Vesting Schedules in Start-ups

1. Meaning

A vesting schedule is a contractual mechanism under which a founder, employee, advisor, or other participant earns the right to retain or acquire equity over a specified period rather than receiving the entire equity interest immediately.

In start-ups, vesting is commonly used for:

• founders' shares;
• Employee Stock Options (ESOPs);
• Restricted Stock Units (RSUs);
• sweat equity arrangements;
• advisor equity; and
• other employee incentive plans.

The principal purpose is to connect continued service or achievement of agreed conditions with the participant's entitlement to equity.

2. Why start-ups use vesting

Start-ups often depend heavily on a small number of founders and key employees. If a founder leaves shortly after incorporation while retaining the entire equity allocation, the remaining founders and investors may be left with a significant ownership and governance problem.

A vesting arrangement attempts to address this by providing that equity is earned over time.

For example, a founder may be allocated 20% of the company, subject to a four-year vesting arrangement.

If the founder leaves after two years, the founder may have earned only the portion that has vested, depending upon the precise contractual arrangement.

3. Typical four-year vesting schedule

A commonly used structure is:

4 years + 1-year cliff

Illustration:

After the first anniversary, 25% vests, and the remaining 75% may vest periodically over the following three years.

This is only a common commercial structure; the actual arrangement depends upon the company's documents and applicable law.

4. What is a cliff?

A cliff is a minimum period that must be completed before any equity vests.

For example, with a one-year cliff:

• employee joins on 1 January;
• employee leaves on 30 September;
• nothing vests if the agreement provides a strict one-year cliff.

If the employee remains until 1 January of the following year, the first tranche becomes vested.

The purpose is generally to prevent very short-term service from creating an equity entitlement.

5. Time-based vesting

Under time-based vesting, equity becomes vested according to the passage of time.

For example:

25% after one year and the remaining 75% in equal monthly instalments over the following 36 months.

The employee's performance does not necessarily determine vesting unless the agreement separately imposes performance conditions.

6. Performance-based vesting

A start-up may instead or additionally make vesting dependent upon specified milestones.

Examples include:

• achieving revenue targets;
• obtaining regulatory approval;
• launching a product;
• completing a funding round;
• achieving specified customer numbers; or
• remaining employed for a specified period.

Performance conditions should be clearly defined. Ambiguous milestones can lead to disputes concerning whether equity has actually vested.

7. Founder vesting

Founder vesting is particularly important.

Suppose:

• Founder A owns 60%;
• Founder B owns 40%.

If both founders agree that their shares are subject to four-year vesting and Founder B leaves after one year, the company's constitutional and contractual arrangements may provide a mechanism for dealing with the unvested portion.

The precise treatment depends upon the share structure, shareholders' agreement, articles, employment/service agreement and applicable company law.

8. Reverse vesting

Founder arrangements frequently use reverse vesting.

Under this structure, the founder may initially hold the shares, but the company or other shareholders have contractual rights concerning shares that have not yet vested.

The purpose is to prevent an early departing founder from retaining an economically disproportionate interest in the business despite making only a limited contribution after incorporation.

9. Good leaver and bad leaver provisions

Vesting provisions frequently interact with good-leaver/bad-leaver clauses.

Good leaver

A good leaver might include someone who leaves because of:

• death;
• permanent disability;
• redundancy;
• termination without cause; or
• another agreed circumstance.

The agreement may permit some or all additional treatment of vested equity.

Bad leaver

A bad-leaver provision may apply where departure results from:

• fraud;
• serious misconduct;
• material breach;
• competing with the company; or
• other specifically defined circumstances.

The consequences must be carefully drafted because attempts to force the transfer of vested shares at an excessively low price can generate legal disputes.

10. Acceleration of vesting

Acceleration means that some or all unvested equity becomes vested earlier than originally scheduled.

There are two common forms.

Single-trigger acceleration

Vesting accelerates upon a specified event, such as a change of control.

Double-trigger acceleration

Acceleration requires two events, commonly:

1. a change of control; and
2. termination or substantial reduction of the person's role within a specified period.

Double-trigger arrangements can therefore link acceleration to both the transaction and the person's subsequent employment circumstances.

11. Vesting and ESOPs in India

For Indian start-ups, employee equity arrangements commonly involve Employee Stock Option Schemes.

The Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014 contain requirements concerning employee stock options.

An ESOP arrangement should therefore be examined together with:

• the company's ESOP scheme;
• board/shareholder approvals;
• employment agreement;
• grant letter;
• exercise terms;
• Articles of Association;
• shareholders' agreement; and
• applicable tax requirements.

A contractual promise of equity should not automatically be treated as equivalent to an immediately transferable shareholding.

12. Important Indian case laws

1. Bharat Forge Co. Ltd. v. Uttam Manohar Nakate, (2005) 2 SCC 489

The Supreme Court considered employment-related contractual and disciplinary principles.

Relevance to vesting:
Although the case was not an ESOP case, it illustrates the importance of clearly defined contractual employment conditions and consequences. Start-ups should similarly define the circumstances in which employment termination affects unvested equity.

2. V.B. Rangaraj v. V.B. Gopalakrishnan, (1992) 1 SCC 160

The Supreme Court considered restrictions concerning transfer of shares and the relationship between shareholder arrangements and the company's constitutional documents.

