|June 24, 2014|
Previously published on June 19, 2014
The importance of time-based vesting for equity and/or rights to acquire equity granted to founders and subsequent employees of venture-backed companies should not be understated. Equally important is what events should cause the agreed upon vesting schedule to accelerate. While the possible permutations for acceleration are endless, three primary flavors arise with great frequency: (i) termination by the company “other than for cause”, (ii) termination as a result of death or disability, and (iii) change of control.
Most employees of venture-backed companies work for the company at-will, meaning that either the company or the employee can terminate the employment relationship at any time, for any reason or no reason. Because there is no need to show “cause” in terminating an employee (and in light of the cost and difficulty associated with proving “for cause” termination), most such terminations are “other than for cause”. While there is certainly logic to the notion that if an employee gets fired for reasons other than his/her performance, the employee should not be punished by having vesting cease: (i) the amount of equity into which the employee has already vested as of termination should be commensurate with the value that he/she has provided to the company (assuming that the vesting schedule was formulated correctly) and (ii) the company will need to make an equity grant of corresponding magnitude to the terminated employee’s replacement, which will result in unwarranted dilution to remaining employees/investors if vesting is accelerated for the terminated employee. Investors are well aware of these realities and generally push the dilution for equity grants that vest on “other than for cause” termination on existing equity holders, essentially treating all such equity as issued and outstanding when negotiating valuation. Nevertheless, acceleration on “other than for cause” termination may still make sense for certain founders or employees, especially when viewed as an element of pre-negotiated severance.
The same concerns associated with acceleration on “other than for cause” termination apply to termination as a result of death or disability, although the impact may be somewhat mitigated since it is far more likely that an employee will be fired than that he/she will die or become disabled while working for the company. Acceleration on termination as a result of death or disability may make sense from a moral perspective, but companies should remain mindful of the consequences when making grants with such terms.
Acceleration on change of control perhaps presents the most difficult quandary. On one hand, to the extent that a company gets sold at an impressive valuation, there is a strong argument that employees have earned the full value of the accelerated equity that they receive. On the other hand, any amounts paid on accelerated equity come out of the pockets of founders, investors, and employees who have fully-vested into their equity through long-term service to the company. Further, buyers may be concerned that employees will be less motivated to keep working after receiving a substantial pay-out and, in any event, will need to make new equity grants to such employees in order to keep them incentivized, both of which may come at a cost to valuation. While “double-trigger” acceleration strikes a middle ground by providing for acceleration of vesting following a change of control only if the employee is subsequently terminated by the buyer within a prescribed period of time, this too may impact valuation since the buyer will essentially be in a situation where employees have acceleration on termination once the acquisition has been consummated.
While there is no clear cut right and wrong in the world of acceleration, companies should think about the long-term impact of their choices in this area.