Keeping it simple with employee share schemes, part 1: vesting conditions
Why is it hard to keep it simple?
Keeping it simple isn’t easy – the government already throws enough complexity at businesses in the form of the tax rules, regulation, company laws and accounting rules that apply to employee shares schemes.
The biggest hurdle to keeping it simple is often the very valid concerns of founders. This is the first in a series of posts looking at some of the most common concerns, and why these shouldn’t be a barrier to simplicity.
The focus of this post is vesting conditions.
What is a vesting condition?
It’s a part of the agreement with the employee that says in effect “you can’t have your shares until X has happened”. ‘X’ might the employee remaining in employment for a certain time, it might be the sale of the business, or it might be the employee hitting performance targets (such as appraisal ratings, project milestones or sales).
Why are vesting conditions complicated?
They don’t have to be. If the vesting condition is whether the business has been sold, or the employee has been in employment a certain length of time, it can be easy to create the condition, and easy to check if it has been satisfied.
Conditions tend to get complicated when they focus on performance targets. The nature of an employee share scheme means that vesting conditions need to be certain from the outset. If you create a condition based on an appraisal rating, what if your rating system changes? If you create one based on a milestone in a project, what if the project changes? If you create one based on sales of particular product, what if you change the products you sell?
There are ways to future proof performance conditions, but only at the cost of introducing complexity, uncertainty or both.
Are performance conditions unsuitable for all businesses?
If your business has ‘found its groove’, and long term planning is likely to be accurate, performance conditions are likely to be both helpful and necessary.
However, suppose you have an early stage business which is still ‘finding its groove’, experimenting with different products, services and markets. Performance targets are unlikely to survive any significant change to the business. You might even find it more difficult to make the change if your key employees are motivated to prevent it. Performance targets might not only be ineffective, they may be damaging to an early stage business.
For an early stage business, I cannot recommend strongly enough sticking to simple vesting conditions, based on time or a sale of the business.
Are time based conditions just as simple as ones based on the sale of the business?
Not quite. The difference is in whether the employee becomes a shareholder for a meaningful length of time.
If the vesting condition is a sale of the business, the employee will only receive the shares immediately before the sale, and then sell them immediately. There isn’t any period during which they might receive dividends or be involved in voting.
If the vesting condition is time, it’s inevitable that employees will become shareholders, and you will need to decide how they should be treated when it comes to dividends, voting, and other issues that affect shareholders.
In short, you can simplify your scheme significantly by only attaching one vesting condition. That condition should be ‘has the business been sold?’