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ESOP

What Are the Different Types of Vesting and Why Do They Matter?

Companies offer employee stock options as part of their pay package or as an incentive for reaching performance targets. But employees can receive the stock options only on meeting certain conditions.

Some of these conditions are inserted to ensure that employees only get the option to purchase full ownership of their stock only after demonstrating a long-term commitment to the company. This notion of earning the right to own stock options is known as vesting.

Continue reading to know more about vesting in detail, its types, why startups use this system, its benefits, drawbacks, and the bottom line.

What Is Vesting?

Share vesting is the process by which an employee is given shares or stock options but only gets full rights to them after a certain time has elapsed or, in some cases, after a certain milestone has been met – usually, one specified in an employment contract, stock options policy or a shareholders’ agreement.

Building a startup can be challenging, especially with limited access to capital. As a result, an early-stage firm may not have much to offer when rewarding, hiring, and retaining personnel — or finding potential investors.

Many businesses, therefore, use stock options to attract the right employees in these scenarios. Giving away a portion of your company, on the other hand, comes with a lot of risks: if the terms aren’t suitable, someone could become a long-term owner without adding value to the startup in the long run.

Share vesting may be a viable solution to some of the issues that a startup faces during its early phases of development.

Employees do not have full ownership of the stock options unless these options are fully vested.

Instead, vesting schemes control what the vesting schedule entails and how and when employees can exercise stock options issued to them.

Type of Vesting

The different types of vesting schedules are as follows:

1. Time-based vesting

Time-based vesting is the most popular type of vesting. Employees earn their share of stock options over time, generally based on a fixed timeline and a cliff – the period when the employee’s first option is granted and exercisable.

After the cliff has been reached, the remaining options are granted on a quarterly/monthly basis, depending on the vesting schedule.

2. Graded vesting

Gradual ownership of an asset, known as graded vesting, allows employees to gain incremental ownership of the stock option over time, eventually leading to 100 percent ownership.

For instance, employees might receive 10% in the first year, 15% in the second year, 25% in the third year, and 50% in the fourth year.

3. Milestone-based vesting

Milestone-based vesting is a vesting mechanism in which the employer gives stock options and bonuses depending on the accomplishment of particular tasks or the attainment of specific employer-set milestones.

4. Cliff vesting

Cliff vesting gives an employee a lump sum payment at a predetermined date. For example, in a three-year cliff vesting schedule, employees do not earn any benefit until they have worked for that time frame.

5. Hybrid vesting

Hybrid vesting is a combination of milestone-based vesting and time-based vesting. Employees must stay at the company for a given amount of time and achieve a specific goal or milestone to be eligible for exercisable stock options under this system.

Why Do Startups Use Share Vesting?

In general, share vesting can assist a startup in achieving three broad objectives:

  • Encouraging employees to stay with the company for a long time,
  • Displaying a dedication to the company’s expansion, and
  • Safeguarding the business if the relationship does not work out.

First, the prospect of share or stock options, for example, incentivizes employees to stay loyal to the company. Only when the employee has stayed with the company for the duration of their vesting period, do they have the full number of options to which they are entitled. This motivates employees to stay with the company till the vesting period ends.

Second, despite having limited funds to pay employees in cash, vesting conveys that employees are committed to expanding the company.

Third, startups willing to use stock options to attract and retain top-tier employees are a better investment (for investors) since the startup’s value is more likely to rise with long-term involvement from talented employees.

Last, share vesting safeguards the startup by working as an insurance policy against an employee who proves to be an unfit match. Without share vesting, an employee can leave their job but still be a part-owner of the firm; assuming the startup doesn’t have much cash, the startup may not be able to pay market value to buy back their shares.

Incorporating share vesting into a shareholders’ agreement or an employment contract helps ensure that stock buybacks aren’t excessively expensive.

Benefits and Drawbacks of Share Vesting

Share vesting has both benefits and drawbacks. Take a look at them below:

Benefits

1. Preserving cash flow

Minimizing unnecessary spending is essential, especially if the company is still in its early stages. One of the most significant advantages of adopting share vesting is that it protects the company’s cash flow by using stock options rather than cash, but in a way that assures the recipient fulfills their responsibilities over time.

Instead of paying with cash, a startup can pay with stock options by using the company’s potential. A startup can leverage stock options for long-term relationships when share vesting is used in payment terms.

2. Employee retention

Employee turnover can stifle a startup’s progress and affect its cash flow. Therefore, minimizing turnover is a significant concern when effort and cash are precious resources in a startup environment.

Share vesting is a powerful tool for retaining top people and keeping them loyal to the company. In addition, employee turnover rates are much lower for employees who have not finished their vesting period.

In addition, the prospect of future benefits motivates present employees to stay with the company, especially when it is in its early stages of development.

3. Employee productivity

Employee productivity can be improved by including share vesting (and equity) as part of an employee’s compensation.

Giving employees stock options makes them co-owners of the business. Even if their share of company equity is minimal, it can transform an employee’s mindset from thinking about what’s best for them to think about what’s best for the business.

Using share vesting in an employee equity arrangement renders this situation more of a win-win for company owners: the employee develops an ownership mindset from the outset, while the company bears less risk related to giving away equity.

Furthermore, if the terms of share vesting are carefully defined, it can motivate employees to improve their performance by promising a stock option for key performance milestones and outcomes.

Drawbacks

1. Wrong vesting period

The use of share vesting to attract top talent is a common practice. However, vesting alone may not be enough to close the sale; the options  must vest in a fair amount of time for the offer to be appealing.

Therefore, it’s critical to strike the right balance between guaranteeing the company reaps the long-term benefits of employee retention while also making the vesting time feel manageable.

2. Short-term compensation needs

Although share vesting is appealing as a supplement to a pay package, the promise of long-term monetary benefit does not negate the necessity for immediate monetary compensation.

While share vesting can help an offer stand out, if the pay or other tangible perks are below market, few employees are willing to accept stock options—especially those subject to vesting.

The Bottom Line

Share vesting is a precious tool to consider when a startup wants to grow and develop, incentivize and retain talented employees, and protect and preserve limited capital.

When implemented correctly, share vesting can help a startup reduce cash outflow, develop the business, and keep employees happy and productive. However, like with most entrepreneurial issues, it should be done strategically to maximize the rewards while minimizing the risks.

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