One of the important differences between shares and options is that shares reverse vest and options forward vest. For more information on this topic please read Shares vs. Options: What’s the difference?
Vesting means that the shares or options are ‘earned’ over a period of time, and the person will own the full amount only when the full vesting period has passed.
Reverse Vesting of Shares
Shares are issued and allocated to the shareholder upfront. If the shareholder then leaves the Company before the end of the vesting period, then the shareholder will be required to sell their unvested shares back to the company.
For example, you issue and allocate 100,000 Ordinary Shares to your Founder with reverse vesting over a 4-year period. After year 1, the Founder leaves and because of the reverse vesting, the company has the right to repurchase the 750 shares unvested shares.
Founders are commonly the only Company employees on reverse vesting schedules, the exception being early employees that are issued shares before a funding round. The advantage of reverse vesting compared to forward vesting is that the Founders, who often own the majority of the Company equity, get the full voting rights attached to those shares from the point of share issue even while they are on a vesting schedule.
Reverse vesting is super important for early stage Companies because it protects the Company against a situation where a Founder leaves, taking a large proportion of the Company shares with them. We always recommend you vest the Founders shares, especially when you have a team of 2 or more Founders.
Forward Vesting of Options
Options forward vest, whereby the option holder is granted with options incrementally, usually over a 3-4 year period. Options vest as when the Employee/Advisor/Consultant reaches the vesting milestone (usually every month or every year), if they leave before the end of the vesting schedule then the unvested options lapse.
The aim is to incentivise the option holder to stay with the company for the long term and to keep their motivation high. In some circumstances, options are used to top up an individual's salary in the situation where the startup may be unable to pay the market rate.
The longer the option holder stays with the company, the more options they will get and be able to convert into shares in the future. It’s important to note that options are not shares, so the option holder does not have rights in the company before they exercise their right to convert to shares.
For example, you issue and allocate 1,000 Options to your employee with forward vesting on a 4-year period. After 1 year, your employee leaves. Because a forward vesting mechanism was in place, the 750 options that were yet to vest are still with the company and your employee is not able to exercise them.
Forward vesting is a huge advantage when issuing sweat equity to Employees, Consultants or Advisors because you can issue the options as and when the work has been completed and you don’t have to worry about complicated share buy back procedures if the employment is terminated early. This is why we always recommend issuing sweat equity as options to any non-Founder shareholders
If you still have questions about options and shares vesting or would like to know more about how SeedLegals can help you give out equity to your team, just hit the chat button, we’d love to help.