Equity compensation may prove to be the most significant compensation a startup grants its employees.
In recent decades, thriving start-up businesses have benefitted hundreds of employees granted with equity based compensation. Employees in these start-ups typically agreed to work for lower salaries than those offered by established corporations, and in return were granted with a substantial package of options or shares, linking their long-term monetary rewards with the success of the startup.
Legislators around the world recognized the practice of equity grants as a legitimate “tool” used to incentivize employees, directors, and officeholders. Moreover, in light of the fact that the success of small businesses strengthens local economies, a number of strategies were put in place to encourage the growth of small startups with low financial resources and to allow them to compete with larger corporations. Appropriate taxation routes were established, and preferred taxation with respect to such equity grants was regulated, supporting the efforts of startups to recruit talented employees who are motivated to work hard to achieve success for themselves and their company.
With the practice of dealing with options or share incentive grants through recognized tax routes now standard in the marketplace, commercial mechanisms have also evolved, allowing companies and boards of directors greater control over how incentive equity is handled and how different categories of employees are compensated.
One of the key elements in equity-based incentive agreements for management officials and senior employees is vesting acceleration. To effectively link a startup’s success with an employee’s contribution to company performance, and to encourage employees to continue their engagement with the startup, equity grants usually vest over a certain period of time (two to four years is the current market standard). As such, if an employee is granted the option to purchase shares from a startup, his or her right to exercise these options is dependent on a specific amount that was vested at a certain point in time.
Senior employees and management officials often worry that their vesting schedule will deny them potential financial benefits that may become available during the vesting period. These concerns have led to a legitimate demand for a mechanism that will accelerate the vesting schedule.
How does vesting acceleration works?
The vesting acceleration mechanism is triggered when a ‘financial benefit’ is expected. In general, these events include (i) an event where a startup is going to be publicly traded (IPO), (ii) the purchase of all of startup shares (Exit), or (iii) the sale of all of the assets of the startup. The list of events can also include the grant of exclusive license regarding the startup’s technology to a third party, or other circumstances of change of control. By accelerating the vesting schedule in such an event, the incentive equity holder can benefit from all of the equity that was granted to him or her, and not just from the vested portion.
This mechanism is typically stated as follows:
“Notwithstanding the Options Vesting Schedule described under Appendix X, in the event on an M&A Event, all of the unvested Options shall, immediately prior and subject to the M&A Event taking place, become vested and exercisable”.
From the perspective of startup management, there are five main issues to consider before adding an acceleration clause:
- Seniority – Is the person who is going to be included under the vesting acceleration benefit sufficiently senior? The startup would want to ensure that the acceleration benefit is preserved and used as a “carrot” to attract highly worthy personnel, and must therefore ensure that its equity grant policy clearly defines the minimum seniority level entitled to receive this benefit.
- Events of Acceleration – It is not recommended to negotiate the acceleration terms separately with each employee or senior management member. Every standard option plan should include a definition approved by the board of directors, and it is highly recommended to adhere to these guidelines. This precaution prevents destructive situations in which an event may qualify as an event of acceleration for one employee, but not for another.
- Minimum Engagement Period – As an event of acceleration could potentially occur at any time, a minimum period of engagement with the startup is a legitimate requirement. This ensures that the employee or senior management official actually contributed to the startup in the given time period, and that the interest of the remaining shareholders, who lose money as a result of the acceleration, is preserved.
- Full vs. Partial Acceleration – Acceleration does not have to be in full. A partial acceleration, for example, of 50% of the unvested equity, should be a valid consideration for companies looking to differentiate between seniority levels.
- The Double Trigger – An acquirer of a startup will frequently demand that senior employees stay engaged following the acquisition. One of the ways to insure such involvement is to use a ‘double-trigger’ mechanism, which essentially permits the acceleration to be subject to continued engagement following an acquisition. The acceleration mechanism may be thought of as the ‘carrot’ for senior employees, while the double trigger acts as the ‘stick’.