What Is A Vesting Schedule?
A vesting schedule is a term that is part of an employment compensation agreement that outlines what an employee needs to do to earn the ownership of certain assets – which are usually employee stock options or retirement funds. Vesting schedules are used by employers to create incentives for their employees to hit certain milestones or stay at the employer for a certain amount of time.
For example , you join a startup and are granted incentive stock options (ISOs) as part of your compensation package. Let’s assume the ISOs have a vesting schedule of four years. In order to earn all of the ISO shares granted to you, you will need to stay at the employer for a minimum of four years.
Here is an article about vesting stock.
What Is Vesting?
Vesting is a legal term that essentially means earning the right to own an asset. The best way to think about vesting is you, as an employee, will need to accomplish certain achievements in order to earn the stock that was granted to you.
For example , you join a company and Restricted Stock Units (RSUs) are part of your compensation package. In order for you to receive the RSUs, you need to stay employed by the employer for a certain amount of time. The period of time between your grant of RSUs and you being transferred full ownership of the RSUs is considered the time your stock is vesting .
Here is an article about restricted stock units.
Types Of Vesting Schedules
Vesting schedules have two main types of terms – time and milestones. Employers, however, have the flexibility to create a vesting schedule that best aligns with their business objectives so you can see a variety of offers to employees.
One of the most important things to keep in mind is vesting schedules are created with the sole purpose of creating incentives for the employees to help the business achieve its goals. In other words, as an employee, you will need to complete certain objectives to earn your shares or assets which will ultimately help the business perform better over the life of your employment.
Here is an article that goes deeper into vesting schedules.
Let’s explore the two major terms of vesting schedules:
TERM 1: Time-based Vesting
Time-based vesting is exactly what it sounds like. Time-based vesting is when an employee will need to stay a certain amount of time at a company in order to earn their stock options, restricted stock, etc.
With time-based vesting, there is typically some sort of ‘ cliff’ , which means you will need to stay a minimum amount of time to earn any shares. You will often see vesting schedules with a ‘one-year cliff’, meaning you need to stay employed for a minimum of one year in order to have any assets vest.
Example : You join an early-stage startup and are granted 10,000 stock option shares on a four-year vesting schedule with a one-year cliff, where shares vest 25% each year. After the first year, shares will vest monthly, equally, until the shares are fully vested. This means:
- You will need to stay at the startup for one year in order to earn 2,500 shares (this is your one-year cliff and 25% of the shares).
- After year one, there will be 7,500 remaining shares to vest (10,000 – 2,500 = 7,500).
- The 7,500 shares will vest equally over the next 36 months, which means roughly 208.33 shares will vest each month (7,500 / 36 = 208.33).
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TERM 2: Milestone-based Vesting
Milestone-based vesting is when a vesting schedule is set up around achievements, or “ milestones ”, that create value for the business. The employer may assign one milestone or multiple milestones as part of the vesting schedule.
These achievements are normally very important to the business. If you think about it, they must be important to the business if the employer is willing to trade equity for them.
Examples of milestones that may be part of a mile-stone based vesting schedule:
- A developer receiving stock option shares to build the first version of a technology product for a startup.
- A marketer receiving stock options to build out a marketing playbook and program for a startup.
- An operations professional receiving stock options to build out a new accounting and payments system for a startup.
It is worth noting that many think milestone-based vesting schedules are more advantageous for employers since they are lower risk and shares only vest for value creating activities as opposed to an arbitrary measure, like time.
Hybrid Vesting Schedule
Hybrid-based vesting schedules are a combination of the two above terms; time-based and milestone-based. Sometimes employers will mix the two types in order to get the results they want from an employee.
Here is an article that goes deeper into the different types of vesting.
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Typical Vesting Schedules
Vesting schedules can differ from employer-to-employer or even employee-to-employee. Let’s go over some of the typical vesting schedules you may see.
Example of Typical Startup Vesting Terms
Startups like to issue startup stock options to their early employees so they can benefit in the success of the company. It also allows them to offset the low salaries they can afford to pay since capital is typically scarce.
Below is an example of typical terms you may find in a startup vesting schedule clause:
- Four Year Vesting Schedule
- 25% of Shares Vest Each Year
- One Year ‘Cliff’
Example : You are an early member of the founding team of a company and are issued 1,600,000 shares with the terms above; four-year vesting schedule, 25% of shares vest each year, one-year ‘cliff’.
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Scenario 1
: You leave after 6 months.
- In this scenario, you will receive no shares when you leave the company. Given there is a one-year ‘cliff’, you did not stay the minimum amount of time to receive shares.
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Scenario 2
: You leave after 2 years.
- In this scenario, you will leave with 800,000 shares. Given the shares vest 25% each year, staying two years means 50% of your shares will have vested which equals 800,000 shares.
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Scenario 3
: Your startup gets acquired after 4 years.
- In this scenario, congrats! This is likely a good scenario for the founding team. In this scenario, you would have had all 1,600,000 shares vest given you stayed for four years.
Click here to learn what it means to exercise stock options.
What Is A Vesting Agreement?
A vesting agreement is a legally binding contract that outlines the terms of vesting for an employee. In other words, this agreement is signed by the employee receiving shares and will outline what happens to options in all scenarios.
It is important for an employer to put a vesting agreement in place, which can sometimes be a vesting clause in the options grant, so there are no surprises down the road with their employees.
Here is an example of a founder’s vesting agreement.
Getting Help Understanding Vesting
Vesting schedules can be a difficult to understand if you have never worked with them before. If you need a consultation or review of your options agreement, feel free to post a project in ContractsCounsel’s marketplace to get free bids from lawyers on our platform.
