Vesting, restricted stock, stock repurchase, vesting schedule, cliff … do you understand these terms?
In US startups, ‘vesting’ is defined where the equity interest held by a founder or key employee is no longer subject to (i) forfeiture or (ii) repurchase by the company (where it is a restricted stock), based on an agreed vesting schedule. In other words, a vesting schedule sets out the equity a person can own at any given time or upon the occurrence of any given milestone/target.
For example, a vesting schedule can be over 4 years, with equity vesting at 25% each year or 1/48th per month. Sometimes, a ‘cliff’ is built in, where if the founder leaves before the expiry of the cliff (say a 1-year), he leaves with no equity.
These essentially US-centric terms have arrived at our Malaysian startup scene. However, are these US terms of vesting, restricted stock, stock repurchase, vesting schedule, cliff etc. recognised under Malaysian company law? Or are we lost in translation? Let’s break it down.
US terminology
Firstly, the term ‘vesting’ in the Malaysian Company’s Act 1965 (“MCA”) only appears where a company’s property vests in a liquidator by an order of court. Shares of Malaysian companies are allotted, issued or transferred. There is no ‘vesting of shares’ per se.
The term ‘vesting’, in relation to a company’s shares, is more commonly used where employee share options are granted. Upon granting of an option, the passing of a time period or an event will cause the option to vest in the holder. Upon vesting of the option, the holder becomes entitled to exercise the option to purchase shares in the company at a prescribed (and hopefully still favourable) price.
Secondly, unlike the US, there is no distinct class of ‘restricted stock’ recognised under the MCA. The MCA recognises only ordinary shares and preference shares. Any restrictions to be imposed on the issuance or transfer of ordinary or preference shares will therefore be purely contractual or a special class of ordinary shares, by using a shareholders’ agreement or via the company’s articles.
Thirdly, under the Table A articles and the upcoming Companies Bill, the forfeiture of shares can occur where a shareholder fails to fully pay for his shares upon a call for payment of such shares being made. Can the company’s articles be amended to allow for forfeiture by the company of fully paid up shares upon certain events occurring?
Fourthly, section 67A of the MCA expressly provides that only a public company may effect a share buyback (commonly known as ‘stock repurchase’ in the US). The shares repurchased by a public company are called ‘treasury shares’. On the other hand, a private company, which most startups use, cannot repurchase shares after having issued them to a founder.
The Malaysian position
Does Malaysian company law allow founders to implement a ‘vesting schedule’ for its shares? How do Malaysian startups guard against the “Eduardo Saverin” scenario dramatized by the Social Network – where a co-founder leaves the company taking a chunk of shares with him, and sits on them until the company turns into a multi-billion dollar business by the remaining co-founders?
Under Malaysian company law, there are 2 possible ways to implement a vesting schedule for shares.
- Upfront Issuance
Issue the full number of shares a founder is entitled to keep at the end of the vesting period, but impose contractual terms to restrict or mandate the transfer or disposal of such shares before the expiry of such vesting period. In the UK, this is called ‘reverse vesting’.
Under this approach, a tailored shareholders’ agreement can address considerations like:
- whether the founders are actually conferred with all the rights and benefits attached to the issued shares for voting rights, dividends, distribution of and participation in capital upon liquidation;
- restrictions to transfer and disposal of ‘unvested’ shares;
- consequence of exit prior to the cliff or bad leaver provisions where the founder’s shares (already legally issued in his name) must be sold or transferred back to the other shareholders and at what value;
- what happens if additional shares are issued along the way to investors.
Also, there should be no income tax exposure if the founder fully pays or subscribes to the shares at par value at the start, even if the shares appreciate in value later.
- Share options
Grant share options to the founder to purchase or subscribe to the company’s shares at a pre-agreed price (a nominal value), and for the options to be vested based on a schedule. An option holder does not have to fork out his own cash upfront to subscribe / purchase shares and there is no liability to fully pay up on the issued shares.
Unlike issuing actual shares, unexercised options do not entitle the option holder voting rights, rights to dividends, or afford the option holder similar rights a shareholder has. These features of an option may concern founders but can be addressed with a shareholders’ agreement and amendment to the articles.
This method raises the question of how the shareholding ratios will change vis a vis other shareholders if and when the option is exercised. Also, options may give rise to income tax exposure as share options are considered to be ‘benefits in kind’ by the tax authorities.
Vesting schedules are not complicated, but the implementation and consequences of each method need to be carefully considered.
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About the Author: Shawn Ho is a partner of Donovan & Ho. He is experienced in corporate matters such as acquisitions, cross-border transactions, restructuring exercises, sale of businesses, joint venture arrangements, shareholder agreements, and franchise businesses. His background in tax advisory has enabled him to assist several multi-national companies achieve considerable tax-savings through cross-border tax planning, implementing tax-efficient structures using Labuan companies, and incorporate tax advice into commercial transactions.
