Equity & Vesting: Earning Your Stake
Joining a start-up often means the opportunity to earn equity – a stake in the company's future success. It's a powerful incentive, but understanding how equity works, particularly the concept of vesting, is essential. Vesting ensures that equity is earned over time, aligning founders, employees, contractors and advisors' interests with the company's long-term growth.
Time-Based Vesting: The Steady Climb
Time-based vesting is the most standard model in Australia. You earn a portion of your equity over a defined period, typically four years. Often, this includes a one-year cliff. The cliff acts as a probationary period; if you leave the company before completing one year of service, you may forfeit all of your equity, as it has not yet been earned.
After the cliff, your equity vests gradually over a certain period of time. At the one-year mark, generally 25% of the shares will vest and then, from that point onwards, they vest at just over 2% per month until you reach 100% (assuming they vest monthly over a further 3 years). This structure rewards consistent contributions and commitment.
You can structure your vesting period flexibly. For example, you may not require a cliff, or you may backdate to when you and your co-founder(s) first started working on the idea – even if you did not incorporate the company until later.
Milestone-Based Vesting: Achieving Targets
Milestone-based vesting ties equity ownership to the achievement of specific, pre-determined goals. These milestones could include launching a new product, securing a round of funding, or reaching a specific revenue target. Milestones work best when they're specific, measurable and within the participant's influence. While effective for motivating progress towards key objectives, milestone-based vesting can be more complex to define, measure, and administer fairly.
Why Vesting Matters
Share vesting has three broad purposes: incentivise the co-founder or employee to stay working in the business so that their shares vest; protect the business if a co-founder or employee leaves; and signal to investors the founder's commitment to growing the start-up.
For Employees and Team Members
If a co-founder or employee leaves, they will only receive the benefit of the shares that have vested. Otherwise, they will receive no benefit at all if they leave before reaching the vesting cliff. This arrangement can potentially cost the co-founder or employee a significant amount of money if the shares they are forfeiting are (or could be in the future) worth a substantial amount of money.
Vesting helps align team members' goals with the startup's vision. Since shares vest gradually, those who hold vested equity are incentivised to stay longer and work harder, knowing they're part of the company's future success.
For Founders
For founders, understanding vesting is equally critical, although from a different perspective. While you may be granting equity to employees, your own equity may also be subject to a vesting schedule. This might seem counterintuitive, but it's a crucial element of good governance.
Vesting your own shares reinforces your commitment to the long-term vision of your company and aligns your interests with those of your investors. It also protects the company in unforeseen circumstances, such as a founder's departure, ensuring that equity is tied to continued contribution.
One of the primary drivers behind the idea of vesting is to help reduce the impact of a co-founder leaving by ensuring they don't leave with a disproportionate amount of equity. Vesting helps ensure that should a co-founder leave during the vesting period, there is enough equity left in the company to adequately incentivise the remaining founders and team.
A well-structured vesting schedule for founders demonstrates professionalism and strengthens investor confidence. It's a foundational element for building a sustainable and successful venture.
Australian-Specific Considerations
Legal Requirements
Issuing shares or options must comply with the Corporations Act 2001 (Cth) and your company's rules. Check your Company Constitution for processes around new issues, buy-backs, transfers, and board/shareholder approvals. Share buy-backs and cancellations are also regulated.
Tax Implications
Australia has specific tax rules for employee share schemes (ESS). Tax outcomes depend on the type of equity (shares vs options), valuations, discounts, deferral conditions, and whether startup concessions apply. Reporting to the ATO is often required. Because tax impacts timing and structure, it's smart to settle your plan design before making offers and to coordinate with your accountant.
Be clear in writing about when tax may arise (grant, vesting, exercise, or sale), and who is responsible for tax. Maintain accurate records of offers, acceptances, valuations and board approvals for each grant.
Good Leaver vs Bad Leaver Provisions
A founder who has to leave due to misfortune such as illness, injury or death is generally regarded as a "Good Leaver" which means the founder can retain the equity as compensation for the effort they've expended up until that point.
There are also scenarios in which it could be justified to have a mechanism to claw-back the vested equity of a founder. This is usually when a founder does something seriously "bad". For example, commits a criminal offence, acts fraudulently or commits a material breach of their employment contract. In such scenarios the founder is usually regarded as a "Bad Leaver" and is required to forgo unvested equity and potentially have their vested equity purchased or bought-back by the company (at a discount to market value).
Acceleration on Exit
In the scenario of an acquisition of the startup company, founders should wholly participate in the value they've created and have accelerated vesting if as part of the acquisition transaction they agree to leave the business. If they are staying in the business it's likely that the new shareholders may want to keep the founder incentivised pursuant to a vesting regime.
Essential Documentation
Strong, consistent documents are essential. At a minimum, most Australian employers consider the following:
Company Constitution: Your company's rules around issuing shares, options, buy-backs, and transfers should support your plan mechanics
Shareholders Agreement: For founder and investor alignment, addressing vesting, leaver outcomes, rights of first refusal, and valuation/buy-back processes
Equity Plan Rules: The "master" plan document that sets the framework for grants (eligibility, vesting, leavers, acceleration, transfers, buy-backs, valuations, and board discretion)
Offer/Grant Documents: Individual terms that sit under the plan (number of shares/options, vesting schedule, exercise price, and any special terms)
Board/Shareholder Approvals: Resolutions approving the plan and each grant, and authorising issues or buy-backs
Employment/Contractor Agreements: Cross-reference equity in the remuneration clause and ensure consistency with the plan rules
Common Pitfalls to Avoid
Common mistakes include:
Vague leaver provisions: Ambiguity causes disputes. Define "good leaver" and "bad leaver" precisely and set outcomes for each
Assuming nominal buy-back prices: Buy-backs are regulated. Set a lawful pricing method in your documents and follow the Corporations Act process
Forgetting tax timing: The tax point can be grant, vesting, exercise, or sale depending on the structure. Coordinate with your accountant before you issue offers
Misalignment across documents: Ensure your plan, Shareholders Agreement, employment contracts and Company Constitution say the same thing about vesting, leavers and buy-backs
No approvals or records: Missing resolutions, registers or signed offers causes cap table headaches (and investor due diligence issues) later
Key Takeaways
Equity vesting helps you retain and motivate key people while protecting your cap table – but it only works if the rules are clear and consistently documented. A typical schedule is four years with a one-year cliff, but you can tailor vesting with milestones and acceleration to suit your goals.
Unvested equity is generally forfeited on exit unless your documents expressly accelerate it; outcomes for vested equity and buy-backs should follow lawful pricing and Corporations Act processes. Share vesting can help mitigate risk, protect your startup and demonstrate to investors that you are committed to growing the company.
For Australian startups, implementing a properly structured vesting arrangement that complies with the Corporations Act 2001 (Cth) and considers the tax implications under Australian employee share scheme rules is essential for long-term success and investor confidence.