What Are Common Vesting Schedules?
These days, most startup compensation packages include some type of equity award. Not only can the promise of equity-based compensation help attract top-tier talent, but it can keep that talent around via a mechanism called a vesting schedule.
Startups depend on vesting schedules to ensure that employees demonstrate a sustained commitment before receiving full ownership of their equity. Would it make sense to grant a huge pile of employee stock options with no strings attached on an employee’s first day? Probably not, because then the employee would have little financial incentive to stick around. A vesting schedule stipulates exactly what needs to happen before an employee earns the right to exercise options or own shares of common stock (depending on the type of equity award).
Vesting schedules tend to vary between companies, but some are more common than others. In this guide, we’ll review the most common types of vesting schedules and how they work. Whichever vesting schedule makes the most sense for your startup, rest assured that Pulley’s cap table software can support it.
- What is a vesting schedule?
- Common types of vesting schedules
- Are longer or shorter vesting schedules better for my startup?
- How to manage complex vesting schedules
What is a vesting schedule?
Equity is valuable! If you make a habit of giving it away for nothing, it becomes…less valuable. That’s why pretty much every equity grant your company hands out should be subject to vesting and include a vesting schedule.
Time-based vesting schedules are the most common. As the name implies, these vesting schedules are based on a prescribed period of time from the grant date. The grant should specify how many months or years of service must pass before the employee is considered fully vested.
Milestone-based vesting schedules are less common, but they can make sense in certain situations. These schedules tie vesting to milestones such as job performance or company performance, rather than to time of service. (A vesting schedule may account for both time- and milestone-based benchmarks, so this isn’t a strictly binary comparison.)
Before we get into specific types of vesting schedules, it’s important to note that stock vesting doesn’t always happen gradually. A four-year vesting schedule doesn’t necessarily mean that 25% of the equity award vests at the end of each year. Knowing this will help you make sense of the next section, in which we’ll look at the two most common types of vesting schedules.
Common types of vesting schedules
The two most common types of vesting schedules are graded vesting and cliff vesting. Companies use these schedules for different reasons, and each comes with pros and cons for employer and employee alike.
More recently, companies such as Snapchat have begun to use back-weighted vesting, which further encourages employee retention (possibly at the cost of morale) by incentivizing employees to stick around longer.
Graded vesting schedules
Employees tend to like graded vesting schedules, as they’re easier to understand and a bit more favorable to the employee. A graded vesting schedule grants the employee ownership of their equity gradually, over the course of the full vesting schedule.
Here’s an example of what a graded vesting schedule would look like for a grant of 10,000 Restricted Stock Units (RSUs), spread across a typical vesting period of four years:
- Year 1: 2,500 RSUs vested quarterly (25% of the total equity award)
- Year 2: 2,500 RSUs vested quarterly (50% of the total equity award)
- Year 3: 2,500 RSUs vested quarterly (75% of the total equity award)
- Year 4: 2,500 RSUs vested quarterly (100% of the total equity award)
Note that many startup vesting schedules split up vesting into quarters, rather than years. So, an employee on a graded vesting schedule might begin to receive equity ownership after as little as three months.
This isn’t great for employers, who may not take kindly to an employee quitting after a few months and still taking some equity with them. For this reason, the vesting cliff was invented.
Cliff vesting schedules
Vesting cliffs prevent an employee from reaping any value from an equity award if the employee leaves within a short period of time—typically one year. With a cliff vesting schedule, the bulk or entirety of the award is granted only after the employee has stayed with the company for a certain period of uninterrupted service.
This can look extreme or pretty standard, depending on how it’s set up. Let’s look at a standard example you’ll run into at lots of startups, which includes a four-year vesting schedule with a one-year cliff. We’ll use the same 10,000 RSU grant as in the example above:
- Year 1: 2,500 RSUs vested at the end of the year (25% of the total equity award)
- Year 2: 2,500 RSUs vested monthly (50% of the total equity award)
- Year 3: 2,500 RSUs vested monthly (75% of the total equity award)
- Year 4: 2,500 RSUs vested monthly (100% of the total equity award)
As you can see, the above schedule looks remarkably similar to the graded vesting schedule example. The key difference is that no RSUs vest until the end of the first year. After that, RSUs vest on a monthly schedule.
In a more extreme example, you might see three-year cliff vesting in which the employee receives no portion of the equity award until the end of the third year.
Back-weighted vesting schedules
Back-weighted vesting is a newer type of vesting schedule that more heavily favors the employer. It places the most significant vesting events toward the end of the vesting period, and minimizes the equity ownership an employee receives in their first years of employment.
Here’s an example with an equity grant of 10,000 RSUs, in which lower percentages of the total award vest in years 1 (10%) and 2 (20%) and greater percentages are back-weighted in years 3 (30%) and 4 (40%).
- Year 1: 1,000 RSUs vested (10% of the total equity award)
- Year 2: 2,000 RSUs vested (30% of the total equity award)
- Year 3: 3,000 RSUs vested (60% of the total equity award)
- Year 4: 4,000 RSUs vested (100% of the total equity award)
While a back-weighted vesting schedule emphasizes loyalty and can prevent share dilution, it can also lead to issues in terms of recruitment and employee morale. You’ll need to weigh the pros and cons carefully before moving forward with this type of schedule. You’ll also want to think about how to communicate it to your employees.
Are longer or shorter vesting schedules better for my startup?
The examples above all include a typical four-year vesting schedule, but that’s not the only option on the table. Vesting schedules of two years, three years, five years, and even six years have also been spotted in the wild. Some early-stage startups may even dangle immediate vesting as a means of attracting foundational talent.
There are some real trade-offs to consider when setting the length of your company’s vesting schedules. A vesting schedule longer than four years may help with employee retention, but at what cost? You might find yourself struggling to attract talent, especially since a four-year schedule is currently the industry norm.
Shorter vesting schedules can help you attract employees initially, but you risk employees leaving sooner with their full allocation of vested shares. You may need to offer them additional equity awards to get them to stay, but handing out too much company stock can lead to issues with dilution.
How to manage complex vesting schedules
Are some vesting schedules more common than others? Sure, but that doesn’t mean you should discount complex options that better suit your overall equity picture.
At Pulley, we understand that no two startups are alike. That’s why our cap table management software supports vesting schedules of all types. We even support hybrid time- and milestone-based vesting schedules, which tend to be the most difficult to track without a dedicated platform like Pulley. Once you see how easy our software is to use, you may even feel more confident in moving forward with the vesting schedule of your choice.
We’ve also built out tools that offer clarity and transparency to your employees. With Pulley, your employees can track their equity grants and get motivated to stick around for the long term. They can also electronically exercise their vested options via ACH when the time comes—all within one platform.
Schedule a demo to get started today.