Success of any business is determined by the team behind it. Be it the founders, employees or the business’s resources, a company succeeds only when all these forces come together to contribute the best of their skills and hard work. Needless to say, such dedicated efforts have to be adequately compensated by the company. An employer offers compensation in the form of salary packages or equity in the company. While regular salary structures are assuring, offering equity is also an ingenious way to reward your hard-working employees.
Equity grants employees rights over company shares. The employee does not gain immediate ownership over these shares. Even though the actual benefits are realized at a later date, in the long run, owning equity can prove to be more profitable than monthly salaries. The process of providing these shares is known as vesting and a vesting schedule for stock options is a timeline for crediting these stocks. Let us try to understand this process better.
Vesting & Vesting Schedules
A company has to account for many factors before designing vesting schedules for shares and share options.
What is vesting?
Vesting is a process by which companies offer contractual benefits to employees in the form of equity. If you are a startup, vesting will help attract and retain promising talent. Whereas in established companies, vesting can be part of their retirement packages. However, there is no rule of thumb for vesting. Depending on the mode and scale of operation, you can design a unique vesting schedule for your business.
Usually, companies use a special type of shares for their vesting, called Restricted Stock Units (RSUs). These investments are time-bound and defined by a cliff period, vesting period, and expiration. A vesting schedule for stock options will identify these markers. In simple terms:
- Cliff period – The qualifying period for assigned stock options. If employees leave before the cliff period, they cannot claim ownership of any shares.
- Vesting period – The time over which your company will spread out stock distribution. It will vary depending on the nature of your vested resource. They could be employees or contractual resources like consultants and advisors.
- Expiration – Last date by which employees have to sell their stocks before they lapse.
Vesting in high potential employees is always a profitable option for companies. A Startup’s work environment is challenging and everything is built hands-on, as the business develops. Employees will not find the well-run stability of a mature company, as it takes some time before a startup can see any tangible profits.
Hence it is normal for a startup team to lose steam mid-way. This is why vesting is useful because:
- It develops a sense of ownership in employees towards the company. Vesting creates avenues for mutual growth and ensures employee’s long-term work with the business. In many ways, vesting protects the interests of a startup team ensuring rewards over their collective profits.
- “Cliff” period in the vesting schedules acts as a safety valve, especially for startups. Despite a promising resume, an employee’s true potential can be realized only after a certain period of service. By vesting, startups can protect themselves from giving away incentives to bad hires. Thus vesting protects the business from collapsing due to premature exits.
What is a Vesting Schedule?
Now that we have a basic understanding about vesting, the next question is, when does an employee receive these benefits? The answer is based on vesting schedules. In simple terms, a vesting schedule is a time-table for stock distribution. For employees, this translates as professional milestones in the company. A vesting schedule is the blueprint of an employee’s incentive plan offered in the form of company shares.
A standard graded vesting schedule for stock options looks like this:
After the cliff, assigned stocks vest in incremental monthly installments throughout the year. Staggered credit of stock options motivates employees to stay longer in the company. However, vesting schedules terminate in case of death, disability, or retirement, and all accrued benefits reach employees based on company policies.
What does a vesting schedule look like?
A vesting schedule is a detailed timeline for the benefit package an employee will receive at the end of a vesting period. It dictates when the employee will get full ownership over their shares. Any money contributed by the employee is vested immediately and vesting schedules apply only for the company contribution. As every business has specific designs for their vesting schedule, it may be difficult to easily define benchmarks.
However for startups, a standard vesting schedule for stock options looks like this:
- Founding team – 25% on joining and the rest realized in installments over the next three to four years.
- Employees – 25% after the cliff period and the rest realized in installments over the next three to four years.
- Consultants/Advisors – Usually no cliffs with short vesting periods of one or two years. The stocks credit as equal monthly increments over the vesting period.
Vesting schedules are established by the company founders. Terms of the vesting plan is an important negotiating point during recruitment, with attractive vesting plans helping your company stand out in the job market.