Relevance:
Vesting arrangements frequently contain restrictions concerning transfer or compulsory transfer of shares. The case highlights the importance of ensuring that restrictions concerning shares are legally compatible with the company's constitutional documents.

3. M.S. Madhusoodhanan v. Kerala Kaumudi Pvt. Ltd., (2004) 9 SCC 204

The Supreme Court examined arrangements relating to shares and shareholder rights.

Relevance:
The decision is useful when considering how contractual arrangements concerning ownership and transfer of shares interact with corporate rights. Start-ups should ensure that vesting, transfer and exit provisions are properly reflected in the relevant corporate documents.

4. Dale & Carrington Investment (P) Ltd. v. P.K. Prathapan, (2005) 1 SCC 212

The Supreme Court examined corporate actions involving allotment of shares and principles governing directors' powers.

Relevance:
Equity arrangements in start-ups ultimately affect shareholding and corporate control. Proper authorisation and compliance with corporate law are therefore important when implementing equity-based arrangements.

5. Needle Industries (India) Ltd. v. Needle Industries Newey (India) Holding Ltd., (1981) 3 SCC 333

The Supreme Court considered issues relating to share allotment, corporate powers and shareholder interests.

Relevance:
The case demonstrates the importance of examining the corporate purpose and legal validity of transactions affecting shareholding. Vesting-related allotments or transfers should similarly be implemented through appropriate corporate procedures.

6. Sangramsinh P. Gaekwad v. Shantadevi P. Gaekwad, (2005) 11 SCC 314

The Supreme Court considered shareholder rights and disputes concerning corporate affairs.

Relevance:
Start-up equity arrangements can become particularly contentious when founders disagree over ownership, control or transfer. Properly documented vesting arrangements can reduce uncertainty about the parties' respective rights.

7. Cyrus Investments Pvt. Ltd. v. Tata Sons Ltd., (2021) 9 SCC 449

The Supreme Court considered corporate governance, shareholder rights and management/control issues in the Tata group dispute.

Relevance:
While not a vesting case, it illustrates the broader significance of shareholder rights and corporate governance arrangements. Founder vesting should be drafted consistently with the company's governance structure and constitutional documents.

13. What happens when an employee leaves?

The agreement should clearly distinguish:

Vested equity

Equity that has already vested generally remains subject to the applicable exercise, transfer, buyback and other contractual conditions.

Unvested equity

Unvested equity generally does not become the employee's unconditional economic entitlement merely because it was included in the original grant.

The exact consequence depends on the governing documents.

For example:

Employee receives an option over 10,000 shares with four-year vesting. After two years, 5,000 options have vested. If the employee leaves at that point, the treatment of the remaining 5,000 unvested options will depend upon the ESOP scheme and contractual terms.

14. Vesting versus exercise

These concepts should not be confused.

Vesting = the participant earns the right under the applicable scheme.

Exercise = the participant actually exercises an option to acquire shares, where the arrangement is an option-based plan.

Thus:

Grant → Vesting → Exercise → Shareholding

may represent the relevant sequence for an ESOP.

An employee can therefore have vested options without necessarily already being a shareholder.

15. Documentation

A start-up should normally ensure consistency among:

1. employment agreement;
2. ESOP scheme;
3. grant letter;
4. shareholders' agreement;
5. Articles of Association;
6. board resolutions;
7. shareholder resolutions where required;
8. cap table; and
9. applicable statutory filings.

Conflicting documents can create significant disputes.

16. Tax considerations

Vesting and taxation are separate questions from corporate ownership.

Depending upon the structure, taxation may arise at different stages, including:

• grant;
• vesting;
• exercise; and/or
• sale of shares.

The tax treatment can also differ between employees, founders and other participants.

Accordingly, the vesting schedule should be examined together with applicable income-tax provisions rather than assuming that vesting automatically produces the same tax consequences as an outright share transfer.

17. Drafting points for employers

A start-up's vesting documentation should clearly specify:

• number of shares/options;
• vesting commencement date;
• vesting period;
• cliff period;
• vesting frequency;
• exercise period;
• treatment on resignation;
• treatment on termination;
• good-leaver provisions;
• bad-leaver provisions;
• treatment after death/disability;
• change-of-control treatment;
• acceleration provisions;
• repurchase/transfer rights;
• valuation mechanism;
• tax responsibilities; and
• governing law and dispute resolution.

18. Example

Suppose an employee receives 12,000 ESOPs subject to four-year vesting with a one-year cliff.

After one year:

3,000 options vest.

Thereafter, the remaining 9,000 options vest over the next 36 months at 250 options per month.

If the employee leaves after 30 months, the employee's vested entitlement would depend upon the exact vesting date and the scheme's calculation method, while the remaining unvested options would ordinarily be treated according to the termination provisions.

Conclusion

Vesting schedules allow start-ups to link equity ownership with continued service, founder participation and, where appropriate, specified performance conditions. A well-designed arrangement should clearly distinguish grant, vesting, exercise and ownership, and should expressly address resignation, termination, good/bad leaver situations, change of control and acceleration.

For Indian start-ups, vesting should also be coordinated with the Companies Act, 2013, applicable ESOP rules, Articles of Association, shareholders' agreements and tax requirements. The case law on share transfers, allotments, shareholder rights and corporate governance further demonstrates why equity arrangements should be properly documented and implemented through the company's authorised corporate processes.