Vesting clause

A vesting clause in an investment agreement can prove crucial in effectively motivating company management to commit to the company over the long term. This mechanism can certainly be viewed as a factor that increases the likelihood of investment success. It allows investors to control how, when, and under what conditions shares or equity are granted, thereby motivating the management team to achieve long-term goals and minimizing the risk that key individuals will leave the company before achieving business objectives. This ensures that investors can be confident that their capital is being invested in a team committed to building the company’s value over time.

What is vesting?

Vesting is a motivational system similar to the Employee Stock Ownership Plan (ESOP), which is used in company agreements (bylaws) and investment agreements. Its primary premise is to grant rights to shares or equity after a specified period and upon meeting certain conditions. The acquisition of new shares is usually carried out through a capital increase procedure. The investment agreement should precisely outline this process, specifying the deadlines for the relevant actions, including managing issues related to existing clauses, particularly the right of first refusal.

How does vesting work?

Vesting provisions, in their simplest form, entitle individuals to acquire shares or equity under certain conditions—either in full or gradually after working through a transition period, typically lasting several years. This ensures that key individuals remain engaged in the company’s development for an extended period of time. Such a solution is particularly important when the success of an investment largely depends on the founders fulfilling their managerial duties for the company.

Vesting is typically used in the event of a financial investor’s involvement, , as it is clear to the investor that the future success of the investment is closely tied to the maximum engagement of individuals, most often the founders, who best know and understand the business. While the investor may initially lose some percentage of capital (as their share in the equity may decrease), they will likely gain much more—the company will likely develop much better under the leadership of committed, internal managers than under disengaged, external ones.

What are the benefits of a vesting clause in agreements with the Management Board?

Vesting is also often used in agreements with members of the management board. It is possible to stipulate a condition, such as achieving a specific financial result which, once met, enables the acquisition of shares or equity. This approach motivates managers to achieve better results, as their benefits are directly linked to the company’s success.

How does reverse vesting work?

Reverse vesting, a variation of the vesting mechanism, is worth mentioning. In reverse vesting, participants acquire shares or equity at the time of the agreement’s execution. However, if certain conditions of the agreement are not met, they may lose these shares, as the company will have the right to repurchase the shares at a predetermined price. The purpose of this clause is to mitigate the risk of key individuals leaving the company prematurely, taking with them shares or equity that may increase in value. Reverse vesting motivates founders and management to continue working on the company’s development, as their full right to the shares is contingent upon their continued engagement with the company.

Vesting as a protection in case of company sale or IPO

An essential element of vesting is the possibility of acceleration, also known as accelerated vesting. In situations such as the sale of the company or its initial public offering (IPO), the entitled individual may receive full rights to the shares or equity for the period they have not yet worked. This provision protects the interests of beneficiaries and ensures that they receive the benefits they are entitled to in the event of strategic changes within the company.

Conclusion

Vesting is an effective tool that contributes to the better engagement of key individuals in the company’s development. For investors, incorporating this mechanism into investment agreements increases the likelihood of investment success by motivating founders and managers. For management boards, vesting offers a profitable way to align themselves with the long-term business success of the company.

It is important to remember that the detailed provisions regarding vesting should be precisely outlined in the investment agreement to avoid potential issues and ensure compliance with the law and the interests of all parties involved.

We understand that this is a complex and demanding subject matter, therefore, if legal support in this area is needed, we invite you to contact the Hoogells team.