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Reverse Vesting – Definition

Reverse Vesting Definition

Reverse Vesting is a concept applied to founder equities. Although they own the shares of their company at the outset, the company has the option to buy back their shares if they decide to leave. The percentage of shares the company can buy back in such an eventuality decreases as the duration of the founder’s stay with the company increases. It’s kind of a ‘Reverse Vesting’ scenario where the longer a founder stays with the company, the lesser the number of shares the company can buy back from them if they decide to quit.

A Little More on What is Reverse Vesting of Stocks

Reverse Vesting is an equity distribution system to keep founders – who already own the shares of a company, from leaving the firm.

Example of Reverse Vesting

If a company founder ‘X’ owns 30% stake in the company, and the Reverse Vesting plan in place specifies that X gains permanent ownership of 20% of the shares every year, then X needs to stay with the company for 5 years to actually own all of the shares permanently, to be sold at his discretion, or passed on to heirs. This doesn’t mean that 30% stake of the company is unowned, the voting power for that 30% stake rests with X in the interim. After 5 years, this ‘Reverse Vesting’ schedule is complete and the company cannot buy back X’s shares even if he decides to quit.

Suppose X decides to quit the company after 3 years, he retains 18% stake in the company. The remaining 12% of his shares can be bought back by the company at a reduced cost to retain voting powers.

Importance of Reverse Vesting

Venture capital firms use Reverse Vesting as a way to monitor their investments and safeguard them from founder turmoil. Such agreements protect the interests of the company, shareholders, and investors, in the eventuality of a founder deciding to quit the company and taking away with them a large chunk of shares. It also helps companies retain voting rights for members who are actively responsible for the growth and operations of the company. The agreement between investors and founders/co-founders that facilitates ‘Reverse Vesting’ and the option to buy back stocks, is called the ‘Restricted Stock Purchase Agreement’.

References for Reverse Vesting

Academic Research on  Reverse Vesting

Equity vesting and managerial myopia, Edmans, A., Fang, V., & Lewellen, K. (2014). Equity vesting and managerial myopia. This paper sheds light on the short sighted decision making by management in light of equity vesting schedules.

The value of vesting restrictions on managerial stock and option holdings, Chi, J. D., & Johnson, S. A. (2009). This paper explores the implications of vesting restrictions on stock options and holdings for managers.

Absolute Certainty of Vesting Under the Rule Against Perpetuities-A Self-Discredited Relic, Tudor, O. (1954). BUL Rev., 34, 129. This paper takes a look at vesting in perpetuity and the rules that come into play in this scenario.

Vesting of Executory Interests, Makdisi, J. (1984). Tul. L. Rev., 59, 366. This paper takes a look at the rules and exceptions of vesting of executory interests.

Retirement Income Credit and Community Property: A Problem of Vesting, Lay, N. L. (1967). Tul. L. Rev., 42, 304. This journal examines the issue of vesting in community properties and retirement income credits.

Growth and vesting changes in private pension plans, Landay, D. M., & Davis, H. E. (1968). Monthly Lab. Rev., 91, 29. This paper takes a look at the vesting options and growth of PPF.

Federal Taxation: Pension Plan Vesting Differentials Not Per Se Discriminatory, TAX, F. This paper sheds light on the court ruling in the case of employee pension plans vesting of the Internal Revenue Codes’ section 401(a)(4).

Reverse-Piercing of the Corporate Veil in Canada, Spiro, P. S. (2018). Forthcoming, Canadian Business Law Journal. This paper takes a look at ‘Reverse Piercing’ of the veil in Canadian corporate world.

Equity vesting and investment, Edmans, A., Fang, V. W., & Lewellen, K. A. (2017). The Review of Financial Studies, 30(7), 2229-2271. This paper examines the concerns regarding stock price fluctuations and equity vesting.

Accelerated vesting of employee stock options in anticipation of FAS 123‐R, Choudhary, P., Rajgopal, S., & Venkatachalam, M. (2009). Journal of Accounting Research, 47(1), 105-146. This paper takes a look at the equity vesting changes implemented by firms in anticipation of the Financial Accounting Standards Board (FASB) rule FAS 123‐R.

Performance-based equity incentives, vesting restrictions, and corporate innovation, Liu, B., Huang, W., & Wang, L. (2018). Nankai Business Review International. This paper examines the relationship between performance based vesting of equities, the restrictions there upon, and its impact on innovation in the corporate world.

The retention effects of unvested equity: Evidence from accelerated option vesting, Jochem, T., Ladika, T., & Sautner, Z. (2018). The Review of Financial Studies, 31(11), 4142-4186. This paper makes the case for deferred equity pay to retain executives by analysing data from 723 firms.

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