Vesting schedules are a critical tool for startups that want to attract and retain talented employees, while ensuring that everyone is working toward the same goals. The concept is simple. Instead of earning equity all at once, the founder or employee earns it over a set schedule.
Vesting acts as both a reward and a motivator for employees. The reward: The longer you add value to the company, the higher stake you’ll have in the company. The motivator: If you’re not adding value to the company, you’ll have less (or potentially no) ownership in the company.
By thoughtfully designing these schedules to meet each person’s needs and the company’s objectives, startups can create a culture of commitment and collaboration that leads to long-term growth and success.
Types of Vesting Schedules
Startups use different types of vesting schedules to incentivize employees and keep them in the company. The most common types are:
- Time-Based Vesting: This is the simplest type of vesting schedule, where an employee’s shares become fully vested over a period of time. This is the most common type of vesting in startups.
- Performance-Based Vesting: This type of vesting schedule ties the release of shares to specific performance criteria set by the company. For example, an employee may have to achieve certain revenue targets or product milestones before their shares begin to vest.
- Hybrid Vesting: Some startups use a combination of these different types of schedules to tailor their incentives to individual employees or teams. For instance, they may use performance-based vests for executives and time-based vests for entry-level hires.
It’s important for startup founders and employees to understand the different types of schedules available and how they affect equity compensation over time.
In startup vesting, a “cliff” is a period of time that must pass before an employee becomes eligible to start earning equity. Typically, the cliff is one year from the employee’s start date. After the cliff, the employee can start vesting their equity over the remainder of the vesting schedule.
The purpose of the cliff is to ensure that the employee is a good fit for the company. Hiring is a challenging process, and it’s not uncommon for a prospect to perform poorly once they join. Generally, it becomes apparent within the first year whether the employee is a good fit. If they are not, the company can terminate them without the employee taking any ownership of the company with them as they leave.
The Four-Year Vesting Schedule with a One-Year Cliff?
The most common vesting term for startups is four years with a one-year cliff. So, how does it work?
Let’s say an employee is granted 1,000 shares on a four-year vesting schedule with a one-year cliff. For the whole first year, the employee receives zero shares. But on the one-year anniversary, they receive all of the equity from year one: In this case, 250 shares or 1/4th of the total equity award. Then they will vest the remaining 750 shares over the remaining three years on a monthly schedule, or 21 shares per month.
Here is typical language for a four-year vesting schedule with a one-year cliff:
1/4th of the Vesting Shares shall be released from the Repurchase Option on the 12-month anniversary of the Vesting Commencement Date (as defined below), and an additional 1/48th of the Vesting Shares shall be released from the Repurchase Option on the corresponding day of each month thereafter (and if there is no corresponding day, the last day of the month), until all Vesting Shares are released from the Repurchase Option. The Vesting Commencement Date is the date of this Agreement.
The Benefits of Vesting Schedules
Vesting schedules offer several benefits to both startup founders and employees. For founders, vesting schedules help ensure that employees remain committed to the company over the long term. This is especially important in the early stages of a startup when retaining key talent can make or break the success of the business.
By using a vesting schedule, founders can incentivize employees to work harder and achieve specific goals. This can be particularly effective when combined with performance-based vests, as it ensures that employees are working toward shared objectives that align with the company’s overall vision.
For employees, vesting schedules provide an opportunity to earn equity in a company over time. This can be a valuable source of income if the company eventually goes public or is acquired by another business. Additionally, it gives employees a sense of ownership in the company and motivates them to work harder and contribute more to its success.
Common Mistakes to Avoid When Implementing a Stock Vesting Plan
Stock vesting plans incentivize employees and align everyone around common goals. For startups implementing these plans, there are several common mistakes to avoid. Here are some of the most important ones:
Failing to Communicate Clearly with Employees
One of the biggest mistakes that startups make is failing to communicate clearly with their employees about how the stock vesting plan works and what it means for them. Startups should be transparent and upfront with their employees about how the vesting schedule works, what milestones they need to achieve in order to earn more shares, and updates on progress toward these goals. Startups should also be available to answer any questions or concerns that employees may have along the way.
Using a One-Size-Fits-All Approach
Another common mistake that startups make is using a one-size-fits-all approach that doesn’t take into account individual employee needs and motivations. While it’s important to have a consistent framework for how shares are earned and distributed, startups should tailor these plans based on factors such as age, experience level, job function and personal goals. By taking these individual needs into account, startups can create compensation packages that attract and retain top talent while also driving long-term growth and success.
Failing to Revisit Vesting Schedules Regularly
Finally, another common mistake that startups make is failing to revisit their schedules regularly as business conditions change over time. While it’s important to have a clear framework in place for how shares are earned and distributed, startups should be flexible enough to adjust these schedules as needed based on factors like market conditions, employee turnover rates and shifts in corporate strategy. By revisiting their vesting schedules regularly and making adjustments as needed, startups can incentivize their employees effectively while also remaining agile enough to respond quickly as business conditions evolve over time.
By avoiding these common mistakes, founders can create compensation packages that attract top talent while fostering commitment and collaboration among team members alike.
The Impact of Stock Vesting on Company Culture and Employee Retention
Stock vesting is crucial for company culture and employee retention. Startups can incentivize team members by offering equity compensation packages to reward long-term commitment. This creates a sense of ownership and investment among employees, leading to a more collaborative work environment where everyone works toward shared goals.
Vesting can also retain top talent by allowing them to earn equity over time. Vesting schedules can be tailored to individual needs and motivations, such as a one-year cliff followed by four years of time-based vests or performance-based vests tied to specific business metrics. In summary, stock vesting creates a culture of collaboration and engagement that drives long-term growth and success.
If you’re working on an employee equity plan and are looking for legal support, feel free to reach out to us here.