In this ownership article, we’ll be explaining the different types of vesting that you as an employee or employer can choose from when dealing with – employee – stock options.
What is vesting?
In startups, key employees are usually offered stakes in the company. Now, these shares shouldn’t be immediately possessed fully by the employee, because they could theoretically decide to leave the company after 1 month, having full ownership of all shares given to them. Instead, vesting schemes control what the vesting schedule stands for how and when employees can exercise their stock options granted to them. The standard vesting period is 4 years, during which employees don’t have overall ownership of the full amount of options until these options are fully vested (at the end of the 4-year period). If it’s still not clear, glance through this article.
What complicates the story is that the vesting schedule doesn’t have to be the same for all the employees. Primarily, you can choose from 2 different vesting schemes:
Time-based vesting
In time-based vesting, the allocation of ownership is divided through time (days, month, quarters or years).
Immediate vesting
A more uncommon schedule is immediate vesting, where the signing employee receives 100% ownership of their shares immediately.
Graded vesting
- During the graded vesting period, the ownership is provided over a certain amount of time. In Linear (Traditional) Vesting, equal portions are given (25% after the first year, then 50% after the second year, 75% after the third year, and 100% after the fourth year). In Back-Loaded Vesting, instead of giving the same amount of options per year, back-loaded vesting offers to give away 10% after the employee’s first, then 20% after the second, 30% after the third, and 40% after the fourth year. Several companies, like Amazon, Snap, and Farfetch use this schedule.
Both time-based vesting schemes can include a Cliff. When the vesting period starts with a ‘cliff’, it means that no options are vested during this time. The usual one-year ‘cliff’ serves as a trial phase. If the employee decides to leave the company during this time, they don’t receive any equity. When the cliff ends, the respective vesting schedule starts. A one-year cliff is usual in the startup world, but different agreements can also be arranged.
Should you go for daily, monthly or annual vesting?
We cannot stress enough, how important details in the contract are: is it daily, monthly or annual vesting? Usually, founders set daily linear vesting for themselves since the increase in shares happens on a daily basis. With employees, daily vesting might not be the best option. It is essential to motivate them and recognize their work, but it’s also important to set some boundaries to be sure they won’t quit from one moment to another. In this case, an annual back-loaded vesting schedule is better, like a long-term investment program.
Performance-based vesting
In Performance-based Vesting, the allocation of ownership is divided through performance rather than time.
It’s becoming more common to reward executives with performance-based stock options, rather than time-vested ones. This means employees are only given stock options if they hit targets that drive your long-term value, like revenue growth. That’s why performance-based vesting is more suitable for a CMO or a Head of Sales – rather than a CTO. It’s still a good idea, though, to use a traditional, time-based system for up to half of their stock. This is because there may be external factors outside the control of a single executive which affect performance targets.
Conclusion
The world of shares can be confusing at times with all the complex startup-related terms. Vesting is no different, but after you read through our quick, easy-to-understand explanations of the different vesting schemes along with hands-on examples, you’ll see everything will get clearer. And don’t forget: if you decided, what kind of vesting you should go for, it is also important to keep in mind that at the end of a vesting period, a new plan needs to be arranged!
(This article by no means replaces official legal consultancy. It serves as a guide – for concrete legal advice please reach out to a lawyer.)
