Written by Ian Sharp PhD on June 11th, 2019
Ian Sharp here and you are listening to The Good Doctor Sharp on DoctorsInTech.com Today's topic is vesting of company shares, specifically as a function of time. This type of vesting schedule is known as time-based vesting. So, let's start this off by saying that I certainly have yet to witness any time-based vesting agreement "empower" or cultivate growth at a technology startup company. Founder: "But Dr. Sharp... I've got a 4 year vesting schedule WITH a one-year cliff and I'm proud of it. I'm proud of knowing how to say it, and I'm proud of knowing what it means." Dr. Sharp “Sorry to hear that man... you might want to seek counsel" I can only openly tell you what I've seen in my life experience and empirically delineate to the best of my ability what I've seen, while building technology companies for the past 15 years. The truth is, as I recount my time, that I just haven't seen anything good come of time-based vesting. It's been a long time and I haven't seen the good that is supposed to be there. I'm not saying I've invested money and then checked in with the founders once every month or so, because I haven't. What I am saying is that I have done the work, with groups or alone, building product during nearly 100% of my waking hours for stretches spanning several years. And I've done this while being bound to time-based vesting agreements. I know what the excuse to do time-based vesting, you do it because you “just want to get started and time-based vesting is the easiest way to start”. Though, just because something is easy, doesn't mean it's good or worth while doing. If you want to stop reading here, you're fine. You've already gotten the main take-away and you already know what to do. If you're a founder, don't do a time-based vesting agreement for your startup. If you're an investor, be concerned about investing in a company that has been operating under a time-based vesting schedule. If you're an investor and you just convinced the founders to sign off on a time-based vesting agreement, then shame on you. You should know better. If you're still curious, and would like to know possible reasons "why" time-based agreements are pretty much guaranteed unfold the way they alway do, and would like to see be shown the path from someone who's already traveled this road, then read on. In the paragraphs that follow, I will offer my best understanding of what it is exactly about time-based vesting agreements that makes them so incredibly detrimental to long term growth, and stifles movement like being caught in a bear-trap. Before we begin, let me add some context before we begin by saying this: "The main lie you hear is that time-based vesting is what 'keeps a founder from walking away with too much equity in the company after a few months.' " The truth is, the founder should've never had equity to walk away with if he hadn't earned it yet. #1. Time-based vesting is not capitalism Capitalism is an economic system where goods and services are assigned a perceived value and are allowed to be exchanged in a free market. A free market allows competition, and transactions are meant to be for-profit. If the buyer is to give the seller money or equity of value X, then the seller is expected to return a product of value X. Can this economic system represent founders in a startup company? Yes it can. In startup land, buyers are companies and the sellers are founders. For early stage startups without money, the value is represented by equity. As such, a capitalist economy between company and founder could exist. If you're going to design a company in a capitalist society that operates for-profit, then you might want to make the internal operating agreements principles and practices of your startup coincide with the capitalist ideology. One pre-requisite that might help you determine whether your company demonstrates capitalist ideology, would be to run your company vesting agreement through the following test: When my company gives a founder equity (valued at X), the founder gives my company product (valued at X). If you company vesting agreement passes the test, then congratulations. There's an indication your startup may want to operate for-profit. On the other hand, if you're startup elected a time-based vesting agreement, the previous statement is definitely FALSE. In that case, you have not elected capitalism as the economic system for your startup. You have elected something else. The reason is because, the only thing a founder is expected to give the company in a time-based vesting agreement is their "time". The value that the founder provides the company is irrelevant. And because time-based vesting isn't really time-and-space place vesting, the founder could technically spend all their time in a completely different place altogether on the planet altogether and still vest. There's a funny phrase. It's funny because it's true. It was popularized by a series, which I never watched, that states, "rest and vest". As days tick roll by, founders are rewarded with equity. Founders are free to put value in, or not put value in... but one thing is for certain, they always get to take equity value out of the company. No fair-and-equitable-exchange