This is a short post. Yes, yes, I always say this and I’m generally lying because, let’s face it, I’m a champion talker. But this really is going to be short. Because, between you and me, I’m sick and tired of writing about options and want to be done with this section of the Due Diligence Handbook already so I can get on with my life and move onto the next section: Financing, Loans and Encumbrances. Does that not sound thrilling? Yes! It does!
Right—so to start, do you remember what vesting is? When it comes to options, vesting is how you earn the right to exercise options. So if you receive 1,000 options, and they vest over four years, at the end of the first year you will have the right to exercise 250 options to buy 250 shares, and the end of the second year, the right to exercise a further 250 options and so on.
A situation can arise, however, where a company might want to grant actual shares, not options. For example:
- As part of a Founders’ Agreement, the founders will divide up ownership in the company (in the form of shares) between themselves.
- An early-stage senior employee might receive actual shares in lieu of options.
- A supplier or director might not want to receive options due to tax ramifications. They would prefer to just have the right to buy shares from Day One (and then exercise that right).
The problem in the above cases is that you lose the benefit of the “earning element”. It’s like you paid someone their entire annual salary on their first day of work. They already have the whole carrot, and you have gone and torched the stick. So a person can receive shares or buy shares on Day One and then do jack. Not show up to work. Now show up for board meetings. Not provide the agreed upon services. And so on.
Unless…you have reverse vesting and repurchase rights. In that case, while the shares are issued and registered in the name of the recipient, the company starts out with the right to buy them back, and loses that right over time (hence “reverse”). If we take the above example, this time for 1,000 shares, and with reverse vesting over four years: on Day One the company has the right to repurchase all of the shares; at the end of the first year the company will have the right to repurchase 750 shares;at the end of the second year, 500 shares and so on.
The repurchase and reverse vesting terms will be set in the share grant or purchase agreement, and will include points such as:
- what the recipient is expected to do to fully earn the shares (e.g. work for a set number of years)
- under what circumstances the company can exercise the rights;
- the reverse-vesting schedule (that is, the rate at which the repurchase rights lapse);
- the amount, if any, to be paid for the shares in the event the right is exercised (e.g. nothing, the purchase price, at a set markup or some other value).