermined number of shares will vest when an agreed milestone is reached, or at some uncertain future event, such as the attainment of a revenue target, funding event or acquisition.
A vesting cliff normally provides for a period during which a suddenly departing shareholder will not be entitled to any equity, ‘forfeiting’ even already-vested shares.
This takes place through a discounted buy-back provision where the company agrees to buy back the shares for a nominal amount. But, shareholders need to be sure it is structured effectively to mitigate any potential tax implications.
A vesting cliff seeks to mitigate the risk of deadweight equity, which means that a shareholder simply holds equity but does not add any value to the company — something that any future shareholders or investors will want to avoid.
This period, generally a year, is analogous to a trial-before-hire or probation period for the whole founding team, where a shareholder or co-founder’s commitment to the business may be tested prior to obtaining any shareholding.
Naturally, this all needs to be agreed to and regulated by a legally binding agreement, particularly before there is any big money on the table.