Why Startups Should Embrace Performance Vesting
Many different types of investors love to quote Warren Buffet and Charlie Munger, but it’s somewhat less cliché among VCs, so you’ll have to permit me one Munger quote: “Show me the incentive and I’ll show you the outcome”.
Arguably one of the most important factors in the success of startups and venture capital in the US has been employee equity ownership of companies. Equity is a powerful incentive tool, and startups should be thoughtful in how they approach it. Today, that approach has been effectively templatized. There are good sources of equity benchmarking that can inform Boards about how many shares to grant, and the VC industry has coalesced around a standard four-year vesting period with a 1-year cliff.
This is table stakes – but we shouldn’t treat it as a one-size-fits-all approach as has largely become the norm today. There is a big opportunity to further incentivize value creation if startups also embraced situational performance vesting for key executives.
First, let’s address why this is not already commonplace. Startup businesses are dynamic and ever-changing. In general, they seek to hire employees capable of helping across functions and want to ensure there are no internal silos or executives with any goal other than overall company success. Further, it’s common for priorities and even entire business models to change. No executive wants to be shortchanged equity because of a priority shift they couldn’t control.
Time-based vesting is considered an imperfect, but plausible measure of overall success. If an executive remains at the company, then they must be contributing enough overall to justify continued vesting. Boards also tend to push companies towards this vesting approach for simplicity as it is the industry norm. To persuade an employee to accept performance-based, rather than time-based equity vesting would likely require increasing the total size of the package which could make existing investors wary.
Nonetheless, there are still powerful reasons to consider adding performance vesting to the arsenal of possibilities.
Incentive Alignment: There are certain measurable events that greatly increase the overall value of a business. Individual executives often play an outsized role in directly creating this value and would be highly motivated to deliver if they are able to capture some of that value, too. Some examples: hiring a head of EU sales and vesting a portion of their equity based on revenue targets for the region; tying a piece of equity to FDA approval for a medical device company’s head of regulatory affairs; incentivizing a head of infrastructure building out an AI data center to deliver on time and on budget by tying their equity grants to completion milestones.
Positive Selection: Interviewing is hard and even the best-run processes do not have 100% success rates. The more senior an employee becomes, the higher likelihood there is a divergence between being good at interviewing vs. being good at the actual job. Employee reactions to vesting based on specific performance can help companies gauge whether they are actually committed to succeed – or actually believe they will – versus those who are simply skilled at bloviating.
Inertia is not a Measure of Value: This approach can be clarifying for CEOs and Boards in how they evaluate c-suite performance and value creation. Just because an executive is still in the job, doesn’t mean they are creating value commensurate with their option package. Frequently, startups that let go of an executive regret not doing so sooner, but it can be difficult to know whether it’s time to cut bait or not. Startups can very often dither around these decisions and worry that recruiting and replacing a new leader will slow their momentum more than a subpar leader already in the job. Evaluating these questions against clearly articulated performance benchmarks keeps things crystal clear.
Equity Vesting is not a One-Way Door: There are legitimate reasons for concern if a company pivots away from the performance equity goal. However, startup Boards have significant flexibility versus public companies – they can just change the vesting schedule!
Effectively using performance vesting is all contextual. More often than not, traditional time-based vesting will serve as a fine, straightforward option. But it is a missed opportunity for many companies if they consider it the only tool. Performance vesting should be used when there is a measurable outcome that the executive directly impacts. If achieved, it should vest more equity than would have been vested under a time-based schedule. Win-win.
In other words, let the incentives drive the outcomes.