required. No questions asked. "I gave my time like you asked for... what more do you want?" You might say, "but, but but... I could take them to court and make a case for 'breach of fiduciary duty' and I can get 'm good and get the equity back!..." Maybe ... But how long are you going to wait until that happens? Right now you might be stuck in a bear-trap, wasting away... burning time and money... and I would ask you, "Why are you here? Why did you allow for this possibility? Isn't it going to be a lot of work to get out of this now? What competitors are going to swoop in and overtake you while you're piddling around focusing on who you're going to sue instead of how you're going to build value in your company?" Then in general I'd think... why you would you want to cultivate a working environment where people brewed over equity holders like a hawk, looking for an opportunity to take them to court. Who wants to work at a company like that, "sign me up!?" (maybe not ...) When someone tells me they've elected a time-based vesting legal agreement, it makes me envision welfare. Then I think of their company like the island of Cuba in the 1980s. There's a big sign that reads, "everyone eats for free", but then you look around and there's no food. #2. Time-based vesting is not a free market In a free market, anyone is allowed to create value. In a time-based vesting agreement, only a small group of people are allowed to create value. What's wrong with that? Maybe nothing but... I can tell you I've seen resentment grow in companies where someone wanted the 'exclusive right' to be compensated with equity by bringing in new customers. Imagine the scenario where a connected businessman wants to bring in a colleague he knows to drive high growth and sales... but wait ... he can't get equity ... so pay him ? We can't pay him, we don't have any sales... bear-trap. In a time-based vesting agreement, you'd have to change everyone's potential equity earnings to give the equity to someone else. Sounds like a lot of work again. Stuck in a bear-trap. Wouldn't it be easier if anyone who wanted to add value was given the chance to do so? The exchange of value in capitalism doesn't discriminate or care 'who' provides the value, so long as it is provided. Time-based vesting agreements put barriers around the free market. #3. Time-based vesting undermines hard-work and builds tense relationships Here's a theoretical example of how time-based investing ruins relationships between makers (i.e the engineers of the world), takers (business men and lawyers) and disincentivizes bringing a product to market. Maker: "I built the product. My vision. We've got MVP!" Taker: "But wait .... NO! I'm scared. I can't do this without you. I'm not done with you. You keep.... you stick around here... I have an opinion there would be some cool features... and we need to change font and color scheme again too. If you leave now you don't get nothing. Spend 3 more years of your life here with me! Maker: "You've got more than enough. It's your turn to do work and you still haven't sold anything... " Taker: "Well if I haven't sold, or can't sell... then it's your fault ... it might be because the colors are all wrong. If it were just for the colors and rounding edges on the button then I think I could sell... " (silence) Maker: "Did you look at amazon's first website?" (silence) Taker: ... #4. Time-based vesting rewards lethargy If you read point #1, then there really is no thing else to say here except that you could have a challenging time getting additional funding, when the guy who did nothing gets his equity diluted the same as the guy that carried the company. #5. Time-based vesting is like a federal retirement plan. No government has ever been known to be a shining example of efficiency, production or customer service, but why? Is it the environment? Perhaps one reason is that government employees are on a time-based retirement vesting plan. As long as they show up to work and "give time", they get to retire. Value-exchanged is irrelevant again. #6. Evaluating a data point This is probably the most important section of this read. I've delimited reasons that align with my life experience, but what would be more convincing would be some actual data, from people who are not me, so here it is. This paper published at the University of Oregon suggests that moving from time-based investments to another model can actually turn around a failing company. Performance-vesting firms have significantly better subsequent operating performance than control firms. Carr Bettis, John Bizjak, Jeffrey Coles, Swaminathan Kalpathy, Stock and Option Grants with Performance-based Vesting Provisions, The Review of Financial Studies, Volume 23, Issue 10, October 2010, Pages 3849–3888, https://doi.org/10.1093/rfs/hhq060
Dr Sharp helps founders in startups make better deals with their team-mates. This leads to higher levels of moral, respect, integrity and a feeling of being "treated fairly" by setting value-based expectations early and often. If you're thinking about starting a technology company soon, or already have and you're wondering if it's too late to restructure your incentives, then definitely reach out and request your free strategy session today.