A Primer on Vesting
When a founder or an employee receives equity in a business, a key consideration is timing—the question of when exactly the founder or employee receives possession of the ownership interest. Vesting occurs at the moment in time when the founder or employee takes irrevocable possession of an ownership interest. While it is possible to have equity vest immediately, this is uncommon since it can result in misaligned incentives. This article is a short primer on how vesting works.
For simplicity, all examples below will be for an employee set to receive 1,200 shares over a 4-year period. Most vesting schedules also contain a vesting cliff, meaning that no equity vests until the employee has been with the business for a certain amount of time. In these examples, the vesting schedule contains a one-year vesting cliff.
There are three common mechanisms for vesting: time-based; milestone-based; and a hybrid.
If our example employee is given a time-based vesting schedule, then the equity compensation is going to look like this:
If vesting is on an annual basis, then the employee will receive 300 shares on the one-year anniversary of the start date, with 300 more shares to follow after years 2, 3, and 4.
If vesting is on a quarterly basis, then the employee will receive 300 shares on the one-year anniversary of his or her start date, with 75 more shares to follow after each subsequent quarter through the end of 4 years.
If vesting is on a monthly basis, then the employee will receive 300 shares on the one-year anniversary of his or her start date, with 25 more shares to follow after each subsequent month through the end of 4 years.
The reason for time-based vesting is to provide an incentive for employees to continue working for the company during the time when their equity is vesting. If an employee leaves the company to take another job before all shares have vested, then those unvested shares are returned to the company’s employee equity pool. It is more common to have monthly or quarterly vesting after the vesting cliff is reached, but all three methods are found in equity grants.
If our example employee is given a milestone-based vesting schedule, the equity compensation will look very different. Say a business wants to incentivize its head of sales, so the equity grants are linked to hitting certain sales goals. Another situation where milestone-based vesting can occur is for a CEO whose equity compensation is tied to increasing the valuation of the business. Milestone-based vesting schedules are not as common as time-based vesting schedules and only make sense when there are limited metrics against which an employee’s contribution is to be evaluated.
Hybrid vesting schedules are probably the least common of the three models. In a hybrid vesting schedule, there are milestone-based equity grants for the employee to meet certain business goals AND there is also a vesting cliff so that the employee must work in the business for a certain amount of time before any equity vests. In a thriving labor market where potential employees have options, it is unlikely that a company will find great people willing to have their equity vest using this model.
As the above examples are designed to be simple and illustrative, real world situations are going to be more complex. If you want assistance in reviewing an equity compensation offer from a potential employer or in establishing vesting schedules for your founding team or employees, email us at email@example.com and we will find the best solution for your situation.