What Does ‘4 Years With a One Year Cliff’ Mean?
In a vesting agreement, ‘4 years with a one-year cliff’ is a typical vesting schedule used by startups. A one-year cliff means that nothing vests for the first year. After a year, vesting reaches 12/48; the remaining balance will vest for three years at 1/36 a month for 36 months.
Cliff investments are standard employee stock options. They serve as incentives for employees who become “vested” in a benefit plan that outlines employee rights to receive their benefits.
So, rather than receiving partial benefits over a period of time, employees become fully vested at a specific point. Vesting incentive stock options are widespread in startups, and the 4 years with a one-year cliff model are the most common.
Here is an article to learn more about vesting stock.
What is a Vesting Schedule?
A vesting schedule outlines an employee’s right to buy or own stock. A four-year vesting schedule, for example, qualifies the employee to purchase or own stock after a four-year period for a fixed price.
The cliff in four-year vesting with a one-year cliff means that you aren’t given rights to any stocks until your employment anniversary. You will own 25% of your vested shares at the one-year mark.
The number of shares you gain access to increases incrementally after the cliff. While many employees dislike the one-year cliff model, it helps startup founders and venture capitalists maintain investments and retain talent.
It is important to note that you must remain an employee during your vesting cliff. Employees who leave their job 10 months into a one-year cliff forfeit all their earned benefits.
However, employees can retain their earned benefits or purchase stocks after the cliff period. Still, they may not be entitled to future investments. So, leaving a job after three years would still grant you benefits, just not 100% of your original offer.
Your vesting schedule will be outlined in your employment agreement, covering all your employee and nonqualified stock options. You can consult a lawyer for startup contracts if you’re a founder exploring your incentive stock options.
Here is an article with more information on the vesting process.
What Does a ‘Cliff’ Mean in Stock Vesting?
Cliffs are periods when employees do not receive any shares. So, a one-year cliff in a four-year plan means that employees aren’t entitled to any shares until their first anniversary with the company.
A one-year cliff is a time-based cliff, but there are also milestone cliffs. For example, some startups use hybrid vesting, a combination of time-based and milestone cliff vesting. However, the majority of companies always set a one-year cliff at a minimum to ensure an employee stays onboard for at least a full calendar year.
Cliffs are, in a sense, a security measure for companies. Giving employees access to their total shares upfront would be hazardous for a startup. People could be hired, collect their stock, and leave without giving back to the company.
As a founder, you can explore cliff vesting options to secure your company’s financial future and incentivize your employees.
Here is an article about cliff vesting to help you learn more.
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Who Uses Vesting Schedules?
Any company that offers stock options to employees usually uses a vesting schedule. These schedules help prolong the period of time employees have access to stocks, retirement accounts, and other assets.
It’s highly common for startups to employ the ‘4 years with a 1-year cliff’ model to retain employees as it scales. Growth is unpredictable for many new companies, and startups rely entirely on their employees to reach their goals.
Vesting schedules offer greater security for the VCs and other shareholders. In addition, because employees cannot terminate their employment agreement without losing shares, they’re more likely to stay with the company.
Startup costs can be volatile during the first several years, so retaining talent and upscaling are two high priorities. Vesting schedules offer more security, but they prevent the company from giving up too many shares simultaneously. This measure is especially important for companies hiring dozens of new employees monthly.
Here is an article to learn more about vesting schedules in startups.
4 Year With a One Year Cliff Example
An example of a 4 year with a one-year cliff example is an employee at a startup who is offered 10,000 shares. However, because of the one-year cliff, they won’t receive any shares during their first year of employment.
Upon their one-year employment anniversary, they will gain 25% of their promised shares. From this point forward, they will continue to acquire shares gradually for the next three years. This would entitle them to 1/36 of the remaining shares monthly after reaching their cliff.
Here is an article with more examples of three and four-year cliff vesting.
Other Types of Vesting Schedules
There are three main types of vesting schedules to know:
- Cliff, or time-based, vesting
- Performance-based, or milestone, vesting
- Hybrid vesting with time and milestone requirements
One- or two-year cliffs are the most common types of vesting schedule. Employees don’t lose shares they’ve acquired after their cliff. So, if they terminate their employment agreement after 2 years, they would take 50% of the shares they’ve acquired.
Performance-based vesting schedules rely on stock performance. For example, if an employee was offered 500 stocks at $70/share, a performance vesting schedule might set the bar for purchase at $80/share.
Milestone vesting is much broader; it could be tied to reaching a business objective, completing a project, or helping the company increase its profits by a certain percentage.
Hybrid vesting merges performance-based, milestone, and/or time-based vesting to create a unique schedule.
Here is an article with more details about stock vesting schedules.
Do I Own Stock Once My Options Vest?
The type of stock that you are offered influences what happens after your vesting period. Cliffs can grant you ownership or give you the right to purchase stocks.
Employees given ISOs (incentive stock options) or NSOs (non-qualified stock options) do not acquire any stocks after their cliff. Instead, they are given the right to purchase a certain amount. The rights to buy more stock increases as their vesting schedule progresses.
For vesting RSUs (restricted stock units), employees gain ownership over stocks after their cliff/milestone. The stocks vest when the company hits a certain milestone or a specific amount of time passes.
Vesting for retirement plans is slightly different. An employee’s own contributions are always fully vested, but their access to employer contributions will likely increase with time.
Cliff benefits operate on an all-or-nothing basis. Ending employment before your cliff date automatically forfeits all rights to benefits.
Here is an article with information about how employee stock options vest.
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