Five-Year Vesting

There is no denying that our Boston is a winning town.  Since last year, John Henry’s  Red Sox won another World Series title… we are now leading the Yankees 2-0 in world championships during this Millennium, the Patriots were one Asante Samuel missed interception away from winning another Super Bowl and Red Auerbach’s smoky ghost reappeared in a smoke free Garden to allow the Celtics’ new owners Wyc Grousbeck and Steve Pagliuca to return the championship to Beantown.

Red used to smoke a Hoyo de Monterey “Governor”, which is nearly impossible to come by these days.  JR Tobacco still has a supply if your Celtics fan at home is in need.  What I am pondering these days when I light up my Rocky Patel “Decade” is how much longer it takes us venture capitalists to build our world class companies and how we keep our founding team and managers motivated to stay in the game.  If it takes 86 years to eradicate the curse of the Bambino and 21 years to win a smoke free NBA championship, it now takes at least 5-8 years to build the type of world class companies that LPs have come to expect from us.

Stock option vesting has long been an area of contention between entrepreneurs and venture capitalists. Having worked in the venture capital business for over 18 years, I’ve learned first-hand the important role vesting plays at fragile start-up companies where engaged executives, value-add shareholders and uncluttered capitalization structures are required to succeed in today’s ultra-competitive technology environment.  I’m going to add some fuel to the fire and argue not only that vesting is absolutely a good thing, but that five year vesting should be the new norm in today’s market.

Vesting is a necessary evil. Not only does it motivate founders to create large and valuable businesses, but it also helps protect start-ups’ delicate ownership structures to ensure shareholders are active participants in creating a successful company. Vesting ensures that founders can’t leave a start-up shortly after its funding and retain significant ownership. I’ve seen situations where former employees no longer involved in a company have significant ownership stakes because the VCs involved didn’t appreciate the importance of vesting. In those situations, it’s hard to motivate current employees and even harder to hire new executives because there are fewer shares to go around. Just as detrimental, during exit discussions those “dead wood” shareholders can distract companies and boards from determining what is best for a company and can even derail potentially lucrative deals.

The exit outlook for start-up companies has changed significantly in recent years, and I would argue that today’s typical vesting schedules don’t reflect the demands of the new market environment. VC financings today often employ four year vesting with a one-year cliff. However, according to Thomson-Reuters, it now takes an all-time high median of seven years for venture-backed companies to achieve an M&A exit and more than eight years on average to achieve an IPO exit. That means that while many founders vest fully in four years, a company needs at least three additional years to provide returns to its shareholders. During those three plus years, the importance of stock options to motivate employees and hire new executives is more pronounced than ever. Four years after funding, a company might need to hire a CEO who has significant experience in finessing M&A deals, or it might need to hire a CFO who can navigate the public markets for an IPO transaction. But when inactive founders own a meaningful slug of a company, it’s almost impossible to provide enough ownership to current employees and new executives who are often so important for attaining significant exits.

Do the math and you’ll see the difference between four year vesting and five year vesting is not onerous for entrepreneurs. For example, assuming a one-year cliff, founders with four year vesting will vest 25% of their shares after year one, and founders with five year vesting will vest 20% of their shares after year one. After two years, they will vest 50% and 40%, respectively; after three years, they will vest 75% and 60%; and after four years, they will vest 100% and 80%. As you can see, five year vesting doesn’t have much effect in the first few years; it’s in the later years where the difference becomes more pronounced.  Given today’s treacherous exit environment, I believe that’s exactly how it should be.

I assure you, I want each and every one of my companies to succeed, and I want every entrepreneur to be fairly and fully compensated for his or her accomplishments. But venture investing today requires bigger checks and more patience than ever. For the sake of entrepreneurs, employees, investors and all other parties involved, I encourage venture capitalists to take a hard look at five year vesting for today’s new investments.  Even if you drop the fourth quarter pass that could have ended the game and won the championship for the Patriots, the Krafts’ still lost their star cornerback to my former hometown Eagles for $57 million when he became fully vested (a free-agent) with the Patriots.  Now it’s back to building a winning NFL franchise for Boston and another billion dollar portfolio company for our LPs.