Vesting Agreements: Why they should be the first thing you do when you start a company

Vesting is an industry standard in US startups, but from what we’ve seen, the vast majority of Chilean startups and pymes do not use vesting, most of the time because they haven’t heard about it or don’t completely understand what it is.

Think of vesting as an insurance policy for you and your cofounder in case circumstances change after you start your business. When you start a business, its all sunshine and rainbows. You talk with your partner(s) about how you’re going to take over the world. Everyone is completely motivated and ready to tackle any problems that come up.

It’s been said that having a business partner is like being married, just without the sex. And we all know that while nobody wants it from the start, many marriages end. It’s the exact same with business partners.

But you need to think about the things that could go wrong.

  1. What if a cofounder isn’t the person you thought he was when you started the business?
  2. What if he gets bored with the idea?
  3. What if she leaves the country to travel or finds a better opportunity?
  4. What if she gets a job offer she just can’t pass up?
  5. What if he hooks up with your girlfriend?
  6. What if he gets married and doesn’t have the time he promised he would when he started?
  7. Or what if he just doesn’t pull his weight and you need to find another partner?

What happens to cofounder equity if any of these things happen? Without vesting, you have to rely on the good will of your partner to come to an agreement about what is fair. You’re relying on your business partner’s good faith and sense of fairness to come to an agreement. But as I’ve seen too many times to count, when money and work come into the picture, all bets are off. And its even worse if your business partner was your friend.

Let’s look at an example company that does not have vesting.

Best friends Juan and Pedro start a company. Each have 100 shares. They’re both really excited about starting the business and get to work. After three months, it’s much harder than Pedro expected and starts to come to the office less and less. Juan is still fully motivated and continues to work full time on the project.

Juan tells Pedro he needs to leave the company, as he isn’t working anymore. Pedro agrees that he isn’t working hard anymore, but says that Juan must buy the shares for $1,000,000 because that’s what his shares in the company might be valued at in three years. Pedro says no way. They have a big fight and Pedro stops working entirely. Juan keeps working on the company and Pedro still has his 100 shares, doing nothing while Juan works hard to make the business a success. Even worse former best friends Juan and Pedro don’t speak anymore becuase they both think that they were acting honorably and fairly.

What is vesting?

Vesting is simple. It protects you from all of the above situations by laying out a protocol to deal with these situations that ALL cofounders agree to BEFORE starting the business.

In practice, it gives cofounders the option to buy back each others stock at an agreed-upon low price, on a set schedule, usually over three or four years. We prefer four year vesting. Vesting, when applied equally to all cofounders, makes sure everyone plays by the same rules and avoids problems later when relationships are complicated by time, effort, ip and worst of all money.

Vesting states that if a cofounder leaves during the first year, they will sell all of their shares to their partner(s) at a previously agreed on price. If the partners stay together for a full year, 25% of the buyback options expire. This means that no matter what happens, they will each have 25% of their shares in the company. This is called a one year cliff, because you get nothing until you go over the “cliff” then 25% of your shares are vested.

For the next three years (36 months), 1/36th of the options will expire, meaning that if a cofounder leaves after 1.5 years, he would get to keep 25% of his stock (the amount vested in year 1), plus 6/36ths of the total amount.

After four full years, a cofounder can leave and all of his shares are vested. See table:

Amount Vested Monthly Cofounder

Months 0-12

0.00%

Month 12

25.00%

Month 13

27.08%

Month 14

29.17%

Month 15

31.25%

Month 16

33.33%

Month 17

35.42%

Month 18

37.50%

Month 19

39.58%

Month 20

41.67%

Month 21

43.75%

Month 22

45.83%

Month 23

47.92%

Month 24

50.00%

Month 25

52.08%

Month 26

54.17%

Month 27

56.25%

Month 28

58.33%

Month 29

60.42%

Month 30

62.50%

Month 31

64.58%

Month 32

66.67%

Month 33

68.75%

Month 34

70.83%

Month 35

72.92%

Month 36

75.00%

Month 37

77.08%

Month 38

79.17%

Month 39

81.25%

Month 40

83.33%

Month 41

85.42%

Month 42

87.50%

Month 43

89.58%

Month 44

91.67%

Month 45

93.75%

Month 46

95.83%

Month 47

97.92%

Month 48

100.00%

Vesting example

Here’s the same example with best friends Juan and Pedro from above, this time with vesting.

Best friends Juan and Pedro start a company. Each have 100 shares and agree to four year vesting with a one year cliff. They’re both really excited about starting the business and get to work. After three months, it’s much harder than Pedro expected and starts to come to the office less and less. Juan is still fully motivated and continues to work full time on the project.

Juan tells Pedro he needs to leave the company, as he isn’t working anymore. Pedro agrees that he isn’t working anymore. Per their vesting agreement, Juan must pay Pedro $10 per share, $1000, to buy back his shares.

Juan keeps working on the company, now with 200 shares, doing what he can to make the business a success. Juan and Pedro are still friends.

If Pedro had left after 18 months, he would have 25 shares from year one, and 12.5 shares for the six months that he stayed in the second year. Pedro would need to sell his remaining 62.5 shares to Juan for the agreed upon $10 per share, or $625.

With vesting you protect yourself and your cofounder from unforseen circumstances. At Magma, we believe vesting should be a required term in your operating agreement when you start your business.

2 comments

  1. Great explanation!
    I wonder how to implement a vesting model iin Chile considering laws and SII

    1. Nathan Lustig says:

      Eduardo, check out our version in spanish, it has the actual model in spanish:

      https://www.magmapartners.com/es/vesting-por-que-deberia-ser-lo-primero-que-hagas-cuando-fundas-una-empresa/

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