Milestone Vesting for Your Startup
For cash-strapped startups with a bright future, which is mostly every startup, equity compensation might be the ONLY way for you to get the talent, partnerships, and specialized services you need to get your fledging enterprise off the ground and make interesting deals come to life.
But it can also be a ticking time bomb.
This is especially true with milestone vesting—an arrangement where your business’ service provider or partner only gets your valuable shares or options when they deliver the goods, i.e. hitting certain milestones set out in the equity compensation agreement.
Consider the all too common example of trading equity for software development that doesn’t quite deliver. Sure, you can argue that the developer didn’t do what “they said they were going to do.” But in a lot of disputes, contracts are impossibly vague, memories have worn thin, and all those emails that spelled out the details were deleted years ago. As a result, you ended up having to cede equity to a less-than-ideal partner. It’s also the kind of mess that often scares away dilution-weary investors.
Milestone-based vesting can be a great tool to power your startup. But you need to make sure it’s set up right, AND that it’s the right tool to use in the first place. Here, we discuss the basics of milestone vesting, when (and when not) to use it, and how to avoid some common pitfalls.
What is milestone-based vesting and when should you use it?
The premise here is simple; vesting incentivizes people to stick around and it guarantees that each contributor gets a share of the company’s value that is commensurate to their relative contribution.
Most incentive vesting arrangements are time-based, with a certain amount of equity “granted” up front but which only vests over time. For example, the “industry standard” vesting schedule for startup employees is for one-quarter of equity to vest after one year of service and the other 75% to vest equally over the remaining three years in monthly installments.
But that approach doesn’t always make sense when you want to reward clearly identified deliverables or metrics—like the completion of a big software development project. Here, a time-based vesting schedule would completely misalign incentives; a service provider that takes longer to deliver would end up getting more compensation than one who completes the work more efficiently.
In this case, milestone vesting can be a great solution. Equity is earned only when the vendor or employee hits a specific target or milestone, like sales revenues, marketing targets, or the development of a specific product.
Milestone-based vesting tends to work best for objectives that are relatively short-term, predictable, and very clear—for example, in securing the production of creative assets, such as IP, IT services, and software, or when somebody (like a sales partner) achieves clearly identifiable metrics.
If you ARE considering using milestone-based vesting as part of your equity compensation arrangements, here are some other things to keep in mind.
3 Milestone Vesting Mistakes and How to Avoid Them
Make sure milestone vesting is the right tool for the arrangement.
Milestone vesting can be a really valuable and powerful tool to align a deal, but you need to make sure that your vesting schedule and mechanisms are well-suited to the job.
For example, using milestone vesting for an employee or outsourced executive makes no sense. These team members handle a plethora of individual tasks that are constantly reset and replaced, so trying to tie milestone vesting to their responsibilities is ridiculously difficult to do in a way that is fair to both the company and them. An outsourced CTO is a great example of this. They are tasked with a zillion different responsibilities rather than a few discrete outcomes. As a result, it’s nearly impossible to detail (or manage) an equity agreement that gives them a fraction of their equity shares for each tiny activity or deliverable.
Milestone-based vesting works best when the deliverables or milestones are very specific, straightforward, and clear. If you’ve set out to negotiate a milestone-based vesting agreement but your milestones are turning into a complicated pages-long laundry list, it’s usually a sign that the vesting tool isn’t well aligned with the tasks at hand. In this case, it’s wise to step back and see how (and if) you can simplify the structure of those terms. If you can’t, then time-based vesting might be a better solution for your situation.
2. Understand the risks of milestone-based vesting.
Even when well-thought-out, milestone-based vesting arrangements are rarely, if ever, perfect. That’s because ultimately—just like a contract where someone gets paid cash for providing specific deliverables—unless an agreement is tens of pages long, there is almost always going to be some ambiguity about whether the equity has been properly earned or not. If that’s not a risk you want to take with your company’s equity, you might want to consider using a different tool.
If you do choose to go with a milestone-based vesting arrangement, you need to be OK with the fact that you might ultimately have to give up valuable ownership rights in your company to someone who didn’t get the job done right. And to mitigate against this risk, there should be legal language in place that either sets out the minimum requirements or clearly refers to those requirements if they are included in another agreement, such as the applicable service provider agreement.
3. Make sure you’re level set on the terms and conditions of the milestones.
If you decide that milestone vesting is the right option for your arrangement, you need to make sure that BOTH the services agreement AND the equity compensation agreement itself are unambiguous about what needs to happen for that equity to be earned—but without being overly complicated or turning it into a novel.
For example, if your agreement states that the vendor will deliver a new website in exchange for equity, what does “delivery” really mean? The first version? The final version after all parties have signed off that they are satisfied? Or something in-between?
Your equity agreement should be drafted in a way that ensures you get what you want out of the deal. To this end, it’s helpful to consider what specific goals you want to accomplish through the arrangement and how your milestones are designed to achieve those goals.
Another common oversight here is forgetting to make sure that the vesting terms are tied into the service contract. Even big companies make this mistake all the time; the service contract is drafted with brilliant precision, but the stock option or restricted share agreement is fuzzy and contradicts the former. It’s important to make sure that BOTH the vesting and service agreements are drafted complementarily to clearly set out the conditions that need to be satisfied for vesting to occur.
Of course, the best way to ensure this is by engaging experienced startup counsel early on in the process. Even an early-stage company that doesn’t have a lot of money needs to think carefully in this respect. The last thing you want at exit is a prolonged legal dispute from a service agreement gone wrong. Lawyers fees could be the least of what you lose in this circumstance.
Have questions about using milestone-based vesting for your startup? We’d love to help.