While vesting schedules for a startup with a handful of employees can be handled in a simple excel sheet, with larger companies, vesting schedules have to be customized to suit every employee. Companies also offer multiple rounds of benefits to an employee during their tenure, many accruing to retirement benefits. Hence a comprehensive understanding of vesting schedules is important for efficient execution and minimal errors.
3 Common vesting schedules
The purpose of a vesting schedule is different for each category of employee. While new hires have to be nurtured for loyalty, seasoned performers need a boost in motivation. On the other hand, contractual resources will need immediate compensation. Thus a standard stock vesting timeline will not work for everyone. As an employer, you can choose schedules that suit your business and the scale of operations. But you will have to take note of federal laws that dictate certain pockets of these schemes as well. Broadly, the 3 popular vesting schedules are:
- Immediate vesting – This schedule will provide your employees immediate access to their assets. There is no waiting period. This is usually offered to highly valued employees as a spot incentive.
- Cliff vesting – On attaining a cliff, your stakeholders get a percentage stock ownership in one go. For example, if you are vesting 50 shares over a one year cliff, at the end of the year, they will have 100% ownership of all 50 shares at a time. But if they discontinue service anytime during the year, you do not owe them anything. By law, a cliff vesting schedule can not exceed three years.
- Graded vesting – This enables your company to provide a gradual increment in stock ownership eventually leading to 100%. Graded vesting schedules for stock options are usually allotted to retirement accounts. As mentioned in the previous section, after the cliff period, your employees will have 100% rights over their shares, as and when they get credited. If they choose to leave the company midway, before completion of the entire vesting period, they will keep all the shares earned until that time. According to federal laws, graded vesting for retirement plans can not be longer than six years.
Vesting schedules for Stock Options
As an entrepreneur, when you provide stock options to employees, it entitles them to buy company shares at the fixed rate you are offering. This is a discounted rate as compared to the market price, and your employees will be able to profit from this for their hard work in the company when they decide to sell their shares.
How do vesting schedules work for stock options?
Stock options use cliff and graded schedules. If you have vested 500 shares in Anne for two years, as per the cliff schedule she will have complete ownership of all 500 shares, only at the end of these two years. If she chooses to leave before the maturity period, Anne will lose rights over all 500 shares.
Whereas, according to a graded vesting schedule which usually spans over five years, Anne’s 500 shares are distributed over these five years. After the one year cliff period, based on the company’s vesting policy, Anne will get 125 shares each year, for the next four years. If she chooses to leave in her third year of service, Anne will have 100% ownership over the 250 shares vested so far.
Vesting Schedules for Nonqualified Options
Non-qualified stock options (NSOs) are the type of stock options where an employee has to pay regular income tax on the difference between the grant price and exercise price. They can be issued to anyone, i.e.employees, director, vendors, etc. These are called non-qualified options because they do not meet the guidelines of the Internal Revenue Code. Since taxation is higher than qualified options, NSOs are offered as an alternative form of compensation.
Some basic features of vesting schedules for non-qualified options are:
- They are flexible
- Not bound by regulations
- Broad-based graded vesting schedules for nonqualified options can extend between three to five years.
- A specific percentage of shares is vested every year. As a company, you can decide on this percentage. For eg. in a five year vesting schedule, after the one year cliff, the share distribution could be 25% – 50% – 75% – 100% or 40% – 20% – 20% – 20% or 20% – 20%- 30% – 30% and many other variations based of the company’s priorities.
Vesting Schedules for Qualified Stock Options
Qualified stock options are offered only to employees, especially the top-management and other highly valued employees. They are also known as Incentive Stock Options (ISOs). These options are taxed on capital gain rates, which are much lower than regular income tax rates. ISOs usually have a vesting period of at least two years and a holding period of one year before they can be sold. Some basic features of vesting schedules for qualified stock options are –
- They are regulated
- Vesting schedules for qualified options span over five years
- After the cliff period, equal percentages have to be vested for the next four years.
- They are offered through ESOPs (Employees Stock Ownership Plans)
- These are monitored by the Employees Income Security Act of 1974 and are part of retirement benefits.
Vesting Schedules for Startups
Offering equity to attract talent is common practice in startups, as vesting schemes enable cash savings through equity distribution. For startups, vesting schedules for stock options also play an important role in protecting the business. As a founder, building a trusting team is crucial to the startup’s success. Many a time one of the founding team members faces a premature exit, which put the company in jeopardy.
However, vesting schedules help preserve the integrity of both the company and the employee. As part of these schedules, a startup can also reserve the right to buy back stock options from the exiting founder. All unvested shares thus return to the company’s option pool and are available to be invested in other resources.
Investors prefer startups operating with vesting schedules for stock options as it adds credibility to their operations and provides investors with an assurance over their equity. When startups approach investors, a thorough check of vesting documents is common practice. Hence it is better that startup founders agree on vesting schedules at the initial days of the business. This will indicate the overall health and stability of the startup.
Why do startups need vesting schedules?
Imagine a startup run by four founders – A, B, C, and D, but without vesting schedules for stock options. All hold equal shares in the company – 25% each. Within the first year, they realize that Founder D is not matching up to his promised potential. He is turning into a liability and the company would be better off without him. They ask Founder D to leave at once and off goes 25% shares of the company as well. In the third year of operation, Founder C’s father passes away and she moves back home to take care of their family business. Founder C exits reserving rights to 25% of company shares as well. Founders A and B will now bear the sole responsibility of the company whereas Founders C and D will reap benefits without any contribution.
But with a vesting scheme, things can be very different. Popular vesting schedules are 5 years long, where the first year is ‘cliff’. Stock ownership is conditional. Since Founder D leaves in the cliff year, in spite of holding 25% shares, his ownership does not qualify. When Founder C leaves in the third year, based on the type of vesting, she could leave with rights over the accumulated shares. With the saved shares, Founders A and B can now invite new talent on board.
By offering stock options to employees in a startup, you are granting them rights to benefit from the business’s success as well as successfully protecting your rights from people walking away from the company.
How to choose the right vesting schedule for Startups?
Startups offer equity only to those who have the potential to earn it. An employee’s contribution to the business and their position in the organizational hierarchy determines stock allocation.
Whatever be the choice of vesting schedule for stock options, it should be fixed before planning any milestone events such as product launches, scaleup, acquisitions, or IPOs. With possibilities or goals of acquisitions, vesting schedules should include an exit plan as well.
Here are some frequently used layouts:
- For Employees – These schemes normally follow standard monthly rates. With a standard vesting schedule of four years, an employee receives stocks in 48 parts (1 part per month) for the next four years. For new talents, there might be a “cliff” clause during the first year of service.
- For Consultants – Consultants hired with possibilities of at least one year’s engagement vest monthly throughout their consultancy. Usually, there is no “cliff” and vesting schedules for stock options are shorter. Sometimes performance milestones determine vesting. For eg. 10% vested after signing up 5 distributors.
- For Founders – Startups invite founders to join with a certain % of shares as a sign-up bonus. This is besides a detailed vesting schedule of four years. Needless to say, they are resources who contribute valuable intellectual property rights to the company. Normally there is no “cliff”( unless the startup team is young and has multiple founders with minimal work experience). Vested shares credit in equal monthly installments over 48 months.
Easily create vesting schedules on Eqvista
Vesting schemes are your friend and guide for equity distribution. In startups, it is crucial to have clarity on the vesting schedule for stock options with clear timelines, as it can be a vital tool to manage your company finances. Since there are many options to choose from, you can customize vesting schemes to suit your operations. In the initial stages of operation, vesting can begin on a simple excel sheet. However with time, the team will grow, and the business will need multiple players with multi-dimensional talent. This will create the needs for more creative incentives and an evolved mechanism for creating vesting schedules for the company.
Eqvista’s sophisticated equity management software allows companies, investors and company shareholders to track, manage, and make intelligent decisions about their companies’ equity. Eqvista’s platform helps you to easily issue stocks, create vesting schedules, and stay connected with your stakeholders, all in real time. This saves a lot of time and allows entrepreneurs to avoid cumbersome paperwork. To ease your stock vesting process, Register now!